Praveen Chawla
A quick way to check if a stock you are thinking about is good value is to use a simple formula.
Factor of Safety = Operating profits ÷ (enterprise value × 10 year US treasury bond rate).
The higher the result, i.e., "Factor of Safety" the safer the investment is.
The logic of the formula is as follows:
Numerator: Operating Profits are the pre-tax profits a company generates. (for this exercise we ignore taxes).
Denominator: The enterprise value is the logical value an external buyer would pay for the entire company on the open market. This includes market capitalization minus debt plus cash. Multiplying enterprise value by the 10 year treasury rate gives us the "risk free" return an investor would get if was to invest the entire amount in 10 year US treasury bonds.
Basically you want the operating profit of the company to be higher than the amount you would get if you were to invest the same amount in treasuries. The higher the factor the better it is. Note that this does not take into account growth of operating profit and enterprise value. Therefore it is a conservative estimate. Here are some examples.
Here are some examples:
|
Ticker |
Company |
Current Price |
Operating Income |
Enterprise Value ($M) |
Factor of Safety over 10-yr T-Bill |
5-Year Total EBITDA Growth Rate |
Enterprise Value ($M) |
Market Cap ($M) |
|
Microsoft Corp |
$367.75 |
93,900 |
2,674,258.47 |
0.87 |
17.40 |
2,674,258.47 |
2,733,214.47 |
|
|
NVIDIA Corp |
$490.97 |
20,613 |
1,205,441.90 |
0.42 |
19.50 |
1,205,441.90 |
1,212,695.90 |
|
|
Walmart Inc |
$156.71 |
25,319 |
479,484.94 |
1.30 |
3.20 |
479,484.94 |
421,899.94 |
|
|
Exxon Mobil Corp |
$102.63 |
52,290 |
418,497.96 |
3.09 |
12.70 |
418,497.96 |
410,188.96 |
|
|
Verizon Communications Inc |
$40.20 |
29,502 |
336,864.89 |
2.16 |
3.60 |
336,864.89 |
169,004.89 |
Looking at Microsoft at present you can get 13% better risk-free income from 10 year US T-Bill while with Verizon you can get 116% more income. This income is not the same as dividend as a portion of this is retained earnings and also this does not include taxes. Nvidia is of course growing very fast and you may well decide that the low factor of safety does not matter in the long run. But you are taking this decision with eyes wide open. Same with Exxon, while the factor of safety is very high, it may be temporary given the high price of oil and it may well evaporate in the years to come.
