eBook - How to pick undervalued stocks in 3 simple steps

Investors generally underperform in the market because they do not buy healthy and cheap
stocks, but they buy stocks that get their attention.
The reason why this approach leads to underperforming returns is that the stocks covered in
the media are closely followed by the masses. Thus, they are less likely to be undervalued.
Furthermore, if you invest in stocks that everyone else is investing in, your performance will
be equal to that of the others, average at best.
However, you cannot really blame people for this approach, because analyzing thousands of
publicly traded companies is a daunting task. Or is there an easy way to filter out the hidden
gems? I would argue that there is a way, and in this eBook, I take you through my simple 3-
step process to find healthy, undervalued stocks to invest.
What inspired me to write this detailed guide was the realization that I learned this stock
discovery process by combining information from several books and countless online
articles. This eBook is simply the guide I wish I had had available to me when I was starting
out as an investor. If you found this guide useful, just email me at hello@wallstnerd.com.

How to find undervalued stocks in 3 simple steps .................................................................. 1
Step 1: Generate ideas ............................................................................................................ 3
Step 2: Create your wish list ................................................................................................... 5
Consistently high profitability ........................................................................................ 5
Low leverage ................................................................................................................... 5
A sustainable competitive advantage .............................................................................. 5
Honest, competent, shareholder-friendly management .................................................. 5
A company you understand ............................................................................................. 6
Step 3: Estimate the intrinsic value ........................................................................................ 7
Price-Earnings Multiplier ................................................................................................... 7
Discounted Cash Flow (DCF) Model .................................................................................... 7
Return on equity valuation ................................................................................................. 7
Explanation of the 3 valuation methods using an example ................................................. 7
Method 1: Price-Earnings Multiplier ................................................................................... 8
Method 2: Discounted Cash Flow (DCF) Model ................................................................. 11
Method 3: Return on equity valuation .............................................................................. 16
Conclusion ........................................................................................................................... 20
Appendix .............................................................................................................................. 21
Wonderful companies ....................................................................................................... 21
Earnings Manipulation - Identifying Value Traps ............................................................. 23
How can you determine a realistic growth rate for a company? ........................................ 25
Tools .................................................................................................................................... 29
Glossary ............................................................................................................................... 30
Index .................................................................................................................................... 35
Table of figures .................................................................................................................... 37
Author .................................................................................................................................. 38

Goal: Identify about 30 companies to analyze further.
Finding stocks to analyze is something many individual investors struggle with, but it is not
really that hard. In fact, the Internet has led to an information overload and there are
thousands of stocks listed on U.S. exchanges alone, but the internet has also provided us
with powerful tools to filter out the junk. Using free online stock screeners is my favorite
way to find stock ideas as they allow you to make an independent, rational choice that is not
biased by the opinions and emotions of others.
Remember, although we look for undervalued stocks, a favorable valuation is of no use if the
financial situation of the underlying company is poor. Therefore, the first step is to
determine when you consider a stock to be garbage and when you consider it to be a
wonderful company 1 .
„It is far better to buy a wonderful company at a fair price than a fair company at a wonderful
price” – Warren Buffett
The basic criteria I always use at this stage are:
Return on equity 2 > 15%.
Indicates high profitability and a potential competitive advantage
Debt to equity ratio < 0.8
Indicates that the company is not heavily dependent on debt to finance its growth
Current Ratio > 1
Ensures that the company is able to service its current liabilities
It is tricky to filter by P/E ratio because P/E ratios vary widely by industry, so you may be
excluding perfectly sound investment ideas. Moreover, the P/E ratio itself does not tell you
much about whether or not a company is undervalued relative to its intrinsic value. For
similar reasons, I do not like to filter by EPS growth rate, because a solid company with 0%
growth can still be an interesting buy if the price is right.
Sometimes I add dividend yield > 1% as a criterion as I like to receive a steady dividend
income. In addition to this, I sometimes filter by market cap < 1 billion USD owing to the
fact that smaller companies are generally less closely watched by analysts and therefore
1
Appendix explains in detail what wonderful companies are.
2
Definitions of terms can be found in the glossary.

more likely to be mispriced. This theory is corroborated by Ibbotson Associates who found
that small cap stocks have significantly outperformed large cap stocks 3 over the last century.
Once you have set your criteria, use one of the following free online stock screeners and try
to end up with about 30 ideas:
Finbox
A stock screener with a simple interface to filter out the good companies. (Available as a free
and a paid premium version).
Yahoo Finance
Yahoo offers a comprehensive, free online screener.
WallStreetZen
WallStreetZen offers its Stock Finder, a free English-language option to screen stocks.
Alternatives
Some would suggest reading blogs and following the financial news, but I suggest largely
ignoring these sources because hypes and other people's opinions may cloud your rational
judgment. If you use other creative methods to come up with stock ideas, please share and
email me at hello@wallstnerd.com.
3
(O’Shaughnessy Asset Management, LLC, 2020)

