People new to Model Price have to weigh fundamental information given to them in the form of our lines on our model price charts. Remember our Model Price charts gives or calculates two pieces of information for users – the first is our purple line or model price and the second is our parallel lines known as EBV lines or Economic Book Value lines. Each product deliverable, model price and EBV lines, is independent of the other. Sometimes these two data sets can confirm each other or offer major divergences from each other. I use both pieces of data independently but often give higher importance to our calculated EBV lines.
This blog post will discuss each product, model price and EBV lines, to give you a better or a more full understanding of the similarities or differences between the two.
Model Price (Purple Line on our Model Price Charts)
Our objective in the calculation of model price is to calculate what we believe to be fair market value of the company. The algorithm that calculates this number is long and complicated but the most relevant piece of data in the calculation of model price is analysts “mean” earnings estimates. For convenience sake we use estimates from of a group of published analysts from services that can be found on any popular financial news website. (Yahoo is a popular example)
Whether people realize this fact but analysts’ earnings estimates change all the time when taken as a group mean average. Individual analysts can change their quarterly estimates by fractions having an impact on the group “mean” estimate. Also material changes can occur during a quarterly earnings release and conference call, for example, as analysts adjust earnings when new information maybe released by company management impacting future financial results. We capture these changes on a daily basis and calculate a new model price based on the most up-to-date financial information. We maintain a database of our calculated model price and obviously use this price series to maintain our model price charts.
Probably the most interesting aspect of our model price calculation is the forward calculation of model price for the next year (long term model price chart – right chart) to give our users some perspective of the future trend of model price based, of course, on analysts’ estimates of future earnings. We take great care to grow the balance sheet in future periods so the earnings estimates are current with the relevant balance sheet. Obviously we cannot anticipate future corporate actions like M&A activity or common stock sales however most large cap stocks have stable capital structures that any projections of model price can be very accurate using past history as a guide.
For those of you who don’t know the job of equity analyst of Wall or Bay Street is one of the most demanding jobs in the security business. A top analyst can receive millions in compensation from their investment bank if they are the most accurate in terms of a company’s quarterly earnings estimate. The pressure to be right about their coverage not only about the company itself but also the industry can be intense. As a general rule of thumb, the larger the company the more analysts cover the company yielding higher quality earnings estimate data and relevance for the purposes of our calculation of model price.
This is the good news.
See my blog “Loblaw’s Deal with Shoppers Confirms our Model Price Calculation” as an example of our model price confirming fair market value (FMV) of a company.
The bad news is that equity analysts can also be wrong!
When company and industry trends are placid and predictable equity analysts are usually 99% on the mark in forecast quarterly estimates. This makes sense. Unfortunately when the company or industry is in turmoil the vast majority of the analyst’s freeze or hold their changes in estimates until the company comes clean or more information is available to quantify potential changes, usually in a quarterly conference call, or clearer trends manifest itself in the industry. These are major transition points where the stock price and the fundamentals of the company start to diverge.
These divergences – between the perceived fundamentals and actual fundamentals – is, in my opinion, where investors are the most vulnerable.
Enter Economic Book Value (EBV Lines)
Our second product deliverable is our EBV lines. These are parallel lines that run through our model price charts. Some of the EBV lines are coloured (green, blue, red and yellow for example) and others are grey or black. In constructing these EBV lines we start with our green line or EBV. As we add lines above our green line on a constant basis and we number each line in sequence (i.e. EBV+1, EBV+2…EBV+10). For EBV lines below or calculated green line we label EBV-1, EBV-2, and our last one EBV-3.
Once these EBV lines are constructed we add a simple open hi-lo-close price bar of the company’s publicly traded equity price. We use a weekly price bar for our left hand chart – our definition of short-term view – and monthly price bars for our right hand chart. It should be noted that these two pieces of data, EBV lines and public equity prices, interact independently of each other. When the stock price of a company transits an EBV line, either positively or negatively, fundamental information is given to the observer of our model price chart. A positive transit, stock price transits up through one of our EBV lines indicates fundamentals are improving for the stock in question and conversely if the stock price has a negative transit fundamentals are deteriorating.
Magically over time and experience users of model price will become convinced of the usefulness of our EBV lines. Equity prices of companies seem to use these EBV lines as support and resistance. When transits do occur, both positive and negative, usually prognosticate major future company news that can have a major influence on the company’s future share price and direction.
See my blog “$76 Billion Reasons to Sell Gold Stocks.”
These computed EBV lines can also give observers a quick reference point in terms of a company’s valuation. When comparing a basket of equities together in indices or in the same industry an observer can quickly evaluate the valuation of the company in question. For example, company ABC can trade above EBV+5 where as company XYZ may trade just over EBV+3 indicating a lower market valuation level for comparative purposes. Our computed EBV lines can provide a quick reference and apples to apples comparison of individuals companies.
Back to the question, “Who do You Believe: Equity analysts or the Market?”
So you, the user of our Model Price App, get two pieces of financial information of a company that appears no where else on the internet and is not taught in any financial course at university – Model Price and EBV lines.
Users of Model Price App, a service that provides these calculations, have to weight these two pieces of information carefully. Yes, knowing the fair market value of a company is indeed insightful when contemplating either a sale or a purchase of a particular company however analysts are the primary driver of this calculation and users should know their fallibility. Where as our EBV lines are derived from the company’s balance sheet that in my opinion is more robust – a balance sheet has to balance after all – and less likely manipulated by management, except in the case of fraud.
In a nutshell a lot of times, these two pieces of information – Model price and EBV lines – are confirming each other.
Here is a recent example of Yahoo having a positive transit of EBV+3 being confirmed by a positive and upward sloping model price calculation.
Yahoo Inc. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)
At major transition points, in equity markets in general and company dynamics in particular, I weight our EBV lines more heavily than our model price calculation. “The Market” is usually smarter at transition points than the equity analysts following the company on a group basis.
Barrick Gold back in February 21, 2013 having a negative transit even through our model price calculation is substantially above the current selling price is a good example of the divergance between model price and our EBV lines.
Barrick Gold Corp. with weekly price bars, EBV Lines (colored lines) and model price (dashed line)
The weighting of the relevancy between model price and our EBV lines usually takes the user a short period of time and experience however in my opinion worth the time spent in terms of profitable investing.