A merger takes place when two companies decide to combine into a single entity. An acquisition involves one company essentially taking over another company. While the motivations may differ, the essential feature of both mergers and acquisitions involves one firm emerging where once there existed two firms. Another term frequently employed within discussions on this topic is takeover. Essentially, the difference rests in the attitude of the incumbent management of firms that are targeted. A so-called friendly takeover is often a euphemism for a merger. A hostile takeover refers to unwanted advances by outsiders. Thus, the reaction of management to the overtures from another firm tends to be the main influence on whether the resulting activities are labeled friendly or hostile.
MOTIVATIONS FOR MERGERS
AND ACQUISITIONS
There are a number of possible motivations that may result in a merger or acquisition. One of the most oft cited reasons is to achieve economies of scale. Economies of scale may be defined as a lowering of the average cost to produce one unit due to an increase in the total amount of production. The idea is that the larger firm resulting from the merger can produce more cheaply than the previously separate firms. Efficiency is the key to achieving economies of scale, through the sharing of resources and technology and the elimination of needless duplication and waste. Economies of scale sounds good as a rationale for merger, but there are many examples to show that combining separate entities into a single, more efficient operation is not easy to accomplish in practice.
A similar idea is economies of vertical integration. This involves acquiring firms through which the parent firm currently conducts normal business operations, such as suppliers and distributors. By combining different elements involved in the production and delivery of the product to the market, acquiring firms gain control over raw materials and distribution out-lets. This may result in centralized decisions and better communications and coordination among the various business units. It may also result in competitive advantages over rival firms that must negotiate with and rely on outside firms for inputs and sales of the product.
A related idea to economies of vertical integration is a merger or acquisition to achieve greater market presence or market share. The combined, larger entity may have competitive advantages such as the ability to buy bulk quantities at discounts, the ability to store and inventory needed production inputs, and the ability to achieve mass distribution through sheer negotiating power. Greater market share also may result in advantageous pricing, since larger firms are able to compete effectively through volume sales with thinner profit margins. This type of merger or acquisition often results in the combining of complementary resources, such as a firm that is very good at distribution and marketing merging with a very efficient producer. The shared talents of the combined firm may mean competitive advantages versus other, smaller competition.
The ideas above refer to reasons for mergers or acquisitions among firms in similar industries. There are several additional motivations for firms that may not necessarily be in similar lines of business. One of the often-cited motivations for acquisitions involves excess cash balances. Suppose a firm is in a mature industry, and has little opportunities for future investment beyond the existing business lines. If profitable, the firm may acquire large cash balances as managers seek to find outlets for new investment opportunities. One obvious outlet to acquire other firms. The ostensible reason for using excess cash to acquire firms in different product markets is diversification of business risk. Management may claim that by acquiring firms in unrelated businesses the total risk associated with the firm's operations declines. However, it is not always clear for whom the primary benefits of such activities accrue. A shareholder in a publicly traded firm who wishes to diversify business risk can always do so by investing in other companies shares. The investor does not have to rely on incumbent management to achieve the diversification goal. On the other hand, a less risky business strategy is likely to result in less uncertainty in future business performance, and stability makes management look good. The agency problem resulting from incongruent incentives on the part of management and shareholders is always an issue in public corporations. But, regardless of the motivation, excess cash is a primary motivation for corporate acquisition activity.
To reverse the perspective, an excess of cash is also one of the main reasons why firms become the targets of takeover attempts. Large cash balances make for attractive potential assets; indeed, it is often implied that a firm which very large amount of cash is not being efficiently managed. Obviously, that conclusion is situation specific, but what is clear is that cash is attractive, and the greater the amount of cash the greater the potential to attract attention. Thus, the presence of excess cash balances in either acquiring or target firms is often a primary motivating influence in subsequent merger or takeover activity.
Another feature that makes firms attractive as potential merger partners is the presence of unused tax shields. The corporate tax code allows for loss carry-forwards; if a firm loses money in one year, the loss can be carried forward to offset earned income in subsequent years. A firm that continues to lose money, however, has no use for the loss carry-forwards. However, if the firm is acquired by another firm that is profitable, the tax shields from the acquired may be used to shelter income generated by the acquiring firm. Thus the presence of unused tax shields may enhance the attractiveness of a firm as a potential acquisition target.
A similar idea is the notion that the combined firm from a merger will have lower absolute financing costs. Suppose two firms, X and Y, have each issued bonds as a normal part of the financing activities. If the two firms combine, the cash flows from the activities of X can be used to service the debt of Y, and vice versa. Therefore, with less default risk the cost of new debt financing for the combined firm should be lower. It may be argued that there is no net gain to the combined firm; since shareholders have to guarantee debt service on the combined debt, the savings on the cost of debt financing may be offset by the increased return demanded by equity holders. Nevertheless, lower financing costs are often cited as rationale for merger activity.
One rather dubious motivation for merger activity is to artificially boost earnings per share. Consider two firms, A and B. Firm A has earnings of $1,000, 100 shares outstanding, and thus $10 earnings per share. With a price-earnings ratio of 20, its shares are worth $200. Firm B also has earnings of $1,000, 100 shares outstanding, but due to poorer growth opportunities its shares trade at 10 times earnings, or $100. If A acquires B, it will only take one-half share of A for each share of B purchased, so the combined firm will have 150 total shares outstanding. Combined earnings will be $2,000, so the new earnings per share of the combined firm are $13.33 per share. It appears that the merger has enhanced earnings per share, when in fact the result is due to inconsistency in the rate of increase of earnings and shares outstanding. Such manipulations were common in the 1960s, but investors have learned to be more wary of mergers instigated mainly to manipulate per share earnings. It is questionable whether such activity will continue to fool a majority of investors.
Finally, there is the ever-present hubris hypothesis concerning corporate takeover activity. The main idea is that the target firm is being run inefficiently, and the management of acquiring firm should certainly be able to do a better job of utilizing the target's assets and strategic business opportunities. In addition, there is additional prestige in managing a larger firm, which may include additional perquisites such as club memberships or access to amenities such as corporate jets or travel to distant business locales. These factors cannot be ignored in detailing the set of factors motivating merger and acquisition activity.
TYPES OF TAKEOVER DEFENSES
As the previous section suggests, some merger activity is unsolicited and not desired on the part of the target firm. Often, the management of the target firm will be replaced or let go as the acquiring firm's management steps in to make their own mark and implement their plans for the new, combined entity. In reaction to hostile takeover attempts, a number of defense mechanisms have been devised and used to try and thwart unwanted advances.
To any offer for the firm's shares, several actions may be taken which make it difficult or unattractive to subsequently pursue a takeover attempt. One such action is the creation of a staggered board of directors. If an outside firm can gain a controlling interest on the board of directors of the target, it will be able to influence the decisions of the board. Control of the board often results in de facto control of the company. To avoid an outside firm attempting to put forward an entire slate of their own people for election to the target firm's board, some firms have staggered the terms of the directors. The result is that only a portion of the seats is open annually, preventing an immediate takeover attempt. If a rival does get one of its own elected, they will be in a minority and the target firm's management has the time to decide how to proceed and react to the takeover threat.
Another defense mechanism is to have the board pass an amendment requiring a certain number of shares needed to vote to approve any merger proposal. This is referred to as a supermajority, since the requirement is usually set much higher than a simple majority vote total. A supermajority amendment puts in place a high hurdle for potential acquirers to clear if they wish to pursue the acquisition.
A third defensive mechanism is a fair price amendment. Such an amendment restricts the firm from merging with any shareholders holding more than some set percentage of the outstanding shares, unless some formula-determined price per share is paid. The formula price is typically prohibitively high, so that a takeover can take place only in the effect of a huge premium payment for outstanding shares. If the formula price is met, managers with shares and stockholders receive a significant premium over fair market value to compensate them for the acquisition.
Finally, another preemptive strike on the part of existing management is a poison pill provision. A poison pill gives existing shareholders rights that may be used to purchase outstanding shares of the firms stock in the event of a takeover attempt. The purchase price using the poison pill is a significant discount from fair market value, giving shareholders strong incentives to gobble up outstanding shares, and thus preventing an outside firm from purchasing enough stock on the open market to obtain a controlling interest in the target.
Once a takeover attempt has been identified as underway, incumbent management can initiate measures designed to thwart the acquirer. One such measure is a dual-class recapitalization; whereby a new class of equity securities is issued which contains superior voting rights to previously outstanding shares. The superior voting rights allow the target firm's management to effectively have voting control, even without a majority of actual shares in hand. With voting control, they can effectively decline unsolicited attempts by outsiders to acquire the firm.
