Fajasy

Updated: December 26, 2021
Reading Time: 10 minutes

In this article, I will show you how to value companies using the 10 cap stock valuation method. This is a method of stock valuation that originated within real estate, and was created by Phil Town to value companies in the stock market. This valuation method is particularly useful for more established businesses and should be used alongside other valuation methods to gain a better understanding of a company's worth. Completing the 10 cap stock valuation method will provide investors with a "cap rate," which can then be used to determine whether a company is currently trading at an "overvalued" or "undervalued" price in the stock market.

The 10 cap stock valuation method is based on the "real estate cap rate" calculation found within investing in real estate properties. To understand the concept of the 10 cap stock valuation method, it's important to understand how this applies to real estate investment properties before applying the valuation method to companies in the stock market.

The real estate cap rate formula is shown below:

Capitalization rate = Net operating income / Current market value

**where**:

- Net operating income: Rent payments collected from tenants, minus any expenses (i.e., repairs to maintain the property, taxes, insurance, etc) the property has on an annual basis.
- Current market value: The price an investor pays to buy and own an investment property.

Solving for the cap rate will provide you with the yield return percentage you would make from the profits produced by the property, as compared to the price paid for the property itself. In other words, the cap rate will provide you with an estimate on the potential return amount you could make from a real estate investment. Therefore, from an investor's perspective, the higher the cap rate, the better.

To provide an example of the capitalization rate, let's assume you, as a real estate owner renting out to tenants, generated $12,000 last year in rent ($1,000 per month) and $2,000 last year in expenses for an investment property. This leaves you with $10,000 last year in net operating income. If you paid $120,000 to buy the property (ignoring property value appreciation/depreciation), then your cap rate would be 8.3% ($10,000 / $120,000). Clearly, your cap rate would increase the greater the net operating income figure, or the lower the cost you paid to buy the property.

In the book "Invested," Phil Town applies the real estate cap rate method to valuing companies in the stock market, which he calls the "10 cap stock valuation method." In short, this method takes a profit figure from a company in the stock market and divides it by the value of the entire company. Much like the real estate cap rate, this will result in a yield return percentage, which you can then use to evaluate whether it's worth purchasing a particular stock at its current stock market price or not.

The 10 cap stock valuation method formula is shown below:

Capitalization rate = Owners earnings / Market capitalization

**where**:

- Owners earnings: Warren Buffett's method of estimating what most investors know as "free cash flow."
- Market capitalization: The total value of a company's outstanding shares of stock.

In practice, investors can consider a company to be "undervalued" if the cap rate is 10% or more, and "overvalued" if the cap rate is below 10%.

In the sections below, I've provided a more detailed explanation on how to accurately calculate and interpret the 10 stock cap valuation method.

The primary difference between the real estate cap rate and the 10 cap stock valuation method is the type of profit figure we're using (in the numerator). With real estate, the default is to use net operating income. However, when it comes to a business in the stock market, investors can use Warren Buffett's "**owners earnings**" figure for cash flow. Finding owners earnings will provide you with a better understanding on how much cash is left over after the normal operations of the business.

Warren Buffett's first mention of the phrase "owners earnings" was in his 1986 Berkshire letter, as quoted below:

"If we think through these questions, we can gain some insights about what may be called "

—owner earnings." These represent (a)reported earnings plus(b)depreciation, depletion, amortization, and certain other non-cash chargessuch as Company N's items (1) and (4)less(c)the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fullymaintain its long-term competitive positionand its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c). However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)"Warren Buffett | 1986 Letter to the Shareholders

The formula below captures what Buffett is saying here about calculating owners earnings:

Owners earnings = Net income + Non-cash charges - Maintenance capital expenditures (CapEx)

**where**:

- Non-cash charges: Includes depreciation, depletion, amortization, impairment charges, and any other non-cash charges.
- Maintenance CapEx: Money a company spends to maintain the normal operations of the business.

