Here’s our valuation model for Devon, Ford, Cat and Joy Global

Author: CJ Brott, Capital Ideas

Covestor models: Macro Plus Income, ETF Only

Disclosure: Long DVN, JOY, F, CAT

One of the most widely recognized metrics of investment valuation is the discounted cash flow (DCF) method.

It would seem anyone with a spread sheet and the ability to read a financial statement could derive a company’s future value using this simple criterion. But in the investment world value is very much in the eye of the beholder.

Many of the variables used to determine the discount factor are estimates and subjective in nature. Proper discount factors depend upon judgments of the future which may vary widely from actual outcomes.

So it is possible to derive widely differing future valuations for the same company depending on who is doing the analysis. That is why we place emphasis on macro-economic elements when determining our overall investment outlook.

We believe those elements add the greatest weight to Weighted Average Cost of Capital (WACC) calculation. In our thinking WACC is the most important element in determining a “correct” discount factor.

Determining WACC requires that we take into account corporate size, barriers to entry, and many other factors to determine what Warren Buffet calls and economic moat. A wider moat lessens uncertainty and therefore lowers the WACC.

Importantly WACC is not static. It changes as assumptions concerning future economic conditions change. This is where the process of judgment comes into play.

This month we would like to value four of our investments using this type of process. The companies are Devon Energy (DVN), Ford Motor (F), Joy Global (JOY), and Caterpillar (CAT).

Interestingly Morningstar uses a process similar to ours in valuing stocks. Using DCF as the core of their analysis they determine an estimate of the future value of a company which they call “fair value.” Then using other criteria they determine buy and sell prices for stocks they cover. Presented below are the Morningstar prices for our four companies:

In each case the current price per share is well below what Morningstar considers its “fair value”. We believe these companies are currently out of favor for a variety of reasons.

We believe the most important macro factors which will drive these companies to “fair value” are macro in nature. In the case of Devon Energy that is natural gas pricing and the speed of petroleum pipeline build outs.

For Caterpillar it may well be the speed of mining development and infrastructure build out in China. For Ford Motor the drivers may well be the continuing recovery in housing and the speed of a recovery in Europe.

For Joy Global the Chinese demand for coal may be secondary to the speed with which Canadian tar sands expand production. We are invested in these companies because we believe that consensus expectations for changes to these economic conditions are wrong.

If conditions change in our favor we hope to see better outcomes and through the markets discounting function exaggerated price movements in our favor.

Disclosure: The investments discussed are held in client accounts as of September 30, 2012. These investments may or may not be currently held in client accounts.The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or that investment decisions we make in the future will be profitable.

Certain of the information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. Covestor believes that such statements, information, and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.