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Why Value Investing and Building Financial Models Is More Important Than Ever

Earlier this year, I suggested to investors that they focus on two key principles when thinking about how to build their portfolio. I’d like to reiterate a recent quote by David Einhorn on why investors need to focus on value investing as a core principle in these current times:

“What I was basically saying was: look, value investing over time has worked; we think this is the best and right way to invest, it’s not going to be true every day, in every environment, but we are in an environment right now, where it doesn’t seem to be working at all, and in fact the opposite seems to be working, because people are looking at things and saying, the ownership of a company is something other than the risk adjusted future profits of the company, maybe it’s the social disruption, maybe it’s the social desirability, maybe is the charismatic value of the CEO.”

While new-age investors often point to companies with track records of providing disruption to the market (i.e., cryptocurrency firms, cannabis plays, and high-tech companies), the valuation multiples ascribed to such companies often blow the long-term potential of these companies way out of proportion.

As a way of avoiding falling into the trap of becoming enamored with the “story” that so many energetic CEOs are very good at telling, building a valuation model to provide a net present value of the risk-adjusted discounted cash flows for a given company is one way to double-check whether a company is fairly valued, undervalued, or overvalued based on assumptions made relating to the growth prospects of the company and the current economic environment.

Removing hype from the equation is one way investors can gain a good sense of just how good an investment is over the long term. In June of last year, when Altagas Ltd. (TSX:ALA) was trading at around the $30 level (and had already dropped substantially from a peak of above $50 per share in mid-2014), I plugged the company’s financials into my valuation model and came up with a $20-$22 valuation for the company. This told me two things. First, based on my assumptions as of June 2017, the company was overvalued by the market. Given the premium investors were paying to the net intrinsic value I had calculated, this would be a company I would avoid until the stock price depreciated to a level that made sense. Despite a strong balance sheet and fundamentals that showed that Altagas may turn out to be a solid investment in the future, the decision to wait on Altagas until the market re-valued its shares appeared to be prudent one.

Bottom line

This week, shares of Altagas have depreciated to a level closer to the intrinsic value many value investors may have placed on the company’s future cash flows. As such, Altagas appears to be nearing a level that makes sense over the long-term. Given the company’s very attractive yield of nearly 9% along with a commitment from the company’s management team to continue to raise its dividend between 8%-10% per year until 2021, investors should consider this one.

Should the company dip to the $20-$22 level, I would encourage investors to jump on board. My intention is to place a bid for Altagas’ shares at the $20 level.

Stay Foolish, my friends.

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Fool contributor Chris MacDonald has no position in any stocks mentioned in this article. Altagas is a recommendation of Stock Advisor Canada.

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