Wednesday, December 20, 2006
Method of evaluating and selecting stocks (Part 3)
Again, this is in response to Jojo. Yes, I totally agree that a summation of all FCF or otherwise could be known as the total earnings that a business will generate, till infinity is the best way to figure out the intrinsic value of a business.
And of course, the most difficult part is to determine a fair growth rate. And to determine this, it encompasses many factors from the quality of the management, the goal of the management, the plan for expansion or where the company is heading to few years down the road, the historical performance of the business and many more. To determine a growth rate is a large part for me personally can be attributed to both having an explicit plan for the future and to determine how the past performance matches the explicit plan at that time in point.
For example, a very recent acquisition of mine - Walgreens, I determined its growth rate and estimated value as described as follows, guided by the general guidelines as aforesaid.
In Walgreens latest annual report ended fiscal 2006, they plan to operate 7000 drugstores by 2010 as stated explicitly. This represents a 400 stores per year increase from today. So you can be pretty sure they are still growing at some decent pace.
So how sure can one be that they can achieve their goal? Then, we shall back-track to year 1994. In 1994 annual report, they had a plan to grow to 3000 drugstores in 2000. And they exceeded it. So if we compare the period b/w 94 to 00, & 06 to 2010, you will see that they grew from 1966 stores in 1994 to 3181 stores in 2000 which represents an increase of 61% from 94. If they can grow to 7000 stores in 2010 from the existing 5481 stores at end Aug 2006, it is about a 27% increase. Though if you compare it period to period, obviously the one from 94 to 00 is growing much more but then, it gotta be so when it is easier to grow it when on a smaller scale. But if you look at its per store sales, in 94, a store generated about USD4.7M, in 2000 it was US$6.67M, in 06, it was US$8.68 millions, in 2010, I estimate at about US$9.68 millions. I think my estimation is pretty conservative. I maintain a file to play around with the valuations, in 2010 if you use a PE of say 25, it can hit a price of USD74. In 2008, if you use PE of 22, it can goes to US$48.
Then it is important to be conservative in valuation in order to have a margin of safety too. And the calculation I did for the above are pretty conservative in my view if it was to compare it to how the market valued Walgreen a decade prior from now. If I were to use the same set of constants to calculate "Walgreen estimated value" from 94 to 00, the actual result, i.e. the actual average trading price then, was way a lot more than what I estimated. If I had bought in 94 at USD4.84, my valuation done in 1994 for the stock price was estimated to be about US$13 in 00, but it hit US$29.63 in reality....not only in that year was my calculation way off from the actual, any year before that is also way off but it is better to calculate conservatively.