Value Stock Investing

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• Value Stock Investing
• (chapter 11)

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Value 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 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 Value

• Present Value Model
• The value today, of receiving a dividend and next
  years price, is
• k is the risk-adjusted discount rate.
• But what is next years price?
• So,

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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

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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

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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 gt g

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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 g0.
• Notice how much more valuable a growing firm is!

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What is the appropriate discount rate?

• Various methods
• CAPM
• Requires company beta, market return, risk free
  rate
• From the constant growth model

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Graham Dodd Approach

• Coauthors of Security Analysisvalue 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

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• Most important idea margin of safetypositive
  difference between price and value
• Degree of bargain-ness
• Enlightened stock analysisprice 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
investing strategy

• 10 lessons from Warren Buffett
• Better to buy a wonderful company at a fair price
  then a fair company at a wonderful price.
• 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.
• Management does better by avoiding dragons, not
  slaying them.
• Like Newtons law of motion, an institution will
  resist any change in its current direction.
• 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 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.
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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

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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.

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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/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-a-reason
able-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.
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Finding Value Stocks

• Common Criteria for Value Stocks
• Ample cash reserves (cash gt 10 of market cap).
• Ample free cash flow to fund necessary investment
  (EBIDTA gt capital spending).
• Conservative dividend payout policy (dividend lt
  75 of EPS).
• Conservative financial structure (debt lt 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 lt 75 of SP 500
  average).
• Low price-cash flow ratio relative to the market
  and a company's own history (P/CF lt 75 of SP
  500 average).
• Low price-earnings ratio relative to the market
  and a company's own history (P/E lt 75 of SP 500
  average).
• Negative investor sentiment as reflected in poor
  financial ratings (SP rating of B- or worse).
• Significant dividend income (yield gt 150 of SP
  500 average).

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Value InvestingAdvantages 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?

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Learning objectives
Discuss the characteristics of value
investing Know how to apply the value model using
discounted dividends Know the constant growth
model Know the use of P/E ration calculate the
intrinsic value (slide 6) Know the two formulas
to calculate the cost of equity/ discount
rate Discuss the main investment ideas behind the
Graham and Dodd approach to value
investing Discuss five investment ideas behind
Warren Buffett approach to value
investing Discuss 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