Many thanks your site is top notch for the learning value investor, I too am really looking forward to the book. Keep up the valuable work.

Many thanks

Stuart

After that, I’ll head over to the NASDAQ or NYSE sites to see which stocks are posting the biggest drops. Wall Street tends to overreact to “bad” news that doesn’t necessarily affect the business but pushes the stock price around.

I also run a screen on MSN Money to see which stocks have a P/E less than 10, $500 million market cap, Book Value greater than zero, and profit margins above 20. (I’ll play with these numbers to get more results.)

Finding the companies is easy – look for beat up stocks and see if the news that beat them up will affect their business. Then, look for the moat.

As an aside- how do you personally search for business’ that you believe may be undervalued? In other words, what do you screen for to find a stock that is worth doing more research on?

Thanks for all the help.

For those not clear on the difference between GAAP earnings and Owner earnings, check out The Importance of Earnings.

In my opinion, there are a few fundamental flaws with Hagstrom’s approach. Here is my “short” response, but this is worthy of a stand-alone post next week.

Hagstrom’s Method Relies On Earnings

Earnings are for the government; cash is for the owners. Can you try to predict future GAAP earnings and use that as a basis? Perhaps. But, to what end? Owners don’t get earnings and businesses can’t use them for growth. Over the long-term, businesses will grow at roughly the same pace as their cash does, regardless of what earnings do. The opposite is not always true (in fact, it rarely is).

The Business Sense Of Hagstrom’s Valuation

From a business standpoint, Hagstrom’s valuation doesn’t make sense. A business can’t use GAAP earnings to pay down long-term debt; so, why would the calculation subtract the debt? Admittedly, I haven’t looked at the Quicken site for JNJ, but where do the rest of JNJ’s assets/net worth come into play? When buying a business, that is a critical portion of the valuation.

Munger’s Take On The Warren Buffett Way

This Quicken/Hagstrom valuation is based on Hagstrom’s teachings in The Warren Buffett Way. Charlie Munger, Warren Buffett’s partner, criticised the book as

not much of a contribution to human knowledge

(See the end of the linked article)

The Audited Results of Hagstrom’s Methods

If Hagstrom is using these methods to invest like Warren Buffett, they aren’t working for Hagstrom as they are for Buffett. According to Morningstar (as of the date below), Hagstrom’s Legg Mason Growth Trust Primary mutual fund has returned 9.04% on average for the past ten years.

As I said, that’s the “short” response. After the current series on business moats, I’ll play with the Quicken site and post a more detailed comparison.

In the meantime, I hope that helps!

Quicken.com provides a intrinsic value calculator based on Robert Hagstrom’s interpretation of Buffett’s writings on the topic. Here are the comments provided for JNJ:

“If we assume initial earnings of $10.6 billion grow at a rate of 9.31%, and we discount those future earnings at a rate of 15.00%, we arrive at a net present value for the company’s next 10 years of earnings of $80.9 billion. To account for potential earnings beyond the 10th year, we estimate a growth rate of 6.00%, a discount rate of 12.00%, and we arrive at a continuing value of $113 billion. To complete the calculation we add these two figures together, subtract the long-term debt for JNJ ($2.01 billion), and divide by the outstanding shares (2.90 billion) to get a per share intrinsic value of $66.09.”

One major difference in your approach and the one detailed above is using FCF vs. GAP earnings. The other difference observed is adding the book equity to the DCF versus the approach above which only subtracts the amount of long-term debt. Any comments on the difference in these two approaches and perhaps some logic behind them? No explaination is needed for the difference between FCF and GAP earnings.

Thanks, Michael