How I Invest Part II

Linear Technology had their Q4 2010 conference call last Wednesday. I have been a Linear investor off and on since 2000. Linear has the best management in semiconductors. I remember in a 2000 conference call, Linear fiscal 2001 Q1, the CFO said, I forget the exact words, but I took what he said to mean the customers were double or triple ordering, and I sold the stock. I didn’t make out like a bandit but I didn’t loose anything either.

I wanted to upload an excel spreasheet which contains the DCF analysis I did for Linear, but unfortunately wordpress does not allow upload of excel files (!)  So, I exported it as a pdf.   dcf_example   If you want the spreadsheet email me and I’ll send it to you.  I promise I won’t put a macro virus on it.  Anyway, DCF of course is the forecast of the future cashflows of an investment (in this case Linear), discounted for the time value of money, in this case: inflation, riskiness of investment.

The first line lists the year. Up to 2010 are actuals and are not used (directly) for the forecast. Below the year is the discount rate. The discount rate here depends on the risk of the investment and the interest ratefor a risk-free (or nearly risk-free) investment.  To the right, in the K column, is the forecast for year 5->infinity.  I put it at 10% because that’s my best guess at this point.

Lines 10-33 look exactly like Linear’s Income Statement.  Or at least they should for 2008 -2010.  For 2011 and beyond, I forecast the numbers.  I think it is best to use this approach because it is easy (when you use a spreadsheet) and you can see if the company is using gimmicks to pad the earnings statement, when you look into the future and try to decide what each line should be.  I picked Linear for this DCF example because its earnings are very consistent and its margins are incredible.  If the gross margins get below 76% they start taking drastic measures to increase profitablity (fire people, shut lines down, reduce salaries and profit sharing).  Linear is very forthright in calls about what their upcoming tax rate will be and what they forecast revenue growth or decline will be for the next quarter.  They are ususally very accurate. 

DCF is the theoretically correct way to value stocks.  I’ve searched around the web and I haven’t seen a good, clear way regular investors do it.  I’ve seen some strange things in the way people do DCF analysis:

  • extrapolating future performance based upon prior performance
  • having the earnings and dividends grow forever — unless this is a utility, and you are only growing the dividend at a very slow rate, do not do this! If a company grows at 15% forever, it will eventually grow its earnings and dividends infinitely.
  • forecasting earnings for 15 years.  Really?  You know what the world will be like 15 years from now?  I think you should pick a more realistic timeframe.  I picked 5 years but you could argue for a different number.

Keep in mind you want to be pessimistic enough that you discount investments that will not pay off for you. 

You can see that I think LLTC is slightly overvalued at current share price. 

This has been a valuable tool for me and since I started using it as a tool to help screen potential investments, I’ve been much more consistent in my returns.  This is not the optimum screener for REITs and utilities.  I’m still working on that.  (time to read Damoradan again)

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