How to Value Stocks Conservatively: A practical guide from Graham, Buffett and Piotroski

"I don't look to jump over 7-foot bars: I look around for 1-foot bars that I can step over." - Warren Buffett

The stock market is a mysterious beast. There are thousands upon thousands of stocks trading everyday. For that many businesses, there are at least that many analysts and brokers that keep the machine running.

Those of us without PhD's in finance can become lost listening to their babble. What's astounding is that, save for a few exceptions that we will look at later, most professional money managers fail to deliver market-beating returns. Those that can clear the bar can offset those gains with management fees. Some of the most successful investors in the world claimed that individuals fare better if they would just do their own research and lower the amount of trades in their portfolio.

But what do we research? Well, if you have an internet connection and Microsoft Excel (or equivalent spreadsheet program), then you can do more thank you think. This guide will cover a simple method to evaluating stocks using ideas from some of the best investors including Benjamin Graham, Warren Buffet, and Joseph Piotroski.

Before we begin, let's get a couple of points on the table. This is not a guide that guarantees market-beating returns. This is not a guide that will cover day-trading. This is a guide that cover the method that I use to pick individual stocks. These are stocks that I feel comfortable with holding for five years or longer.

Now, let's begin by taking a look at some key tenets of successful investors.

"We urge the beginner in security buying not to waste his efforts and his money in trying to beat the market. Let him study security values and initially test out his judgment on price versus value with the smallest possible sums." - Benjamin Graham

Warren Buffett once said the best book ever written on investing was Security Analysis by Benjamin Graham and David Dodd. This textbook was written in the 1930s, but many value investors still study it today. The principles behind value investing remain largely unchanged. Benjamin Graham also wrote The Intelligent Investor. This second book was written with advice for individual investors and contains two of Graham's most important tenets in investing.

The Margin of Safety

Graham liked to buy securities for $.66 on the dollar. He theorized that stocks selling this low did not have much room to fall. By buying securities for a 33% discount gave Graham his margin of safety. If his valuation was wrong, then he had room to move and still make a profit.

Net-Net Working Capital

Graham used this measure as a replacement for book value. He took the companies cash at full value. He added in receivables due at a 25% discount (75% of the value stated on the balance sheet), and then added in other current assets at a 50% discount (items such as inventory, which would sell for a heavy discount if the company folded). Then Graham subtracted all liabilities on the balance sheet. This estimation gave Graham a rough valuation of the liquidation value of the company. If Graham found a stock trading at a 33% discount to its NNWC, he would buy it.

Today, there are very few stocks that sell for a 33% discount to it's Net-Net Working Capital. There are few stocks that even sell to a 33% discount to their full book value. These concepts are still important as they will serve as the foundation of our valuation technique. For more information on Benjamin Graham and his tenets of value investing, please get a copy of Security Analysis and The Intelligent Investor. You'll be glad you did!

"...simple accounting-based fundamental analysis strategy, when applied to a broad portfolio of high book-to-market firms, can shift the distribution of returns earned by an investor." - Joseph Piotroski

Joseph Piotroski is currently an associate professor of accounting at the Stanford University Graduate School of Business. We wrote a seminal paper in 2002 while teaching at the University of Chicago that took Graham's valuation methods to the next level. He reasoned that securities that sell at a discount to their book value, the kind of stocks Graham loved, sold at a discount because they were often troubled firms that are on the verge of folding. He came up with a nine point system to rate how healthy the firm was, and tested his theory using data on stocks that sold to a discount to book value and scored 9 points overall.

To do all nine tests on every stock you want to look at is a little taxing. It's also intimidating to someone who has never looked at a balance sheet. I feel that it is far better to pull up a balance sheet at Google Finance or Yahoo! Finance and do the tests yourself, but for those that are intimidated, you can find a Piotroski screener that will give you the Piotroski score of stocks on many indices. One of my favorites is here: http://members.cox.net/econisvoodoo/piotroski/

If you wish to do these nine tests yourself, which is preferred, here they are. Score one point for each test passed.

1. Net Income: Score 1 if last year's net income is positive.
2. Operating Cash Flow: Score 1 if last year's cash flow is positive.
3. Return On Assets: Score 1 if last year's ROA exceeds prior-year's ROA.
4. Quality of Earnings: Detects "creative accounting." Score 1 if last year's operating cash flow exceeds net income.
5. Long-Term Debt vs. Assets: Score 1 if the ratio of long-term debt to assets is down from the year-ago value. If LTD is zero but assets are increasing, score 1.
6. Current Ratio: Score 1 if current assets divided by current liabilities is greater this year compared to the previous year.
   
7. Shares Outstanding: Score 1 if the number of shares outstanding is no greater than the year-ago figure.
8. Gross Margin: Score 1 if the full-year GM exceeds the prior-year GM.
9. Asset Turnover: Score 1 if the percentage increase in sales exceeds the percentage increase in total assets.

How do I use the Piotroski Score? I use it to screen stocks before I valuate them. If the firm is not healthy, it will have a low Piotroski score. I typically toss those on the backburner. The healthy firms with high Piotroski scores are valuated immediately.

If you wish to read Piotroski's paper, you can find it here: http://www.chicagobooth.edu/faculty/selectedpapers/sp84.pdf

Using the principles summarized earlier, we can now analyze a stock. This is the best part of investing, sifting through all these businesses to find a few that you would feel comfortable owning equity in. For this Hub, I will use AAPL (Apple) as an example of my method. The reason is that many people follow Apple. It is a popular stock, and it has given great gains over the past couple years. Is it still worth buying? Let's find out!

