Streetsmart Guide to
Valuing a Stock
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Other Books in the Streetsmart Series
Streetsmart Guide to Managing Your Portfolio
Streetsmart Guide to Short Selling
Streetsmart Guide to Timing the Stock Market
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Streetsmart Guide to
Valuing a Stock
The Savvy Investor’s Key to Beating the Market
Second Edition
Gary Gray, Patrick J. Cusatis,
and J. Randall Woolridge
McGraw-Hill
New York Chicago San Francisco Lisbon
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Copyright © 2004 by The McGraw-HIll Companies, Inc. All rights reserved. Manufactured in the
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and a wonderful wife and mother.
G.G.
To my wife, Deborah, my children,
Jacob and Julia, and my parents.
P.J.C.
To my daughters, Jillian, Ainsley, and Ginger.
J.R.W.
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Preface xi
Acknowledgments xv
CHAPTER 1 INTRODUCTION AND OVERVIEW 1
Financial Flameout 1
Good Companies—Hot Stocks—Ridiculous
Prices 2
The Investment Decision 4
The 10 Principles of Finance 5
Overview of the Book 7
CHAPTER 2 THE 10 PRINCIPLES OF FINANCE AND HOW TO
USE THEM 13
Principle 1: Higher Returns Require Taking
More Risk 14
Principle 2: Efficient Capital Markets Are Tough
to Beat 21
Principle 3: Rational Investors Are Risk Averse 29
Principle 4: Supply and Demand Drive Stock
Prices in the Short-run 31
Principle 5: When Analyzing Returns, Simple
Averages Are Never Simple 34
vii

CHAPTER 4 HOW TO VALUE A STOCK 97
Some Definitions Relating to Cash Flow 97
The Free Cash Flow to the Firm Approach 102
Why DCF and Not EPS? 108
The Discounted FCFF Valuation Approach 110
Microsoft—A Simple DCF Example 115
Valuation—Growth versus Value, Large Cap
versus Small Cap 123
Valuation—The Next Step 124
CHAPTER 5 FORECASTING EXPECTED CASH FLOW 127
The Five Chinese Brothers 127
Growth Rates and the Excess Return Period 128
Net Operating Profit Margin and NOP 138
Income Tax Rate and Adjusted Taxes 141
Net Investment 143
Incremental Working Capital 147
viii
CONTENTS
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Free Cash Flow to the Firm 151
Valuation Exercise: Estimating Free Cash Flow
for Cisco 152
CHAPTER 6 ESTIMATING THE COST OF CAPITAL 157
Don’t Count Until You Discount 157
WACC and Market Capitalization 161
Estimating ConEd’s WACC 166
The Cost of Common Equity and Shares
Outstanding 167
The After-Tax Cost of Debt and Debt
Outstanding 174

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Streetsmart Guide to Valuing a Stock is a how-to book that provides
you with the tools to make money in the stock market. The book’s fo-
cus is on stock valuation—an area of great interest to many investors,
but understood by very few.
When you’ve finished this hands-on, easy-to-use guide, you will
have learned how to:
• Value stocks of general market and high-tech companies, such
as Microsoft and Cisco Systems;
• Value stocks of financial companies and real estate investment
trusts, such as Citigroup, Merrill Lynch, Berkshire Hathaway, and
Washington REIT;
• Spot undervalued or overvalued stocks for buying and selling op-
portunities;
• Estimate important valuation inputs such as growth, operating
margin, and cost of capital;
• Find valuation inputs on free Internet Web sites;
xi
Preface
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Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
• Develop a spreadsheet to value a stock;
• Combine stocks in an efficiently structured investment portfolio;
• Manage your risk; and
• Use the 10 principles of finance to your advantage.
This book is a complete revision of Streetsmart Guide to Valuing a
Stock (1999). In the four years since the publication of Streetsmart, the
stock market has crashed, managers of many corporations such as En-
ron, WorldCom, and Adelphia have been indicted for fraud, and cer-

