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No. of Recommendations: 13
I start with the financials, copying and pasting the last several years' worth into my Earnings Power Spreadsheet from a Reuters database. Then I go into the actual 10-Ks and double check the data, as well as pull out footnote items like operating leases. After deciding if there is any growth capex, what the cost of equity is (usually the 10-year Treasury yield plus 500 basis points), how long intangibles like R&D should be depreciated, etc., I build an Earnings Power Chart.

The Earnings Power Chart answers the first of my three questions: can I trust this company's numbers? Specifically, if GAAP profits are rising, is defensive (free cash flow) and enterprising (net return on capital) profits also rising. I am looking for a reasonably tight correlation between all three income types. This work usually takes 2 hours.

Step two is figuring whether a firm has a competitive advantage and, if so, how long will it last? If a company is situated in the Earnings Power Box's upper-right box, or even better, if it is forging an Earnings Power Staircase, then it probably has a competitive advantage (but not always).

Morningstar identifies four types of competitive advantages: 1) low-cost provider, 2) high switching costs, 3) intangibles (patents, brands, store locations, etc.), and 4) network effect. Having a competitive advantage is important, because it enables a company to have the best possible mix of "value drivers": sales growth, operating profit margins, and low investment rates in fixed, working capital, and intangibles. I also look at management...how they are compensated, their capital allocation track record, this sort of thing. This work takes 3-4 hours, but you never really "know" a company. Also, this research is ongoing.

My last step is valuation. Here I estimate a range of intrinsic values (no decimal points!) to see if the company is selling for less than it is worth. I have 4-5 ways of estimating intrinsic value, including 2-3 DCF models. If you are able to get a rough sense of what the business is worth using conservative assumptions, then go one step further to decide what your "buy around" and "sell around" prices are.

The DCF models I use have several "margin of safety" features to protect me from overpaying (or should I say protect me from my inclination to want to buy everything) They are:

1. Using numbers I trust (Earnings Power Chart).
2. Three growth scenarios, with the high growth forecast based on analyst five-year forecasts. Analysts are usually wrong (read David Dreman), so my Low and Medium scenarios are less than what they forecast.
3. Have a "pothole" year in years 1-5, as most companies do not grow their earnings (GAAP, free cash, EVA) in an unblemished "hockey stick" straight line.
4. Earnings growth for all three scenarios declines over time to 3%, which is a proxy for the inflation rate.
5. 75% of my intrinsic value estimate is based on my Low and Medium growth forecasts.
6. Subtract debt, operating leases, and other contingent liabilities from firm value.
7. Pay no more than 65-75% of my intrinsic value estimate.

Valuation takes a few hours. Also, after every quarter's results are made available, I check to see if my estimates need updating.

Unless you are an experienced investor, you should not buy a full position right away. Buy in increments over time. Lost opportunities are better than realized losses.


Hewitt

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