This is the first step I take when looking at any stock. It is my starting point for my business valuation. You can use any finance service that lists company balance sheet information. You can even look at a copy of the company's SEC filings. My favorite platform to use is Google Finance. We can see the balance sheet information for AAPL here: http://www.google.com/finance?q=NASDAQ:AAPL&fstype=ii (just click on "Balance Sheet"). Note that Google Finance gives all numbers on this page in millions of $US. Be careful, some companies are reported in billions, and others are reported in foreign currencies.

As of this writing, here are the metrics listed on the balance sheet:

Cash and Cash Equivalents: $29,234.00M

Total Receivables, Net: $11,095.00M

Total Inventory: $930.00M

Other Current Assets: $5,738.00M

As listed above, take cash and cash equivalents at their face value. Take the receivables at a 25% discount, and then take the other items at a 50% discount.

Discounted Current Asset Value: $40,889.25M

Now, subtract the total liabilities listed of $33,427.00M

Net Net Working Capital: $7,462.25M

Over seven billion dollars, theoretically, if AAPL had to liquidate. Now, find out how many shares of the stock are outstanding. Make sure this number is also in millions so that you valuation is not incorrect. Divide the NNWC by the number of shares outstanding to find the NNWC per share.

Shares Outstanding: 921.28M

NNWC Per Share: $8.10

At $8.10 per share, Benjamin Graham would not buy this stock. The price is many multiples higher than the NNWC. I think it's a promising sign since most companies have a negative NNWC per share value. I'm not ruling the stock out until I take a look at earnings and project future earnings and calculate the Piotroski Score. 

Before we start this step, I want to let you know that there are many methods to valuating future earnings. Many of them are sophisticated equations that are hard to understand. My goal, like Benjamin Graham, is to keep my formula and observations simple.

Head on over to MSN Money. Here, we will pull up a quote for AAPL and access the ten year earnings history. You can find this here: http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?lstStatement=10YearSummary&symbol=aapl

This is where I pull out my spreadsheet and start plugging in the numbers. The first year listed is year 1, and the last year is year 10. This is the most recent year. Make one row the numbers 1 through 10, and then start plugging in the earnings per share that you see on MSN Money. Next, make a graph of the data. If you are using Microsoft Excel, you have an easy-to-use interface to do this. If you are using OpenOffice Calc or another product, please refer to user forums on how to plot data in a graph. I like to do this to give myself not only the raw numbers, but a visual representation of what the past ten years has looked like for earnings.

Once I have a graph completed, I use the equation solver to map a best-fit natural log function to the data. Why? I operate under the assumption that the larger a business grows, the more difficult it becomes to increase earnings, and therefore the business growth rate slows. The curve of the natural log function represents this as a curve that is steep early on and then plateaus later. For Microsoft Excel, it will also display the equation that fits the past data the best, which we will use to project future earnings. Please see the screenshot I took above that shows how to plot this data and also the result of the graph produced with it.

Once I have my best-fit curve mapped, I use the equation to project the next ten years' of earnings based on that equation. Note that these estimates are conservative in order to stay in line with the principle of having a margin of safety. After I project the next years, I then discount these figures using the principle of Time Value of Money. This principle states that money has a value based on time, and that money in your hand today is worth more than money earned in the future. You know, the old saying, "A bird in the hand is worth two in the bush." I use a discount rate of 6% per year. You may want to use a different discount rate. Once all ten years' projections are discounted, I total the amount. In the case of AAPL, as you can see in the example above, the projections I have total $71.57 in earnings, valued in today's dollars. I add that to my NNWC per share calculation we did earlier, giving me a total value of $79.67 per share.

At a price of $350.70 as of Friday, April 22, AAPL is overvalued compared only to my conservative growth estimates for the ten years. I would not be comfortable buying this stock at this time. AAPL may very well be able to increase it's earnings faster than I have projected. As you notice in my graph above, the past earnings have grown at a faster rate than my equation predicts. There are many people who are comfortable buying shares of AAPL at it's current price. For as many people who say AAPL is too expensive, there will be an equal number saying that it's cheap. The thing is, I don't want to buy a stock unless it is in line with my low valuations. That is my margin of safety.

If you wish to apply this method to other stocks, be sure to include dividends! This is cash returned to the shareholder rather than used by the business. Estimate the dividend growth rate in a similar fashion to the earnings growth rate, and factor in ten years of dividend payments to your valuation. AAPL does not pay a dividend, but if it did, and if the dividend was less than AAPL's earnings, then it would increase the valuation I have for this stock.

"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." - Warren Buffett

Let's stop for a moment and pretend that I was going to buy shares of AAPL. Before I did, I would need to slow down and start examining the business model. I do that by asking and answering questions. Could I explain what AAPL sells to a child? Has the market for AAPL's product changed? Will their products be around for five years or more?

Asking questions like these may throw up a red flag on your stock. One example is Books-A-Million (BAMM). This company is heavily undervalued based on earnings and book value, however the game has changed. Book retailers are earning less and less thanks to the introduction of eBooks and eBook readers. Even though I could explain BAMM to a child and know that books will be around for longer than five years, I would be uncomfortable buying this stock at this time because the market for the product has changed.

This is the last step in evaluating a stock. If you are comfortable with the business model, comfortable with the price based on projected earnings and dividends, and would be comfortable holding the stock for five years or more, then you've found yourself a winner! As Benjamin Graham said, the worst enemy of any investor is himself. Only by ensuring that you are entirely comfortable with a stock purchase before the purchase is made will anyone be successful as an investor.