Important Updates for Investors
Carla Pasternak's Premiere Issue of High-Yield International Just
Released
Income expert Carla Pasternak's debut issue of High-Yield
International covers a Taiwanese manufacturer yielding 9.5%... a
rare Mexican monopoly yielding 13.4%... and other top-performing
investments yielding up to 19.0%.
Government's Biofuel Timetable Could Spell +15,900% Growth
+15,900% growth might seem far-fetched... but it's not. In fact, it
is mandated by law. And I've identified the ONLY stock positioned to
capture this growth.
The
Silver Lining to a Falling Dollar
Despite the U.S. national debt, there is a silver lining for income
investors. This massive spending, combined with movement out of U.S.
Treasuries, is going to take its toll on the dollar, and
international income investors could reap the rewards in the form of
higher dividends. |
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| How
to Calculate a Stock's Actual Fair Value |
Published: May 12, 2006
When searching for undervalued
companies, investors commonly rely on the most tried-and-true financial
measures: Price/Book, Price/Earnings, Price/Cash Flow, etc. To be sure,
such traditional valuation metrics can be useful, but they only tell
part of the story.
Potential Drawbacks
For example, a low Price/Sales ratio means little when a company has
razor-thin profit margins and is having trouble converting those sales
to profits. Meanwhile, a single-digit trailing P/E ratio might look good
on paper, but it can be misleading if the company's earnings are
forecast to fall sharply in the years ahead.
Even when properly applied, the aforementioned valuation ratios are
extremely subjective and they can only tell us how expensive a stock is
relative to something else. For example, a company might look
"cheap" when stacked alongside its peer group, but what if the
entire industry is overvalued?
And let's not forget, in many cases a stock that appears sharply
undervalued might belong to a deeply troubled company that deserves its
rock-bottom price tag. Therefore, investing solely on the basis of price
can be a recipe for mediocre performance.
Part of the problem is that ratio-based analysis often leads to
inconclusive results. To help illustrate this point, let's review the
example below. At first glance company "A", which is trading
at 15 times last year's earnings, might look like a bargain compared to
company "B" at 20 times trailing earnings.
However, let's take a deeper look.
| |
Trailing
P/E |
Industry
Avg. P/E |
Five-year
P/E range |
Long-Term
EPS Growth |
| Company
A |
15 |
10 |
9.0
– 15.0 |
+10% |
| Company
B |
20 |
30 |
20.0
– 32.0 |
+20% |
As the table shows, company
"B" likely belongs to a high-growth industry, and the stock is
trading at a 50% discount to that of its competitors. Meanwhile, company
"A" operates in a mature business and is changing hands for a
50% premium to the rest of its industry group.
At the same time, company "B" is selling at the low-end of its
own historical P/E range, versus the high-end for "A".
Finally, company "B" is expected to deliver double the
earnings growth of company "A" in the years ahead.
Clearly, the decision is not so cut-and-dried now; other considerations
must be made. Based on these additional factors, it now appears as if
company "B" might be the more undervalued stock -- despite its
higher P/E.
So now the question remains, is company "B" just cheaper than
"A", or is it actually undervalued and worthy of additional
consideration? Well, the next step might be to use a forward-looking
ratio like PEG (price/earnings to growth). Currently, the company's P/E
matches its expected growth rate, which yields a PEG of 1.0.
Does this represent an undervalued stock? Again, that simple question
has no definitive answer. According to conventional thinking, any firm
with a PEG of 1.0 or below is considered underpriced. However, is it
really prudent to base your portfolio decisions on loose
"rule-of-thumb" type methodology?
Discounted Cash Flow (DCF) Modeling
Our point is not to discredit traditional valuation techniques. Like
many other analysts, we have relied on them in the past and will
continue to do so in the future. Rather, we are merely pointing out that
they have their limitations, and assigning value using ratio-based
analysis exclusively is a flawed approach.
Going back to company "B", we may or may not consider
investing in the company at this point. After all, the firm's P/E of 20
and its PEG of 1.0 don't really tell us whether the firm is actually
undervalued.