Buffett's formula for owners earnings can also be simplified into the formula below:

Owners earnings = Operating cash flow - Maintenance capital expenditures (CapEx)

**where**:

- Operating cash flow: Cash generated by a company's normal business operations.

The difference here is that "net income + non-cash charges" in the formula above is replaced with cash flow from operations, from the cash flow statement. I find this alternative owners earnings formula to be more accurate as net income can be manipulated and non-cash charges often differ between companies. This formula also happens to be easier to calculate, which is always a plus.

Maintenance capital expenditures (CapEx) is the required expenditures a company undertakes (i.e., repairing/updating machinery) to continue operating in its current state. The other type of CapEx is growth CapEx, which is used to undertake new projects or investments made by the company (i.e., buying new machinery).

To calculate maintenance CapEx, which is required in order to calculate owners earnings, you must deduct the growth CapEx amount from the total CapEx (aka Property, Plant and Equipment (PP&E)) number found under "Investing Activities" on a company's cash flow statement. See the article linked below to understand the various ways of estimating maintenance CapEx, which goes more in-depth than this article. Note that this can be a lengthy process depending on how accurate you want the valuation to be.

In short, here are the main ways to estimate maintenance CapEx if it's not clearly stated in the 10-K annual report (which is often the case):

- Be conservative and calculate free cash flow (FCF) instead. Make an assumption that the total CapEx (PP&E) amount is maintenance.
- Use the definition of growth and maintenance CapEx to imply the amount of maintenance CapEx. This can be done if the company has a CapEx table or a detailed description of CapEx components in their 10-K annual report.
- Use your understanding of the business, the industry, and management's discussion in the 10-K annual reports to estimate a percentage of maintenance or growth CapEx.
- Simply use the "depreciation and amortization" figure in the most recent 10-K annual report as maintenance CapEx, but realize that depreciation can be misleading at times.
- Use Bruce Greenwald's maintenance CapEx calculation, but realize that it can fall short for commodity-based businesses or companies who may have a sales growth number greater than PP&E.

Regardless of the method used, use annual numbers found on the most recent 10-K annual statement, as this is required to calculate owners earnings on an annual basis.

Market capitalization is the total value of a company's outstanding shares of stock. In other words, the market cap of a company is the total worth of a company, as determined by investors in the market.

The market cap of a company can be calculated using the formula below:

Market cap = Shares outstanding * Current market price per share

The total shares outstanding for a company can be found on its 10-K annual reports. Multiplying this by the company's current stock price will get you the market cap. The current stock price of a company and its market cap can also be found on almost every financial data website.

The more accurate representation of what it would cost to buy a whole business is known as "enterprise value." Enterprise value, unlike market cap, is not affected by changes in a company's capital structure. In short, this is because enterprise value incorporates debt and cash to determine the entire value of a company.

The enterprise value calculation is shown below:

Enterprise value = Equity value + Total debt + Preferred Stock + Non-controlling interest - Cash and cash equivalents

**where**:

- Equity value = share price * fully diluted shares outstanding
- Total debt = short-term debt + long-term debt
- Preferred stock: Stock with dividends paid out to shareholders before common stock dividends are paid out.
- Non-controlling interest (aka minority interest): Ownership position of less than 50% in a company.
- Cash and cash equivalents: Cash and any assets that can be converted into cash immediately.

In theory, dividing owners earnings by the enterprise value of a company (instead of market cap) will lead to a more accurate cap rate valuation. However, for simplicity's sake, the market cap of a company can be used as well.

In this section, I'll show you how to apply the 10 cap stock valuation method to McDonald's Corporation (MCD), one of the largest restaurant franchises in the world.

The first step is to calculate owners earnings. To do this, begin with operating cash flow. This can be found in McDonald's most recent 10-K annual statement on its cash flow statement, as shown below:

As you can see, operating cash flows equal $6.265 billion in 2020.

Although the maintenance CapEx number is not explicitly stated, McDonald's does provide a chart which shows capital expenditures by type, as seen below:

Clearly, it's reasonable to say that "New Restaurants" means growth CapEx while "Existing Restaurants" means maintenance CapEx. As you can see, total capital expenditures in 2020 is equal to $1.641 billion, with maintenance capital expenditures at $1.060 billion.

