How to value a public company and find the right price to pay for a share
The ideas in this article are aggregated from resources on value investing by Phil Town and Warren Buffet, and are not my own. This is not investment advice.
In 1973, Princeton University professor Burton Malkiel theorized in his best-selling book, “A Random Walk Down Wall Street,” that “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts” [1]. In 1984, Warren Buffet addressed students at Columbia Business School and explained how, by successfully beating the return of the S&P 500 for 20 consecutive years, he had become a successful monkey: by searching for discrepancies between the value of a business and its price in the market [2].
This is the secret of value investing. Select a business with intrinsic characteristics that give it a durable, competitive advantage. Then, based on its historical performance, determine what its value is. Finally, buy shares only when its price in the market is significantly below this value.
How to find the right price
Selecting a company with intrinsic characteristics that give it a durable, competitive advantage enables a value investor to sit back through vicissitudes and market fluctuations, and not worry about the company’s ever-changing price; the investor is confident in the inherent value of the business and its ability to grow consistently in the long run. In theory, the investor could retain shares in the company for several years because of this conviction. Selecting appropriate companies and identifying pertinent characteristics that grant it an “economic moat” is a topic for another day.
Phil Town breaks the process of finding the right price to pay for a share into four steps in his book “Rule #1” [3], and podcast “InvestED” [4]. The idea is to determine the price of the company 10 years from now based on its current and past performance, and deduce what should be paid today for a share to yield a minimum acceptable rate of return (MARR) over these 10 years.
Step 1. Collect some numbers
Select a company with a durable, competitive advantage. As an example, let’s select NVIDIA (ticker symbol NVDA). Its competitive advantage is GPUs for accelerating AI and computer graphics. In May 2019, over 95% of all cloud computing instances with dedicated accelerators used NVIDIA hardware [5].
Use a tool such as Yahoo! Finance to find 3 numbers:
- The trailing twelve months earnings-per-share (TTM EPS): $4.43
- The analysts’ forecasted earnings growth rate for the next 5 years: 12.5%
- The average historical price-to-earnings (P/E) ratio: 24.93
Some advanced notes: select a company with with at least 5-10 years of consistent growth in metrics such as book value, earnings-per-share, sales, and operating cash flow to ensure quantitatively that the company does indeed have a durable, competitive advantage. These numbers can be determined from the company’s 10K reports through its SEC filings, and provide a holistic picture of the company’s health beyond earnings-per-share alone. If the analysts’ forecasted earnings growth rate is higher than the average of these four metrics over the 5–10 year period, use the average of these historical growth rates as the forecasted growth rate instead in this analysis, to attain a more conservative valuation. Note that the historic average earnings growth rate of companies on the S&P 500 over the history of the stock market has been 7% to 7.5%, and the historic average P/E of these companies has been 13 to 15 (2 times greater than the historical average earnings growth rate) [6]. Hence, if the average P/E of the selected company’s growth rate is higher than 2 times the forecasted earnings growth rate, multiply the forecasted growth rate by 2 and use this lower value for the P/E value instead, again for a more conservative valuation.
Step 2. Find the EPS in 10 years
Estimate the earnings-per-share 10 years from now, using the future value formula. Excel can also be used (FV), plugging in forecasted earnings growth rate for rate, 10 for nper, 0 for pmt, and the negative of the TTM EPS for [pv]. Hence, the earnings-per-share of NVIDIA, 10 years from now is $14.39.
Step 3: find the value in 10 years
Now, a value of share can be estimated for the company in 10 years. Since the average P/E ratio (24.93 in the case of NVIDIA) is multiple on the earnings that investors have on average been willing to pay historically, simply multiply this P/E by the future value of earnings-per-share determined in Step 2 ($14.39). This yields a (rough estimated) value of each of NVIDIA’s shares, in 10 years, to be $358.74.
Thus, based on the earnings of the company in the last year, the company’s historical average price-to-earnings ratio, and the forecasted earnings growth rate of the company, a price can be deduced for one share in 10 years. The present value formula can now be used to determine what the present-day value of one share should be. Once again, using Excel (PV) and plugging in the average U.S. inflation rate (3.15%) for rate, 10 for nper, 0 for pmt, and the negative of the price of the company’s shares in 10 years for [fv], the value of one NVIDIA share today should be roughly priced at $263.08.
For fun, the calculated price of the company today can be multiplied by its number of shares outstanding (616 million in NVIDIA’s case). This yields $162 billion, i.e. the value of NVIDIA today based on our analysis.
Step 4: find a fair price to pay
On the day of writing (October 7, 2019), NVIDIA is trading for $207.63. Multiplying this by 616 million yields $127 billion, i.e. the market cap of NVIDIA, that is, its price in the market. Great! Its price in the market ($207.63) is cheaper than its inherent value ($263.08) based on our analysis. So should a value investor buy it?
No. The investor’s desired return on investment must be taken into account to figure out exactly what price is favorable for which to buy a share. Given that the S&P 500 index yields an average return of 7.96% per year [8], a minimum rate of return (MARR) of at least 15% would be nice. For comparison, Warren Buffet through Berkshire Hathaway has an average annual return of 21% [9]. Phil Town, who by contrast is a private investor (like us) and has the liberty of rapidly reallocating capital as desired, has an average annual return of 40% [4].
To find this “right” price to pay, reconsider the values in Step 3. In 10 years, assuming that the number of shares outstanding does not change, each of NVIDIA’s shares will have a value of $358.74; in today’s dollars, this is $263.08. This means that the share must be bought today for a price much less than $263.08 in order to achieve the desired MARR when it is (hypothetically) sold in 10 years.
Excel, or the formula directly, can be used to calculate the present value of one share that an investor should pay such that a MARR of 15% is achieved. Alternatively, the Rule of 72 can be employed for a quick and (very awesome) estimation. Note that 72/15% = 5 is the number of years it would take a principal today, growing at 15%, to double once; hence in 10 years, it will have doubled twice — that is, grown four-fold. Thus, simply divide the value of one NVIDIA share in 10 years by 4 to determine what price should be paid today to achieve a 15% MARR in 10 years: $89.69.
For an extra margin of safety, cut this value in half to adequately shield against the various vicissitudes of the market. Perhaps the evaluation of the company’s intrinsic characteristics is flawed or perhaps proactive action needs to be taken against imminent events such as trade wars or the advent of quantum computing to dethrone NVIDIA’s commanding position. Thus, $44.85 is the maximum price a value investor should pay for NVIDIA shares to generate at least a 15% MARR with a sufficient margin of safety.
This method of determining a public company’s value, along with an intelligent MARR and margin of safety realizes the very idea that Buffet described to Columbia students in 1984: search for discrepancies between the value of a business and its price in the market. Since the value investor has empirically determined that the company of choice has intrinsic characteristics that give it a durable, competitive advantage, she is confident in its inherent value that has been calculated in this article. And once she finds it on sale at this margin of safety price, she can be sure that over time, it will undoubtedly grow. This, as Phil Town calls it, is the art of “buying 10 dollar bills for 5 dollars.”
On the day of writing (November 7, 2019), NVIDIA was trading for $207.63 per share.
References
[1] https://www.amazon.ca/Random-Walk-Down-Wall-Street/dp/0393330338
[2] https://www8.gsb.columbia.edu/articles/columbia-business/superinvestors
[3] https://www.amazon.ca/Rule-Strategy-Successful-Investing-Minutes/dp/0307336840
[4] https://www.ruleoneinvesting.com/podcast/
[6] https://www.investopedia.com/investing/use-pe-ratio-and-peg-to-tell-stocks-future/
[8] https://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp
