Streetsmart Guide To Valuing A Stock (Mcgraw Hill-2004) (pdf)
Streetsmart Guide to Valuing a Stock is a how-to book that provides
you with the tools to make money in the stock market. The book’s fo-
cus is on stock valuation—an area of great interest to many investors,
but understood by very few.
Streetsmart Guide to
Valuing a Stock
Other Books in the Streetsmart Series
Streetsmart Guide to Managing Your Portfolio
Streetsmart Guide to Short Selling
Streetsmart Guide to Timing the Stock Market
Streetsmart Guide to
Valuing a Stock
The Savvy Investor’s Key to Beating the Market
Second Edition
Gary Gray, Patrick J. Cusatis,
and J. Randall Woolridge
McGraw-Hill
New York Chicago San Francisco Lisbon
London Madrid Mexico City Milan New Delhi
San Juan Seoul Singapore Sydney Toronto
Copyright © 2004 by The McGraw-HIll Companies, Inc. All rights reserved. Manufactured in the
United States of America. Except as permitted under the United States Copyright Act of 1976, no part
of this publication may be reproduced or distributed in any form or by any means, or stored in a data-
base or retrieval system, without the prior written permission of the publisher.
0-07-143623-5
The material in this eBook also appears in the print version of this title: 0-07-141666-8.
All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after
every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit
of the trademark owner, with no intention of infringement of the trademark. Where such designations
appear in this book, they have been printed with initial caps.
McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales pro-
motions, or for use in corporate training programs. For more information, please contact George
Hoare, Special Sales, at [email protected] or (212) 904-4069.
TERMS OF USE
This is a copyrighted work and The McGraw-Hill Companies, Inc. (“McGraw-Hill”) and its licensors
reserve all rights in and to the work. Use of this work is subject to these terms. Except as permitted
under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not
decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon,
transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without
McGraw-Hill’s prior consent. You may use the work for your own noncommercial and personal use;
any other use of the work is strictly prohibited. Your right to use the work may be terminated if you
fail to comply with these terms.
THE WORK IS PROVIDED “AS IS”. McGRAW-HILL AND ITS LICENSORS MAKE NO GUAR-
ANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF
OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMA-
TION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE,
AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT
NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A
PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the func-
tions contained in the work will meet your requirements or that its operation will be uninterrupted or
error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inac-
curacy, error or omission, regardless of cause, in the work or for any damages resulting therefrom.
McGraw-Hill has no responsibility for the content of any information accessed through the work.
Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental,
special, punitive, consequential or similar damages that result from the use of or inability to use the
work, even if any of them has been advised of the possibility of such damages. This limitation of lia-
bility shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort
or otherwise.
DOI: 10.1036/0071436235
To Katie O’Toole, a great writer, a terrific editor,
and a wonderful wife and mother.
G.G.
To my wife, Deborah, my children,
Jacob and Julia, and my parents.
P.J.C.
To my daughters, Jillian, Ainsley, and Ginger.
J.R.W.
This page intentionally left blank.
For more information about this title, click here.
