Streetwise for Sunday, November 29, 2020

As we approach the New Year, let me again address the process of how to initially vet candidates. While bookstore shelves sag under the weight of mighty tomes that attempt to answer the selection question, the answers can be overwhelming.

Although describing all the necessary vetting criteria in detail is too complex for a newspaper column (see my next class offering at the end of this column), let’s slice the proverbial Gordian knot of valuation and couch the answer in terms of intrinsic value.

Simply put, intrinsic value is the present value of a specific cash flow that a company could potentially generate into perpetuity. Yes, perpetuity is a long time. However, there are mathematical shortcuts that address the issue. More importantly, an integral and key part of present value is the discount rate used. This is the rate of return you require of your investments.

Finally, there is the question of which cash flows to utilize. Three of my favorites are free cash flow to the firm, earnings, and dividends.

The intrinsic value calculation is nothing more than projecting forward in time a specific flow of cash and then determining what the present value of that cash flow is today.

For example, the dividend discount model projects dividends going forward, at a specific rate of increase into perpetuity, and then calculates the present value of that dividend flow. Among those companies that have been raising dividends for more than 10-years, the dividend growth rate is about 7 to 10 percent.

I know what you are thinking; you have not seen the inside of a mathematics textbook for many years and you would like to keep it that way. Not a problem. There are numerous Internet web sites, such as ValuePro.net where you enter a stock symbol and in turn receive an intrinsic value. Please be sure to use ValuePro.net and not .com.

In the case of ValuePro, the methodology utilized is free cash flow to the firm. You could also calculate the intrinsic value using an earnings model and/or a two-stage dividend growth model.

Information on the ValuePro methodology and the use of the model is readily explained the authors’ book, “Valuing a Stock,” by professors Gray, Cusatis, and Woolridge, available on Amazon.

A rule of thumb regarding what the intrinsic value should be is to start with an intrinsic value that is about 5 to 8 percent above a current share price. However, that number is whatever you are comfortable with. However, if the intrinsic value is less than the current share price, you might want to consider looking elsewhere. One objective you might want to consider is trying to find 10 to 15 candidates to investigate further, i.e., where the intrinsic value meets the number you set.

I would suggest that you do yourself a favor and pick the low hanging fruit, i.e., well known and easily researched companies with a track record of annual dividend increases.

Before sending me all the other possible permutations and combinations of investment criteria you feel should be considered, keep in mind that intrinsic value is just one possible hurdle to jump in the stock selection process. However, it might be considered a good place to start.

If you use ValuePro, always be aware that ValuePro data is not always up to date. You will need to use the Internet to find the most recent data and type it in to replace what is there.

For example, you might want to update the 10-year treasury rate, along with the shares outstanding, operating profit, and tax rate.

Note to Readers - I will again be teaching Advanced Investment Analysis, for Ringling College’s Osher Lifelong Learning Institute beginning in January. Call 941-309-5111 for registration/information. Classes will be on two different days, depending on whether you select classroom teaching or Zoom classes, and will run for 8 weeks.

Unfortunately, we have had to cancel my 10th annual talk scheduled for the third Thursday of January 2021, due to the Corona virus.

Lauren Rudd is a Financial Advisor with Raymond James & Associates, Inc., member New York Stock Exchange/SIPC, located at 1950 Ringling Blvd #401 Sarasota, FL 34236. You can contact him at 941-706- 3449. This market commentary is provided for information purposes only. The information provided is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of the author and not necessarily those of Raymond James. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past Performance does not guarantee future results.

Dividends are not guaranteed and may fluctuate. Holding stocks for the long-term does not insure a profitable outcome. Links are being provided for information purposes only. Raymond James is not affiliated with and does not endorse, authorize or sponsor any of the listed websites or their respective sponsors. Raymond James is not responsible for the content of any website or the collection or use of information regarding any website's users and/or members. Raymond James is not affiliated with Ringling College. Lauren's teaching activity is independent of his role as a financial advisor with Raymond James.