Another reaction to undesired advances is an asset restructuring. Here, the target firm initiates the sale or disposal of the assets that are of primary interest to the acquiring firm. By selling desirable assets, the firm becomes less attractive to outside bidders, often resulting in an end to the acquisition activity. On the other side of the balance sheet, the firm can solicit help from a third party, friendly firm. Such a firm is commonly referred to as a "white knight," the implication being that the knight comes to the rescue of the targeted firm. A white knight may be issued a new set of equity securities such as preferred stock with voting rights, or may instead agree to purchase a set number of existing common shares at a premium price. The white knight is, of course, supportive of incumbent management; so by purchasing a controlling interest in the firm unwanted takeovers are effectively avoided.
One of the most prominent takeover activities associated with liability restructuring involves the issuance of junk bonds. "Junk" is used to describe debt with high default risk, and thus junk bonds carry very high coupon yields to compensate investors for the high risk involved. During the 1980s, the investment-banking firm Drexel Burnham Lambert led by Michael Milken pioneered the development of the junk-bond market as a vehicle for financing corporate takeover activity. Acquisition groups, which often included the incumbent management group, issued junk bonds backed by the firm's assets to raise the capital needed to acquire a controlling interest in the firm's equity shares. In effect, the firm's balance sheet was restructured with debt replacing equity financing. In several instances, once the acquisition was successfully completed the acquiring management subsequently sold off portions of the firm's assets or business divisions at large premiums, using the proceeds to retire some or all of the junk bonds. The takeover of RJR Nabisco by the firm Kohlberg Kravis Roberts & Co. in the late 1980s was one of the most celebrated takeovers involving the use of junk-bond financing.
VALUING A POTENTIAL MERGER
There are several alternative methods that may be used to value a firm targeted for merger or acquisition. One method involves discounted cash flow analysis. First, the present value of the equity of the target firm must be established. Next, the present value of the expected synergies from the merger, in the form of cost savings or increased after-tax earnings, should be evaluated. Finally, summing the present value of the existing equity with the present value of the future synergies results in a present valuation of the target firm.
Another method involves valuation as an expected earnings multiple. First, the expected earnings in the first year of operations for the combined or merged firm should be estimated. Next, an appropriate price-earnings multiple must be determined. This figure will likely come from industry standards or from competitors in similar business lines. Now, the PE ratio can be multiplied by the expected combined earnings per share to estimate an expected price per share of the merged firm's common stock. Multiplying the expected share price by the number of shares outstanding gives a valuation of the expected firm value. Actual acquisition price can then be negotiated based on this expected firm valuation.
Another technique that is sometimes employed is valuation in relation to book value, which is the difference between the net assets and the outstanding liabilities of the firm. A related idea is valuation as a function of liquidation, or breakup, value. Breakup value can be defined as the difference between the market value of the firm's assets and the cost to retire all outstanding liabilities. The difference between book value and liquidation value is that the book value of assets, taken from the firm's balance sheet, are carried at historical cost. Liquidation value involves the current, or market, value of the firm's assets
Some valuations, particularly for individual business units or divisions, are based on replacement cost. This is the estimated cost of duplicating or purchasing the assets of the division at current market prices. Obviously, some premium is usually applied to account for the value of having existing and established business in place.
Finally, in the instances where firms that have publicly traded common stock are targeted, the market value of the stock is used as a starting point in acquisition negotiations. Earlier, a number of takeover defense activities were outlined that incumbent management may employ to restrict or reject unsolicited takeover bids. These types of defenses are not always in the best interests of existing shareholders. If the firm's existing managers take seriously the corporate goal of maximizing shareholder wealth, then a bidding war for the firm's stock often results in huge premiums for existing shareholders. It is not always clear that the shareholders interests are primary, since many of the takeover defenses prevent the use of the market value of the firm's common stock as a starting point for takeover negotiations. It is difficult to imagine the shareholder who is not happy about being offered a premium of 20 percent or more over the current market value of the outstanding shares.
CURRENT TRENDS IN MERGERS
AND ACQUISITIONS
Mergers and Acquisitions were at an all-time high from the late 1990s to 2000. They have slowed down since then—a direct result of the economic slowdown. The reason is simple, companies did not have the cash to buy other companies. In 2005, however, we are seeing a robust economy and corporate profits, which means that businesses have cash. This cash is being used to buy companies—mergers and acquisitions. The end of 2004 saw several deals: Sprint is combining with Nextel, K-Mart Holding Corp is buying Sears, Roebuck & Co., Johnson & Johnson is planning to buy Guidant. These big corporation deals are spurring on an environment triggering more acquisitions. The telecom industry, the banking industry, and the software industry are potential areas for big mergers.
Read more:
http://www.referenceforbusiness.com/management/Mar-No/Mergers-and-Acquisitions.html#ixzz0WmWdCjTV
http://www.referenceforbusiness.com/management/Mar-No/Mergers-and-Acquisitions.html
Saturday 14 November 2009
Why private companies tend to be valued lower than public firms
Valuation of Private vs. Public Firms
Why private companies tend to be valued lower than public firms
By Loraine MacDonald | July 03, 2001
Q: Why are public companies in my industry valued so highly, often times at price/earnings multiples of more than 20, when a recent valuation of my privately held business says I'm worth only four to five times my earnings?
A: There are a number of factors that are considered differently in the valuation of privately held vs. public companies-even those that are in the same industry-making a direct comparison for valuation purposes difficult. In some cases, it's like comparing apples to oranges. Following is a list of some of the issues that may result in differences between the valuations of public and private firms:
1. Market liquidity. A lack of market liquidity is usually the biggest factor contributing to a discount in the value of companies. With public companies, you can, if you choose, switch your investment to the stock of a different public company on a daily (if not more frequent) basis. The stock of privately held firms, however, is more difficult to sell quickly, making the value drop accordingly.
2. Profit measurement. While private companies seek mostly to minimize taxes, public companies seek to maximize earnings for shareholder reporting purposes. Therefore, the profitability of a private firm may require restatement in order for it to be directly comparable to that of a public firm. In addition, public-company multiples are generally calculated from net income (after taxes), while private-company multiples are often based on pre-tax (and many times, pre-debt) income. This discrepancy can result in an inaccurate formula for the valuation of a private company.
3. Capitalization/capital structure. Public companies within a specific industry generally maintain capital structures (debt/equity mixes) that are fairly similar. That means the relative price/earnings ratios (where earnings include the servicing of debt) are usually comparable. Private companies within the same industry, however, can vary widely in capital structure. The valuation of a privately held business is therefore frequently based on "enterprise value," or the pre-debt value of a business rather than the value of the stock of the business, like public companies. This is another reason why private-company multiples are generally based on pre-tax profits and may not be directly comparable to the price/earnings ratio of public firms.
4. Risk profile. Public companies usually provide an assurance of continuing operations above that of smaller, privately held firms. Downturns in the economy or a change in the environment (such as an increase in competition or regulatory changes) often have a greater impact on private firms than public firms in terms of performance and market positioning. That higher risk may result in a discount in value for private firms.
5. Differences in operations. It is often difficult to find a public company operating in the same niches as private firms. Public companies typically have operations spanning a broader range of products and services than do private companies. In addition, even if the products and services are the same, the revenue mix is often different.
6. Operational control. Although private companies are more likely to receive valuation discounts than public companies, there is at least one area where they may receive a value premium. While the sale of a private company usually results in the purchase of the controlling interest in the business, ownership of public-company stock generally consists of a minority-share ownership-which may be construed to be less valuable than a controlling-interest position.
Given all these examples, you can see how the valuation of private companies is complex and often cannot be determined through the direct application of public company price/earnings ratios. Due to the complexities involved, I'd advise you to find yourself a professional well-versed in private-company valuations to help you with this task.
Loraine MacDonald is director of advisory services at USBX, an investment banking firm specializing in the mergers and acquisitions of small to midsized businesses. She has been involved in the valuation and sale of privately-held businesses for over ten years.
http://www.entrepreneur.com/growyourbusiness/sellingyourbusiness/article41972.html
Why private companies tend to be valued lower than public firms
By Loraine MacDonald | July 03, 2001
Q: Why are public companies in my industry valued so highly, often times at price/earnings multiples of more than 20, when a recent valuation of my privately held business says I'm worth only four to five times my earnings?
A: There are a number of factors that are considered differently in the valuation of privately held vs. public companies-even those that are in the same industry-making a direct comparison for valuation purposes difficult. In some cases, it's like comparing apples to oranges. Following is a list of some of the issues that may result in differences between the valuations of public and private firms:
1. Market liquidity. A lack of market liquidity is usually the biggest factor contributing to a discount in the value of companies. With public companies, you can, if you choose, switch your investment to the stock of a different public company on a daily (if not more frequent) basis. The stock of privately held firms, however, is more difficult to sell quickly, making the value drop accordingly.
2. Profit measurement. While private companies seek mostly to minimize taxes, public companies seek to maximize earnings for shareholder reporting purposes. Therefore, the profitability of a private firm may require restatement in order for it to be directly comparable to that of a public firm. In addition, public-company multiples are generally calculated from net income (after taxes), while private-company multiples are often based on pre-tax (and many times, pre-debt) income. This discrepancy can result in an inaccurate formula for the valuation of a private company.