Contents
Preface xi
Acknowledgments xv
CHAPTER 1 INTRODUCTION AND OVERVIEW 1
Financial Flameout 1
Good Companies—Hot Stocks—Ridiculous
Prices 2
The Investment Decision 4
The 10 Principles of Finance 5
Overview of the Book 7
CHAPTER 2 THE 10 PRINCIPLES OF FINANCE AND HOW TO
USE THEM 13
Principle 1: Higher Returns Require Taking
More Risk 14
Principle 2: Efficient Capital Markets Are Tough
to Beat 21
Principle 3: Rational Investors Are Risk Averse 29
Principle 4: Supply and Demand Drive Stock
Prices in the Short-run 31
Principle 5: When Analyzing Returns, Simple
Averages Are Never Simple 34
vii
Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
viii CONTENTS
Principle 6: Transaction Costs, Taxes, and
Inflation Are Your Enemies 36
Principle 7: Time and the Value of Money Are
Closely Related 40
Principle 8: Asset Allocation Is a Very Important
Decision 43
Principle 9: Asset Diversification Will
Reduce Risk 48
Principle 10: An Asset Pricing Model Should be
Used to Value Investments 54
Summary 56
CHAPTER 3 STOCK VALUATION: SOME PRELIMINARIES 61
Introduction to Valuation 61
DCF Stock Valuation 63
We Caused the High-Tech Bubble 69
Return to Stockholders 72
Stock Price—Too High?—Too Low?—Just Right? 77
Stock Valuation—Art, Science, or Magic? 82
Stock Valuation Approaches: Fundamental,
Technical, and MPT 83
Stock Value, Stock Price, and Emotions 88
Stock Value, Stock Price, and Analyst
Recommendations 90
When to Buy, When to Sell:
Our Recommendation 92
Where Do We Go Next? 94
CHAPTER 4 HOW TO VALUE A STOCK 97
Some Definitions Relating to Cash Flow 97
The Free Cash Flow to the Firm Approach 102
Why DCF and Not EPS? 108
The Discounted FCFF Valuation Approach 110
Microsoft—A Simple DCF Example 115
Valuation—Growth versus Value, Large Cap
versus Small Cap 123
Valuation—The Next Step 124
CHAPTER 5 FORECASTING EXPECTED CASH FLOW 127
The Five Chinese Brothers 127
Growth Rates and the Excess Return Period 128
Net Operating Profit Margin and NOP 138
Income Tax Rate and Adjusted Taxes 141
Net Investment 143
Incremental Working Capital 147
Contents ix
Free Cash Flow to the Firm 151
Valuation Exercise: Estimating Free Cash Flow
for Cisco 152
CHAPTER 6 ESTIMATING THE COST OF CAPITAL 157
Don’t Count Until You Discount 157
WACC and Market Capitalization 161
Estimating ConEd’s WACC 166
The Cost of Common Equity and Shares
Outstanding 167
The After-Tax Cost of Debt and Debt
Outstanding 174
The Cost of Preferred Stock and Amount
Outstanding 177
WACC Calculation—ConEd 178
WACC Calculation—Cisco 179
Balance Sheet Items in the Valuation Process:
Our Recommendation 179
Valuation Exercise: Cisco 182
After the Cost of Capital—The Next Step 183
CHAPTER 7 FINDING INFORMATION FOR VALUATIONS 185
Save a Tree—Use the Internet 185
The Internet and Investment Information 186
Cash Flow Valuation Inputs—Easy to Find 194
Cash Flow Valuation Inputs Requiring
Estimation 199
Cost of Capital Valuation Inputs 200
Custom Valuations—The Next Step 203
Valuation Exercise: Cisco 203
CHAPTER 8 VALUING A STOCK—PUTTING IT ALL TOGETHER 205
Overview 205
Valuing Citigroup—December 17, 2002 208
Valuing Merrill Lynch—December 18, 2002 220
Valuing Berkshire Hathaway—December 18, 2002 228
Valuing Washington REIT—December 20, 2002 237
Summary 247
Glossary 249
Acronyms 259
Bibliography 261
Index 265
This page intentionally left blank.
Preface
Streetsmart Guide to Valuing a Stock is a how-to book that provides
you with the tools to make money in the stock market. The book’s fo-
cus is on stock valuation—an area of great interest to many investors,
but understood by very few.
When you’ve finished this hands-on, easy-to-use guide, you will
have learned how to:
• Value stocks of general market and high-tech companies, such
as Microsoft and Cisco Systems;
• Value stocks of financial companies and real estate investment
trusts, such as Citigroup, Merrill Lynch, Berkshire Hathaway, and
Washington REIT;
• Spot undervalued or overvalued stocks for buying and selling op-
portunities;
• Estimate important valuation inputs such as growth, operating
margin, and cost of capital;
• Find valuation inputs on free Internet Web sites;
xi
Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
xii PREFACE
• Develop a spreadsheet to value a stock;
• Combine stocks in an efficiently structured investment portfolio;
• Manage your risk; and
• Use the 10 principles of finance to your advantage.
