How to Tell When a Stock is Cheap/Expensive (Masterclass in Stock Valuation)

Here's a comprehensive summary of the YouTube video transcript, maintaining the original language and technical precision:

Key Concepts

• Relative Valuation: Valuing a stock by comparing it to historical averages or similar companies (peers).
• Valuation Multiples: Ratios used to compare a company's stock price to its financial metrics (e.g., PE ratio, P/FCF).
• Price-to-Earnings (PE) Ratio: Stock price divided by earnings per share. Can be trailing (historical earnings) or forward (analyst estimates).
• Margin of Safety: The difference between a stock's intrinsic value and its market price, providing a buffer against errors in valuation or unforeseen events.
• Discounted Cash Flow (DCF) Analysis: Valuing a company based on the present value of its future free cash flows.
• Free Cash Flow (FCF): Cash generated by a company's operations after accounting for capital expenditures.
• Discount Rate: The rate used to discount future cash flows to their present value, reflecting the time value of money and risk.
• Terminal Value: An estimate of the value of a company's cash flows beyond the explicit forecast period in a DCF analysis.
• Exit Multiple: A valuation multiple applied to a company's projected future earnings or cash flow to estimate its terminal value.
• Perpetuity Growth: A method of calculating terminal value by assuming cash flows grow at a constant rate indefinitely.
• Intrinsic Value: The perceived true value of a company, independent of its market price.
• Triangulation: Using multiple valuation methods to arrive at a more robust estimate of a stock's value.

Valuation Methods for Stocks

This video outlines three methods for properly valuing a stock: relative valuation using PE ratios, discounted cash flow (DCF) analysis, and a third, less common method that bridges the gap between the two.

1. Relative Valuation Using Valuation Multiples

This method involves comparing a stock's valuation to its historical averages and to those of its competitors (peers). The core idea is that a stock is attractive if it's cheaper than its historical norms or its peers, assuming similar quality.

• Concept: It's not about the absolute price of a stock (e.g., Ford vs. Berkshire Hathaway), but rather its price relative to its earnings or other financial metrics. As Warren Buffett states, "Price is what you pay, value is what you get."
• Price-to-Earnings (PE) Ratio:
  • Trailing PE: Current stock price divided by the company's earnings per share over the past 12 months. For Coca-Cola (KO) at $72 per share with $2.5 earnings per share, the trailing PE is 28.8 years (72 / 2.5). This represents the payback period if earnings remain constant.
  • Forward PE: Current stock price divided by analysts' expected earnings per share for the next year. For KO, the forward PE is 24.3, indicating analysts expect higher earnings.
• Historical Valuation:
  • For Coca-Cola, investors have historically been willing to pay a forward PE of 23 over the last 10 years. Since the current forward PE is 24.3, it suggests KO is slightly expensive relative to its historical valuation.
• Peer Comparison:
  • Comparing KO to peers like PepsiCo, Dr. Pepper, Monster, and AG Barr. The average forward PE for this group (including KO) is 21.3.
  • If KO were valued at the peer average, its stock price would need to fall by approximately 12%.
  • Case Study: AG Barr (BAG)
    • AG Barr shows a potential upside of 18% if valued at its historical average forward PE.
    • If valued at the peer group average, it has a 33% upside. This makes AG Barr appear more attractive than KO on a relative basis.
• Margin of Safety (Benjamin Graham):
  • This concept is crucial for relative valuation. Investors should buy stocks when their price is significantly below their intrinsic value, not just slightly.
  • Seth Klarman emphasizes that a margin of safety is necessary because valuation is imprecise and the future is unpredictable.
  • Warren Buffett's Perspective: Buffett prefers businesses he understands well, reducing the need for a huge margin of safety. For stable businesses like Coca-Cola or See's Candies, he might buy them at "much closer to a dollar on the dollar" if he's confident in his assumptions, rather than waiting for a 40% discount. He would require a lower margin of safety for dominant, stable businesses.
• Limitations of Relative Valuation:
  • Industry-Wide Overvaluation: If an entire industry is overpriced, a "cheap" stock within that industry might still be a bad investment (e.g., IT companies at PE 100 in 2000 when others were at PE 2000).
  • Changing Fundamentals: Historical multiples and peer comparisons assume "everything else is equal," which is rarely true. Competitors might be growing faster, or the company's own strength might be declining.
  • "Cheap for a Reason": As Joel Greenblatt warns, avoid stocks that are cheap because the company is fundamentally flawed ("it stinks").
  • Focus on Cash Flows: Warren Buffett highlights that multiples are only useful as clues to the amount and timing of cash flows, not as valuation endpoints themselves.

