We’ve discussed in detail about stock investing, personal budgeting, real estate investing and cryptos. But beyond setting up a portfolio of diversified passive and/or active positions, along with the basic properties of what makes a good company (great products, growing sales, profits etc.) we have not fully answered the most difficult question – what stocks are best to buy?
The caveat here is that for the majority of people the best thing to do is have a portfolio of 10-15 good companies that you know well, along with a few diversified ETFs and simply hold them for a long time.
If you want to go the extra mile with your stock portfolio, by picking undervalued stocks and selling overvalued ones, then its going to require more work! For some people it will be more fun and rewarding as well 😊
The best stock to buy is a great business that is both undervalued relative to its industry peers (based on Comparable ratios) AND undervalued based on the present value of its expected future cash flows (“Discounted Cash Flows” or DCF). This might not always be the case as the analysis could point in several different directions, so your own judgement is also required. Ultimately, we are using these methods to make an estimate of what a stock might be worth, which is uncertain.
We will be going through an example created while making the tools in July 2020, to demonstrate the “Stock Analysis Tool” analyzing Costco ($COST). Now, one year later, we can see if the tools, assumptions and estimated value panned out as the analysis suggested.
Disclaimer: Nothing on Breaking Finance is a recommendation to make any specific investment. Everything is our own opinion for educational and entertainment purposes only. Always do your own due diligence.
Tools That Can Be Used to Analyze Individual Stocks
Personal Investment Tracker – Stock Comparables tab (FREE)
All in One Personal Financial Planner – Stock Comparables tab ($9.95)
Stock Analysis Tool – Advanced Stock Comparables Tab + DCF page ($13.89)
Company Background – Costco ($COST)
Costco is a large, established, global retail and wholesale company with steady growth and significant profits. They sell high quality products in bulk, at a discount to its paying members, while offering extra services (such as car maintenance). Most people seem to have a positive view of Costco and I enjoy their stores as well. From this point of view Costco fits our definition of a good company.
If we were to buy and hold its stock for many years it's likely it would continue to rise with the business, while paying us a nice dividend along the way.
But to find out if it’s a great investment, we need it to be undervalued today. The first step to finding that out is to get the basic facts on the company’s business.
Once we input the values (note: these were inputted in July 2020), we have a good sense of the scale of the business and some key ratios which help us better understand the current stock price of $323 per share.
In the last twelve months (LTM) Costco generated $161 billion in sales and $3.7 billion in net income (profit). It has $45 billion in total assets and a net book value of $15.5 billion. Its current market value is $142 billion based on the stock price of $323 per share, and it pays a near 1% dividend of $2.80 per share.
Based on its market value it trades at a PS (Price to Sales) ratio of 0.9, a PE (Price to Earnings) ratio of 38.4, an EV/EBITDA of 20.3, and a PB (Price to Book) ratio of 9.1.
Next, we have to compare these ratios to Costco’s industry (Retail) to get a sense if it's trading in line, below or at a premium to its peers.
Comparable Valuation
By comparing ratios for companies in its industry to Costco’s, we gain a much better understanding of Costco’s business environment, how the market currently prices its industry and what a reasonable value range for the stock might be.
Normally, we would emphasize profitability to market value ratios (such as PE or EV/EBITDA) to evaluate large, established retailers. However, due to the global pandemic and store closures, many of Costco’s competitors have had their profits impacted (due to lower sales and higher operating costs), so we will focus more on the PS and PB ratios.
Comparable Valuation Tab in the Stock Analysis Tool
(Time to fill in yellow cells from Yahoo Finance aprox ~ 28min)
Utilizing PS the value of Costco trading at its industry average would be $426 per share and using PB it would be $376. The range of $376 to $426 represents a significant 16.5% to 32.1% upside from the current share price of $323. This is a very positive sign as it shows that Costco is trading at a discount to its peers.
