Another look at (one of the) Valuation methods

Following up with Aug 19th post, I noticed that forward EPS could be more reliable then trailing EPS. Nway, following is one the email I sent to one of my colleague on finding fair value of an equity. Here is the example for HPQ which could be extended to any stock:-

First of all you need to find what is the minimum ROI (Return on Investment) you have to have to invest. Following is the calculation assuming that 15% is the bare minimum you would need.

FOR HPQ:
* on 10/17/2008 the price is: 40.73$/stock
* P/E = 12.60 (forward PE is 9.92 as per the http://finance.yahoo.com/q/ks?s=HPQ)
* EPS = $2.93 (current year) (http://finance.yahoo.com/q/ae?s=HPQ)
* EPS growth rate = 28.9 % (this is the conservative general growth estimate by WSJ.com we will use this conservative number).
If you look at paste few years’ actual EPS number then average is 38.83% but then there is on sharp rise in between. I took 2008 and 2009’s estimate numbers as well.
2009e: 4.10 ==>2 14%
2008e: 3.61 ==> 2 34%
2007: 2.68 ==> 2 23%
2006: 2.18 ==> 2 165%
2005: 0.82 ==> (-18%)
2004: 1.15==> 15%
2004: 0.83

* Dividend on earning = 0.32c for 3.23$ EPS so it will be 9.9% of EPS. http://finance.yahoo.com/q?s=hpq


So using TMV (Time Value of Money/ http://www.zenwealth.com/BusinessFinanceOnline/TVM/TVMCalculator.html) at current rate the 5Y earning will be 10.43$ (using 38.83% growth rate it would be 15.11$ )
At 10.43$ EPS the 9.9% dividend would be 1.033$. So total Earning at 5Y = 10.43+1.033=11.463$.

So at current P/E rate, using TVM after 5Y the price would be = (P/EPS) * (EPS) = 9.92 * 11.463 = 113.71$. So if this assumptions/stat holds true then to get 113.71$ with 15% growth the fair value should be 56.53$. The current price of 40.73 is below this number so HPQ could be attractive business to own with 15% gain expectations.

Remember, here I used only one (EPS) of the many yardsticks to measure the fair value. If any of this number changes our outcome would change. When I will get some free time I will try to automate this computation using excel sheet.

Book4: Warren's 15% rule.

Reference: "How to pick stocks like Warren Buffett" chapter-12.

Warren is interested only in those stocks where he expects 15% or above return in long (say 10Y) period. This is how he isolates the attractive equities....

For instance if you are looking for IBM stock on 8/1/2008 then you would need following information.

• What is the avg P/E ratio ? Let's say it is=15.11
• What is the Earning ? Let's say it is = $8.11
• What is the Earning growth rate ? Let's say it is: 11.21% (reference).
• What is the price today (8/01/2008) ? Let's say it is: $128.00
• What is the dividend (if any) rate ? Let's say for IBM it is 25% of the Earning.

So at this rate, in next 10Y the earning will grow to (using TVM formula) $23.47/year. That makes dividend=$5.87. So total earning = 23.47 + 5.87 = $29.34.

So at current P/E rate the price of the IBM stock will be = (P/E) * (Earning) = 15.11 * 29.34 = $443.29.

On the other hand, for stock to return 15% return on your investment of $128, we need to have (using TVM formula) $ 517.83. So, we have a big gap between what is expected ($517.83) and what can be achieved ($443.29).

If we are going to get $443.29 price after 10Y then to get 15% return the expected price should be: $109.57 (on 8/1/2008). This value will compensate investor from inflation, tax, commission and risk-free return.

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Let's take the example of AXP (American Express)...

• 8/1/2008 price: $36.73
• P/E = 12.17
• Earning = $3.02
• Earning growth rate = 12.5%
• Dividend = ~24%

So, after 10Y earning = $9.80 and 10Y dividend=$2.35. Total E=9.80+2.35=$12.15.
So, at current P/E rate, after 10Y the price would be = (P/E) * E = 12.17 * 12.15 = $147.87

Now, at the current price and 15% expected return the 10Y price should be=$148.59. Ideally speaking, to get 15% return today the AXP should be priced at $36.7292, almost what is it right now. Assuming that all above assumptions hold true any price below $36.73 will be attractive to get 15% return.