3. Capitalization/capital structure. Public companies within a specific industry generally maintain capital structures (debt/equity mixes) that are fairly similar. That means the relative price/earnings ratios (where earnings include the servicing of debt) are usually comparable. Private companies within the same industry, however, can vary widely in capital structure. The valuation of a privately held business is therefore frequently based on "enterprise value," or the pre-debt value of a business rather than the value of the stock of the business, like public companies. This is another reason why private-company multiples are generally based on pre-tax profits and may not be directly comparable to the price/earnings ratio of public firms.
4. Risk profile. Public companies usually provide an assurance of continuing operations above that of smaller, privately held firms. Downturns in the economy or a change in the environment (such as an increase in competition or regulatory changes) often have a greater impact on private firms than public firms in terms of performance and market positioning. That higher risk may result in a discount in value for private firms.
5. Differences in operations. It is often difficult to find a public company operating in the same niches as private firms. Public companies typically have operations spanning a broader range of products and services than do private companies. In addition, even if the products and services are the same, the revenue mix is often different.
6. Operational control. Although private companies are more likely to receive valuation discounts than public companies, there is at least one area where they may receive a value premium. While the sale of a private company usually results in the purchase of the controlling interest in the business, ownership of public-company stock generally consists of a minority-share ownership-which may be construed to be less valuable than a controlling-interest position.
Given all these examples, you can see how the valuation of private companies is complex and often cannot be determined through the direct application of public company price/earnings ratios. Due to the complexities involved, I'd advise you to find yourself a professional well-versed in private-company valuations to help you with this task.
Loraine MacDonald is director of advisory services at USBX, an investment banking firm specializing in the mergers and acquisitions of small to midsized businesses. She has been involved in the valuation and sale of privately-held businesses for over ten years.
http://www.entrepreneur.com/growyourbusiness/sellingyourbusiness/article41972.html
Earnings multiplier of 2 equals 50% ROI.
What Is The Multiplier?
At times when I use the term “multiplier” or “multiple” as a business broker, many business owners screw up their faces and go “What?”. So I thought I might explain it here for your benefit.
The multiplier is the number of years it takes to recoup an investment in a business, based on the value of money today. For example, if I bought a business at $350,000 and EBIT (earnings before interest & tax) is $100,000 a year, then the multiplier for that business is the purchase price of the business divided by EBIT, which is 350K / 100K = 3.5x.
If we raise the profit to $150,000 a year, then the multiplier lowers to about 2.3x.
So a rule of thumb is – the smaller the multiplier, the more money it makes (and vice versa). But always keep in mind… if a business makes more money in a shorter amount of time, there’s probably a higher level of risk involved as well.
It’s Not All About Earnings!
However, the word “multiplier” need not only apply to earnings. It can also apply to sales, or to put another way, a business can be roughly appraised on its weekly or annual turnover. As an example, convenience stores are generally appraised on their weekly sales. So if a store does $15,000 a week, you might obtain a very rough indication of its value by multiplying it by 10 – the industry average in Queensland, Australia (as of October 2009). So an indicative price of the business might be $150,000.
So whenever you hear the word ‘multiplier’, you should clarify whether they’re talking about earnings or sales.
How About ROI or P/E?
You can also convert the earnings multiplier into a ROI (return on investment) figure by calculating 1 divided by the multiplier. So if you have an earnings multiplier of 2, 1 divided by 2 equals 50% ROI.
And also for all you share investors out there, the earnings multiplier is exactly the same as the P/E ratio (price earnings ratio).
http://www.businessforsaleblog.com.au/what-is-the-multiplier/
At times when I use the term “multiplier” or “multiple” as a business broker, many business owners screw up their faces and go “What?”. So I thought I might explain it here for your benefit.
The multiplier is the number of years it takes to recoup an investment in a business, based on the value of money today. For example, if I bought a business at $350,000 and EBIT (earnings before interest & tax) is $100,000 a year, then the multiplier for that business is the purchase price of the business divided by EBIT, which is 350K / 100K = 3.5x.
If we raise the profit to $150,000 a year, then the multiplier lowers to about 2.3x.
So a rule of thumb is – the smaller the multiplier, the more money it makes (and vice versa). But always keep in mind… if a business makes more money in a shorter amount of time, there’s probably a higher level of risk involved as well.
It’s Not All About Earnings!
However, the word “multiplier” need not only apply to earnings. It can also apply to sales, or to put another way, a business can be roughly appraised on its weekly or annual turnover. As an example, convenience stores are generally appraised on their weekly sales. So if a store does $15,000 a week, you might obtain a very rough indication of its value by multiplying it by 10 – the industry average in Queensland, Australia (as of October 2009). So an indicative price of the business might be $150,000.
So whenever you hear the word ‘multiplier’, you should clarify whether they’re talking about earnings or sales.
How About ROI or P/E?
You can also convert the earnings multiplier into a ROI (return on investment) figure by calculating 1 divided by the multiplier. So if you have an earnings multiplier of 2, 1 divided by 2 equals 50% ROI.
And also for all you share investors out there, the earnings multiplier is exactly the same as the P/E ratio (price earnings ratio).
http://www.businessforsaleblog.com.au/what-is-the-multiplier/
Friday 13 November 2009
The goal is to make good returns over the long-term.
Making Money In The Stock Market - Demystified
posted December 9, 2008 - 1:36am
The key to making money in the stock market is to earn a high-level finance degree, or listen to those on TV who already have one… right?
Of course not. You don’t need a financial degree to make good money in the stock market. Neither do you need to listen to the so called “gurus” on TV, in fact you would be better off ignoring what the gurus are saying. All you need to make money in the stock market is a little knowledge, and a check on your emotions. The toughest enemy that investors face is their own emotions. Let me throw out an example:
John Q. Investor watches a stock market expert on TV and hears, “Sales of XYZ software company has tripled over the last six months and the stock price has skyrocketed to its 52-week high. The company is expected to increase revenue another 25% in the next year. There looks to be a lot more upside for this company.” This news sounds great! So a very excited John Q. Investor calls up his stock broker, or logs into his online brokerage account the next day, and buys 100 shares of XYZ company at $50.00 per share. Confident that making a lot of money on this stock is a sure thing (after all, a financial guru is pushing it) John Q. prepares to watch the stock price soar. Maybe this is the stock that will enable an early retirement! Two weeks later, some bad news is revealed. A fortune 100 company installed the latest version of XYZ’s software, only to discover a security glitch that exposed top secret product design drawings on their website. Immediately, XYZ’s stock price plummets to $30.00 per share. John Q. is very concerned when he sees his $5,000 investment drop to $3,000 over night. The next day doesn’t help the stock at all and it drops another $10 per share. John Q. Investor is strapped with fear as he sees that his $5,000 investment is now only worth $2,000 and still dropping quickly. He panics, and by the time he can sell all 100 shares it has dropped to $15 per share. So his “sure thing” $5,000 investment lost him $3,500 in two weeks. John Q. is determined that he has no business investing in the stock market and pledges to never invest in the market again.
The scenario above is quite common… especially with the recent problems in the economy. People have just gotten hammered by this current market! But here is the problem with the above scenario. What prompted John Q. Investor to purchase stock in XYZ company? He heard a supposed expert saying that the stock was soaring higher and higher… a sure thing, and he got “greedy” and bought the stock. Greed is an emotion that needs to be kept in check. Something that is overlooked by many people trying to make money in the stock market, is that making money is only half of the equation. The other half of the equation is the possible down-side risk of a stock. This stock was up at its 52-week high… its most expensive price. If you look at buying stocks the same way you would look at buying a car, or a washing machine you would make wiser decisions in your stock picking. Let me explain what I mean. If you are in the market for a new washing machine, do you go buy it at the most expensive price that you can find? Of course not. You may call or visit different stores, or go online looking for the “best price” that you can find for that particular washing machine. Stocks should be bought the same way. You buy them, ideally, at the lowest possible price. This reduces the “down-side” part of that equation. You don’t buy a stock at, or even near, its 52-week high… the down-side risk is too high. When you buy stocks, you look for companies that are financially strong; with history of good growth, good revenue, little to no debt, nice profit margins, and a low profit/earnings ratio for its industry. The lower the profit/earnings ratio (Profits divided by Earnings), the least expensive that stock is. If you are comparing two consumer goods companies with comparable revenue and debt, but company A has a P/E of 16 and company B has a P/E of 11. Company B has less down-side potential (less risk) than company A. Company B is less expensive than company A… even if company B’s stock price is higher than company A’s.