However, what if we had a reasonably accurate way to measure a firm's
true intrinsic value? By employing this methodology, what if we knew the
shares were currently trading at $25, yet their estimated fair value was
$50? In this case, we would have removed much of the doubt, and the
company would indeed be well worth a closer look. Our mission is to
scour the market in search of such half-priced stocks.
The difficult part of this process is to quantitatively determine why
company "B" is worth $50 per share. To accomplish this task,
we place a great deal of emphasis on a superior analytical tool
-- discounted cash flow models.
At its core, ownership in a company entitles shareholders to a stake in
the profits generated by the firm over time. Because GAAP earnings are
subject to manipulation and can be distorted by depreciation, goodwill
writedowns, and a host of additional non-cash charges, we believe that
cash flows are a much truer gauge of a firm's true profitability.
Therefore, to determine a fair value price for a company, we simply
project the amount of operating cash flow that the firm is likely to produce
in the years ahead. From there, we determine how much those future cash
flows are worth in today's dollars by discounting them back to the
present at a rate sufficient to compensate investors for the risk taken.
Finally, we then divide that figure by the total number of fully-diluted
shares outstanding to arrive at our per-share fair value estimate.
An extremely scaled-down version
Suppose that a "club" offered to pay each of its members $108
in precisely one year. Next, assume that you are fairly confident of
being able to earn an 8% rate of return over the next twelve months on
your money. Based on those assumptions, how much would you pay in order
to "join" this club today?
Well, if you invested $100 dollars anywhere else, then based on the 8%
rate of return, you could reasonably expect it to be worth the same $108
in one year's time. Therefore, it would be a poor financial decision to
pay one penny more than $100 to join the club. Why? Because your annual return from such
an investment would be less than 8%. However, it would be profitable to
join the club for anything less than $100, as it would offer a higher
return than you could get elsewhere.
In this simplified example, the club (company) is expected to pay its
members (shareholders) pro-rata cash flow of $108 in one year's time.
Thus, based on the required rate of return (discount rate) of 8%, the
breakeven mark (fair value) for this investment would be $100.
Thus, if memberships were selling for $90, then they would be
"trading" at a 10% discount to their fair value -- and thus probably worth buying.
Of course, in the real world, there is no guarantee that a company can
deliver on its cash flow projections. As such, we demand a premium to
the risk-free interest rate. The riskier the company, the larger the
discount rate we apply. Also, our valuation models look much further out
than just the next year.
Though this description sounds fairly straightforward, discounted cash
flow modeling is actually a complex process that incorporates
assumptions regarding short and long-term growth rates, capital
expenditures, weighted average cost of capital (WACC), and many other
factors. Naturally, such variables are impossible to predict with exact
precision, so we err on the side of caution by using deliberately
conservative growth rates and other figures. Of course, if the companies
we profile overshoot our forecasts, then their upside potential will be
even greater.
Putting it all together
Calculating fair values according to the discounted cash flow method can
be an exhaustive process -- but we don't stop there. After narrowing
down an initial pool of thousands of potential stocks, only the most
deeply undervalued qualify for more extensive analysis. Of this group,
we then combine our work with additional fair value calculations
determined by several of Wall Street's most prominent firms to arrive at
our final fair value estimate.
With all of the above in mind, in each and every issue of our premium
value investing newsletter -- Half-Priced
Stocks -- we make certain to list our fair value estimate for
every company we profile. In addition, we bring you a table of ten
companies in our coverage universe that are trading at some of the
steepest discounts to their fair value. Considering that fair value
incorporates future growth rates and other fundamental factors, each
company that appears on this list probably merits additional research.
Without further delay, in the table below you'll find
our most recent listing of ten of the most undervalued stocks in our
coverage universe . . .
Editor's
Note:
Throughout the remainder of this article, co-editors Nathan Slaughter
and Paul Tracy provide a table of ten stocks that are now trading at
some of the largest discounts to their estimated fair value. To view the
remainder of this article, you'll need to subscribe to our premium value
investing newsletter -- Half-Priced Stocks. Please visit
one of the following links to continue . . .
Thanks for reading!
|
Nathan Slaughter
Editor
Half-Priced Stocks, The ETF Authority
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in-depth guidance on today's leading value opportunities, plus educational guidance, please subscribe to
Nathan Slaughter's premium value investing newsletter --
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Stocks |
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