Investments Analysis and Behavior Chapter 11

Learning Objectives n n n 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 n Finding securities considered to be temporarily undervalued or unpopular for various reasons. ¨ Determine Economic Value of the firm n ¨ n Compare to current price Value investing is a contrarian philosophy ¨ n Sometimes called Fundamental Value Not following the herd… Why might a stock be selling below its economic value? 11 -3

Finding Fundamental Value n Present Value Model ¨ The value today, of receiving a dividend and next year’s price, is: n k is the risk-adjusted discount rate. ¨ But what is next year’s price? ¨ So, 11 -4

¨ Continuing the substitution, leads to the general present value equation: ¨ How n is Pn estimated? One method is to use the P/E ratio. Note that: 11 -5

n n 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? n Solution Estimated price in five years: n Future dividends are: n Present Value is: n 11 -6

n n 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 11 -7

n 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? n If the stock is a preferred stock (pays a constant dividend), then g=0%. n Notice how much more valuable a growing firm is! 11 -8

What is the appropriate discount rate? n Various methods ¨ CAPM n return Requires company beta, market return, risk free rate ¨ Average historical return of the firm ¨ From the constant growth model: 11 -9

Graham & Dodd Approach n Coauthors of Security Analysis —value investor’s bible ¨ ¨ n 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

n Most important idea: margin of safety—positive difference between price and value n Degree of “bargain-ness” n Enlightened stock analysis— price vs. true intrinsic or real economic value ¨ Liked firms that sell below liquidation value 11 -11

Characteristics of Value Firms n 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. n 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

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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. 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 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. 11 -15

Dividends: An Important Part of Total Return from Value Firms n n 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. n Valuable indicator of corporate health 11 -16

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Quality at a Reasonable Price n 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 Intel Ford Motor Procter & Gamble VRE 19. 6% / 20. 0 = 0. 98 24. 1% / 6. 3 = 3. 83 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 Motor’s 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 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. 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. 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 n n n n n 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

Table 11. 7 Stock Screens Can Help Turn Up Stock-market Bargains Minimum 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 Price Mkt Cap P/E Earnings Growth Est Next 5 y Return On Equity Earnings Growth Past 5 Year Total Debt/Equity GPS GAP INC 17. 17 14. 931 B 13. 6 12 21. 6 22. 8 0. 09 PH PARKER HANNIFIN C 73. 98 8. 860 B 13. 5 11 17. 1 11. 6 0. 27 AEOS AMER EAGLE OUTFIT 24. 87 3. 718 B 13. 6 14. 5 31. 1 12 0. 00 NOVL NOVELL INC 8. 99 3. 489 B 10. 2 10 31. 6 27. 9 0. 43 NX QUANEX CP 60. 26 1. 535 B 9. 9 15 30. 6 33. 6 0. 21 OFIX ORTHOFIX INTL NV 41. 28 660. 8 M 8. 9 14 23. 5 15. 3 0. 15 ASFI ASTA FUNDING INC 29. 75 404. 4 M 13. 9 15 23. 9 17. 4 0. 20 WSTL WESTELL TECH CL A 4. 12 287. 5 M 7. 9 20 31. 1 44. 5 0. 00 CRMT AMERICA'S CAR-MAR 18. 40 218. 2 M 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 strategy—constant recycling of stocks through portfolio; constant research and vigilance • Popular rules-of-thumb already factored into market? 11 -26

Investments Analysis and Behavior Chapter 11 — Value