In a nutshell:
Intrinsic value of a stock tells us what the stock is currently worth. We then want to apply a margin of safety to buy a stock when it is undervalued to maximise our return and reduce our error. This method teaches you one way to calculate the margin of safety price of a stock.
- We need 4 components: Current EPS, Future EPS, Future P/E and Required Rate of Return
- All figures needed to calculate the margin of safety price can be found for FREE online
- Apply a margin of safety of 50% to minimise losses
- Intrinsic Value – what we need
- Current EPS
- Future EPS
- Future P/E
- Required Rate of Return
- Margin of Safety
- Final Calculation
In our last blog post we talked you through an investment strategy – Rule #1 Investing, by Phil Town.
As part of this strategy we try to calculate the ‘intrinsic value’ of a company, and then ensure that the current stock price gives us a large enough margin of safety for us to invest confidently.
The reason why we need a margin of safety is two-fold. Firstly, because the stock market is unpredictable and even the best looking companies could fail. Secondly, because of human error in our calculation – we need to ensure that we are buying with a margin of safety.
If you would like a more in-depth look into this method, then get the book here!
Intrinsic Value – what we need
Using this method, to calculate the intrinsic value of a stock, we need four components:
- Current EPS (earnings per share)
- Future EPS (earnings per share)
- Future P/E (price to earnings ratio)
- Required rate of return
Luckily for us, all of this information is available online, for free! In the next few sections we will explain where and how to find these numbers, then you can start calculating the intrinsic value of a stock.
In this example we will walk you through Facebook.
To get current EPS we just need to look online.
We can go to Yahoo! Finance, type in Facebook in the search bar at the top, and then navigate to the ‘Summary‘ tab.
As you can see below, the ‘EPS (TTM)’ is 6.74. This is the first number we need – so far so good.
There are two ways we can use to calculate Future EPS. What we want to do here is to calculate Future EPS using both methods, and then use the most conservative (the lowest) estimate.
Firstly, we can use Yahoo! Finance again to see what the analysts are predicting. Navigate to the ‘Analysis’ tab, and then scroll down near the bottom to ‘Next 5 years (per annum)’ under ‘Growth Estimates’. The figure we get here for Facebook is 17.55%.
Secondly, we can use historical equity growth rate – this is because stock prices most accurately resemble equity, if equity is increasing over time so should the stock price.
Ideally we want to do this over 5 or even 10 years. However, to keep it simple, and to use only one platform, we can use Yahoo! Finance once again which has four years worth of data.
Head over to the ‘Financials’ tab, go to the ‘Balance Sheet’ and then scroll down to ‘Total Stockholder Equity’. To calculate this we are simply going to use Phil Town’s online calculator here. Plug in the numbers and get a growth rate – for Facebook we get 17%.
Therefore, we are going to use the 17% analyst growth rate, as this is more conservative. Important to note that usually the two methods won’t be this close together. But, in this case it just compounds the fact that 17% is a solid figure!
However, this is where your knowledge of the company and industry is very useful – if you think that it 17% is way too conservative, then maybe use something higher, like 20%.
Once again, there are two ways to calculate Future P/E, and once again we will be using the more conservative estimate.
Firstly, simply take the equity growth rate we worked out and double it – this gives us 34.
Secondly, we can head over to MSN Money and use their 5-year low and 5-year high P/E ratios to get a 5-year P/E estimate. Go to Facebook’s quote page and then navigate to the ‘Analysis’ tab and then ‘Price Ratios’.
In Facebook’s case this gives us a 5-year high of 80.96 and a 5-year low of 17.32. Add them both together and divide by two to get a 5-year average of 49.14.
Hence, we will use the 34 figure as it is more conservative.
Required Rate of Return
Lastly, we need a required rate of return. This should always be 15%, as the market typically gives us 10% a year over the long-term, and we are taking on more risk by investing in individual companies, so we want a higher return!
We always want a required rate of return of at least 15%.
Margin of Safety
On top of this, we want a 50% margin of safety, so whatever we work out the intrinsic value to be we want to divide by two (or multiply by 0.5) to ensure there is a 50% margin of safety.
This helps to shield us from the unpredictable market, and incase we made any errors when calculating the intrinsic value.
Intrinsic Value – Final Calculation
We want to take the Current EPS and multiple it by (1+Future EPS) to the power on 5, to give us $14.7. We have chosen 5 because we want to predict the stock price 5 years into the future. This gives us the EPS in 5 years time.
We then multiply this figure by the Future P/E ratio we worked out, which is 34. This gives us the future value of a share, which works out to be $502.
Next, we take this number and divide it by 2 – this is because we want a 15% minimum rate of return each year, meaning we double our money every 4 years. This gives us $251 – which is the intrinsic value.
Lastly, we multiply by 0.5 to give ourselves a 50% margin of safety, which works out to be $125. This is our margin of safety stock price for Facebook!
The stock price we have calculate for Facebook is $125 dollars.
Clearly, this is way below what it is currently trading at, at around $188 dollars. What we would do that is to put in on our watch list and when it hits $125 then we would buy some stock then.
Obviously I know some of you will be thinking we will never be able to buy Facebook at such a low price – but this is why we have a margin of safety, as it helps us to not lose money nine times out of 10.
Also, remember around Christmas 2018 when Facebook dropped to around $124? Well at that time it was trading at its margin of safety price – and we could’ve bought it with confidence!
This is how to calculate the intrinsic value of a stock using Rule #1 Investing.