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calculate and estimate, long-hand, a company’s free cash flow and cost
of capital—these are the essential ingredients of stock valuation. In
Chapter 7 we show you how and where to get the information that you
need for serious valuations. In Chapter 8 we value Citigroup, Merrill
Lynch, Berkshire Hathaway, and Washington REIT. This book will help
you to learn a lot about valuing stock even if spreadsheets and com-
puters are too intimidating for your personal tastes.
Our goal is to teach you about stock valuation by using a simple
and powerful valuation model. This book will make you a better in-
formed, more intelligent, more profitable investor and will help you to
understand why stocks such as Cisco trade at $14.45 and Berkshire
Hathaway trades at $72,000 per share. Our valuation approach revolves
around some very simple calculations that use only addition, subtrac-
tion, multiplication and division—no calculus, differential equations,
or advanced math. So let’s begin by taking our initial plunge into stock
valuation.
Good luck, tight lines, and happy valuations!
Gary Gray
Patrick J. Cusatis
J. Randall Woolridge
Preface
xiii
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The original Streetsmart Guide to Valuing a Stock was conceived and
outlined on a trip to Spain. The concepts underlying stock valuation
crystallized only as real livestock (6 fighting bulls and 8 steers) at-
tempted to run over us on the narrow, crowded streets of Pamplona.
Integral to the book’s progress were the discussions, over many fine

late Uncle Bob.
As always, the input of the members of the Aspen Ski Institute has
always been helpful. Those members include: John H. Foote V, Tom
Carroll, Bob Jones, Alec Arader and Bill McLucas, among others.
Many thanks to all of the professionals at McGraw-Hill who
brought this book to publication, particularly: Stephen Isaacs, acqui-
sition editor; Sally Glover, senior editing supervisor; and Ruth Man-
nino, production supervisor.
A special thank you to Deb Cusatis and Katie O’Toole, whose writ-
ing and editing skills are greatly appreciated.
xvi
ACKNOWLEDGMENTS
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1
Financial Flameout
Even the creations of brilliant rocket scientists sometime flame out of
control. The financial equivalent of incineration occurred during Sep-
tember 1998, at Long Term Capital Management (LTCM), a multi-
billion-dollar hedge fund
1
that was owned by some of Wall Street’s
greatest intellects. After several years of spectacular returns (43 per-
cent in 1995, 41 percent in 1996, and 17 percent in 1997) for its own-
ers and investors, LTCM suffered a massive collapse and was rescued
from bankruptcy by a consortium of its creditors.
Ironically, in 1997 two of LTCM’s general partners shared the No-
bel Prize in Economics for their breakthrough academic research re-
lating to risk management techniques and the valuation and pricing
of stock options. The writings of Dr. Robert C. Merton and Dr. Myron
Scholes laid the groundwork for the creation and growth of the finan-

dices consistently. The stock market was manic during the late 1990s.
Exhibit 1-1 shows the blastoff and then the plummet of the stock mar-
ket averages over the past five years.
When the stock market soars, cocktail party chatter centers on hot
tips and inside information. As Martha Stewart can attest, that infor-
mation is sometimes true—and in the end, incredibly costly! Stock
market touts hype dozens of once-in-a-lifetime opportunities. Every
business day on CNNfn and CNBC, promoters and analysts push the
current new, new thing—the next Starbucks or Krispy Kreme. Beware,
place a hand on your wallet, and hold on! The hype associated with
former hot stocks (such as Internet Capital Group once at $200.94—at
$0.36 at the end of 2002, Corning down from a high of $75 to $3.31 per
share, and JDS Uniphase once at $140.50, now $2.47) propelled their
prices to such high levels that they were grossly overvalued. As an ex-
2
STREETSMART GUIDE TO VALUING A STOCK
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ample, look at Exhibit 1-2 to see the five-year performance of the stock
of ICGE.
The prices of many stocks during the late 1990s defied the laws of
gravity. It’s important that you understand that what goes up without
reason eventually must come down. At one point in 2000, the market
equity (shares outstanding times stock price) of ICGE was more than
$50 billion, even though its book value was negative, and JDSU had a
Introduction and Overview
3
EXHIBIT 1-1 S&P 500, DJIA, and NASDAQ: Five-Year Stock Index Chart
EXHIBIT 1-2 ICGE: Five-Year Stock Price Chart
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market equity of over $200 billion—more than 200 times its revenue.