Comparing to PE the value of Costco trading at its industry average would be $269 per share and using EV/EBITDA it would be $246. These represent a downside of 16.6% to 23.8%, respectively, from Costco’s current share price. But, due to the effects of the pandemic, we are making a judgement to deprioritize these in this case. They do still provide us with an idea of the downside risk if investors began to assign these lower multiples to Costco, however, this is unlikely due to Costco’s stronger position in a pandemic/post-pandemic world.
If we were to stop the analysis here, we could be satisfied that we are buying a large, excellent business, getting a near 1% dividend while we own it, and that there is some upside potential in the stock if it traded in line with its industry multiples.
Discounted Cash Flow (DCF) Valuation
Next we attempt to estimate the intrinsic value of Costco using a DCF, which is independent of the market values of its competitors. This is determined by estimating its future cash flows and finding their present value. With reasonable assumptions we should be able to better understand how valuable Costco is.
Fill Out the Past Years Financials in the Stock Analysis Tool
(Time to fill in the yellow cells from Yahoo Finance aprox ~ 5min)
This step is critical because it gives us a stronger understanding of the firm’s past operating margins, costs and growth. It helps us form the assumptions from which we will project their future cash flows.
Input Your Assumptions for the Future
Revenue growth is assumed at a relatively high 5% for the next 5 years, mainly due to the effects of the pandemic funneling more shoppers into Costco along with the post pandemic's widely anticipated “boom”. For years 6 to 10 revenue growth is estimated at a more modest 3.5%, only slightly above inflation and common for a business of this size. The long term growth rate of cash flows (past year 10) is assumed to be 2% as this is usually cited as the long term economic growth rate. Cost of Goods Sold (COGS) percentages are assumed to be inline with previous years while expenses and depreciation are expected to grow at near the same rate as sales. Finally, the income tax rate is assumed to be 22% inline with what Costco has paid in the past and the discount rate is placed at a low 5% (since the riskier a business the higher the discount rate).
The Assumptions Above Auto-Generate a 10 Year Projection
Review to make sure that final year revenue seems reasonable and that margins are also similar or only slightly improved as the company matures. It's easy to input assumptions that have huge unrealistic impacts in the later years of a projection.
Analyze the Output DCF Valuation
With those assumptions the value comes out to $392.54 per share or a 21.5% upside from the price (at the time of initial analysis). What’s interesting is that it's similar to our Comparable analysis and should give us significantly more confidence that Costco is undervalued at $323 per share.
Note on DCFs: Your assumptions will control the final value. If they are too optimistic it will overvalue, too pessimistic and it will undervalue the firm. As the old saying goes “garbage in, garbage out”. To account for this compare the results of the DCF to the Comparables and to try different assumptions (especially for revenue growth) to see how different scenarios effect the value. If the least optimistic (but still realistic) assumptions yield a positive result then its more likely to be a sound investment.
Investment Decision
Given both valuation methods are pointing to values for Costco above $376 per share Costco looks like a good opportunity as of July 2020. On several major metrics it trades below its peers, and the DCF value is 21.5% higher than the current stock price. We also know it’s a large, stable, global business with a near zero chance of bankruptcy.
Costco at $323.00 per share in July 2020, is a BUY based on our analysis, our assumptions and the values of its peers.
Result of the Investment One Year Later
Costco stock has risen to $423 per share since July 2020. Over the course of the year we earned a return of 31.0% and we got paid the $2.80 per stock dividend which added another 0.9% for a total return of +31.9%.
Costco ($COST), 1 year stock and volume chart
If we had invested $10,000 into Costco last July based on the analysis we just walked through, it would have grown to $13,190 or a profit of $3,190!
At this point we can update the valuation for Costco's current results to see if the $423 price is justified or if it's still undervalued. Based on that, we could keep Costco as a long term hold or sell it for better opportunities, or sell a portion of it.
Feel free to try out the tools on stocks you are interested in, keep in mind the limitations of excel tools as well as the perils of bad assumptions, and hopefully you will uncover even more valuable investments! Happy Hunting!