2. Discounted Cash Flow (DCF) Analysis

This method values a company based on the present value of its projected future free cash flows. It's considered a more fundamental approach.

• Core Principle (Warren Buffett): Intrinsic value is the sum of all future cash a business will generate, discounted at the appropriate rate. The key questions are: "How much cash are you going to get? When are you going to get it? And how sure are you?"
• Steps in DCF Analysis:
  1. Project Future Free Cash Flows (FCF):
     • Focus on Cash, Not Earnings: DCF uses free cash flow, which is cash from operations minus capital expenditures (CapEx). This accounts for investments in inventory, machinery, etc., making it a more accurate measure of cash generation than earnings.
     • Historical Data: Use historical FCF data (available on platforms like Ticker or in annual reports) as a proxy for future performance. Adjust for non-recurring items (e.g., a $6 billion tax item impacting KO's 2024 results).
     • Forecasting Period: Typically forecast for 10 years.
     • Growth Rate Assumptions:
       • Be realistic. Avoid overly optimistic growth rates (e.g., 15% annually for large companies).
       • Reality checks include historical company/industry growth and analyst estimates.
       • For KO, historical FCF growth since 2019 was ~3.5%. The global carbonated beverage industry is projected to grow at 6.4% annually (2025-2030). The video uses a 4% growth assumption for KO.
       • This leads to an estimated FCF of $14.8 billion in 10 years, assuming a $10 billion starting point.
  2. Calculate Terminal Value: This represents the value of cash flows beyond the 10-year forecast period.
     • Exit Multiple Method:
       • Apply a valuation multiple (e.g., Price-to-Free Cash Flow or P/FCF) to the projected FCF in the final forecast year (Year 10).
       • The multiple is derived from historical averages for the company and its peers. For KO, a 10-year median P/FCF of 33 is used, which is close to industry peers.
       • Terminal Value = Year 10 FCF * Exit Multiple. For KO, this is $14.8 billion * 33 = $488.4 billion.
     • Perpetuity Growth Method:
       • Assume cash flows grow at a constant, lower rate (e.g., 3% for KO, slightly above inflation) indefinitely.
       • Terminal Value = (FCF in Year 11) / (Discount Rate - Perpetual Growth Rate).
       • If growth rate exceeds the discount rate, this method breaks down.
  3. Discount Future Cash Flows to Present Value:
     • Discount Rate: This is crucial. It reflects the time value of money and the risk associated with receiving cash in the future.
     • Buffett's Approach to Discount Rate: He doesn't use formal discount rates but seeks returns significantly higher than government bonds. He wants enough return to be comfortable even if the market closes for years or interest rates rise.
     • Historical Context: In 2007, long-term government bond rates were ~4.9%. Buffett wanted more than that. In 1994, with 7% bond rates, he suggested discounting at "at least a 10% rate."
     • Practical Application: A common approach is the 10-year Treasury yield + 3 percentage points. If the 10-year Treasury is 4.5%, the discount rate would be 7.5%.
     • Impact of Discount Rate:
       • Using a 10% discount rate for KO results in a value of $260 billion (a loss at current prices).
       • Using a 5% discount rate results in $394 billion (a decent purchase with a 20%+ margin of safety).
       • Using a 7.5% discount rate (4.5% Treasury + 3%) yields a value of $320 billion for KO.
  4. Sum Present Values: Add the present values of the projected cash flows and the terminal value to get the total intrinsic value of the company.
• DCF for AG Barr:
  • Estimated current FCF: £33 million.
  • Perpetuity growth: 2%.
  • Discount rate: 7.5%.
  • Exit multiple (P/FCF): 28 (slightly lower than KO due to historical volatility).
  • Calculated value: £660 million to £860 million, depending on the terminal value method. This suggests it might not be a compelling buy at current levels, but could have been on January 14th when it traded at £620 million.
• Buffett's Third Question: "How Certain Are You?"
  • This relates to the predictability and stability of the business.
  • Coca-Cola: Has a stable, growing financial history, making it predictable.
  • IBM, GE, Ford: Less predictable.
  • Buffett's Preference: He seeks businesses that are unlikely to change significantly over 10-20 years. Change is viewed as a threat, not an opportunity. He avoids businesses with "lots of change coming."
  • Implication: Buffett would likely avoid high-growth, rapidly changing tech companies like Nvidia, Eli Lilly, or Netflix, even with strong past performance, due to their susceptibility to change.
  • Margin of Safety vs. Certainty: While some might apply a larger margin of safety or higher discount rate for uncertain businesses, Buffett tends to avoid them altogether rather than trying to compensate for uncertainty.
• Buffett's Practical DCF Application:
  • Charlie Munger notes that Buffett rarely shows himself doing a DCF calculation. If the value isn't "blue-perfect obvious" with a "huge margin of safety," he moves on. This suggests that for Buffett, the analysis should be so clear that a detailed calculation is almost unnecessary.
  • The video creator acknowledges that this "mental math" ability is unique to Buffett and that most investors benefit from using calculators and spreadsheets.

