From annual report to fair value: what the calculator does for you

Transcript

Hey, I'm Peter. Do you know how long an annual report is? The median US annual report had about 23,000 words in 1996, and more than 49,000 by 2013. That is a whole book, every year, for every company. No wonder hardly anyone reads them. In this lesson I'll show you what the Fair Value Calculator does with these reports.

At its core there are three statements. The income statement shows what the company sells and how much of it is left as profit. The balance sheet shows what it owns and what it owes. And the cash flow statement shows how much real money actually comes in. That is often the most honest of the three, because profit can be shaped, cash in the bank much less so.

The calculator reads these numbers for more than 35,000 stocks worldwide, around 2,000 data points per stock, many going back decades. That adds up to about 70 million numbers, matched with the new price every day. Along the way it cleans up: one-off effects, currencies, stock splits. Otherwise you would be comparing apples and oranges.

Now the most important distinction. The price is what others pay for the stock today. The value is the money the company can bring you as an owner over the years, translated back into today's terms. Benjamin Graham, Warren Buffett's teacher, put it this way: in the short run the market is a voting machine, in the long run a weighing machine. The fair value is our attempt to read that scale.

A single valuation model can easily be wrong. That is why the calculator runs 26 models from eight families, for example models that look at future cash flows, models that compare with similar companies, and models for dividends or assets. Each model computes a cautious, a middle and a good case. Only the blend gives the fair value. Think of a weather forecast built from many runs: when most models point the same way, the answer is more reliable.

So which numbers say anything about the future at all? Vanguard tested 15 popular metrics against the following ten years of returns, from 1926 to 2011. Market valuation explained the most, but only about 40 percent. And some popular metrics, like expected earnings growth, predicted less than rainfall. That is exactly why we test every ingredient against history before it goes into the calculator. Our back-testing reaches 34 years into the past.

Next to the value, the calculator shows you a quality score from 0 to 100. It draws on 37 factors from ten areas, such as how stable the profits are and how solid the financing is. And sometimes the calculator deliberately shows no fair value. That happens when the data is not enough or contradicts itself. Better no number than a wrong one that leads you astray.

In short: the calculator reads the reports, cleans up the numbers, lets many models do the math and tells you whether the price sits above or below the value, and how sure that is. The decision is yours. In the next lesson, we look more closely at how we value. Important: this is not financial advice.