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I was asked by a friend how to decide if a stock price is fair or not. Here is a major part of my decision when evaluating a Legacy stock (aka a value stock). Please keep them coming by submitting a question here.
For starters, this proven strategy is founded on three main influences in my life:
- My dad who runs a Main St business and impressed upon me the importance of value (among many other lesson)
- My grandfather who impressed upon me the importance of investing
- Naturally, I was then drawn to Value Investing as a means to analyze a company’s financials, which means I subscribe largely to Benjamin Graham and Warren Buffett methodologies
So here we go…
I typically support two portfolios for most people – each with its own specific purpose:
- A Legacy Portfolio, and
- A Growth Portfolio (read here)
Regarding a legacy portfolio, below is a technical post on how I value a company – a critical step when picking stocks for a legacy portfolio. One needs solid routines and procedures to manage this portfolio properly, so I will lay out those too.
The main reasons why a Legacy Portfolio is important are:
- You will need money when your traditional working years are over
- Time is on your side when you invest for the long term
- Significant wealth can be accumulated and well-purposed
The Process for Legacy Portfolio Investing:
(HON Honeywell will be the stock we evaluate and use as an example below.)
Since I love analyzing companies and assessing value, the lynchpin of my process is determining the value of a company. I do this literally and not just with a “feel” for a company. My first step when looking for a stock to buy is this:
1. Discounted Cash Flows (also known as DCF): this is a method to determine the future free cash flow (which is the amount of cash remaining after paying operating expenses and capital expenditures, which are upgrading/maintaining company assets) of a company based on financial data, then discounting it (because the value of money changes over time) back into today’s dollars. We would not want to treat $1 five years from now like it is worth as much as $1 today because it will not be. If the current (stock) price of the investment is below your DCF calculation, then the stock is undervalued and a good candidate to buy.
Note: With Legacy Portfolio I do not just want to buy a stock that will go up. I want to identify numerous stocks that will go up, then choose the ones that fit our priorities best! Think of your portfolio like a team: you don’t want just any good quarterback, you want a quarterback that can run your system and is best overall for the team.
This is by far the most important step in the process so do not be discouraged if you need many reviews and repetitions to understand DCF properly! Get this concept down, and it will pay off!
How to calculate Present Value:
1. PV = FCF/(1+r)1 + FCF/(1+r)2+ FCF/(1+r)3 + FCF/(1+r)4 + FCF/(1+r)5 … + FCF/(1+r)n
FCF = Free Cash Flows
r = interest rate or discount rate
n = the period (or iteration) number
Get the HON financial information here:
You will see tabs to click for Income Statement, Balance Sheet, and Cash Flow Statement
(We will use all 3)
Note: I personally would get their financial information here, but it is far more detailed/complex:
Fast Search: HON
Filing Type: 10-k
Open: 10-k documents from 2020 and 2016 (open both)
Open: Seq 1 10-k hon1231201910k (and do the same for 2016 too)
To start, open the Cash Flow Statement
Go to the bottom of the statement and find Free Cash Flow
For 2019, the FCF is reported by HON as: 6,060,000,000
Let’s begin finding Present Values (PV), which is a key step in the DCF process
For r we will use 0.0192 (0.023 – 0.0038 = 0.0192 ) More about this number in another post
For n we will use 5 years (5 iterations) Use 5-10 years for the DCF process
The math would look like this:
2019 PV = 6,058,000,000/(1+0.0192)1 = 5,943,877,551 = 5,944,000,000 for ease
2018 PV = 5,610,000,000/(1+0.0192)2 = 5,400,625,109 = 5,401,000,000 for ease
2017 PV = 4,940,000,000/(1+0.0192)3 = 4,666,042,648 = 4,666,000,000 for ease
2016 PV = 4,400,000,000/(1+0.0192)4 = 4,077,697,609 = 4,078,000,000 for ease
2015 PV = 4,380,000,000/(1+0.0192)5 = 3,982,694,878 = 3,983,000,000 for ease
Terminal (Exit) Value (3-5 times present FCF) = 6,058,000,000 x 3 = 18,174,000,000 so Terminal (Exit) Value’s PV = 18,174,000/1+0.10)4 = 12,413,000,000 for ease
36,484,000,000 for ease
+ Non-Operating Assets (2019 Balance Sheet: Cash, Mkt. Securities, Receivables, Unutilized Assets)
17,910,000,000 = 9,070,000,000 + 1,350,000,000 + 7,490,000,000 + 0
– Non-Equity Claims (2019 Balance Sheet: short term debt + long term debt + capital leases + pref stock)
16,166,000,000 = 5,060,000,000 + 10,950,000,000 + 156,000,000 + 0
38,230,000,000 Equity Value (what would be left for the shareholders)
712,599,803 (The number of shareholders)
Found here (10-k page 1, bottom left corner: Common Stock Outstanding):
But as of April 4th, 2020 the stock is trading at $127.45 so we conclude…
Based on DCF alone HON is OVERVALUED at this time.
Of note, we want a company that is UNDERVALUED by 25% or more, which means our DCF process would have to yield a price of $40.24 (53.65 x 0.75). So HON is overvalued by more than $87/share in my view.
So what if we find a stock that is undervalued? Well, you can put it on your Target List!
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