3. A Third Valuation Approach (Bridging the Gap)

This method is less common but can be very useful, especially with modern financial tools. It often involves plugging key assumptions into a model that performs the calculations.

• Ticker.com's Valuation Tool:
  • This platform offers a tool where users input sales, operating margins, interest/tax rates, buybacks, dividends, and an evaluation multiple.
  • The tool then generates a valuation chart based on these inputs and historical/analyst data.
  • Example with Coca-Cola:
    • Inputs: Historical financials, analyst estimates, a projected 4% revenue growth rate (aligned with analyst forecasts).
    • Output: The model suggests KO should be worth $91 per share by the end of December 2029, implying a ~6.2% annual return.
  • Example with AG Barr:
    • Inputs: Similar assumptions.
    • Output: Implies a ~9.3% annual return.
• Calculating Margin of Safety with this Method:
  • If the target return (based on the discount rate) is 7.5% per year for 4.5 years (until Dec 2029), this equates to a ~38% total return.
  • AG Barr's projected 9.3% annual return over 4.5 years yields a ~49% total return.
  • Margin of Safety = (Projected Return - Target Return) / Projected Return = (49% - 38%) / 49% = 22%. This is considered a decent margin of safety for a stable business like AG Barr.
• Important Note: The accuracy of this method, like all others, depends entirely on the quality of the assumptions made ("garbage in, garbage out").

Conclusion and Synthesis

• No Single "Best" Method: Charlie Munger emphasizes that there's no single, simple mechanical method to guarantee riches. Investing requires a combination of techniques, models, and experience.
• Triangulation is Key: The best approach is to use multiple valuation methods and look for companies that appear attractive across all of them. This helps to triangulate the intrinsic value and build conviction.
• Actionable Insight: Investors should use a toolkit of valuation methods, including relative valuation, DCF, and potentially more advanced modeling tools, to assess investment opportunities. Always apply a margin of safety, especially when dealing with less predictable businesses.
• Sponsor Mention: Ticker.com is highlighted as a platform providing institutional-quality financial data and analyst estimates, with a new valuation tool that can assist in these analyses. A discount is offered for annual plans.