So when you are looking to invest your hard-earned money into the stock market, don’t be frightened away by recent price fluctuations or even by the current economy. Study the financials of strong businesses; compare companies within the same industries and choose the ones with the strongest financials, and the least amount of down-side potential and put your money on those companies… then don’t worry about short-term price fluctuations. The goal is to make good returns over the long-term. This investing style is what is known as “value investing”, and it has been proven the most successful style of investing since its inception in the 1930’s.
http://www.xomba.com/making_money_stock_market_demystified
posted December 9, 2008 - 1:36am
The key to making money in the stock market is to earn a high-level finance degree, or listen to those on TV who already have one… right?
Of course not. You don’t need a financial degree to make good money in the stock market. Neither do you need to listen to the so called “gurus” on TV, in fact you would be better off ignoring what the gurus are saying. All you need to make money in the stock market is a little knowledge, and a check on your emotions. The toughest enemy that investors face is their own emotions. Let me throw out an example:
John Q. Investor watches a stock market expert on TV and hears, “Sales of XYZ software company has tripled over the last six months and the stock price has skyrocketed to its 52-week high. The company is expected to increase revenue another 25% in the next year. There looks to be a lot more upside for this company.” This news sounds great! So a very excited John Q. Investor calls up his stock broker, or logs into his online brokerage account the next day, and buys 100 shares of XYZ company at $50.00 per share. Confident that making a lot of money on this stock is a sure thing (after all, a financial guru is pushing it) John Q. prepares to watch the stock price soar. Maybe this is the stock that will enable an early retirement! Two weeks later, some bad news is revealed. A fortune 100 company installed the latest version of XYZ’s software, only to discover a security glitch that exposed top secret product design drawings on their website. Immediately, XYZ’s stock price plummets to $30.00 per share. John Q. is very concerned when he sees his $5,000 investment drop to $3,000 over night. The next day doesn’t help the stock at all and it drops another $10 per share. John Q. Investor is strapped with fear as he sees that his $5,000 investment is now only worth $2,000 and still dropping quickly. He panics, and by the time he can sell all 100 shares it has dropped to $15 per share. So his “sure thing” $5,000 investment lost him $3,500 in two weeks. John Q. is determined that he has no business investing in the stock market and pledges to never invest in the market again.
The scenario above is quite common… especially with the recent problems in the economy. People have just gotten hammered by this current market! But here is the problem with the above scenario. What prompted John Q. Investor to purchase stock in XYZ company? He heard a supposed expert saying that the stock was soaring higher and higher… a sure thing, and he got “greedy” and bought the stock. Greed is an emotion that needs to be kept in check. Something that is overlooked by many people trying to make money in the stock market, is that making money is only half of the equation. The other half of the equation is the possible down-side risk of a stock. This stock was up at its 52-week high… its most expensive price. If you look at buying stocks the same way you would look at buying a car, or a washing machine you would make wiser decisions in your stock picking. Let me explain what I mean. If you are in the market for a new washing machine, do you go buy it at the most expensive price that you can find? Of course not. You may call or visit different stores, or go online looking for the “best price” that you can find for that particular washing machine. Stocks should be bought the same way. You buy them, ideally, at the lowest possible price. This reduces the “down-side” part of that equation. You don’t buy a stock at, or even near, its 52-week high… the down-side risk is too high. When you buy stocks, you look for companies that are financially strong; with history of good growth, good revenue, little to no debt, nice profit margins, and a low profit/earnings ratio for its industry. The lower the profit/earnings ratio (Profits divided by Earnings), the least expensive that stock is. If you are comparing two consumer goods companies with comparable revenue and debt, but company A has a P/E of 16 and company B has a P/E of 11. Company B has less down-side potential (less risk) than company A. Company B is less expensive than company A… even if company B’s stock price is higher than company A’s.
So when you are looking to invest your hard-earned money into the stock market, don’t be frightened away by recent price fluctuations or even by the current economy. Study the financials of strong businesses; compare companies within the same industries and choose the ones with the strongest financials, and the least amount of down-side potential and put your money on those companies… then don’t worry about short-term price fluctuations. The goal is to make good returns over the long-term. This investing style is what is known as “value investing”, and it has been proven the most successful style of investing since its inception in the 1930’s.
http://www.xomba.com/making_money_stock_market_demystified
Combining P/E and P/Sales to determine a stock's valuation
Stock Valuation - The Price to Earnings Ratio
In my previous article, I wrote about the Price to Sales Ratio, a very valuable tool in a value investor's toolbox. I now continue the Stock Valuation series with another valuable tool - The Price to Earnings Ratio. All of the tools in this series are valuable by themselves, but when combined together, they make the task of stock picking methodical and very profitable.
The Price to Earnings Ratio is also known as the Earnings Multiple or Price Multiple. Most people refer to the ratio simply as the "P/E".
The formula for calculating the P/E is simple: P/E Ratio = Share Price / Earnings per Share
For example, if a stock is trading at $22.00 per share, and trailing earnings is $1.15 per share, the P/E ratio is 19.13 (22.00/1.15).
Typically, the lower the P/E, the more attractive the stock is to a value investor. Just like the Price to Sales Ratio, the P/E is very useful for comparing multiple companies within the same industry.
Let's compare the P/E's for two companies:
Pear Computer:
Share Price: 54.27
Earnings per share: 5.72
P/E Ratio: 54.27 / 5.72 = 9.49
Fastway Computers:
Share Price: 38.12
Earnings per share: 1.96
P/E Ratio: 38.12 / 1.96 = 19.45
As you can see, Pear Computer has a much lower P/E than Fastway Computers.
The P/E is referred to as the "multiple", because it indicates how much investors are willing to pay per dollar of earnings. If a stock is trading at a multiple (P/E) of 15, that means that an investor is willing to pay $15.00 for every $1.00 of earnings. A high P/E is a warning sign that a stock may be over bought, which means it may be "hyped up" and valued too high.
Even though the P/E is a valuable tool, it is very important that you don't base the value of a stock on its P/E alone. The reason for this is, the earnings figure is based on the honesty of the company's accounting practices and is susceptible to manipulation. You should always use the Price to Sales Ratio, that I wrote about previously, in addition to the P/E to determine a stock's valuation.
Let's add in the Price to Sales Ratio to our two stocks and see how they compare (see my previous article for the Price to Sales calculation:
Pear Computer:
P/E = 9.49
Price to Sales = 1.46
Fastway Computers:
P/E = 19.45
Price to Sales = 3.15
By comparing the ratios of these two stocks, it is clear which one has the better value. Both the P/E and the Price to Sales are more than double for Fastway compared to Pear. When it comes to picking stocks for a portfolio of value stocks, Pear Computer is the clear winner.
http://www.xomba.com/stock_valuation_price_earnings_ratio
http://www.xomba.com/stock_valuation_price_sales_ratio
In my previous article, I wrote about the Price to Sales Ratio, a very valuable tool in a value investor's toolbox. I now continue the Stock Valuation series with another valuable tool - The Price to Earnings Ratio. All of the tools in this series are valuable by themselves, but when combined together, they make the task of stock picking methodical and very profitable.
The Price to Earnings Ratio is also known as the Earnings Multiple or Price Multiple. Most people refer to the ratio simply as the "P/E".
The formula for calculating the P/E is simple: P/E Ratio = Share Price / Earnings per Share
For example, if a stock is trading at $22.00 per share, and trailing earnings is $1.15 per share, the P/E ratio is 19.13 (22.00/1.15).
Typically, the lower the P/E, the more attractive the stock is to a value investor. Just like the Price to Sales Ratio, the P/E is very useful for comparing multiple companies within the same industry.
Let's compare the P/E's for two companies:
Pear Computer:
Share Price: 54.27
Earnings per share: 5.72
P/E Ratio: 54.27 / 5.72 = 9.49
Fastway Computers:
Share Price: 38.12
Earnings per share: 1.96
P/E Ratio: 38.12 / 1.96 = 19.45
As you can see, Pear Computer has a much lower P/E than Fastway Computers.
The P/E is referred to as the "multiple", because it indicates how much investors are willing to pay per dollar of earnings. If a stock is trading at a multiple (P/E) of 15, that means that an investor is willing to pay $15.00 for every $1.00 of earnings. A high P/E is a warning sign that a stock may be over bought, which means it may be "hyped up" and valued too high.
Even though the P/E is a valuable tool, it is very important that you don't base the value of a stock on its P/E alone. The reason for this is, the earnings figure is based on the honesty of the company's accounting practices and is susceptible to manipulation. You should always use the Price to Sales Ratio, that I wrote about previously, in addition to the P/E to determine a stock's valuation.