Goal: Reduce your 30 ideas to 3 (or less) wonderful companies.
Got your 30 ideas? Great! That means you have already filtered out most of the junk. Now it
is time to see if any of those 30 stocks have what it takes to be an outperformer. In the first
step you did a simple screening process. Now you need to dig a little deeper to identify the
real gems. By analyzing Berkshire Hathaway's shareholder letters 4 , we learn that super
investor Warren Buffett looks for the following things in a winning stock:
High and preferably rising net margins are a good sign, indicating that a company is either
becoming more efficient or is able to raise its prices. This in turn should lead to a steadily
increasing book value. Also, pay attention to whether the company is generating healthy
free cash flow (FCF). If a company reports net profits but is unable to generate FCF, this
could indicate earnings manipulation 5 .
High debt poses a significant interest rate risk and leads to inflated ROE figures. Debt-laden
companies get into trouble more easily when sales decline or interest rates begin to
fluctuate. A long-term debt ratio of below 0.8 and a current ratio of above 1 are
preferable.
Here the analysis goes beyond numbers and financial ratios. Highly profitable companies
attract competitors, and increased competition usually leads to lower profits unless a
company has a sustainable competitive advantage. Something that cannot simply be copied.
Examples include brands, switching costs, network effects, a toll bridge, secrets and price.
Look out for these important signs.
Stock market genius Peter Lynch suggests looking for companies that any idiot can run,
because sooner or later an idiot will run them. Nonetheless, sound management plays a key
role in business success. Therefore, always google the names of key leaders to find out who
they are and what their track record is. Type "scandal", "fraud" and similar words into your
search to find out if they have been involved in anything shady. Do the same for the
company itself. Also, analyze the company's capital allocation strategy.
As a rule of thumb, a company with a consistently high return on equity and a lot of growth
potential should reinvest its profits (to a large extent) in the business, otherwise
4
(Buffett W. , Berkshire Hathaway Letters, 2000)
5
You can find more information about earnings manipulation in the appendix of this eBook.

shareholders are better off if the company pays a dividend and/or buys back shares.
However, shares should only be bought back if the share is trading well below the company's
intrinsic value.
Buffett once said that he and his business partner Charlie Munger stick to companies they
understand, and I suggest you do the same. Do complex companies have a lower chance of
outperforming the market? Not by definition. However, you should avoid them because the
more complex a company is, the harder it becomes to make a reasonable forecast about
future performance. So stick to consistent performers with a business model you
understand. In other words, avoid bank stocks like the plague.
It takes some work, but if you analyze each of the 30 companies on your list using the
criteria above, you can identify the best possible investment opportunities with the highest
probability of outperforming the market.

Goal: Find out if any of the stocks you have identified are currently undervalued.
Now that you have found a handful of wonderful companies, it is time for the final exciting
step: checking whether the price is right to buy!
A right price is one that gives you a large margin of safety, so you have minimal downside
risk even if the company's future performance is not quite as expected. For example,
consider buying only if the current share price is 30%-50% below the intrinsic value of the
share. This way, the risk is minimized because the stock is already very cheap, while at the
same time the chances of earning a serious return increase. Mohnish Pabrai* describes this
low-risk, high-return strategy as, "heads you win, tails you only lose a little." 6 . A low purchase
price is absolutely critical if you want to make your dream of market-beating returns come
true.
There are several ways to calculate the intrinsic value of a business, such as:
This method calculates a 5-year price target based on a reasonable, historical P/E valuation
and then arrives at an estimate of intrinsic value by taking the net present value.
A powerful calculation of intrinsic value based on the discounted value of cash that can be
withdrawn from a company over its remaining life.
The third and final method I explain in the eBook uses one of Warren Buffett's favorite
profitability metrics: return on equity (ROE).
Now we will use the company Union Pacific Corporation (UNP) as an example to apply the
3 valuation methods.
Union Pacific Corporation is a North American railway company founded in 1862 and
headquartered in Omaha, Nebraska. Union Pacific specializes in the transportation of all
types of freight and has a rail network of 32,340 route miles connecting Pacific and Gulf
Coast ports with the Midwest and Eastern United States.
6
(Pabrai, 2007)

Why did I choose Union Pacific Corporation as an example?
Actually, I chose this company for two reasons. Because the business model is
understandable and easy to follow and because I think railway companies are great.
To give a better understanding of the 3 valuation methods, I have provided the Excel file
here as a download. You can also use the Excel file as a template for your future analyses.
Let’s get started!
This first method is also the simplest. It involves determining a five-year price target based
on a reasonable, historical P/E valuation. We will use Union Pacific Corporation (UNP) to
illustrate this method in practice.
Figure A - Earnings per share - Union Pacific 7
Let us start by finding out how much Union Pacific earned over the last four quarters.
Fortunately, we do not have to add up these quarters manually as most major financial
websites like Yahoo Finance and Morningstar have already done this for us in their EPS
figure.
Union Pacific earnings per share over the last twelve months is 8.78 USD at the time of
writing this eBook.
7
(Yahoo Finance, 2021)

Figure B - Median Historical P/E Ratio - Union Pacific 8
Figure B - Median Historical P/E Ratio - Union Pacific
We also need to figure out what a reasonable P/E ratio is for Union Pacific. If we look at the
last 5 years, we see that Union Pacific historical 5-year average P/E ratio is 18.1, which is
quite common in the technology sector, and even a bit on the lower end.
The final piece of the puzzle is the rate at which Union Pacific's earnings are expected to
grow over the next five years. Coming up with a realistic growth rate for a stock is difficult,
so I recommend you read my detailed report on the subject. 9
If you do not feel like determining your own growth rate, you can also check out what
analysts expect the company to do in the near future. Analysts polled by Yahoo Finance
predict that Union Pacific will grow at a rate of 13.44% year-over-year in the next five years.
Figure C - Estimated Growth - Union Pacific 10
8
(Morningstar, 2021)
9
To be found in the appendix of this eBook.
10
(Yahoo Finance, 2021)