This book is a complete revision of Streetsmart Guide to Valuing a
Stock (1999). In the four years since the publication of Streetsmart, the
stock market has crashed, managers of many corporations such as En-
ron, WorldCom, and Adelphia have been indicted for fraud, and cer-
tain Wall Street stock analysts have been discredited and have attained
a business stature below that of used car salesmen. We feel that it is
time to place stock valuation within the context of some general rules
and concepts that are at the core of finance theory. This book explains
in simple terms the 10 principles of finance and describes how you can
use them to make better investment decisions and to estimate a stock’s
value.
This book is for all of you who mistakenly think you have to be a
stock market guru to value stocks like a pro. All the tools you need to
value stocks are outlined in the chapters that follow. All that is required
is a bit of patience, practice, and persistence.
You don’t need an MBA to understand the book’s concepts or the
10 principles. The goal of the book is to give all stock market partici-
pants—individual investors, investment club members, stockbrokers,
SEC staffers, corporate managers, directors of corporate boards, and or-
dinary people who want to learn about stock valuation—a simple quan-
titative approach for estimating stock values. Our model is a recipe for
correctly and conservatively valuing common stock and increasing in-
vestment profits.
In this book we describe how you can use Excel to write a spread-
sheet to value stocks with a minimum number of inputs. If you don’t
want to write a spreadsheet program, we show you how and where you
can purchase the computer software, which we have developed and
use in the book. Finally, we provide a free online stock valuation ser-
vice on our Web site, www.valuepro.net/.
If you’re technologically challenged, not to worry. You don’t need
a computer or an Internet connection to use the discounted free cash
flow method to value a stock. In Chapters 5 and 6 we describe how to
Preface xiii
calculate and estimate, long-hand, a company’s free cash flow and cost
of capital—these are the essential ingredients of stock valuation. In
Chapter 7 we show you how and where to get the information that you
need for serious valuations. In Chapter 8 we value Citigroup, Merrill
Lynch, Berkshire Hathaway, and Washington REIT. This book will help
you to learn a lot about valuing stock even if spreadsheets and com-
puters are too intimidating for your personal tastes.
Our goal is to teach you about stock valuation by using a simple
and powerful valuation model. This book will make you a better in-
formed, more intelligent, more profitable investor and will help you to
understand why stocks such as Cisco trade at $14.45 and Berkshire
Hathaway trades at $72,000 per share. Our valuation approach revolves
around some very simple calculations that use only addition, subtrac-
tion, multiplication and division—no calculus, differential equations,
or advanced math. So let’s begin by taking our initial plunge into stock
valuation.
Good luck, tight lines, and happy valuations!
Gary Gray
Patrick J. Cusatis
J. Randall Woolridge
This page intentionally left blank.
Acknowledgments
The original Streetsmart Guide to Valuing a Stock was conceived and
outlined on a trip to Spain. The concepts underlying stock valuation
crystallized only as real livestock (6 fighting bulls and 8 steers) at-
tempted to run over us on the narrow, crowded streets of Pamplona.
Integral to the book’s progress were the discussions, over many fine
meals with our friends in Navarra, of its structure and international
appeal. Ana Vizcay and Eduardo Iriso, María Jesus Ruiz Ciordía and
Emilio Goicoechea, Luis Arguelles and Merche Amezgaray, José Marí
Marco and Carmela Garraleta, Fefa Vizcay and Héctor Ortiz, and
Manolo Asiain: We thank you for your hospitality and friendship over
the years.
Many readers reviewed various parts of the book. We’d like to thank
finance Professor Russ Ezzell and management Professor Charles
Snow for peer review and helpful suggestions, and Blake Hallinan for
his research efforts. We’d also like to thank merchant bankers—Scott
Perper of Wachovia Capital Partners and Rusty Lewis of Verisign; de-
rivatives specialists—Patrick Mooney of Calibre Capital, Mark Hattier
of Newman Financial Services, and Dave Eckhart of IMAGE; invest-
xv
Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
xvi ACKNOWLEDGMENTS
ment bankers—Gerry Fallon (retired) and Buck Landry of Morgan Kee-
gan; securities law expert Steve Huff of Kutak Rock; Web masters Joe
and Jen Cusatis of Intelligent Data Management; and noted Washing-
ton bureaucrat—David Seltzer, for their professional and careful re-
view and assistance.
Especially helpful to us were the review and comments from our
friends from investment clubs and the general investing public—
Lassie MacDonald, Ann Barton, Sarah Ezzell, Barbara Snow, and John
Nichols.
