There are several significant differences in the way that we at The Applied Finance Group approach valuing securities, in comparison to traditional accounting based methods and other DCF models. The biggest difference that sets our valuation methodology apart from other models/research providers is that our process begins with a more refined measure of corporate performance (Economic Margins). Economic Margins focus on whether or not the company is profitable from an economic standpoint and if that firm can earn above its true economic cost of capital. Understanding how well a firm has utilized its invested capital and whether or not it is earning above its cost of capital are helpful not only in measuring corporate performance, but also determining if a firm is able to create value for its shareholders.
Once we have a firm handle on whether or not a firm is profitable from an economic standpoint, the next step is to then correct many of the distortions inherent in “as reported” financial statements in order to put companies from different segments of the market on an even playing field. Our valuation framework essentially strives to create a set of economic financial statements for companies that work well across time, industries, sectors, and market caps. We believe that this process puts us in a superior starting position when evaluating the attractiveness of any investment, as we are comparing apples to apples, and not susceptible to many of the shortfalls of traditional accounting approaches to evaluating investments.
Once we are evaluating companies on a level playing field, we then make several company-specific adjustments to come to realistic and insightful valuation conclusions. This includes modelling the effects of competition in order to compete away excess returns over a company specific Competitive Advantage Period, to avoid silly assumptions that a firm can generate the same levels of profit into perpetuity inherent in other DCF models. Other subtle insights are also taken into account such as capitalizing R&D, which is often looked at as an expenditure rather than as an investment. Inflation adjusting the asset base for better comparability between firms. As well as assigning company specific discount rates. These types of adjustments are what set our valuation framework apart and provides our clients significant advantages in the selection of stocks relative to traditional accounting approaches and other DCF models.
This method of valuing companies has proven to consistently help identify companies trading at a discount to their intrinsic value. A significant spread in returns is achieved between companies our model has identified as the most undervalued and the companies that look the most overvalued based on our valuation metric. The chart below highlights the returns achieved within the S&P 500 index from 1998 to 2016. The entire index is broken down into quintile buckets, the “A” bucket contains the most undervalued stocks in the index while the “F” bucket contains the most overvalued stocks. Investors who purchased “A” stocks and avoided the bucket of “F” stocks would have enjoyed a solid spread in returns.
The table below contains 10 companies that are currently identified by our valuation model as undervalued (A Valuation Grade) within the S&P 500 index. This list can serve as a solid starting point for investors looking to add large cap positions to their client portfolios as these firms not only look extremely undervalued according to our model but also exhibit other characteristics common in companies that are likely to outperform.
S&P 500 - 10 Undervalued Stocks