However, predictions are difficult to make, especially about the future, as the Nobel Prizewinning
physicist Niels Bohr 11 once remarked. It is therefore crucial to apply Benjamin
Graham's margin of safety principle to give our estimate of intrinsic value some margin for
error.
We propose a margin of safety of 30%. We apply this margin of safety to the growth rate of
13.44% to arrive at a conservative growth rate of 13.44 * (1 - 0.30) = 9.41%.
Now let us put it all together!
Now that we have all the necessary inputs, we can calculate the five-year price target for
Union Pacific. The formula is:
EPS * average historical price-to-earnings ratio * conservative growth rate^5.
Using the data we collected in the previous steps gives:
8.78 * 18.1 * (1 + 0.0941)^5 = 249.13 USD.
According to our calculation, Union Pacific is worth 249.13 USD in five years. However,
what we really want to know is the value of Union Pacific today, its intrinsic value. To find
this value, we need to discount the five-year price target, which gives us the Net Present
Value (NPV) 12 .
We will use a discount rate of 9%, which is approximately the long-term historical return of
the stock market. This is the minimum return you need to achieve to justify choosing stocks
over investing in an index fund. Without further ado, let us do the math:
249.13 USD / (1 + 0.09)^5 = 161.19 USD
Fantastic, we just calculated our first intrinsic value! Union Pacific is worth about 161.19
USD today according to the P/E valuation model.
Please leave out the decimal places, because remember: this is only a rough calculation. Union
Pacific's share price is around 161 USD at the time of writing this eBook, which means the
company is currently overvalued and we should therefore skip it and look for other
opportunities in the market.
11
(Anker, 2017)
12
The value of a US dollar today is higher than the value of that same US dollar in the future, because
that US dollar could earn an interest rate if you invested it today. Therefore, we use this imaginary
interest rate to calculate how much the future value is worth in today's money. We call this
discounting.

Tip
At what price should you consider buying if you want to earn 15% per year? Simply discount
the five-year price target by 15% to calculate your maximum purchase price. In the case of
Union Pacific, this means you should only consider buying when the price is below 249.13
USD / (1 + 0.15)^5 = 123.86 USD.
Super investor Warren Buffett defines intrinsic value as follows:
"[Intrinsic value is] the discounted value of the cash that can be taken out of a business during its
remaining life." - Warren Buffett 13
The above definition implies that we need to add up all the expected future cash flows and
then take the net present value (NPV) to calculate the intrinsic value in today's money. And
that's exactly what the discounted cash flow model, or DCF model, can do for you!
First, it is important to highlight the difference between cash and cash that can be taken out
of a business, or in accounting terms, cash flow from operating activities or free cash
flow.
Cash flow from operating activities is the amount of money generated by the normal
operations of a business. However, not all of the money can be withdrawn from the business,
as some of it is needed to keep the business running. These expenditures are called capital
expenditures (CAPEX) and are often found in the cash flow statement under investments in
fixed assets.
Free cash flow is the cash flow that a business can generate after it has spent the money
needed to stay in business. We calculate it by simply subtracting capital expenditure from
operating cash flow 14 . What is left is the liquidity that can be freely withdrawn from the
business without disrupting it. This is the cash flow we are interested in.
13
(Buffett W. E., 1996)
14
Actually, there are two types of capital expenditure, maintenance investment and growth
investment, and only maintenance investment should be deducted from operating cash flow to get
the correct value for free cash flow. Why? Because maintenance investment covers the spending
needed to stay in business, while growth investment covers the money invested in fixed assets for
future growth. The problem is that companies do not report these two types of investment separately
in their financial statements. To simplify the calculation, we therefore simply subtract all investments
from operating cash flow.

Now that you know how to calculate our most important input, free cash flow (FCF), we can
take a look at the model.
The DCF model takes the FCF of the last twelve months and projects it 10 years into the
future by multiplying it by an expected growth rate. Then it takes the NPV of the cash flow
and adds them up.
To avoid projecting to infinity, we assume that the firm is sold after year 10. Therefore, we
multiply the FCF of year 10 by a factor of 12 to simulate the multiplier at which the
company would be sold. (This multiplier is usually between 10 and 15, but is rather arbitrary
and this value is then added to the previous calculation).
Finally, the liquid assets that the company has on its balance sheet are added and the total
debt is subtracted from the result to get an estimate of the intrinsic value for the whole
company.
This value then just needs to be divided by the number of shares outstanding and you get an
estimate of the intrinsic value for one share. Confused? Let us make things a little more
concrete.
I will show you how this model works in practice by looking again at Union Pacific
Corporation (UNP).
Figure D - Free Cash Flow - Union Pacific 15
If we look at Union Pacific's cash flow statement, we find that FCF for the last twelve months
is 5,849,000,000 USD (values are in millions).
15
(Morningstar, 2021)

Figure E - Cash & Cash Equivalents - Union Pacific 16
While free cash flows are important, we should also consider the cash and cash equivalents
that the company has in its most recent quarterly balance sheet. For Union Pacific, this entry
has a very respectable value of 1,859,000,000 USD (values are in millions).
Figure F - Total Liabilities - Union Pacific 17
In addition to cash, any debts a company has should also be considered, as shareholders
come last; debts must be repaid first. Union Pacific has managed to finance its growth on its
own so far, but has taken on some debt to pay dividends and buy back shares. Union Pacific
therefore has a total 45,440,000,000 USD in liabilities on its balance sheet (values are in
millions).
The growth rate we apply to free cash flow is the same as we used in method 1, 13.44%, or
9.41% if the margin of safety is applied.
However, as a company grows in size, it becomes increasingly difficult to maintain a high
growth rate. This phenomenon is called the law of large numbers 18 . Therefore, we drop the
conservative growth rate by 5% each year. Just as in method 1, we will use a discount rate of
9%.
16
(Yahoo Finance, 2021)
17
(Yahoo Finance, 2021)
18
(statista, 2020)

Figure G - Outstanding Shares - Union Pacific 19
Ultimately, we want to know the intrinsic value per share, so we need to know the number of
shares outstanding. In the case of Union Pacific, there are 652.12 million shares
outstanding.
19
(Yahoo Finance, 2021)