ects, ventures, or stocks that have uncertain (risky) cash flows to be re-
ceived in the future. The decision to buy or sell any investment or stock
should be based upon three cash-flow-related criteria: a conservative
projection of the amount (rate of return) of the cash flows, the proba-
ble timing of the cash flows, and a reasonable assessment of the prob-
ability or risk associated with receiving the cash flows. Once you esti-
4
STREETSMART GUIDE TO VALUING A STOCK
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mate the amount, timing, and risk, you use financial techniques to de-
termine the true value of the investment or stock.
When you consider an investment in real estate, each property’s
location makes it a unique asset. This is not so in the stock market.
Shares of common stock of a company are identical
2
and plentiful.
Cisco has over seven billion shares outstanding, and after a stock split
in January of 2003, Microsoft has over ten billion shares. When Sarah
buys 100 shares of Cisco through her online broker, it doesn’t matter
if the seller is Lehman Brothers, the Christian Brothers, or the Blues
Brothers—the shares are identical from an ownership perspective. The
world’s major stock markets are extremely liquid. Shares of thousands
of companies trade on a day-to-day, minute-to-minute basis, with
prices reported for all to see.
In this book we teach you how to value a stock. Your buy or sell
decision should be driven by the stock’s valuation ratio—equal to the
stock’s value divided by its price. If the valuation ratio is greater than
1.0, the stock’s value is greater than its price by some margin, and you
should consider buying it. For example, if the value of stock A is $20
and its price is $10, the valuation ratio is $20/$10 ϭ 2.0—a serious buy!

1. Valuation of assets, which affects the amount or the expected
rate of return (rate of returns);
2. Time value of money, which affects the timing of returns (tim-
ing); and
3. Management of risk, which affects the probability of receiving
returns (risk management).
Too frequently, investors have short memories and lose sight of this
amount-timing-risk relationship. “Greed run amok,”
3
is Burton
Malkiel’s description of speculators who caused history’s investment
manias and the inevitable market collapses that followed. The boom
and bust cycle occurred in Holland in the seventeenth century. Dur-
ing the period from 1634 to 1636, prices for tulip bulbs climbed steadily
and beyond reason. Then, in the month of January, 1637, prices in-
creased twenty-fold. In February, the market collapsed and tulip bulb
prices dropped by more than the amount they gained in January. Many
investors lost fortunes and drove Holland’s economy into a severe and
prolonged depression.
Speculation ran wild in the late 1920s when stocks soared in the
United States and then crashed causing the Great Depression. Ac-
cording to Malkiel,
4
most blue-chip stocks fell over 90 percent by the
time the stock market bottomed out in 1932. The same inflate-crash-
burn scene unfolded in the bursting of the high-tech bubble of 2000,
as the NASDAQ Index fell more than 75 percent from its record high.
We could quote dozens of additional examples of investment ma-
nias and the inevitable corrections that followed to show how near-
6

stock.
In Chapter 3, we provide definitions relating to valuation, describe
the stock valuation process, and introduce you to the discounted cash
flow (DCF ) valuation method. We discuss the role that all investors
played in inflating the high-tech bubble. We describe the different
Introduction and Overview
7
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types of stock valuation approaches and examine the importance of
expectations, emotions, and analyst recommendations in determining
a stock’s price. We also differentiate between a stock’s price and its
value.
In Chapter 4, we describe the discounted cash flow approach. We
use Microsoft, the company that at the end of 2002 had the largest mar-
ket capitalization in the world, as our first valuation example. In Chap-
ters 5 and 6, we show you how to value the common stock of most cor-
porations by using a small set of cash flow and interest rate inputs. Our
goals are to demystify the stock valuation process, make stock valua-
tion easier to understand, and show you how to make money in the
stock market by purchasing undervalued stocks and selling overvalued
stocks.
How do we do it? In Chapter 5, using Cisco Systems as our exam-
ple, we explain which corporate cash flow measures are important,
how they are related, and how they influence a stock’s value. In Chap-
ter 6, we look at the simple capital structure of Cisco and the more
complex capital structure of Consolidated Edison, and we examine the
effect of a firm’s capital structure and interest rates on its stock value.
This book helps you put into perspective the various pieces of the stock
valuation puzzle to see the big picture. It makes the seemingly com-
plex world of Wall Street easier to understand.