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I posted this note on Tom Jacob's and Jeff Fischer's Complete Growth Investor board last night, and thought readers here might also find this information useful. - HH


With the markets melting faster than ice cream in the August sun, it is natural to feel helpless.

What to do?

1. Exercise.

2. Keep an active social life.

3. Estimate the Earnings Power Euphoria Ratio for each company you own. The less euphoria, the safer your portfolio from a valuation perspective.

To illustrate, let's look at Seaboard (SEB), which has food processing and shipping interests.

Key data:

Stock price: $1,850
Shares outstanding: 1.26 million
EPS: $203
Tangible book: $949
5-year growth rate: 7% (my estimate)
Discount rate: 10%

The first thing we do is subtract SEB's tangible book value from the stock price. $1,850 - $949 = $901. Thus, $949 of SEB's $1,850 stock price is explained by its "hard" corporate net worth, and the other $901 by future earnings.

Next, subtract projected cumulative earnings over the next five years from this $901 figure above. Given my estimate of an annual 7% growth rate and a 10% discount rate, the present value of SEB's next five years' worth of earnings is $935. Since $935 is greater than $901, SEB's Euphoria Ratio is 0%. Between SEB's net physical assets and the next five years worth of EPS, you more than cover the $1,850 stock price. Investors are not keen on this business, you can say.

Now let's look at Google. Google is a superior company to SEB, no question. But what about valuation? There is, after all, a difference between a good company and a good stock.

I estimate GOOG's euphoria ratio at 68%, based on data from Yahoo and the company's latest 10-Q filing. This is a pretty high number. I own GOOG and I am not going to sell it. On the other hand, GOOG is a small percentage of my portfolio. I do not want to own a lot of companies that have similar Euphoria Ratios. The valuation risk is too great.

Blue Nile, which I owned until management started touting a misleading free cash flow number in Spring 2006, has a Euphoria Ratio of 80%. I am getting altitude sickness!

A caveat. A key element here is the growth rate. But analysts are terrible prognosticators, as David Dreman's research finds. This is why we want to stick with companies with low Euphoria Ratios...we give ourselves a margin of safety in case sand gets in the ointment.

If you are able, estimate your portfolio's weighted average Earnings Power Euphoria Ratio. Mine is 29%, which means 71% of the stock prices of the companies I own weighted in proportion to the stock prices of all other companies in my portfolio is explained by a combination of tangible book and the next five years' worth of earnings. The other 29% is explained by earnings beyond year 6. While I do not like what is happening to my portfolio right now, the low Euphoria Ratio gives me peace of mind.

I will talk more about the Earnings Power Euphoria Ratio at CGI Las Vegas.

To sum up, don't get fearful. Get analytical. The more you know about your companies, the better your investment results.


Hewitt

long SEB and GOOG
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