It is time to run the numbers so we can figure out what the estimate of Union Pacific's
intrinsic value is. The DCF model calculations look like this:
DCF valuation
Input
Cash & Cash Equivalents
Total Liabilities
Free cash flow
Shares outstanding
Expected growth rate
Margin of Safety
Conservative growth rate
Growth decline rate
Discount rate
Year 10 FCF multiplier
$
$
$
1,859,000,000
45,440,000,000
5,849,000,000
650,790,000
13.44%
30.00%
9.41%
5.00%
9.00%
12
$ 113.38
Calculations
Year FCF * Growth rate
1
2
3
4
5
6
7
8
9
10
NPV FCF
$ 6,399,273,920.00 $ 5,870,893,504.59
$ 6,971,215,425.87 $ 5,867,532,552.71
$ 7,563,121,808.28 $ 5,840,117,718.04
$ 8,173,177,129.48 $ 5,790,084,733.03
$ 8,799,477,460.10 $ 5,719,056,584.34
$ 9,440,055,753.88 $ 5,628,796,809.95
$ 10,092,905,891.13 $ 5,521,165,152.43
$ 10,756,005,496.66 $ 5,398,076,462.75
$ 11,427,337,214.68 $ 5,261,463,499.54
$ 12,104,908,198.71 $ 5,113,244,039.61
Total NPV FCF $ 56,010,431,057.00
Year 10 FCF value $ 61,358,928,475.37
Cash & Equivalents $ 1,859,000,000.00
Total Liabilities $ 45,440,000,000.00
Company value $ 73,788,359,532.37
Figure H - DCF Valuation - Union Pacific
Total cash value FCF is the sum of all cash flows in the third column. Year 10 FCF value is
the product of the Year 10 FCF multiplier (12) and the NPV of the free cash flow in Year 10
(5,113,244,039.61 USD).
According to this calculation, you would have to pay a whopping 73,788,359,532.37 USD to
buy Union Pacific in its entirety. Fortunately, we can buy a single share of it for about
113.38 USD per share. This is the estimate of the intrinsic value per share for Union Pacific
at the time of writing this eBook using the DCF model.

Given that the current share price (at the time of writing this eBook) is around 220 USD,
Union Pacific appears to be significantly overvalued even using the DCF model. Keep in
mind that we are only interested in buying shares whose price is significantly below the
calculated intrinsic value.
So far you have learned about two methods to estimate the intrinsic value of a company: the
price-earnings multiple and the DCF model. The third and final method we will explain uses
one of Warren Buffett's favorite measures of profitability: Return on Equity (ROE).
This ratio shows how profitably the equity is used by the company. A consistently high ROE
implies that the company has a sustainable competitive advantage; otherwise, competitors
would have eroded profitability over time.
An ROE of 15% or higher can be considered good. You simply divide the net profit by the
equity of the company to get the ROE value. We use Union Pacific Corporation (UNP)
again as an example.
The ROE valuation model requires several assumptions, so it is no different from the other
models in this respect. We assume that Union Pacific (1) pays out the same percentage of its
profits as dividends over the next 10 years, (2) is able to maintain its profitability on average,
and (3) pays out 100% of its net income as dividends in year 10.
This last assumption is necessary because predicting the future to infinity is not really an
option either.
In addition to some inputs that we already used in the previous two valuation models, such
as shares outstanding, discount rate and conservative growth rate, the return on equity
model also requires some new inputs. And as you might have guessed, return on equity is an
important data input.

Figure I - Return on Equity Union Pacific 20
Since returns can fluctuate over time, we take the average ROE over the last 5 years. This
gives Union Pacific a solid 31.24%. If there are major outliers, use the median instead.
Remember also that the future of a company with highly volatile earnings is much harder to
predict. This in turn makes the estimated intrinsic value less reliable.
Figure J - Equity - Union Pacific 21
The amount of equity, sometimes referred to as shareholder's equity, that Union Pacific
reported on its balance sheet in the most recent quarter is 16,958,000,000 USD.
Figure K - Dividend Rate - Union Pacific 22
20
(Morningstar, 2021)
21
(Yahoo Finance, 2021)
22
(Yahoo Finance, 2021)

The final input we need is the value of the dividend paid per share, called the dividend rate.
Union Pacific currently pays 3.98 USD in dividends per share.
Let us now calculate the estimate of intrinsic value for Union Pacific using the ROE model.
ROE valuation
Input
Shareholders' equity
Return on Equity (5y avg)
Shares outstanding
Dividend rate per share
Expected growth rate
Margin of Safety
Conservative growth rate
Discount rate
$
$
16,958,000,000
31.24%
650,790,000
3.98
13.44%
30.00%
9.41%
9.00%
$ 138.18
Calculations (per share)
Year Shareholders' equity Dividend
1
2
3
4
5
6
7
8
9
10
NPV dividends
$ 28.51 $ 4.35 $ 4.35
$ 31.19 $ 4.76 $ 4.37
$ 34.13 $ 5.21 $ 4.39
$ 37.34 $ 5.70 $ 4.40
$ 40.85 $ 6.24 $ 4.42
$ 44.69 $ 6.83 $ 4.44
$ 48.90 $ 7.47 $ 4.45
$ 53.50 $ 8.17 $ 4.47
$ 58.53 $ 8.94 $ 4.49
$ 64.04 $ 9.78 $ 4.50
Year 10 net income $ 20.01
Required value $ 222.29
NPV required value $ 93.90
NPV dividends $ 44.29
Intrinsic value $ 138.18
Figure L - ROE Valuation - Union Pacific