However, financial market is going through some tough time so probably this price might not compensate for any upward risk in credit market.

There will be more blogs on the topics related to Warren's investment philosophy. So keeping watching.

Origins of the (.Com and Telecom) Crash

After a long pause I am writing another blog. Last week I happen to borrow another book of Roger Lowenstein-- Origins of the Crash (ISBN:159420-003-3) where he talked about the .com and telecommunication bubble, and its bust.

Just the way I anticipated , Roger has explained the factors those eventually manifested in another financial crash of the 20^th century. As the publisher put it very well “Lowenstein explains that it is the boom that needs to be explained; the crash is simply the natural consequence.”

Roger sited reasons, going back in 20 years (in ‘80s) where LBOs created pressure on mgmt to keep their stock prices up to hid any takeover attempt by LBOs. The stock options were unreasonably used as an incentive to CEO, CFO and board members to increase the so called stockholder value. This lead to myopic view of mgmt as well as WallStreet, and all the actions were driven to increase the stock value in short run. Free hand from Govt. regulators, company board and auditors allowed various kind of accounting manipulation to flourish. Company’s mgmt, who has the obligation of long term valuation of the company were busy promoting short term value of the stock. Company executives were awarded huge compensations which were independent of company’s performance.

There was irrational euphoria about every company’s valuation irrespective of their revenue and profit potential. There were earning manipulation using SPV (Special Purpose Vehicles), special accounting methods and various derivatives. The quarterly and yearly financial statement become irrelevant, and even security analyst failed to use their critical thinking to flag the alarm. Overall market failed the “efficient value hypotheses”. Market left with redundant products (in the energy, telecommunication, internet) wit over capacity.

None of the govt/regulator bodies – SEC, Fed, Congress, Board of Directors played needed role to flag the alarm signal, and eventually when they did it was too late to fix anything. As a result small investors and employees lost billions and trillions of dollars, however, company executives made hefty money from there stocks options as well as severance package. General market (once again) lost the faith in the equity market. Though congress came up with Sarbanes-Oxley legislation to make executives and auditors accountable for their actions, huge damage was already done. The US accounting standards were manipulated to a great extend.

It seems as long as there will be greed (which is generally not good) there will be market manipulation. The most recent housing bubble bust and financial firm’s credit trouble suppose that. Over use of SPV (Special Purpose Vehicles) and complex derivatives had let window open for fraud.

Overall Roger made an interesting account of .Com and telecom bubble and bust. Just like his other book on "Buffett", even in this book I had to skip few sentences where I couldn't make great sense; but probably I might be missing some context there. I would give 4-stars to this book.

Table of Contents

	Acknowledgments	ix
1	Origins of a Culture	1
2	Early Nineties--A Culture Is Rich	15
3	Enlightenment Gets out of Hand	35
4	Number Games	55
5	Doormen at Noon	79
6	New Economy, Old Errors	101
7	Enron	127
8	Bankrupt	157
9	Year of the Locusts	189
10	Epilogue	217
	Notes	227
	Index	259

Complete Money & Investing Guidebook

While scanning investment books' stack at my local library, I came across :- "The Wall Street Journal Complete Money & Investing Guidebook" by Dave Kansas. ISBN-13: 9780307236999

The book promises to provide education on basic jargons used in investment field. It is like a '101' for all the investment vehicles in the market right now. I guess, this book has faired very well on its stated objectives. Also, book, being part of the "The Wall Street Journal" series, has lived up to the credit. Dave Kansas delivered non-biased picture of the investment market.

You can find table-of-contents at Barnes & Noble's web-page. One of the useful information is "suggested reading" list after each chapter. For handy reference, here are the sub-topics Mr. Kansas has touched upon...


