Investments: Analysis and Behavior

Chapter 11- Value Stock

Investing

©2008 McGraw-Hill/Irwin

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Learning Objectives

Learn the characteristics of a value investing strategy. Be able to compute fundamental value. Identify undervalued stocks. Learn the value of dividends. Implement computer stock screens.

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Value Investing

Finding securities considered to be temporarily undervalued or unpopular for various reasons. Determine Economic Value of the firm

Sometimes called Fundamental Value Compare to current price

Value investing is a contrarian philosophy Not following the herd…

Why might a stock be selling below its economic value?

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Finding Fundamental Value Present Value Model

The value today, of receiving a dividend and next year’s price, is:

k is the risk-adjusted discount rate.But what is next year’s price?

So,

k1

PDP 11

0

k1

PDP 22

1

2221

0k1

PD

k1

DP

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Continuing the substitution, leads to the general present value equation:

How is Pn estimated? One method is to use the P/E ratio. Note that:

nnn

221

0k1

PD

k1

D

k1

DP

n

n

nnn

gEEP

EEPP

10

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EXAMPLE: According to information obtained from Yahoo! Finance, Freddie Mac (FRE) has a current price of $64 per share, an expected dividend per share of $1.40, an EPS of $7.50, expected EPS growth of 6% per year, and a typical P/E ratio of 12.

According to the Present Value Model, what is the present value of FRE using a discount rate of 14% and a five years analysis period? Is it undervalued or overvalued?

Solution Estimated price in five years:

Future dividends are:

Present Value is:

44.120$06.150.7$121 55055 gEE

PP

57.1)06.01(23 DD

40.11 D 48.1)06.01(12 DD

67.1)06.01(34 DD

77.1)06.01(45 DD

89.67$47.6399.006.114.123.1

14.01

44.12077.1

14.01

67.1

14.01

57.1

14.01

48.1

14.01

40.154320

P

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Note that the model depends on growth rates of the profits and dividends.

Constant Growth Model Also called the Gordon Growth Model If you can assume that the future growth of the

company is constant, then the equation becomes:

Only works for k > g

gk

D

gk

g1DP 10

0

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A company paid a $0.75 per share dividend this year and it is expected to grow at 5%. If the required rate of return for this firm is 10%, what is its fundamental value?

If the stock is a preferred stock (pays a constant dividend), then g=0%.

Notice how much more valuable a growing firm is!

75.15$

05.010.0

05.0175.0$100

gk

gDP

50.7$

10.0

75.0$

0

0100

k

DP

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What is the appropriate discount rate? Various methods

CAPM return Requires company beta, market return, risk free

rate

Average historical return of the firmFrom the constant growth model:

Gain CapitalYield DividendgP

Dk

0

1

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Graham & Dodd Approach Coauthors of Security Analysis

—value investor’s bible

Graham lost fortune in 1929 crash.

Learned that true measure of stock values come from earnings, dividends, future prospects, and asset values, NOT price movements

Graham teamed up with professor Dodd to write the book, 1934

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Most important idea: margin of safety—positive difference between price and value

Degree of “bargain-ness”

Enlightened stock analysis—price vs. true intrinsic or real economic value

Liked firms that sell below liquidation value

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Characteristics of Value Firms Measures

Price to Book: Firms with low P/B (or high B/M) are value stocks

Price to Earnings ratio: Firms with low P/E are considered value stocks.

Earnings could be negative or vary because of extraordinary items.

Price to Sales ratio: Firms with low P/S are considered attractive because they may have potential for large future price gains.

Price to Cash flow: Low P/CF firms are value firms.

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Warren Buffett: Current leader of the value investing strategy

10 lessons from Warren Buffett

1. Better to buy a wonderful company at a fair price then a fair company at a wonderful price.

2. When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that survives.

3. Management does better by avoiding dragons, not slaying them.

4. Like Newton’s law of motion, an institution will resist any change in its current direction.

5. Corporate projects will materialize to soak up available funds.

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6. Cravings of the leader, however foolish, will be quickly supported by detailed studies prepared by the troops.

7. The behavior of peer companies will be mindlessly imitated.

8. It is not a sin to miss a business opportunity outside one’s area of expertise.

9. If your actions are sensible, you are certain to get good results.

10. Do not join with managers who lack admirable qualities, no matter how attractive the prospects of their business.

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Dividends: An Important Part of Total Return from Value Firms

Dividends mitigate risks—bird in hand theory Dividend growth

Dividends give more stable income streams than bonds.

Dividends grow faster than inflation over time. Dividend yields have decreased over the last two

decades.

Valuable indicator of corporate health

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S&P 500 Index

0

1

2

3

4

5

6

7

8

9

19

77

19

79

19

81

19

83

19

85

19

87

19

89

19

91

19

93

19

95

19

97

19

99

20

01

20

03

20

05

Div

ide

nd

Yie

ld (

%)

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Figure 11.3 Reinvested Dividends Are a Big Part of Total Return for the S&P 500 (1976-present)

$10,000

$60,000

$110,000

$160,000

$210,000

$260,000

$310,000

$360,000

$410,000

1976 1980 1984 1988 1992 1996 2000 2004

Year

Inve

stm

ent

Val

ue

Data Source: http:\\www.barra.com

Total Value$364,642

Principal Growth$138,640

Total Value ofReinvested Dividends$226,002

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Quality at a Reasonable Price

value of ROE, or VRE VRE = return on equity divided by the P/E ratio

If VRE ≥ 1, the stock may be worthy of investment attention and possible purchase.