We take the equity per share 16,958,000,000 USD / 650,790,000 = 26.08 USD) and increase
it by the conservative growth rate (9.41%). This gives a value of 28.51 USD at the end of
year 1 and a value of 64.04 USD at the end of year 10. We allow the dividends to grow at the
same rate and then take the net present value of these dividends in each year using the
discount rate of 9%. The net income in year 10 is the earnings per share that the equity can
generate in year 10 (64.04 USD * 31.24% = 20.01 USD).
The required value is the amount of equity that would be required if the company only
generated the historical market rate of return of 9% (20.01 USD / 0.09 = 222.29 USD). In
essence, this amount of 222.29 USD is the value we can assign to the profitable income of
20.01 USD.
However, this is the value in 10 years. So to calculate how much the company is worth today,
we take the present value of the required value (222.29 USD / 1.09^10= 93.90 USD) and add
the sum of the 10 years of discounted dividends 44.29 USD.
This gives us an estimate of the intrinsic value for Union Pacific of 138.18 USD (93.90 USD +
44.29 USD). Again, the current share price at the time of writing this eBook is 220 USD,
which again tells us that Union Pacific is currently significantly overvalued.
This does not mean that Union Pacific's share price cannot go higher from here, because
ultimately it is impossible to predict what a fool would give for it. It just means that it would
be irrational to buy Union Pacific shares today at this seemingly inflated price.
Apply the above valuation models to determine the intrinsic value of a company. The very
last step is then to compare the value you have calculated with the share price at which the
share is currently trading. Is the price far below your estimate of the intrinsic value?
Congratulations, you have just struck gold! Seriously, it is extremely rare to find a company
that has all the great characteristics we were looking for in steps 1 and 2, while trading at a
huge discount to intrinsic value.
At this point, you should revisit your analysis and run the numbers again. If you are sure you
have found a wonderful company that is grossly undervalued, you should jump on it! Again,
you are lucky if you can find a handful of these opportunities per year. If you find more of
them, either the stock market has just crashed or your filter criteria are not strict enough.
If the price is not right at that particular moment, add these stocks to your wish list anyway
so that when the opportunity presents itself, you are ready to grab them at an attractive
price.

Now, you are ready to find more bargains. This e-book explains how to find undervalued
stocks in 3 simple steps. Furthermore, the 3 different methods will help you to arrive at an
estimate of the intrinsic value of a listed company. However, all three methods require
several assumptions about future performance and therefore none of them is perfect.
Nevertheless, the reliability of your estimate can be greatly increased by comparing the
results of the three models and focusing on companies with solid financials that are run by
competent management.
The three estimates vary for Union Pacific, and this example is deliberately chosen to show
you that calculating the intrinsic value of a company is not an exact science.
It is impossible to say which, if any, of the three estimates is correct or more correct than the
other. Therefore, it is crucial to consider all three estimates and use your own common
sense to come up with a reasonable benchmark.
Precise numbers and elegant mathematics have the power to create a sense of trust and
confidence in their correctness. However, be careful and rely on your judgement and
common sense.
" ...techniques shrouded in mystery clearly have value to the purveyor of investment advice.
After all, what witch doctor has ever achieved fame and fortune by simply advising 'Take
two aspirins'? " - Warren Buffett

You have seen that all models make assumptions about future performance and therefore
none of them is perfect.
Despite the fact that historical performance is no guarantee of future performance, you have
a better chance of predicting the growth rate of a company that is consistently doing well
than that of a company with wildly fluctuating earnings.
Moreover, valuation is only one part of investing; the other part is thorough fundamental
analysis. So I will now briefly highlight some important points to consider about companies
before you buy their shares, no matter how undervalued the company is! In the words of
Warren Buffett:
"It is far better to buy a wonderful company at a fair price than a fair company at a wonderful
price."
By analyzing his letters to Berkshire shareholders, we can deduce what Buffett means by a
wonderful company. The following list contains the characteristics of a sound investment
in Buffett's own words:
1. market price significantly below the estimated intrinsic value (margin of
safety).
"...the key to successful investing [is] the purchase of shares in good businesses when
market prices [are] at a large discount from underlying business values".
2. above average and consistent return on equity
"Our preference would be to reach our goal by directly owning a diversified group
of businesses that generate cash and consistently earn above-average returns on
capital."
3. low debt levels
"We prefer businesses earning good returns on equity while employing little or no
debt."
4. Consistently high profitability
"We prefer demonstrated consistent earning power.

5. strong and sustainable competitive advantage
"In business, I look for economic castles protected by unbreakable 'moats'."
6. honest and competent management
"...we try to buy not only good businesses, but ones run by high-grade, talented and
likable managers."
7. within circle of competence
"...we just stick with what we understand."
Companies with the above criteria have, in Buffett's opinion, the highest probability of
providing their shareholders with a good return while reducing downside risk.
These wonderful companies are the only ones he is interested in. This approach significantly
reduces the range of possible investments, but those that remain are strong performers that
are likely to deliver healthy cash flows in the years ahead.
The key lesson here is: look for more than an attractive valuation. Finding financially healthy
companies should be the first priority of any successful investment strategy. The second
step is to see if any of these sound companies will sell at an attractive price relative to their
intrinsic value. Only if these two criteria are met should you consider investing.