Now that we have operating cash flow and maintenance CapEx, we can calculate owners earnings. In 2020, McDonald's owners earnings number is $5.205 billion ($6.265B - $1.060B).

Finally, we can divide this owners earnings number by the total market cap of McDonald's to apply the 10 cap stock valuation method:

McDonald's 2020 cap rate = $5.205B / $198.431B --> **2.62%**

The "10 cap" in the 10 cap stock valuation method refers to targeting a 10% or more capitalization (cap) rate. Undervalued companies, according to Phil Town, will have a cap rate of 10% or more. Therefore, you're aiming for the profits from the business over the most recent year to be 10% or higher than the price of the business.

As you can see, McDonald's has a cap rate of only 2.62%. Without any further diligence, this means that McDonald's is far too overvalued to consider buying at its current stock price (around $265 at time of writing).

However, if McDonald's stock price fell substantially, then the market cap would decrease, which would increase McDonald's cap rate. Then, if the cap rate grew to be above 10%, the company would be classified as "undervalued" according to the 10 cap stock valuation method.

In this section, I will apply the 10 cap stock valuation method to the Dow Jones Industrial Average (DJIA), to analyze whether 30 of the biggest blue-chip stocks in the U.S. stock market (as of writing) are currently considered as being "undervalued" or "overvalued."

Note that because most companies do not explicitly list maintenance CapEx, and for comparison purposes, I will assume that 50% of all CapEx is maintenance for all 30 companies. This is also Phil Town's rule of thumb for estimating maintenance CapEx.

The DJIA 10 cap stock valuation method analysis is show in the image below:

As you can see, 7 out of the 30 DJIA stocks, according to the 10 cap stock valuation method, appear "undervalued" because they have cap rates greater than 10%. However, JPM and TRV (which have cap rates greater than 10%) don't have capital expenditures on their cash flow statements, so they can be ignored. Therefore, only 5 out of the 30 DJIA stocks, as of writing, are really considered "undervalued" and potentially worth buying at their current stock prices.

It's worth mentioning that operating cash flow must be positive (on an annual basis) in order for the 10 cap stock valuation method to work (see "Boeing Co" in the image above). Otherwise, the cap rate will always be negative.

Phil Town's 10 cap stock valuation method is as simple as taking Warren Buffett's owners earnings and dividing it by the value of the entire company. If the percentage result of this calculation is greater than or equal to 10%, then the company's stock price is considered "undervalued" and potentially worth buying. Clearly, given the simplicity of the 10 cap stock valuation method and reliance on positive operating cash flow, it's limited in its application.

The 10 cap stock valuation method is originally a real estate valuation method. Unlike companies in the stock market, profit in real estate tends to remain relatively constant year-over-year, with rent and maintenance expenditures for properties being rather predictable and relatively constant. Therefore, the profit figures generated last year from a property are generally going to be very similar in the following year. As a result, the 10 cap stock valuation is most applicable to mature businesses (i.e., DJIA companies and/or dividend aristocrats) that don't see a lot of growth or overall volatility. Given, a majority of companies in the stock market see substantial year-over-year volatility in their earnings and stock prices, which is where this valuation method falls short.

In closing, although the 10 cap stock valuation method does have its merits, its best to use this method for more established companies and alongside at least one other stock valuation method, such as the discounted cash flow (DCF) method. With the DCF method, in particular, what ultimately matters is the amount of cash a business can deliver to you in the future, not what they produced last year (as the 10 cap stock valuation method teaches). Applying both of these stock valuation methods can therefore provide you with a more thorough understanding of a company's value.

**Disclaimer**: Because the information presented here is based on my own personal opinion, knowledge, and experience, it should not be considered professional finance, investment, or tax advice. The ideas and strategies that I provide should never be used without first assessing your own personal/financial situation, or without consulting a financial and/or tax professional.