Let's add in the Price to Sales Ratio to our two stocks and see how they compare (see my previous article for the Price to Sales calculation:
Pear Computer:
P/E = 9.49
Price to Sales = 1.46
Fastway Computers:
P/E = 19.45
Price to Sales = 3.15
By comparing the ratios of these two stocks, it is clear which one has the better value. Both the P/E and the Price to Sales are more than double for Fastway compared to Pear. When it comes to picking stocks for a portfolio of value stocks, Pear Computer is the clear winner.
http://www.xomba.com/stock_valuation_price_earnings_ratio
http://www.xomba.com/stock_valuation_price_sales_ratio
Difference in Expert Opinion on Valuation of a closely held firm
Valuation of Closely Held Firm: Difference in Expert Opinion
http://www.nafe.net/JFE/j02_1_03.pdf
The paper reviews four basic approaches to the valuation of the equity of a closely-helf firm: net asset value, discounted cash flow, earnings multiples, and captialized earnings. Financial and narrative information on an anonymous closely-held firm were evaluated by 18 valutaion experts.
Findings:
1. All respondents reported valuation methods; 15 recommended values ranging from $6.0 million to $17.5 million.
2. The dispersion of values was not consistent with our expectation of convergence of value estimates.
3. The professional training and background of the experts proved significant in the valuation methodology and estimate. The 8 experts who are investors fvoured, by 7 to 1, a non-DCF approach, such as an earnings multiple or capitalized earnings. The 10 consultants/appraisers expressed a slight preference, 6 to 4, for the DCF approach.
4. The greatest disparity between investor experts and consultants was in the recommended value of the firm. The average value recommende by the consultants was $14.7 million, almost 50 percent higher than the investors' average estimate of $9.87 million.
Conclusions:
Three implications of the study.
1. The substantial variation in valuation opinions suggests that courts cannot expect convergence of expert valuation of a firm even from a large number of experts.
2. The variation in opinion may be related to the professional training and background of the experts. Consultants, those who are not investors or risk bearers, offered significantly higher valutaion opinions than investor experts.
3. The valuation expert who are interested in economically sound valuation opinons would be well-advised to use more than one valuation approach, if circumstances permit, cross verify valuation estimates. The dispersion of values provided by the sample of experts suggests that the expert who can demonstrate the soundness of an opinion by the independent application of two or more methods is likely to have more credibility.
http://www.nafe.net/JFE/j02_1_03.pdf
The paper reviews four basic approaches to the valuation of the equity of a closely-helf firm: net asset value, discounted cash flow, earnings multiples, and captialized earnings. Financial and narrative information on an anonymous closely-held firm were evaluated by 18 valutaion experts.
Findings:
1. All respondents reported valuation methods; 15 recommended values ranging from $6.0 million to $17.5 million.
2. The dispersion of values was not consistent with our expectation of convergence of value estimates.
3. The professional training and background of the experts proved significant in the valuation methodology and estimate. The 8 experts who are investors fvoured, by 7 to 1, a non-DCF approach, such as an earnings multiple or capitalized earnings. The 10 consultants/appraisers expressed a slight preference, 6 to 4, for the DCF approach.
4. The greatest disparity between investor experts and consultants was in the recommended value of the firm. The average value recommende by the consultants was $14.7 million, almost 50 percent higher than the investors' average estimate of $9.87 million.
Conclusions:
Three implications of the study.
1. The substantial variation in valuation opinions suggests that courts cannot expect convergence of expert valuation of a firm even from a large number of experts.
2. The variation in opinion may be related to the professional training and background of the experts. Consultants, those who are not investors or risk bearers, offered significantly higher valutaion opinions than investor experts.
3. The valuation expert who are interested in economically sound valuation opinons would be well-advised to use more than one valuation approach, if circumstances permit, cross verify valuation estimates. The dispersion of values provided by the sample of experts suggests that the expert who can demonstrate the soundness of an opinion by the independent application of two or more methods is likely to have more credibility.
****Earnings Multiples by Aswath Damodaran
PE Ratio and Fundamentals
Proposition: Other things held equal, higher growth firms will have higher PE ratios than lower growth firms.
Proposition: Other things held equal, higher risk firms will have lower PE ratios than lower risk firms
Proposition: Other things held equal, firms with lower reinvestment needs will have higher PE ratios than firms with higher reinvestment rates.
Of course, other things are difficult to hold equal since high growth firms, tend to have risk and high reinvestment rates.
PEG Ratios and Fundamentals: Propositions
Proposition 1: High risk companies will trade at much lower PEG ratios than low risk companies with the same expected growth rate.
• Corollary 1: The company that looks most under valued on a PEG ratio basis in a sector may be the riskiest firm in the sector
Proposition 2: Companies that can attain growth more efficiently by investing less in better return projects will have higher PEG ratios than companies that grow at the same rate less efficiently.
• Corollary 2: Companies that look cheap on a PEG ratio basis may be companies with high reinvestment rates and poor project returns.
Proposition 3: Companies with very low or very high growth rates will tend to have higher PEG ratios than firms with average growth rates. This bias is worse for low growth stocks.
• Corollary 3: PEG ratios do not neutralize the growth effect.
Relative PE: Definition
The relative PE ratio of a firm is the ratio of the PE of the firm to the PE of the market.
Relative PE = PE of Firm / PE of Market
While the PE can be defined in terms of current earnings, trailing earnings or forward earnings, consistency requires that it be estimated using the same measure of earnings for both the firm and the market.
Relative PE ratios are usually compared over time. Thus, a firm or sector which has historically traded at half the market PE (Relative PE = 0.5) is considered over valued if it is trading at a relative PE of 0.7.
The average relative PE is always one.
The median relative PE is much lower, since PE ratios are skewed towards higher values. Thus, more companies trade at PE ratios less than the market PE and have relative PE ratios less than one.
Read: 103 slides on earnings multiples
http://pages.stern.nyu.edu/~adamodar/pdfiles/eqnotes/earnmult.pdf
Proposition: Other things held equal, higher growth firms will have higher PE ratios than lower growth firms.
Proposition: Other things held equal, higher risk firms will have lower PE ratios than lower risk firms
Proposition: Other things held equal, firms with lower reinvestment needs will have higher PE ratios than firms with higher reinvestment rates.
Of course, other things are difficult to hold equal since high growth firms, tend to have risk and high reinvestment rates.
PEG Ratios and Fundamentals: Propositions
Proposition 1: High risk companies will trade at much lower PEG ratios than low risk companies with the same expected growth rate.
• Corollary 1: The company that looks most under valued on a PEG ratio basis in a sector may be the riskiest firm in the sector
Proposition 2: Companies that can attain growth more efficiently by investing less in better return projects will have higher PEG ratios than companies that grow at the same rate less efficiently.
• Corollary 2: Companies that look cheap on a PEG ratio basis may be companies with high reinvestment rates and poor project returns.
Proposition 3: Companies with very low or very high growth rates will tend to have higher PEG ratios than firms with average growth rates. This bias is worse for low growth stocks.
• Corollary 3: PEG ratios do not neutralize the growth effect.
Relative PE: Definition
The relative PE ratio of a firm is the ratio of the PE of the firm to the PE of the market.
Relative PE = PE of Firm / PE of Market
While the PE can be defined in terms of current earnings, trailing earnings or forward earnings, consistency requires that it be estimated using the same measure of earnings for both the firm and the market.
Relative PE ratios are usually compared over time. Thus, a firm or sector which has historically traded at half the market PE (Relative PE = 0.5) is considered over valued if it is trading at a relative PE of 0.7.
The average relative PE is always one.
The median relative PE is much lower, since PE ratios are skewed towards higher values. Thus, more companies trade at PE ratios less than the market PE and have relative PE ratios less than one.
Read: 103 slides on earnings multiples
http://pages.stern.nyu.edu/~adamodar/pdfiles/eqnotes/earnmult.pdf
''We don't buy the cheapest stocks or the fastest-growing businesses. We buy the highest-quality companies.''
INVESTING WITH/Robert A. Schwarzkopf And Sandi L. Gleason; Kayne Anderson Rudnick Small-Mid Cap Fund
By CAROLE GOULD
Published: Sunday, June 17, 2001
AMERICA'S biggest blue-chip companies were once small businesses -- the kind that Robert A. Schwarzkopf and Sandi L. Gleason want for their $69.2 million Kayne Anderson Rudnick Small-Mid Cap fund.
''In an industry where most people classify themselves as growth or value investors, we decided to take another road,'' Mr. Schwarzkopf said from their offices in Century City in Los Angeles. ''We don't buy the cheapest stocks or the fastest-growing businesses. We buy the highest-quality companies in America.''
The companies' returns have been substantial. The fund rose 30.4 percent in the 12 months ended Thursday, compared with a 15.4 percent loss for the small-cap growth group and a 16.1 percent loss for the Standard & Poor's 500-stock index. For the three years ended Thursday, the fund gained 14.8 percent a year, on average, versus 10.4 percent for its group and 4.9 percent for the S.& P.
Mr. Schwarzkopf, 52, and Ms. Gleason, 36, also manage $2 billion for institutions and individuals for Kayne Anderson Rudnick Investment Management, the fund's adviser.