With these valuable techniques, you can identify both the next Enron and the growth stories
of the next decade. Sounds too good to be true? That is what I thought. I was wrong.
Benjamin Graham, the father of value investing, believed that a cautiously greedy
investment strategy gave you the best chance of achieving above-average returns in the
stock market. In his legendary book The Intelligent Investor*, Graham explains that the
main goal of a cautious investor is to avoid serious mistakes or losses, while the main goal
of the greedy investor is to invest in stocks that are both healthy and more attractive than
average. The combination of these two types forms the basis for successful investing.
Rule No. 1: Do not lose money. Rule No. 2: Never forget Rule No. 1.
As a serious investor, you look at the financial statements of a company. Here you notice
that the company has little debt and is highly profitable compared to its competitors. You
estimate the intrinsic value and find that the company is currently highly undervalued. You
invest in this seemingly great company, but a few months later the company files for
bankruptcy. What happened? Well, unfortunately, prudent greed in itself is no guarantee of
good results. Your strategy is based on reported financial statements, which are very
susceptible to manipulation.
This means that a company may appear to show strong profit figures when in fact it is
bleeding money. In his insightful book It's Earnings That Count*, Hewitt Heiserman explains
that the reported income statement has four major limitations that allow for dubious
earnings management.
1. investments in fixed assets are depreciated over time
2. annual changes in working capital are not reflected in the income statement
3. investments in R&D and advertising that pay off over time are expensed immediately
4. equity is considered free, even though there is an opportunity cost for its use
If the above four points are too technical for you, I recommend you read the book. It is profit
manipulation that creates many of the so-called value traps in the market. Therefore, the
importance of recognizing this type of manipulation cannot be overstated. In this situation,
the garbage-in, garbage-out principle applies. Because no matter how sophisticated your
fundamental analysis and intrinsic value estimates are, if they are based on misrepresented
numbers, they are essentially worthless.
Fortunately, Heiserman offers an ingenious solution to the limitations of reported income
statements: Create two alternative income statements! The first, the Defensive Income
Statement, allows you to determine whether a company is able to self-finance its growth or

whether it is heavily dependent on external financing. The second, the Enterprising income
statement, gives you better insights into a company's ability to create value. The book offers
examples of WorldCom and Enron from the years before their demise. It shows that both
companies have defensive as well as entrepreneurial losses, while their reported profits are
growing. With this knowledge, you could have foreseen the impending demise and avoided
these stocks altogether.
Figure M - Enron - Quality of Profits
The process of creating these alternative income statements is too long to describe in this
eBook. However, the book also offers 30-second versions. These are less accurate, but can
still help you avoid costly mistakes.
Simple defensive profits = Cash from operating activities - capital expenditures
Simple enterprising profits = EBIT / (total debt + total equity)
If defensive profits are positive, it means that the company is able to self-finance its growth.
When corporate profits are above 18%, there is a high probability that the company is
creating value. These are the characteristics of stocks that will outperform the market in the
long run, especially if these numbers increase over time. Heiserman suggests looking at
three years of earnings to make an informed judgement.

The first step in any successful investment strategy should be to determine if the reported
gains are trustworthy. This will prevent you from investing in the next Enron, while allowing
you to identify the new growth story. If you want to know all the details, you can order his
book on Amazon*.
Value investors like Warren Buffett have only two goals: 1) to find excellent companies and
2) to determine what they are worth. But to determine what a company is worth, you need to
predict how fast the company will be able to grow its earnings in the future. How to find a
realistic growth rate for your intrinsic value calculations is what this post is about.
"The investor of today does not profit from yesterday's growth."
Warren Buffett
As the above quote makes clear, all your returns depend on the future growth of the
company you invest in. Therefore, the growth rate plays a crucial role in the valuation of a
company. Imagine two identical companies, both earning 10 million USD this year. However,
Company A will grow at 15% per year for the next 10 years, while Company B will grow at
only 5% per year. In this way, Company A will earn 40.5 million USD in year 10 (10 million
USD x 1.15^10), while Company B will earn only 16.3 million USD.
So even though both companies started from exactly the same position, I'm pretty sure you
would rather own Company A than Company B. And it is precisely because the growth rate is
so important that we have to be extra careful when we include it in our calculations. So how
can you determine a realistic growth rate for the company you are analyzing?
By far the easiest way to determine a growth rate is to see what analysts say. Analysts are
employees of financial institutions who sift through all the available information about a
company and then make a prediction about how well they think the company will perform
over the next few years. On Yahoo Finance, for example, you can find out that analysts on
average expect Union Pacific (UNP) to grow its earnings at a rate of 13.44% per year over the
next 5 years.
It seems like a great plan to listen to what these analysts say because they are the experts,
right? They studied for years and then had to pass a series of brutal tests and interviews to
finally become a recognized financial analyst. Yet a study by McKinsey & Co. concluded
that Wall Street analysts are almost always too optimistic. 23
23
(Marc Goedhart, 2010)

But what is too optimistic? Well, the authors found that analysts' forecasts were, on
average, too high by almost 100 per cent. 100%!! So when analysts say they expect a
company to grow profits by 10% a year, the actual growth is most likely closer to 5% a year.
That's an embarrassingly large difference that makes your valuations completely inaccurate.
So although you can use analysts' estimates, you should take them with a grain of salt.
Although a bag of salt might be more appropriate.
Figure N - Earnings per share for S&P 500 companies - Forecast & Realised 24
The over-estimated earnings per share in the chart above alone illustrate the general overoptimism
of Wall Street analysts.
Another way to get an idea of a company's future growth potential is to look at how fast the
company has been able to grow its earnings over the past decade. Let us take Google
(GOOGL) as an example. A look at the company's financials on Morningstar tells us that in
2011 the company had earnings per share of 14.89 USD and currently has earnings per share
of 92.19 USD. This represents an impressive annual growth rate of 61.91% (92.19 USD / 14.89
USD ^ 1/10).
24
(Thomson Reuters I/B/E/S Global Aggregates, 2020)