If VRE ≥ 2, the stock is definitely worthy of investment attention and may represent a very attractive investment.

If VRE ≥ 3, the stock is apt to represent an extraordinarily attractive investment opportunity.

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Use the value of ROE to determine the worthiness of the stock to a value investor for the following stocks:Company ROE P/EIntel 19.6% 20.0Ford Motor 24.1% 6.3Procter & Gamble 40.2% 20.9

Solution: Compute the value of ROE:

Company VREIntel 19.6% / 20.0 = 0.98Ford Motor 24.1% / 6.3 = 3.83Procter & Gamble 40.2% / 20.9 = 1.92

With a VRE = 0.98, Intel is not a candidate for a quality-at-a-reasonable-price stock. Procter & Gamble may be worthy of further investigation. Since Ford Motor’s VRE is greater than 3, it represents a very attractive possibility for a value investor.

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Above-normal profits range

Below-normal profits range

Above-normal profits (+)

Below-normal profits (-)

12%-14%

Entry or nonleading firm growth

Bankruptcy or exit

Profit rate over time

Figure 11.3 Profit Rates and Stock Returns Display a Regression to the Mean Over Time

Over time, entry and nonleading firm growth causes above-normal profits to regress toward the mean. Similarly, bankruptcy or exit by weak competitors boosts profits for depressed industries. As a result, firm profits and stock-market returns converge toward the long-term average of 12-14%.

Regression to the mean: At any point in time, the rate of return on stockholder’s equity varies among firms and industries. Over time, these profit rates tend to converge toward the overall average of 12-14% per year.

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Table 11.5 S&P 500 Operating Earnings Growth by Economic Sector as of 1/19/2006

2002 2003 % Chg 2004 % Chg 2005 % Chg

S&P 500 46.04 54.69 18.80% 67.67 23.7% 76.56 13.1%

Consumer Discretionary 9.53 10.53 10.56% 13.63 29.5% 13.03 -4.4%

Consumer Staples 11.91 11.79 -0.96% 12.82 8.8% 13.18 2.8%

Energy 9.87 16.32 65.34% 24.29 48.9% 34.97 44.0%

Financials 21.03 26.76 27.22% 30.88 15.4% 32.79 6.2%

Health Care 14.89 14.63 -1.73% 17.20 17.5% 18.61 8.2%

Industrials 10.53 10.88 3.27% 13.13 20.7% 16.18 23.2%

Information Technology 3.36 8.04 139.23% 12.60 56.7% 14.83 17.7%

Materials 4.48 5.32 18.66% 10.10 90.0% 11.77 16.5%

Telecommunication Services 6.86 6.81 -0.66% 6.86 0.8% 7.52 9.6%

Utilities 9.69 8.77 -9.42% 8.63 -1.6% 9.50 10.1%

Source: Standard & Poor's

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Finding Value Stocks

Common Criteria for Value Stocks

Ample cash reserves (cash > 10% of market cap). Ample free cash flow to fund necessary investment (EBIDTA > capital

spending). Conservative dividend payout policy (dividend < 75% of EPS). Conservative financial structure (debt < 50% of market cap). Conservative issuance of common stock to managers and other

employees (constant or falling number of shares outstanding). Low price-book ratio relative to the market and a company's own

history (P/B < 75% of S&P 500 average). Low price-cash flow ratio relative to the market and a company's own

history (P/CF < 75% of S&P 500 average). Low price-earnings ratio relative to the market and a company's own

history (P/E < 75% of S&P 500 average). Negative investor sentiment as reflected in poor financial ratings (S&P

rating of B- or worse). Significant dividend income (yield > 150% of S&P 500 average).

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Stock Screener at Yahoo! Finance

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Table 11.7 Stock Screens Can Help Turn Up Stock-market BargainsMinimum stock screen criteria: ROE 15%, 5-year EPS Growth rate average 10%, EPS Growth Next 5 Years 10% (analyst estimate). Maximum stock screen criteria: Current P/E Ratio 14, Debt to Equity Ratio 0.5.

Ticker Company Name PriceMkt Cap P/E

Earnings Growth Est Next

5yReturn On

Equity

Earnings Growth Past 5 Year

Total Debt/Equity

GPS GAP INC 17.17 14.931B 13.6 12 21.6 22.8 0.09

PH PARKER HANNIFIN C 73.98 8.860B 13.5 11 17.1 11.6 0.27

AEOS AMER EAGLE OUTFIT 24.87 3.718B 13.6 14.5 31.1 12 0.00

NOVL NOVELL INC 8.99 3.489B 10.2 10 31.6 27.9 0.43

NX QUANEX CP 60.26 1.535B 9.9 15 30.6 33.6 0.21

OFIX ORTHOFIX INTL NV 41.28 660.8M 8.9 14 23.5 15.3 0.15

ASFI ASTA FUNDING INC 29.75 404.4M 13.9 15 23.9 17.4 0.20

WSTL WESTELL TECH CL A 4.12 287.5M 7.9 20 31.1 44.5 0.00

CRMT AMERICA'S CAR-MAR 18.40 218.2M 13.3 18 15.9 23 0.35

Source: Yahoo! Finance stock screener

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• Careful stock selection should limit downside risk

• Difficulty obtaining reliable and relevant information

• Not necessarily a buy-and-hold strategy—constant recycling of stocks through portfolio; constant research and vigilance

• Popular rules-of-thumb already factored into market?

Value InvestingAdvantages & Limitations