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Value Stock InvestingValue Stock Investing(chapter 11)(chapter 11)

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Value InvestingValue 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…

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Characteristics of Value FirmsCharacteristics 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.

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Finding Fundamental ValueFinding 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?What is the appropriate discount rate?

Various methods- CAPM

Requires company beta, market return, risk free rate

- From the constant growth model:

Gain CapitalYield DividendgP

Dk

0

1

FMiFi RRRRE

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Graham & Dodd ApproachGraham & 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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Warren Buffett: Current leader of the value Warren Buffett: Current leader of the value investing strategyinvesting 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: Dividends: An Important Part of Total Return An Important Part of Total Return from Value Firmsfrom 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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Quality at a Reasonable PriceQuality 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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Finding Value StocksFinding 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! FinanceStock Screener at Yahoo! Finance

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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 InvestingValue InvestingAdvantages & LimitationsAdvantages & Limitations

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Learning objectivesLearning objectivesDiscuss the characteristics of value investingKnow how to apply the value model using discounted dividendsKnow the constant growth modelKnow the use of P/E ration calculate the intrinsic value (slide 6)Know the two formulas to calculate the cost of equity/ discount rateDiscuss the main investment ideas behind the Graham and Dodd approach to value investingDiscuss five investment ideas behind Warren Buffett approach to value investingDiscuss the concept of Quality at a reasonable price Discuss the Contrarian investment philosophy Discuss the role of dividends and value investing (text pages 340 to 343)End of chapter questions 11.1,11.2, 11.4, 11.5, 11.6; Problem 11.2; CFA problem 11.2