So over the last 10 years, Google's earnings per share have grown by an average of 61.91%
per year. Now ask yourself if it is realistic to expect Google to continue to grow at this rate over
the next 10 years? Consider that this means that in ten years Google will need to earn 2 times
more than the 40 billion USD they earn today! This seems highly unlikely. Even our overoptimistic
analyst friends agree and expect a growth rate of 21.00%, which is still very good,
but nowhere near the historical growth rate of 61.91%!
"In the business world, the rearview mirror is always clearer than the windshield."
Warren Buffett
You cannot simply extrapolate historical earnings growth into the future, because the bigger
a company gets, the harder it becomes to maintain a high growth rate. This phenomenon is
called the law of large numbers 25 . So expect growth rates to shrink over time, and do not
blindly extrapolate historical growth rates into the future.
Imagine Iron Inc., a company that sells, you guessed it, irons. They raise 20 million USD
from investors to make their first batch of irons. This money shows up on their balance
sheet as equity. With this 20 million USD, they can generate 5 million USD in net profit,
resulting in a return on equity (ROE) of 25% (5 million USD / 20 million USD).
Iron Inc. now has 20 million USD in equity and 5 million USD in profit. Theoretically, the
company could reinvest all of these profits into the business (such profits are called retained
earnings), which would increase equity to 25 million USD. In this case, equity grows by 25%
(25 million USD - 20 million USD / 20 million USD), which is the return on equity. The next
year they earn a 25% return on equity on their now larger equity, so return on equity can be
considered a growth rate.
However, using return on equity as a growth rate would be a gross oversimplification of realworld
circumstances. For example, part of the earnings might not be reinvested but
distributed as dividends, and part of the earnings might be needed for maintenance and
replacement of equipment and therefore not contribute directly to the growth of the
company. Let us look at how we can optimize this ROE ratio to get a more realistic growth
rate.
There is something called the sustainable growth rate. The name suggests that this is exactly
what we need, so let us take a closer look.
25
(statista, 2020)

The sustainable growth rate is the maximum rate at which a business can grow without
taking on additional debt. This is good because we want to invest in companies that are able
to finance their growth with their own profits. The sustainable growth rate is calculated as
follows:
ROE x (1 - dividend payout ratio).
The ROE ratio is adjusted for dividends paid, as only retained earnings (net profit -
dividends) can be used to grow the company. If Iron Inc. paid out 40% of its net profit as
dividends, the sustainable growth rate would be 15% (25% x 60%). This means that Iron Inc.
should be able to grow at a maximum rate of 15% per year without having to take on
additional debt.
What we are looking for, however, is a realistic rate at which we can expect a company to
grow over the next few years, not a maximum rate. This makes the sustainable growth rate
far from perfect. For example, if the company decides to take on 10 million USD in longterm
debt to generate more profit, the amount of equity would remain the same, but the
ROE would still increase because of the higher profit. So ROE is flawed because it does not
take debt into account, and because ROE is an important input for the sustainable growth
rate, it is also flawed. In addition, part of the retained earnings has to be used for
maintenance and replacement of machinery and therefore does not directly lead to growth.
So how can we fix this? Well, we could add the long-term debt to the equity before
calculating the return, which essentially means that we no longer use the return on equity
but the return on capital. That way we take debt into account. Also, we could use
depreciation and amortization costs as a proxy for the maintenance and replacement costs
of machinery, and therefore subtract these from retained earnings to get a more accurate
view of the amount of money that can be used to grow the business. Let us call this the
Sustainable Growth Rate.
The formula could be written as follows:
(Net profit - Dividends - Depreciation) / (Equity + Long-term debt).
So is this the perfect formula for growth? Not quite. We are still making a lot of assumptions
with this formula. So I suggest you compare this rate to analyst expectations and historical
EPS growth rate to make sure you're not being too optimistic. Also look at how consistent
the company's earnings have been over the last ten years. If earnings have grown steadily
year after year, you can have some confidence in the growth rate. However, if earnings
fluctuate widely, an accurate prediction is almost impossible and you should include a
substantial margin of safety in your calculations. Finally, calculate the sustainable growth
rate for the last few years to see if it is relatively stable or if it fluctuates significantly.

In this text I have highlighted the importance of growth rates in calculating the value of a
business and to show you that this is not an easy task. The most important lesson is that
there is no one perfect way to determine a growth rate, but by combining several sources
and taking a conservative approach, you should be able to make a realistic estimate of future
growth as long as the company has continuous, stable earnings.
Finbox
A stock screener with a simple interface to filter out the good from the bad. (Available in
both a free version and a paid premium version).
Yahoo Finance
Yahoo offers a comprehensive, free online screener.
WallStreetZen
WallStreetZen offers its Stock Finder, a free English-language option to screen for stocks.

Shares outstanding
The number of tradable shares held by investors. Essentially, this number indicates how
many pieces the company is divided into. This number is used to calculate earnings per
share and market capitalization.
Benjamin Graham
A professor at Columbia Business School and mentor to Warren Buffett. Graham is the socalled
father of value investing. He wrote the bestsellers "Security Analysis"* and "The
Intelligent Investor"*, in which he explains the value investing framework in detail.
Balance sheet
A balance sheet is an overview of a company's assets, liabilities and equity.
The name balance sheet refers to the fact that assets should equal liabilities + equity. These
must be in balance as everything a business owns (assets) should be paid for with borrowed
money (debt) or money from shareholders (equity).
Cash flow from operating activities
An item on the cash flow statement that shows how much money a company makes from its
current operating activities.
Current Ratio 26
The current ratio tells us whether a company is able to meet its short-term financial
obligations.
The formula for the Current Ratio is:
Current assets / Current liabilities
A current ratio of 1 or higher is considered good.
Discount rate
An imaginary interest rate, usually equal to the long-term historical return of the stock
market, used to calculate how much an amount of money will be worth in the future in
today's money. This is the minimum return you need to achieve to justify stock picking
versus investing in an index fund.
26
(Buffett & Clark, 2008)

