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First let me say I am a new and unlearned investor with many questions, so bear with me! I appreciate the input on these boards so much b/c it helps me learn. Over the past year I have been reading books like Hewitt Heiserman's ETC, Intelligent Investor, Morningstar books, & Fool products to try to learn. One area that I sort of understand the principles of, but need much more study in is valuation. I would appreciate any thoughts on this question: recently Mr. Heiserman, a very astute investor, posted a list of upper-right box companies with attractive prices. However, Morningstar, which I think is generally considered a good source rates only 4 of the 14 companies as below intrinsic value. It rates 4 of them at value. It rates 4 above value & does not rate 2. Please hear me: I am not saying one is right, I have no ability to make that judgment. Rather my question is: can anyone help me understand the discrepancies you see in value between reputable sources & any possible solutions. Thanks-

Cory
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Cory,

I think valuation is a difficult issue for most of us. A lot of it depends on the valuation approach one is using. There are numerous ways to value a stock. For example, one could use absolute valuation metrics (ie, low forward PE, Price/CF, Price/BV), valuation metrics relative to a benchmark (ie, forward PE below the S&P 500 or industry), discounted cash flow, dividend discount, etc.

I know that Hewitt uses mulitple valuation methods to decide whether a stock is attractively priced. I also try to look at valuation from several different angles.

It is important to note that two analysts using the same model can come up with different intrinsic values for the same stock. For example, I believe Morningstar analysts use a discounted cash flow model. The results of the model (ie, intrinsic value) depend on the assumptions used for growth rates, cost of capital, profit margins, etc. If one analysts believes company X will grow 5%/year for the next 10 years, while the other analysts uses a 7% growth rate, the instinsic values will differ quite a bit.

To sum up, two analysts could have different opinions on the attractiveness of a stock's price due to the valuation method being used and the inputs into the model (among other reasons).

By the way, if you are looking for a straight-forward discounted cash flow model, try www.valuepro.com.

Hope that helps.
Matt
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Cory -

In my haste to provide a list of interesting candidates above, I should have said they all pass the FIRST of the three screens; that is, they all possess earnings power.

As for sustainability of competitive advantage and valuation, these are grayer areas. For a company like ARO, heck if I know what gives it a moat. I do not shop there. But, the teen retailer's chart is impressive. So I intend to buy a starter position and learn more about the business.

One of the items I look for when doing my 5-minute test is year 5 enterprise value/free cash flow yield. I take today's EV/FCF yield, then calculate what this yield will be five years from now if the company achieves growth long-term estimates. If five years from now the yield is over 10%, then I am interested. My list of companies all had Year 5 EV/FCF yields over 10%. But as always, please double-check my work.

I am a big fan of Morningstar's work, including their estimates of intrinsic value.


Hewitt
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