If you copy me on eToro, you already know the last few weeks have been rough, a reminder that volatility is always around the corner. Even if you prepare for these events, it still feels like shit. The one thing that makes me endure these hard times is to know what I am invested in. This is why I have been simplifying my portfolio and reducing the number of tickers I hold in the past few months.

Last week I have been analyzing valuations of my holdings and came up with 8 tickers to close because of what I consider too high expectations. This is also a way to derisk the portfolio for 2022, as the FED confirmed we will get 3 rates hikes. The first casualties are usually the richly valued stocks.

How do I value a stock?

Valuation is sometimes more an art than a science. There are multiple ways to value a stock. I used the textbook definition of value to decide which one I use, then added a little creativity to the implementation.

According to the bible of corporate valuation, companies fundamental value creation is the Free Cash Flow it generates for its investors. Stock price, in turn, is defined by both the value created and the expectations of value creation the market has for the future. So here we go; I take the company valuation / Free Cash Flow, also known as "Price to Free Cash Flow" (P/FCF), and compare it to the P/FCF it would need to be an averaged priced company in the future. What is an average-priced company?  According to GuruFocus, excluding non-profitable companies, the median P/FCF today is 17 for the US market, and 30 for the Technology industry.

Interestingly, the widely used PE ratio is similar (16 for the US market and 30 for Tech). Simplistically, the PE ratio is considered a good value between 15 and 20 (Sp500 median PE is 15).

Instead of putting a fair price on a company, I estimate how much expectation is built in the stock price, or how much value the market expects the company will create in the future. In other terms, I calculate the implied Free Cash Flow growth, by assuming that the company P/FCF will be back at either the company's P/FCF median, or 20, whichever is the lowest. Why 20 instead of the historic median 15? Because I usually invest in high grower and highly optional businesses, for which the market pays a premium.

Then I compare it with how much value it has created in the past, by averaging the Free Cash Flow Growth of 3 periods: the last 12 months, 3 years and 5 years. It is a red flag if the implied next 5 years' growth is higher than the average past performance.

These are the most overvalued stocks in my portfolio.

*JKHY always has managed rich multiples, but even if we take JKHY median P/FCF, it still implies a 18% growth

**The problem is that the last 12 months saw a temporary jump because doctors could not operate in 2020 at the pandemic's peak. So I would instead look at the last 5 years' growth which is 24%

***It only has an erratic 5 quarters history of positive cash flow.

What about the stocks without positive cash flow?

I use the only metric you can do benchmarks with in this case: PS ratio (company valuation / total revenue). I calculate the implied revenue growth by assuming PS ratio will fall back to an average level within 5 years (this is 4x sales). Here I flagged a couple of additional stocks from my portfolio.

Verdict

Valuation is far from a precise science, and there is a lot of error margin with almost any method you can use. I think implied growth is a logical, straightforward, and scalable way of flagging extreme valuations, but it does flag many false-positive results. I only close my position when the overvaluation is notorious. For the stocks where implied growth is not so stretched compared to what I think it can achieve, I give the company some slack and keep holding, with the condition it scores above 13 points of my quality company scorecard.

From the above list, I am closing $JKHY, $MSFT, $NFLX, $U, $MDB, $OKTA. I am holding $TSLA, $INTU, $ISRG, $LMND.

I am not keeping the resulting cash on the side, as I concur with Cathie Wood on the fact we are in the deep value territory for many growths and disruptive stocks, based on that same valuation technique. Many insiders also feel the same, else they would not buy at such a rate. The next post will be the list of the ones I am adding to.