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Narrowing it down
That range is too broad to be very useful. To turn it into a number that means something, I'll need more-exact numbers for 2008 earnings and an end-of-the-year P/E ratio. At this point, I'd say the current P/E ratio for Chevron is too low. It lags the industry average multiple (or P/E ratio) because the company has had difficulty in getting new production on line. That looks ready to move up to the industry average of 11.1 by 2009.For 2008, a transitional year, I'd use a P/E ratio halfway between the current 9.4 multiple and the future 11.1, which would be 10.25. I'd also say that, even with a global slowdown, oil prices will average at least $80 a barrel in 2008. Because the global slowdown will take some profit from the company's refining and gasoline-retailing businesses, however, I'd put my earnings estimate at, say, $9.40 a share.
You can use my simple Excel tool to fine-tune this target price. Plugging in those values gives me a price of $96.35, a 15.25% gain from the Feb. 15 closing price.
The reason it's so important to make these two numbers as accurate as possible is because they're the only inputs, so your final price calculation depends on the accuracy of these two numbers. For example, if Chevron's production plans slip and some of the new oil production that was supposed to take place in 2008 actually winds up in 2009, that will have a huge effect on the value generated by this calculation.
Looking further into the future
As I result, I'd say it's a good back-of-the-envelope calculation for a year ahead or less, but it doesn't really give you a value for a stock that reflects its long-term prospects.To calculate the long-term fair value of a stock, you've got to put time back into the equation and include more than just one year's results. The standard method for doing this is called discounted cash flow, abbreviated to "DCF" in the formula below.
Here's the math:
CF = cash flow
CF1 = first-year cash flow
r = discount rate
Less risky companies show a lower discount rate. Johnson & Johnson (JNJ, news, msgs), for example, I'd peg around 7.7%. Waters (WAT, news, msgs), a smaller and riskier company, I'd put at 9.5%.
The math looks daunting, I'd agree. But don't worry if it's all Greek to you: I'll give the fair values I calculated for the "after the bloodbath 10" at the end of this column, so you don't need to do any of this math yourself.
First, the concepts
But I think it is important that you understand the concepts behind this formula. It's actually common sense.Companies that can generate more cash flow in the future are more valuable today. Take a company -- or any other investment -- that will generate $100 in cash flow per share a year from now (CF1) in my formula. How much would you be willing to pay today for that future cash flow? The formula says that for a company that generated $100 in cash flow at the end of one year and where it cost the company 10% to raise its capital, the present value of that investment would be $100/(1+0.1), or $90.90. That's how much you'd be willing to pay today for that cash flow at the end of a year.
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Raise the per-share cash flow in my example to $120, and the present value becomes $109. Companies that pay less for their capital, either because they're less risky or because interest rates in general are lower, are also more valuable. Lower the cost of capital to 6% from 10% in my example, and the present value goes up to $94.34 from $90.90. The company with $120 in cash flow is worth $113.21 instead of $109.
Wimpy's hamburger finances
Wimpy's discounted cash-flow analysis: "I'll gladly pay you Tuesday for a hamburger today."
To use this formula, it's usually sufficient to use five years of cash flows and then calculate some perpetuity return for the years beyond that.
If you want to do the math yourself, you can use the NPV (net present value) function in Excel and the data on the "financial results" of our stocks page and in standard data sources such as the Standard & Poor's stock reports offered by most online brokerage companies. (S&P includes a weighted average cost of capital in the valuation section for most of the stocks it covers.)
Calculations for 10 stocks
If you don't want to do the math, now or ever, here are my calculated fair-value estimates for each of the "after the bloodbath 10." I've included the stock's closing price on Feb. 15 and the difference between this fair value and the current stock price.| Stock | Fair value | Feb. 15 price | % below fair value |
|---|---|---|---|
$98 | $89.11 | 9.1% | |
$93 | $83.60 | 10.1% | |
$44 | $31.06 | 29.4% | |
$238 | $219.39 | 7.8% | |
$110 | $96.17 | 12.6% | |
$80 | $58.23 | 27.2% | |
$123 | $115.35 | 6.2% | |
$152 | $147.98 | 2.6% | |
$105 | $84.08 | 19.9% | |
$76 | $60.37 | 20.6% |
Which are buys?
It depends on your read of the risk of the individual stock and of the stock market as a whole at the time of the purchase. The size of the discount you want from any stock will depend on your assessment of the risk in the shares, in the economy and in the stock market. And that's still subjective.
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A tough summer ahead for stocks?The stock market rallied during the first couple of weeks of February, and seasonal stock-market patterns suggest the market should continue the upward trend. However, if stocks take a downturn, MSN Money's Jim Jubak says, it could be an indication we’re still in a bear market.
So, no, this exercise hasn't given you some absolute buy or sell signal for any stock. But it does help you know when it might be worth taking the risk and pulling the trigger.
I've started two new threads on my MSN Money message board. "Are these prices insane?" asks for comments on my analysis of these 10 stocks, and "Got gas?" publishes fair values for the five natural-gas stocks I wrote about in my Feb. 15 column.
Continued: Developments on recent columns< previous | 1 | 2 | 3 | next >
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