STOCKS

• Two types of markets: NYSE, NASDAQ, ECN
• Indexes and how they are calculated
• Dow Jones industrials through the years
• Growth, Value and other kinds of stocks
• Bulls and Bears
• Going public (Standard IPO, Dutch-Auction IPO)
• Stock splits, buybacks and dividends
• Stock options
• Insider trading
• International Markets

Suggested Reading:
* Origins of the Crash by Roger Lowenstein
* Reminiscences of a stock operator by Edwin Lefevre
* The Number by Alex Berenson.
* Wall Street Meat by Andy Kessler

MAIN STREET

• Evaluating stocks
• Earnings
• Buying and selling stocks
• Trading online
• Short selling
• Investment clubs
• Margin
• Warren Buffett and Berkshire Hathaway
• Stock strategies
  
• Fundamental investing
• Technical and chart-based investing
  

Suggested Reading:
*Barron's guide to making investment decisions by John Prestbo and Doug Sease @
* Bull ! by Maggie Mahar
* A random Walk down Wall Street by Burton Malkiel
* Wall Street: How it works and for whom by Doug Henwood

BONDS

• The history of bonds
• Treasury bonds
• Municipal bonds
• The rating agencies: Moody's investor service; standard & Poor's.
• Bond laddering
• Agency debt. Freddie Mac, Fannie Mae etc. govt backed debts
  
• Corporate bonds
• Junk bonds
• Convertible and other types of bonds

Suggested Reading:
* The bond Bible by Marilyn Cohen
* Bill Gross on investing by William H. Gross @

WALL STREET

• Securities firms
• Brokerage
• Trading
• Research
• Research Analyst's ratings (WSJ's best on the Street guide to analysts; www.starmine.com; www.investars.com)
• Investment banking
  
• Underwriting
• Merger & Acquisitions
• Asset management
• Prime Brokerage
• Risk managers and compliance
• Wall Street's police
• SEC
• Self-regulatory organizations
• State regulators
• Other regulators
• Investor advocacy groups: CFA, aaii.com, ici.org, nasd.com.
  

Suggested Reading:
* The house of Morgan: An American banking dynasty and the rise of American finance by Ron Chernow @
* Liar's Poker: Rising through the wreckage on Wall Street by Michael Lewis
* Den of thieves by James Stewart
* The great game: The emergence of Wall Street as world power by John Steele Gordon


ECONOMICS AND MONEY

• Business cycle
• Investors and the economy
• Government data
• Jobs data
• Inflation Measures: CPI
• Retail sales
  
• Gross Domestic Product (GDP)
• The Federal Reserve
• The money supply
• Fiscal policy
• Money
• U.S.Money
• The rise of electronic money
• Bank accounts
• Trading money

Suggested Reading:
* The worldly philosophers: The lives, times and ideas of the great economic thinkers by Robert L. Heilbroner
* Basic Economics: A citizen's guide by Thomas Sowell
* Wealth of Nations by Adam Smith @
* The communist manifesto by Karl Marx
* The general theory of employment, interest and money by John Maynard @
* Maestro: Alan Greenspan and the American economy by Bob Woodward


MUTUAL FUNDS

• Stock mutual funds
• Index funds
• Growth funds
• Value funds
• Income funds
• Small-cap, large-cap, midcap
• Bond funds
• Balanced funds
• Money market funds
• Going overseas
• Other funds
• Investing in a fund
• Evaluating a mutual fund
• The rise of ETF (Exchange Traded Funds)
• Closed-end funds

Suggested Reading:
* Common sense on mutual funds by John C. Bogle @
* How mutual funds work by Albert J. Fredman @
* The intelligent asset allocator by William J. Bernstein
* Morning Star ; Smart Money


RETIREMENT INVESTING

• 401(K)
• Catch-up contributions
• Borrowing from your 401(K)
• IRAs and other retirement accounts
• Other retirement accounts
• Red flags
• Investment strategies
• Withdrawing money
• Social security
  

PRIVATE MONEY

• Some hedge fund history
• Venture capital
• Private equity

Suggested Reading:
* When genius failed by Roger Lowenstein @
* Barbarian at the gate by Bryan Burrough and John Helyar @
* The nudist on the late shift by Po Bronson


OPTIONS, FUTURES AND NONTRADITIONAL INVESTMENTS

• Futures
• Options
• Puts and Calls
• Other kinds of options
• Long-term options
• Index options
• Future options
• Nontraditional investments
• Collectibles
• Art
• Coins and stamps
• Miscellany

REAL-ESTATE INVESTING

• Our homes
• Second homes
• Income properties
• REITs (Real Estate Investment Trusts)
  

Suggested Reading:
* The McGraw-Hill 36-hour real estate investment course by Jack Cummings
* What no one ever tell you about investing in real estate by Robert J. Hill