The input of the members of the Spruce Creek Rod & Investment
Club is appreciated. Those members include: John Wilson, Nick Rozs-
man, Manny Puello, Rick Simonsen, Kevin Dunphy, Constantin Nel-
son, Charlie Barkman, Bill Cusatis, Gary Evans, Dean Nelson and the
late Uncle Bob.
As always, the input of the members of the Aspen Ski Institute has
always been helpful. Those members include: John H. Foote V, Tom
Carroll, Bob Jones, Alec Arader and Bill McLucas, among others.
Many thanks to all of the professionals at McGraw-Hill who
brought this book to publication, particularly: Stephen Isaacs, acqui-
sition editor; Sally Glover, senior editing supervisor; and Ruth Man-
nino, production supervisor.
A special thank you to Deb Cusatis and Katie O’Toole, whose writ-
ing and editing skills are greatly appreciated.
Introduction and Overview
CHAPTER
1
Financial Flameout
Even the creations of brilliant rocket scientists sometime flame out of
control. The financial equivalent of incineration occurred during Sep-
tember 1998, at Long Term Capital Management (LTCM), a multi-
billion-dollar hedge fund1 that was owned by some of Wall Street’s
greatest intellects. After several years of spectacular returns (43 per-
cent in 1995, 41 percent in 1996, and 17 percent in 1997) for its own-
ers and investors, LTCM suffered a massive collapse and was rescued
from bankruptcy by a consortium of its creditors.
Ironically, in 1997 two of LTCM’s general partners shared the No-
bel Prize in Economics for their breakthrough academic research re-
lating to risk management techniques and the valuation and pricing
of stock options. The writings of Dr. Robert C. Merton and Dr. Myron
Scholes laid the groundwork for the creation and growth of the finan-
cial derivatives (options, forwards, and swaps) markets. Scholes col-
laborated with the late Fischer Black in developing the famous Black-
Scholes Option Pricing Model.
1
Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
2 STREETSMART GUIDE TO VALUING A STOCK
Merton, along with Dr. Zvi Bodie, coauthored the excellent college
textbook, Finance, published in 1997. The text is structured around
three analytical pillars of finance—the time value of money, the valu-
ation of assets, and the management of risk. At the foundation of these
pillars are the basic principles, rules and theories of finance that should
guide investors to make intelligent financial decisions.
LTCM apparently did not practice properly the risk management
strategies that its Nobel Laureates carefully formulated. Nor did LTCM
adhere to the financial principles that Bodie and Merton articulated
so well in Finance. The collapse of LTCM is evidence that even very
smart people sometimes employ questionable investment strategies.
It also shows that the financial marketplace exacts a heavy toll on those
who stray too far from shore. We all can learn from the mistakes of
LTCM as well as from more recent examples of carnage—WorldCom,
Xerox, Adelphia, Tyco, and Enron among others—in corporate finance
and the stock market.
Good Companies—Hot Stocks—Ridiculous Prices
The long bull market of the 1990s spoiled investors and made us over-
confident in our stock picking abilities. We did not understand risk.
Now that the bubble has burst and we have seen that the stock mar-
ket moves in more than one direction, we realize that it’s not easy to
be a successful investor, to beat the averages, or to outperform the in-
dices consistently. The stock market was manic during the late 1990s.
Exhibit 1-1 shows the blastoff and then the plummet of the stock mar-
ket averages over the past five years.
When the stock market soars, cocktail party chatter centers on hot
tips and inside information. As Martha Stewart can attest, that infor-
mation is sometimes true—and in the end, incredibly costly! Stock
market touts hype dozens of once-in-a-lifetime opportunities. Every
business day on CNNfn and CNBC, promoters and analysts push the
current new, new thing—the next Starbucks or Krispy Kreme. Beware,
place a hand on your wallet, and hold on! The hype associated with
former hot stocks (such as Internet Capital Group once at $200.94—at
$0.36 at the end of 2002, Corning down from a high of $75 to $3.31 per
share, and JDS Uniphase once at $140.50, now $2.47) propelled their
prices to such high levels that they were grossly overvalued. As an ex-
