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 year’s price, is:
D1  P1
P0 
1 k

k is the risk-adjusted discount rate.
 But
 So,
what is next year’s 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  E
 P   E  1  g 
E
Pn  P
n
n
n
n
0
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

Present Value
is: 1.40  1.48  1.57  1.67  1.77  120.44
P0 
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 

kg
kg
 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
kg
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 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
11-10

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
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 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


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
11-16
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
Dividend Yield (%)
S&P 500 Index
9
8
7
6
5
4
3
2
1
0
11-17
Figure 11.3 Reinvested Dividends Are a Big Part of Total Return for the S&P 500 (1976-present)
$410,000
$360,000
T otal Value
$364,642
Investment Value
$310,000
$260,000
T otal Value of
Reinvested Dividends
$226,002
$210,000
$160,000
Principal Growth
$138,640
$110,000
$60,000
$10,000
1976
1980
1984
1992
1988
1996
2000
2004
Year
Data So urce: http :\\www.b arra.co m
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
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.
Figure 11.3 Profit Rates and Stock Returns Display a Regression to the Mean Over Time
Above-normal profits range
Entry or nonleading
firm growth
Above-normal
profits (+)
Profit rate
over time
12%-14%
Below-normal
profits (-)
Bankruptcy or
exit
Below-normal profits range
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%.
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
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
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-andhold strategy—constant
recycling of stocks through
portfolio; constant research
and vigilance
•
Popular rules-of-thumb already
factored into market?
11-26