To find businesses with sustainable competitive advantages, the managers screen 8,000 United States companies for consistent earnings and revenue growth. They look for growth rates that have exceeded the industry average over 10 years.
The portfolio companies have a weighted average market capitalization of $2 billion, comparable to that of the benchmark Russell 2500 index.
The analysts look for rising free cash flow and low debt levels. ''Companies that have lots of cash and little debt are less financially risky,'' Mr. Schwarzkopf said, ''and they can take advantage of opportunities during difficult times, when other companies are struggling.''
The managers trim the pool to 250 companies by eliminating those whose management does not seem focused on building shareholder value, and those that do not dominate their markets. Further research helps them choose the 25 to 35 stocks in the fund. ''We want to find the best businesses, understand what makes them great so we can assess how long they will stay great companies, and determine how much we should pay for them,'' Mr. Schwarzkopf said.
The managers work with sector analysts and visit the companies. ''We want to understand how a company differentiates itself from competition,'' Ms. Gleason said, ''how it creates value for customers, and how it does that in a way that excludes competition.''
To reduce risk, they aim for a diversified portfolio that roughly replicates the Russell 2500 index.
They call their strategy ''quality at a reasonable price.'' The managers prefer companies with above-average return on equity and profit margins, but with below-average valuations based on price-to-sales and price-to-book ratios. Those correlations ''give you a good sense of how your company is valued relative to its industry,'' Ms. Gleason said.
They also review ranges of price-to-earnings multiples over 5 or 10 years. ''You get a P/E band range around which the stock trades,'' Ms. Gleason said. ''You can apply the high and low multiple to target earnings for each of five years to get a target price.''
They trim positions in stocks that reach their target price, and companies whose market capitalization grows too large or that cannot sustain their target growth rates.
IN March, the managers bought shares of the Black Box Corporation of Lawrence, Pa., at $43.42. Black Box, a global marketer of cable, networking and other communications equipment, has carved out a market niche by basing its selling primarily on service, not price, Mr. Schwarzkopf said. It offers technical service 365 days a year in 132 countries. In its last fiscal year, 99.2 percent of calls were answered within 20 seconds, according to the company.
The strategy has let Black Box generate double-digit net profit margins, he said, adding that it avoids economic cycles because it concentrates on the aftermarket, not infrastructure building. He expects 20 percent annual growth in earnings over the next three years.
On Friday, the stock closed at $62.94, compared with their 12-month target price of $75.
Another favorite is the Catalina Marketing Corporation of St. Petersburg, Fla., a leader in customized electronic coupons generated at checkout counters. The company's systems are used in about 15,000 supermarkets, she added, and it has annual and multiyear contracts with major consumer goods companies. It is also expanding into health care advertising linked to drug purchases. She expects earnings per share to grow 22 percent in each of the next three years.
The fund bought shares in March 2000 at a split-adjusted price of $30.14; they now trade at $31.68, compared with the managers' price target of $49.
The managers also like C. H. Robinson Worldwide, a transportation company based in Eden Prairie, Minn. The company dominates a domestic market, Mr. Schwarzkopf said, by using its data processing systems to match small local trucking companies with the needs of large packaged-goods companies.
''They serve as a marketing and information technology department for thousands of small truckers,'' he said.
Unlike most companies in the transportation industry, he added, it carries no debt on its balance sheet. And because it specializes in the food industry, he said, the company can continue growing during bad economic times. He projects annual earnings growth of 20 percent over the next three years.
The managers first bought shares in January 2000 at a split-adjusted price of $19.70. The stock closed at $28.26 on Friday; their price target is $34 within 12 months.
Photo: For their fund, Sandi L. Gleason and Robert A. Schwarzkopf buy small stocks that he calls ''the highest-quality companies in America.'' (Kim Kulish/Saba, for The New York Times) Chart: ''Kayne Anderson Rudnick Small-Mid Cap'' Category: Small growth Net assets: $69 million Inception: October 1996 Managers: Robert A. Schwarzkopf and Sandi L. Gleason Minimum purchase: $2,000 ($1,000 I.R.A.) Portfolio turnover: 50% 3-year annualized return through Thursday: 14.8% Category average: 10.4% SECTOR BREAKDOWN Financial services: 11% Other: 57% Banks: 10% Computers: 9% Medical information systems: 7% Drugs/hospital supplies: 6% FEES Front-end load: None Deferred load: None 12b-1 fee: None Expense ratio: 1.29% (Sources: Morningstar Inc.; company reports)
http://www.nytimes.com/2001/06/17/business/investing-with-robert-schwarzkopf-sandi-l-gleason-kayne-anderson-rudnick-small.html
By CAROLE GOULD
Published: Sunday, June 17, 2001
AMERICA'S biggest blue-chip companies were once small businesses -- the kind that Robert A. Schwarzkopf and Sandi L. Gleason want for their $69.2 million Kayne Anderson Rudnick Small-Mid Cap fund.
''In an industry where most people classify themselves as growth or value investors, we decided to take another road,'' Mr. Schwarzkopf said from their offices in Century City in Los Angeles. ''We don't buy the cheapest stocks or the fastest-growing businesses. We buy the highest-quality companies in America.''
The companies' returns have been substantial. The fund rose 30.4 percent in the 12 months ended Thursday, compared with a 15.4 percent loss for the small-cap growth group and a 16.1 percent loss for the Standard & Poor's 500-stock index. For the three years ended Thursday, the fund gained 14.8 percent a year, on average, versus 10.4 percent for its group and 4.9 percent for the S.& P.
Mr. Schwarzkopf, 52, and Ms. Gleason, 36, also manage $2 billion for institutions and individuals for Kayne Anderson Rudnick Investment Management, the fund's adviser.
To find businesses with sustainable competitive advantages, the managers screen 8,000 United States companies for consistent earnings and revenue growth. They look for growth rates that have exceeded the industry average over 10 years.
The portfolio companies have a weighted average market capitalization of $2 billion, comparable to that of the benchmark Russell 2500 index.
The analysts look for rising free cash flow and low debt levels. ''Companies that have lots of cash and little debt are less financially risky,'' Mr. Schwarzkopf said, ''and they can take advantage of opportunities during difficult times, when other companies are struggling.''
The managers trim the pool to 250 companies by eliminating those whose management does not seem focused on building shareholder value, and those that do not dominate their markets. Further research helps them choose the 25 to 35 stocks in the fund. ''We want to find the best businesses, understand what makes them great so we can assess how long they will stay great companies, and determine how much we should pay for them,'' Mr. Schwarzkopf said.
The managers work with sector analysts and visit the companies. ''We want to understand how a company differentiates itself from competition,'' Ms. Gleason said, ''how it creates value for customers, and how it does that in a way that excludes competition.''
To reduce risk, they aim for a diversified portfolio that roughly replicates the Russell 2500 index.
They call their strategy ''quality at a reasonable price.'' The managers prefer companies with above-average return on equity and profit margins, but with below-average valuations based on price-to-sales and price-to-book ratios. Those correlations ''give you a good sense of how your company is valued relative to its industry,'' Ms. Gleason said.
They also review ranges of price-to-earnings multiples over 5 or 10 years. ''You get a P/E band range around which the stock trades,'' Ms. Gleason said. ''You can apply the high and low multiple to target earnings for each of five years to get a target price.''
They trim positions in stocks that reach their target price, and companies whose market capitalization grows too large or that cannot sustain their target growth rates.
IN March, the managers bought shares of the Black Box Corporation of Lawrence, Pa., at $43.42. Black Box, a global marketer of cable, networking and other communications equipment, has carved out a market niche by basing its selling primarily on service, not price, Mr. Schwarzkopf said. It offers technical service 365 days a year in 132 countries. In its last fiscal year, 99.2 percent of calls were answered within 20 seconds, according to the company.
The strategy has let Black Box generate double-digit net profit margins, he said, adding that it avoids economic cycles because it concentrates on the aftermarket, not infrastructure building. He expects 20 percent annual growth in earnings over the next three years.
On Friday, the stock closed at $62.94, compared with their 12-month target price of $75.
Another favorite is the Catalina Marketing Corporation of St. Petersburg, Fla., a leader in customized electronic coupons generated at checkout counters. The company's systems are used in about 15,000 supermarkets, she added, and it has annual and multiyear contracts with major consumer goods companies. It is also expanding into health care advertising linked to drug purchases. She expects earnings per share to grow 22 percent in each of the next three years.
The fund bought shares in March 2000 at a split-adjusted price of $30.14; they now trade at $31.68, compared with the managers' price target of $49.
The managers also like C. H. Robinson Worldwide, a transportation company based in Eden Prairie, Minn. The company dominates a domestic market, Mr. Schwarzkopf said, by using its data processing systems to match small local trucking companies with the needs of large packaged-goods companies.
