hi i'm jimmy in this video we're going to walk through
a unique way to value stocks known as the 10 cap method
and towards the end of the video i'm actually going to apply this method
to all 30 stocks in the dow jones industrial average
to see if there are any stocks that look like they could be worth a deeper dive
or at least could be inter interesting to perhaps they're undervalued the goal
with this video is to try to give us another valuation
method in our toolbox and hopefully use this information to
get us closer to our goal of achieving financial freedom
okay so this valuation method is used by a lot of very famous investors
warren buffett is said to use versions of it and i actually came across this
stock valuation method from one of our subscribers on this
channel who asked if I could do a review of Phil Town's valuation method Phil Town
is an investor and he's written a few books and he has
a big youtube following at least bigger than we have
okay so let's jump right in and see how it works and see if it's a good
valuation method to use now this method is very similar to the
capitalization rate that's used to value real estate or to
use to analyze the potential profit of a real estate
investment often we'll have capitalization rates
shortened to the cap rate and basically what this is for real
estate specifically for investment properties
is we want to know how much rents are we going to collect
on an annual basis then we subtract expenses expenses would
be things like taxes or insurance or repairs to
maintain the property this is called net operating income so
we take that and we divide that by the cost of the property the cost to
purchase the property so let's imagine that we're going to
collect let's say fifteen thousand dollars a year
in rent also let's imagine that that property has five thousand a year in
expenses to maintain the property taxes insurance
things like that this leaves us with ten thousand a year
in profits now for this example i'm ignoring some
things like uh how we're financing the property
things like that i'm sure there's a few things that are missing it's really the
concept rafter okay so now our question is what are we
paying for the property well if we pay a hundred thousand
dollars for the property well our cap rate is ten percent that's a ten
thousand dollars in profit divided by a hundred thousand dollars that we're
paying but what if we were to pay a hundred and
twenty thousand well our cap rate falls to eight point three percent
and if we're able to get a good deal maybe we only pay 80 000 well our cap
rate jumps to 12.5 so clearly the higher the
better for the cap rate and i'm sure we're all
seeing how the price influences our potential return on an overall basis
now obviously there are a lot of variables being left
out of this this example things like uh what happens if the value of the
property goes up things like that we're ignoring that
it's just the concept of what are we willing to pay for the property itself
okay now let's switch back to stocks so it's pretty much the same method so the
first thing we do and again this is according to filltown
so we take cash flow from operations and we
subtract maintenance capital expenditures now the theory here
is that this is very close to what warren buffett calls
owner earnings warren buffett back in his 1986 letter to shareholders
well he came up with he put out a formula for calculating owner earnings
this is what his owner earnings formula looks like so we take our net income
we add back depreciation depletion and amortization
and then we offset any other non-cash charges
and then we subtract maintenance capital expenditures
this is the formula that buffett gave us in that shareholder letter now this part
of the formula is essentially cash from operations and this is very
simple for us to find because companies are required to list
cash from operations on their cash flow statement and don't
forget we want annual numbers here so when we do it try to pull down the
most recent annual report or if we want you can add up the past
four quarters whichever way you want to do it now when we consider maintenance
capex well this number is a bit trickier for
us to find because most companies don't list maintenance
capex by itself they do list capital
expenditures but they list total capital expenditures
they don't break it out for how much is going towards growth and
how much is going towards just maintaining the business by the way you
might also hear this called property plant and equipment that's the same
thing as capital expenditures or you can shorten it to capex like i
have been so let's imagine that a company that is based in the united
states well they want to expand into europe
well maybe they build a plant in europe to kick off those expansion plans
well though that plant the cost of that plant will fall
under capital expenditures but in theory that plant is being built
to fuel growth not to maintain the current business
and that's the key with what maintenance capex
is we're looking for what the company needs to maintain
the current business not necessarily to grow the business
sort of like maintenance on a house sure we could put it on we could put an
addition on the house and perhaps charge more rent but that's
not what we're considering with this whole thing
what we're considering is as different parts of the house break and
it needs to be maintained what does that cost that's the cost
we're looking for and the tough part is that most companies don't list
maintenance capex now Phil Town has come out and said that he did some research
and he says that most companies fall somewhere between i believe it was 30
and 80 percent of total capex will be maintenance uh will be
maintenance capac capex he suggests using a 50 percent number to
come up with what maintenance capex could be now of course the more research
we do the more thoroughly we know the company the more accurate that number
could get which is a good thing but for now we'll
just say we'll stick with 50 and then we take the result of this and
we divide it by the total market cap of the company
and this will give us our cap rate for whatever stock it is that we're
analyzing so how about we look at one quick
example and then we'll go through the 30 dial companies so let's use coca-cola as
our example so in 2019 coke had cash from operations
of about 10 and a half billion dollars that's right from their cash flow
statement now before we go any further uh a good a fair warning for us to be
aware of with this is that we want to make sure that this
10.5 billion dollar number is a reasonable number
so if we switch just for a moment to coax historical cash from operations
well we can see that their 2019 number does in fact
seem reasonable it seems to be about in line
with previous years but let's imagine for a moment
that this was a crazy high number for some reason
well we're going to want to find out either why it's so high
and if it's unreasonably high perhaps it was
some unusual situation that occurred maybe it makes more sense to adjust this
maybe we use an average or something along
those lines okay now switching back to our 10 cap formula
so we have a reasonable cash from operations number now
we want to get our total capex for 2019. that number came in at about 2 billion
dollars but don't forget that's the entire number
so sticking with phil towns 50 suggestion
well we cut that number in half we end up with a maintenance capex of about a
billion dollars now we can make the case that for coke
coke is a very developed company we think that more of their capex
is tied to maintenance and less is tied to growth if we wanted to we could up
that 50 to a higher number the higher we
increase that the more conservative our valuation becomes but for now we'll just
stick with the 50 because in this case it doesn't matter
all that much we take this number we divide it by the total market cap of the
company for coke that's a bit over 200 billion
dollars well when we do this quick math we end
up with a cap rate for coca-cola of about four and a half percent so is
that good well the reason they call this the
10-cap method is because we want the cap rate to be
higher than 10 percent that's the reason why i say it didn't matter all that much
for coke so in this case it would seem that coke
is not undervalued at this time so in theory if
the stock price falls well then our market cap would
fall and our cap rate would go up so if it fell far enough
eventually it's possible that coke's cap rate goes
over 10 implying that it could be a good buy okay now let's
look at a quick calculation for each of the stocks from the dow
jones industrial average now i used 2019 numbers for all of these
companies to try to keep it even and use 2019 capex and i just took 50
of each of the companies even though if i was applying a company by company if i
was doing a more in-depth dive i would probably adjust those
numbers based on the research but i think 50 is a very fair starting
point okay now with these companies one thing
that i noticed is that it doesn't seem to hold up too
well for financial companies and this is most likely because capital
expenditures is not really a true representation of
the cost of maintaining business in the case of many financial companies
so for looking at financial companies i'm more inclined
to look at some other valuation methods i marked each of those with asterisks
there but besides that companies like chevron
dao intel ibm verizon and walgreens could be
worth a deeper dive now i actually think it makes sense to
pair the 10 cat method with other valuation methods now if you're
curious with cures about different valuation methods
that could work especially for financial companies
well i actually did a video just recently where i walk through some of
the more popular ways to value a stock if you're curious perhaps that could be
a good next video for you to watch i'll get a link right here i've got a
link in the description below and thank you so much for sticking with me all the
way to the end of the video i really appreciate it thanks and i'll
see in the next video