Investments: Analysis
and Behavior
Chapter 11- Value Stock
Investing
2008 McGraw-Hill/Irwin
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.
11-2
Value Investing
Finding securities considered to be
temporarily undervalued or unpopular for
various reasons.
Determine Economic Value of the firm
Compare to current price
Value investing is a contrarian philosophy
Sometimes called Fundamental Value
Not following the herd
Why might a stock be selling below its
economic value?
11-3
Finding Fundamental Value
Present Value Model
The
value today, of receiving a dividend and
next years price, is:
D P
P0
1 k
k is the risk-adjusted discount rate.
But
So,
what is next years price?
D 2 P2
P1
1 k
D1
D 2 P2
P0
1 k 1 k 2
11-4
Continuing
the substitution, leads to the
general present value equation:
D1
D2
D n Pn
P0
2
n
1 k 1 k
1 k
How
is Pn estimated?
One method is to use the P/E ratio. Note that:
E
P
E
Pn P
n
n
En
E 0 1 g
11-5
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
5
P5 P
E0 1 g 12 $7.50 1.065 $120.44
E5
Estimated price in five years:
D1 1.40
Future dividends are:
D2 D1 (1 0.06) 1.48
D3 D2 (1 0.06) 1.57
D4 D3 (1 0.06) 1.67
D5 D4 (1 0.06) 1.77
1.40
1.48
1.57
1.67
1.77 120.44
Present Value
P0 is:
1 0.14 1 0.14 2 1 0.14 3 1 0.14 4
1 0.14 5
1.23 1.14 1.06 0.99 63.47 $67.89
11-6
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:
D 0 1 g
D1
P0
kg
kg
Only
works for k > g
11-7
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?
D0 1 g $0.75 1 0.05
P0
$15.75
kg
0.10 0.05
If the stock is a preferred stock (pays a constant dividend),
then g=0%.
D0 1 0 $0.75
P0
$7.50
k 0
0.10
Notice how much more valuable a growing firm is!
11-8
What is the appropriate discount rate?
Various methods
CAPM
return
Requires company beta, market return, risk free
rate
Average
historical return of the firm
From the constant growth model:
D1
k
g Dividend Yield Capital Gain
P0
11-9
Graham & Dodd Approach
Coauthors of Security Analysis
value investors 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
11-10
Most important idea: margin of
safetypositive 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
11-11
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.
11-12
11-13
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 Newtons law of motion, an institution will resist any change in
its current direction.
5.
Corporate projects will materialize to soak up available funds.
11-14
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 ones 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.
11-15
Dividends: An Important Part of Total
Return from Value Firms
Dividends mitigate risksbird 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
11-16
11-17
11-18
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.
11-19
Use the value of ROE to determine the worthiness of the stock to a
value investor for the following stocks:
Company
ROE P/E
Intel 19.6% 20.0
Ford Motor 24.1% 6.3
Procter & Gamble 40.2% 20.9
Solution:
Compute the value of ROE:
Company
VRE
Intel 19.6% / 20.0 = 0.98
Ford Motor 24.1% / 6.3 =
3.83
Procter & Gamble 40.2% / 20.9 = 1.92
With a VRE = 0.98, Intel is not a candidate for a quality-at-areasonable-price stock. Procter & Gamble may be worthy of further
investigation. Since Ford Motors VRE is greater than 3, it
represents a very attractive possibility for a value investor.
11-20
Regression to the mean:
At any point in time, the rate of return on stockholders equity varies among
firms and industries. Over time, these profit rates tend to converge toward the
overall average of 12-14% per year.
11-21
Table 11.5 S&P 500 Operating Earnings Growth by Economic Sector as of 1/19/2006
2002
S&P 500
2003
% Chg
2004
% Chg
2005
% Chg
46.04
54.69
18.80%
67.67
23.7%
76.56
13.1%
9.53
10.53
10.56%
13.63
29.5%
13.03
-4.4%
11.91
11.79
-0.96%
12.82
8.8%
13.18
2.8%
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%
Consumer Discretionary
Consumer Staples
Energy
Source: Standard & Poor's
11-22
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).
11-23
Stock Screener at Yahoo! Finance
11-24
Table11.7StockScreensCanHelpTurnUpStockmarketBargains
Minimumstockscreencriteria:ROE15%,5yearEPSGrowthrateaverage10%,EPSGrowthNext5Years10%
(analystestimate).Maximumstockscreencriteria:CurrentP/ERatio14,DebttoEquityRatio0.5.
Ticker
Company Name
Price
Mkt
Cap
P/E
Earnings
Growth
Est Next
5y
Return 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
11-25
Value Investing
Advantages & Limitations
Careful stock selection
should limit downside risk
Difficulty obtaining reliable and
relevant information
Not necessarily a buy-and-hold
strategyconstant recycling of
stocks through portfolio;
constant research and
vigilance
Popular rules-of-thumb already
factored into market?
11-26