Dividend yield
The yield you get from dividends paid out by a company. This percentage is calculated as
follows:
Dividend yield = Annual dividend per share / Current share price
Return on equity 27
The net profit of a company divided by its equity. It is a measure of how profitably a
company can use its equity.
Return on equity = Net profit / Equity
Retained earnings
The amount of profits left over after dividends have been paid to shareholders. This money
can then be reinvested in the business.
Retained earnings = Net profit - Dividend
Free Cash Flow
Free cash flow (FCF) is the money that is freely available to the company after it has paid for
the maintenance of its fixed assets. Many investors believe that this figure is a more reliable
measure of profitability than net income because it is less susceptible to manipulation by
management.
Free cash flow = cash from operating activities - capital expenditure
Earnings per share
Earnings per share (EPS) is the amount of net income a company has earned in the last 12
months divided by the number of shares outstanding.
Earnings per share = net profit / shares outstanding
Income statement
An income statement is a statement and shows the income and expenditure and the profit
made over a period of time.
27
(Buffett & Clark, 2008)

Intrinsic value
An estimate of the true value of a company, assuming that the market price does not always
accurately reflect this value. This is the cornerstone of the value investing strategy.
Capital expenditure
A cash flow statement line item that includes investment in property, plant and equipment,
either for maintenance or growth. Used to calculate free cash flow in the discounted cash
flow model.
Financial statements
A table that gives an overview of a company's financial performance. Every listed company is
required to make three of these statements publicly available:
Income statement
Balance sheet
Cash flow statement
Net profit for the year
The amount of money a company has earned after deducting all the costs of doing business
is often called net profit. Net profit can be found on the income statement. It is the most
commonly used figure to judge how profitable a business is. However, beware that this
figure is very susceptible to manipulation by management.
Cash flow statement
A statement that shows the actual cash inflows and outflows of the business.
An income statement might reflect future revenue from a large contract, while actual cash
might not be paid until after that contract expires. The cash flow statement, on the other
hand, shows only the actual flow of cash that has taken place, including cash from operating
activities, cash from investing activities and cash from financing activities.
Net Present Value
Net Present Value (NPV) is the current value of an amount of money in the future as if it
existed today. A US dollar today is worth more than a US dollar in the future because that US
dollar could earn interest if invested today. We calculate the present value of a future US
dollar by discounting it.
Net Present Value = Future Value / (1 + Discount Rate) ^Number of Years from Today

Price-Earning-Ratio
The price-earnings ratio (P/E ratio) is a valuation ratio of a company's profit to its share
price. A high P/E ratio means that investors are willing to pay more money per US dollar of
earnings. Note, however, that P/E ratios vary widely from industry to industry.
P/E ratio = share price / earnings per share
Market capitalization
The current market value of all shares outstanding. So if the company has 1,000 shares
outstanding and the share price is 50 USD, the market capitalization is 1000 x 50 USD =
50,000 USD.
Sustainable growth rate
A measure of how much a company can grow without borrowing more money.
Sustainable growth rate = return on equity x (1 - payout ratio)
Sustainable competitive advantage
Sustainable competitive advantage is an advantage that is not easily copied and can
therefore be sustained over a long period of time.
Margin of Safety
A concept strongly emphasized by Benjamin Graham that suggests buying a stock only when
the market price is significantly below the intrinsic value of the company. By applying a
margin of safety, you reduce the downside risk of underperforming in the future while
increasing the chance of outperforming in the future if the company performs better than
expected.
Value Investing
An investment strategy that aims to buy financially sound companies at a discount to their
intrinsic value.
Liabilities
A liability is something a company owns that costs money. It includes loans, trade payables,
accrued expenses and any other money the company owes to other parties.
Asset

An asset is something that a business owns and that makes money. Examples of current
assets are cash, inventories and receivables. Examples of fixed assets are equipment,
buildings and land.
Warren E. Buffett
The most successful investor of all time. Buffett was a student of Benjamin Graham and has
earned a place in the top 3 richest people in the world by applying value investing principles.

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Figure A - Earnings per share - Union Pacific ................................................................................................. 8
Figure B - Median Historical P/E Ratio - Union Pacific .................................................................................. 9
Figure C - Estimated Growth - Union Pacific .................................................................................................. 9
Figure D - Free Cash Flow - Union Pacific .................................................................................................... 12
Figure E - Cash & Cash Equivalents - Union Pacific .................................................................................... 13
Figure F - Total Liabilities - Union Pacific .................................................................................................... 13
Figure G - Outstanding Shares - Union Pacific ............................................................................................. 14
Figure H - DCF Valuation - Union Pacific ..................................................................................................... 15
Figure I - Return on Equity Union Pacific ...................................................................................................... 17
Figure J - Equity - Union Pacific .................................................................................................................... 17
Figure K - Dividend Rate - Union Pacific ...................................................................................................... 17
Figure L - ROE Valuation - Union Pacific ..................................................................................................... 18
Figure M - Enron - Quality of Profits ............................................................................................................ 24
Figure N - Earnings per share for S&P 500 companies - Forecast & Realised ............................................. 26

Alexander Kelm is a passionate value investor and runs the website
Wall St. Nerd. Here, the passionate value investor writes in-depth
articles on the topic of "Value Investing". Value Investing involves
analyzing a company's fundamentals and can be characterized by an
intense focus on a stock's price, its intrinsic value and the relationship
between the two.
Alexander Kelm offers online courses on stock investing.
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