''They serve as a marketing and information technology department for thousands of small truckers,'' he said.
Unlike most companies in the transportation industry, he added, it carries no debt on its balance sheet. And because it specializes in the food industry, he said, the company can continue growing during bad economic times. He projects annual earnings growth of 20 percent over the next three years.
The managers first bought shares in January 2000 at a split-adjusted price of $19.70. The stock closed at $28.26 on Friday; their price target is $34 within 12 months.
Photo: For their fund, Sandi L. Gleason and Robert A. Schwarzkopf buy small stocks that he calls ''the highest-quality companies in America.'' (Kim Kulish/Saba, for The New York Times) Chart: ''Kayne Anderson Rudnick Small-Mid Cap'' Category: Small growth Net assets: $69 million Inception: October 1996 Managers: Robert A. Schwarzkopf and Sandi L. Gleason Minimum purchase: $2,000 ($1,000 I.R.A.) Portfolio turnover: 50% 3-year annualized return through Thursday: 14.8% Category average: 10.4% SECTOR BREAKDOWN Financial services: 11% Other: 57% Banks: 10% Computers: 9% Medical information systems: 7% Drugs/hospital supplies: 6% FEES Front-end load: None Deferred load: None 12b-1 fee: None Expense ratio: 1.29% (Sources: Morningstar Inc.; company reports)
http://www.nytimes.com/2001/06/17/business/investing-with-robert-schwarzkopf-sandi-l-gleason-kayne-anderson-rudnick-small.html
Finding great values in low P/E stocks that are set to rise
CHEAP STOCKS: ARE THEY TRASH OR ARE THEY TREASURE? A PORTFOLIO OF STOCKS SELLING FOR THE LOWEST PRICE/EARNINGS MULTIPLES WILL DO SIX TIMES BETTER THAN ONE WITH THE HIGHEST P/ES ... ... DO WE HAVE YOUR ATTENTION?
By SUSAN KUHN REPORTER ASSOCIATE KIMBERLY SEALS MCDONALD
October 16, 1995
(FORTUNE Magazine) – EVERY SO OFTEN you've got to say the heck with all those brokerage reports, newsletters, and other materials that entire forests died for. Let's face it, there are only three sure ways to beat the stock market bogey:
One: Get your investment banker brother, or some other well-placed friend, to tip you off about the next big merger;
Two: Undergo a mind meld with stock picker extraordinaire Warren Buffett; or
Three: Be a pirate, and grab a fistful of shares for way less than they're worth.
This story is not about the felonious option No. 1 or the science-fictitious No. 2. But it is a map that will lead you to the X that marks the spot where treasure often lies buried.
The X is the P/E ratio, the price of stocks relative to earnings per share, of various companies. You'll find P/Es right in the newspaper. Your task is to identify the ones that fall short of the market average--it was a recent 16.5 for Standard & Poor's 500-stock index. The signal is clear: Dig here and odds are you'll get rich. Make that very rich. Over time, say numerous studies, a portfolio of these discounted stocks will do six times better--that's right, I said six times--than a portfolio made up of shares with the highest P/E ratio. Are all you technology investors listening?
And those startling numbers are just the averages. You can improve on that performance by finding low P/E stocks that are set to rise. But which ones are they? You've got many shares to choose from in the world of low P/Es, ranging from down-and-out commodity companies to the fallen angels of tech. Some dip into discount territory for a quarter or two while others are relegated to the basement for decades on end. Your job--and the purpose of this story--is to separate the living from the dead.
Few stock groups have spent as much time in low P/E country in recent years as banks, tobacco companies, and retailers, so if you are serious about low P/E investing, you've got to make a call on these. The average major regional bank now sells at a 36% discount to the S&P 500. Tobacco companies are taking a 25% haircut. Department stores trade at an average P/E that is 18% lower than the S&P's. These three groups have spent much of the past 25 years with low P/Es, and in recent years their discounts have grown ever steeper, so their potential looms large.
Even so, as any bargain hunter with muddy boots knows, there are reasons that stocks sink to a discount. Banks, for instance, have had an unerring tendency to sabotage their balance sheets periodically with bad loans that blow up like a Scud missile. And cigarettes? Well, the short of it is that they can kill you. As for putting money into a big department store chain, why invest in an outfit that has lost so many big spenders to specialty stores?
But try to think of these well-known problems as opportunities--not only for companies to turn around but also for you to get in on the change. Still not convinced? Here's a broader perspective: Take a low P/E stock and turn the multiple upside down (that is, divide earnings per share by the stock's price). What you'll get is something called the earnings yield, which tells you how much you'll earn on your money if you buy the stock at that price. Compare this with the interest the same money would earn elsewhere, and you'll see just how bountiful these cheap stocks can be. At 16.5 times earnings, stocks in the S&P 500 earn an average 6% a year, only a very slight edge over the 5.4% paid by most money market funds and well shy of the 7% you'd get on 30-year bonds. On the other hand, regional banks sell for 10.5 times earnings, equal to a juicy earnings yield of 10%. Of course, you get only part of that 10% return mailed to you as a dividend. The rest is plowed back into the company and should boost the stock price by adding value to the company.
Buying discounted shares doesn't always end happily, but it often does. Consider the story of Nike. Beginning in the mid-Eighties, when Wall Street thought the company's days were numbered, the stock sold at six to nine times earnings, at a 50% to 70% discount to the market. From 1983 through 1990, despite some difficult years, the company managed to increase earnings fourfold as it transformed itself into a global marketing giant. This upward earnings trend continued over the next five years, and the market finally awarded the stock a higher P/E multiple. Nike shares increased 230% in value, half that gain coming from better earnings and the other half from a rise in the P/E multiple. Its shares are now trading at $92.50, 17 times earnings, a 3% premium to the market.
Nike investors who bought shares early never had any guarantees that this treasure hunt would end up the way it has, of course. Similarly, it's impossible to be certain that every bank, tobacco company, and department store will transform itself into gold. Nevertheless, if earnings gains keep improving, so should the P/E. And if those gains are as good as or better than the market's average rate of profit growth--11.8% annually over the next five years, according to a forecast by the Institutional Brokers Estimate System--then the P/E multiple should eventually be as good as or better than the overall market's. As long as these wheels are turning, the only thing you need is patience. Explains Robert Rodriguez of First Pacific Advisors in Los Angeles about this potential double-dip payoff: "If I buy a company that is cheap relative to its assets, I let the market worry, not me. If I am right about improvements, then I'll get profitability squared. Rising profits and a rising P/E multiple equals a financial home run."
This twofold kick is something pricey shares can't match. A stock like Microsoft, way out there at some 40 times earnings, must get its earnings to sprint ahead every year just to keep the stock from tumbling. Bill Gates may be able to meet this challenge, but over time the more expensive companies tend to falter. Earnings gains eventually lose speed, the P/E multiples inevitably contract, stock prices fall--and investors lose money.
The technology crowd may not wish to be reminded of this, but their chances of scoring in stocks are actually lower with the high P/E titans of tech than they are with the downtrodden shares of unloved industries. Ken French and Eugene Fama, professors at the Yale school of management and the University of Chicago, respectively, recently pounded this point home with a study of high and low P/E stocks. They measured the performance of shares on the New York Stock Exchange from July 1963 through 1993 and found that the 10% of those with the lowest P/E multiples outperformed the 10% with the highest multiples by an average of 7.6% a year. Over 30 years, every dollar invested in the low P/E group returned at least $100 more to investors--a lot of money by any account (see chart).
LOW P/E stocks don't just do more on the upside; they behave better when the market is falling. David Dreman, chairman of the Kemper-Dreman mutual fund firm in Jersey City, recently compared the total return of 1,200 stocks over a 20-year period ending in 1993 and found that when the market fell, the 20% of stocks with the lowest P/Es outperformed the 20% with the highest P/Es. The difference in quarterly losses averaged a huge 41%.
Of course, you can't make money in stocks just by citing some uplifting academic studies. Eventually you've got to put down some money, and that brings us back to the three industries mentioned above--banks, tobacco, and retailers, which have all been in the market's cellar for years. The last time that banks sold at a premium, John Kennedy was President. Once-fat premiums for tobacco companies petered out in 1953, blipped again in the 1970s, and collapsed once more in the early 1980s as health- related lawsuits scared an increasing number of Wall Streeters. Retailers have had some days in the sun over the years, but there haven't been many. From 1946 to 1953, department stores in S&P's universe, which includes May and Federated, sold at a premium to the market. From 1951 to 1963, "mail-order and general chains" like Sears Roebuck became the investor's darlings. Department stores were back in Wall Street's affections until the 1980s, when specialty stores like the Gap displaced them.
The investor's call now is to decide whether these groups can stage yet another comeback, or whether they are on the slow train to oblivion.
