Valuation/Proprietary B Ratio/ Private Equity LBO – Part V After running a company through the filter and checklist, I further screen my selection using four valuation techniques: my own proprietary B ratio, Free Cash Flow (FCF) Yield, Benjamin Graham’s revised intrinsic value formula, and Private Equity Leveraged Buyout enterprise value. I developed my own proprietary B ratio to analyze a stock relative to its current market cap. I based it on concepts gleaned from Tobin’s Q ratio. Like Tobin’s Q, my B ratio between 0 and 1 implies the stock is “undervalued”. A B ratio greater than one implies the stock is “overvalued”. I use it as a rough guesstimate of my “moat” and in no way is it an absolute red or green light for purchasing a particular stock. It serves as a guide in combination with FCF Yield. Tobin’s Q ratio Tobin’s Q ratio was devised by Nobel laureate James Tobin of Yale University. Tobin theorized the combined market value of all publicly traded companies should be nearly equal to their replacement costs. Simplistically, it is the Total Market Value divided by the Total Asset Value. A low Q between 0 and 1 implies the cost to replace assets is greater than the value ofthe stock market, therefore the market is undervalued. A Q greater than 1 implies the market value is larger than the replacement assets value thereby indicated the stock market is overvalued. Example: International Business Machines (IBM) On 14 June 2016, I used Google Finance to determine the market capitalization of IBM was $143.8b. My proprietary ‘value’ for IBM in determining the B ratio is $175b. $143.8b / $175b = 0.82 In this scenario, the B ratio under 1 shows IBM is currently undervalued. Example: Coca Cola (KO) On 14 June 2016, I used Google Finance to determine the market capitalization of KO was $190b. My proprietary ‘value’ for KO in determining the B ratio is $167b.
$190b / $167b = 1.14 In this scenario, the B ratio over 1 shows KO is currently overvalued. I also take a look at the Free Cash Flow (FCF) Yield. I discovered this valuation yardstick through Terry Smith of Fundsmith. Terry takes the free cash flow and divides it by the market value ofthe company. He then compares this yield with other companies, the market, and the bond yield to take a look at the relative value delivered. Terry has publicly stated he looks for a 5 to 8 percent yield. I calculate Free Cash Flow as Cash Flow from Operations minus Capital Expenditures (CAPEX). Example: International Business Machines (IBM) On 14 June 2016, I used Google Finance to determine the market capitalization of IBM was $143.8b and Free Cash Flow was approximately $12.8b. $12.8b / $143.8b = 8.9% So far, IBM looks undervalued using both the B ratio and FCF Yield. Example: Coca Cola (KO) On 14 June 2016, I used Google Finance to determine the market capitalization of KO was $190b and Free Cash Flow was approximately $7.9b. $7.9b / $190b = 4.2% So far, KO looks overvalued using both the B ratio and FCF Yield. In a third look at potential valuations for shares I’m considering, I go old school and run the numbers through Benjamin Graham’s revised formula: V = EPS x (8.5+2g) x 4.4 / Y Where: V is intrinsic value, EPS is the company’s last 12-month earnings per share. 8.5 represents Graham’s P/E ratio for a no-growth company, g is the company’s longterm projected earnings growth, 4.4 was the average yield of high-grade