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Wednesday, August 29, 2012

Invest or Bet?

Last night I had the inevitable discussion when we talk about how to select stocks. If you stick to value, Tim, you are going to miss all these great companies with such great products. The current spin off these days is where and when do you buy Facebook (FB). After all they have a billion users and are the new face of technology.  How can you just skip a stock like LinkedIn (LNKD) that is the future of networking and job search? What about game changers like Amazon (AMZN)? They have moved reading from paper to bytes and killed big retail for books and electronics.

All of this is true but there is another truth that needs to be considered.  These are great companies but they all have a value as a business. When I evaluate a stock I calculate the tangible book value, an estimated liquidation value, a financial value and strategic acquisition value based on current multiples and an ongoing intrinsic value. My models may not be the most eloquent but the time I am done I have what has proven to be a really good rough estimate of what a company is really worth as a business. Most of these darling stocks are great companies but the price is far disconnected from business value they are little more than betting slips in my opinion.

My more vocal opponents remind that these are great growth companies and you can’t value them based on current numbers. You have to consider all the fabulous growth in earnings and revenues. You have to price in potential. I think that is ridiculous but decided to give a try and see what the results were if we priced these stocks as ongoing concerns and based my ongoing concern intrinsic value based on the sunshine and lollipop estimates of Wall Street for these great companies.

I will start with Facebook the granddaddy stock that is the subject of endless discussion. I will start by saying I think that this company is a great example of Nassim Taleb’s theory of success. They just got lucky and were in exactly the right place at the right time. Management has not shown any exceptional talent for decisions or business and I doubt the company will be the raging success advocates are hoping. Having said that based on today’s numbers my intrinsic value calculation is $9.38 a share. Ridiculous given all the wonderful potential right? Now let’s apply the analysts’ estimates of a 30% earnings growth rate for the next five years. When I use those projections I come up with a value of $25.50 a share for the company. However that is based on numbers five years out so I have to discount it back to today.  Using a 10% discount rate (yes it is high. Using a low discount rate in future value calculations is absurd in my opinion) I come up with a value for the stock of $15.52.  Even with all those rosy assumptions the stock is still overpriced at current levels.

The exercise produces similar results for the other darling stock. LinkedIin on today’s numbers has an intrinsic value of about $14.57. If I use their highly optimistic 66% a year growth rate for the next five years I get a number of $73. Discounted back to today that is roughly $46 a share.

 Amazon today is worth roughly $31 a share. Based on the projected 30% growth rate the numbers based on the potential in five years the valuation is$58.25. Discounted back at a reasonable rate of return that value becomes $36.

 Apple (AAPL) has a value on today’s numbers of $337 a share and using a 21% growth rate the number becomes $769 discounted back to $477.

Just a sure as the sun came up today someone is going to take great umbrage at the discount rate used in my calculation. You would be better served by focusing on the fact that only Apple, and that just barely, trades for less than the undiscounted valuation derived using very aggressive 5 year estimates.

These are great companies that do indeed have world changing potential. However their stock price is not reflective of current or potential business value in my opinion. They are priced as betting slips in a personality contest. Trade and invest accordingly.

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