An Updated Model

Well, I've been away for a while. But the time away was not completely wasted. After poring over the 6th edition of Security Analysis (which is really the 2nd edition with some additional editiorials by current Graham-esque investment professionals) I have developed a model for judging whether a stock is cheap or not based on Graham's ideas. This post gives a high level outline of how the model works.

First, let me summarize what I believe are the main points made by Graham in Security Analysis with respect to judging equity investments. First, Graham emphasizes that a company's valuation should never be based on just a single year's earnings, particularly when those earnings are record-high. He states several times that 5 to 10 years' worth of history must be considered when coming to a proper valuation. Secondly, Graham says that although it's true there is little correlation between book value and market value, there must still be some consideration given to a company's tangible book value when considering a fair price for its stock. Finally, Graham warns against accounting deception and spends a good deal of time instructing the analyst on how to derive a realistic, more-standardized earnings number from the financial statements.

With those 3 points in mind, I devised a model that attempts to incorporate these ideas into a single valuation metric. While it's still in development, the early results seem promising. I use 5 years of earnings data instead of just a single year (a single year's earnings is the standard practice when determining price-earnings ratios nowadays). I also use adjusted cashflow instead of earnings in an effort to filter out any accounting gimmickry (or even legitimate differences in accounting methods used between companies) that Graham warns against. I will expand on what I mean by 'adjsuted cashflow' in future. I also calculate a liquidation value for the company, based on formulas Graham provides. The 5-year cash flow and the liquidation values are then compared to the enterprise value of the firm (basically the enterprise value is the value of all outstanding shares plus all outstanding debt) and we can then tell if the firm is trading at a good price.

I will go into more specifics of the model in future posts and advise readers which stocks the model says represent good value and why. For a taste, here are three small cap Canadian stocks that Graham may have liked: Chartwell Technologies (CWH), Goodfellow Inc (GDL) and Caldwell Partners (CDL.A). All have generated ample cash in the past and all have strong balance sheets. It's true that these companies may be suffering hard times right now (some, such as Caldwll Partners, more than others, such as Goodfellow), but what makes them compelling is that these hard times are already priced into the shares. If things can turn around for these companies, their stock prices could improve dramatically.

And for the record, I own shares in all three of these companies.