BANKS. Among all the low P/E stock groups, none holds as much opportunity for gains as the banks. No doubt, they are in their best shape in years. "It's banking heaven," says CS First Boston analyst Thomas Hanley. Since the dog days of 1990, when earnings and capital reserves had been pummeled to the ground after a disastrous decade of bad real estate loans and defaults on loans to Third World countries, banks have been shaping up their act. Their balance sheets look so fine that the FDIC recently voted to halve the rates banks must pay for deposit insurance. Well capitalized and healthy, many banks are looking to take some of the volatility out of their earnings by developing fee-based businesses. Selling mutual funds, for example, generates a steadier flow of profits than high-risk lending. Helping matters along, the steadily expanding economy and low inflation have been good for business.
Another trend likely to buoy the banks' P/Es: Legislation allowing interstate banking nationwide goes into effect next year, which will allow strong banks to pick up more retail customers. Even more important to investors, the wave of mergers should lead to higher stock prices in this sector as investors accord bank stocks the prices that more closely reflect their potential value as takeovers.
Sound balance sheets, a favorable economy, interstate banking, and consolidation could combine to drive bank stocks to much better valuations. "Before we are finished," says Hanley, "both money center and regional banks will be at or near a market multiple." He predicts this will happen "by the middle or end of 1996." There, in a blink, is a 36% gain in your pocket, as the discount fades away.
Make no mistake, banking as an industry is going through a take-no-prisoners sea change. Some institutions will drown and others triumph in the storm that's already raging in the erosion of interstate banking restrictions and the Glass-Steagall act, which separated the banking and securities business. The latter extends investor opportunities to brokerage firms, which Smith Barney notes carry an average discount of 16%, and to life insurers, 18%.
Clearly, winning banks will pick specialties that suit them, or a breadth of services that sets them apart from competitors--or both. In Minneapolis, for example, Norwest bank has moved smartly into new businesses but continues to lend money very well. As Larry Puglia, co-manager of the T. Rowe Price Blue Chip Growth fund, puts it, "The most important reason to own Norwest is that the credit culture is very strong there, and that's a fancy way of saying that they tend to get repaid when they lend money." (For more, see box.)
Or consider Citicorp. At $67.50, it sells for nine times earnings, a sizable 45% discount to the market. Fans include Richard Dahlberg, director of U.S. equities for Salomon Asset Management, who says, "I think there is a definite potential for financials to break out of their bands. Citicorp is a case in point. They stayed in the international area and strengthened their position in the hard times, and now that's providing an accelerating growth rate. That will be taken into consideration when you look at the multiple on the stock. That kind of company may be held in esteem instead of disrepute."
Banks may be transforming, but like Dorothy on the road to the Wiz, they're not there yet. Final destinations could turn them into one-stop financial-services centers like Charles Schwab, an outfit that offers free checking accounts and ATM cards as well as software that enables investors to use their home PCs to trade stocks, mutual funds, and money market accounts. That wouldn't be the worst fate to befall banks--at a recent $26.75 per share, Schwab commands a P/E of 33.3, or nearly three times the average bank multiple.
Investors looking for banks that might be headed for higher ground should also consider Wachovia and Mellon, which tied for first place in a "1997 cream of the crop" list put together by First Boston's Hanley. He ranked contenders on criteria such as expected return on assets, expense ratios, the mix of interest-rate-sensitive and other earnings, and dividends. Mellon, with its recent Dreyfus acquisition, has been aggressively diversifying into fee-based business, and if it can digest the purchase (see "A Bitter Lesson for Banks," August 21), its earnings may be as predictable as a clock. Wachovia, on the other hand, has stuck with its basic banking business, but the quality of its assets, tight controls on expenses, and strong generation of equity capital are exceptional. Though profits should be plentiful in the years ahead, stock prices are still cheap relative to expected earnings this year. At $45 a share, Mellon trades at 11 times 1995 earnings. At $41 a share, Wachovia carries a P/E multiple of 12.
TOBACCO. Tobacco companies could easily teach everybody a lesson or two about generating profits. For decades the industry has generated margins in the smokin' 20% range and up, vs. a 5% median for the Fortune 500. In earlier days, this meant the tobacco stocks sold at a stiff premium. Not anymore. The Food and Drug Administration's push to regulate tobacco has whacked stock prices, and so too have a host of class-action lawsuits brought by, or on behalf of, smokers who contracted lung cancer and other diseases they say were caused by smoking. The biggest threat: a class-action lawsuit named for Dianne Castano, the widow of a smoker who died of cancer. It would permit all who are or who have been addicted to nicotine, a potential horde of 80 million people, to seek damages as a group. A district court backed the suit. The industry, which wants to make every plaintiff sue individually, is appealing. With so much bad news looming, it's hard to imagine how much lower tobacco stocks could be priced. The industry had its biggest defeat in late August, when a smoker who had sued Lorillard and its filter manufacturer for an asbestos-related disease won $2 million. But the stock of Loews, Lorillard's owner, actually rose when the news hit. That could be a sign that prices for the industry have bottomed out. Says Paine Webber analyst Emanuel Goldman: "These stocks absolutely have the potential for expansion. Say the Fifth Circuit decertifies Castano. It would take 22 seconds to be reflected in higher stock prices." At a recent price of $74.75, industry leader Philip Morris trades at 12.5 times earnings, well below the S&P 500. How high could the multiple go? "If Philip Morris goes to a market multiple today, the stock goes to $110," says he. "Probably more, because it implies the external issues have been pushed to a back burner."
That kind of gain is not puffery. Neither is Philip Morris's financial picture. In the past ten years, sales and earnings have increased at a compound rate of 18.5% per year, dividends have gone up 22% on average annually, and book value has tripled. It bought General Foods in 1985; in 1988 it added Kraft. Food now accounts for over half of revenues and more than a third of operating profits, and is worth plenty. David Dreman has done a dead-or-alive analysis, assuming Philip Morris made no money on its domestic cigarette business. The 40% left was still growing at a 15% clip. If the stock price merely matches the company's annual earnings growth rate of 15% or more, investors will do nicely. Add on a 5.4% dividend, and total returns leap above 20%.
That's not a bad bet for investors willing to wait for multiple expansion. And wait they might. Tony Hitschler, a value manager with Brandywine Asset Management in Wilmington, Delaware, is not as confident as Goldman that multiples will expand right away. Says he: "With tobaccos, I believe the perceived risks and the actual risks are in line. Though the industry has been incredibly successful, the mores of our society are so much against them. I would like to see a significant price correction on bad news, which could be more liabilities, or limits on their markets." Nonetheless, even he cannot resist some of the values in the group. He's choosing RJR Nabisco, which trades at 4.6 times cash flow, half of Philip Morris's price-to-cash-flow multiple, though RJR also has more debt. The stock is now $28.38 a share. Sanford C. Bernstein, a New York City investment management company that specializes in value investing, believes Philip Morris, RJR Nabisco, Loews, and especially UST are all attractively valued, even in light of litigation and regulation risks.
RETAILERS. If you really want to go shopping for bargains, check out department store stocks. After years of watching customers leave for fancier fare, some of the best stores have finally stepped back into fashion. Says Walter Loeb, a longtime retailing-industry analyst at Morgan Stanley who now has his own firm in New York City: "Today, as I see it, there is a resurgent interest in Sears, Federated, even May. I expect there will be multiple expansion in these stocks, to a market multiple or better."
At specialty stores, the big retailers' competition, troubles are rising faster than hemlines. Sales from women's apparel have dropped dramatically, and some former star performers are losing their edge the most. Earnings at the Limited are off 11% in the first half of their fiscal year, ending in January. The Gap's profits have declined 23% compared with the same period a year ago. Their P/E multiples are also falling. The Gap's stock was selling as high as 59 times earnings in 1992. At $33 a share, the multiple is down to 16.3. The Limited's multiple peaked the same year at 32.9 times earnings and is now 15.6.
Yes, there are too many department stores fighting for the customers coming back, particularly given still-weak spending patterns. The big winners will be so-called destination stores, places that seem to hold the biggest drawing power. When you go to a mall in the future, Macy's and every other retailer around want to make sure you go there first.
Nordstrom is the rare diamond that shows what dominance can do. The Northwest-oriented retailer is consistently known for superior customer service, great-looking stores, and nice clothes, all translating to strong profits. Over the past ten years, its P/E on Merrill Lynch's earnings estimates one year out has averaged a high 32% premium relative to the S&P 500. Most department stores sell at discounts. May, for example, has a ten-year average discount of 16% relative to the market.
May, Federated, and Sears (now classified as a department store, having shed Dean Witter, Allstate, and other operations) look especially fit and in shape for investor plays. May and Federated, moreover, are themselves shopping for acquisitions. May, recently $42.50 a share and 14 times earnings, has bought a number of stores, including 13 Wanamaker outlets in Philadelphia. Federated, of course, has swallowed Macy's, and announced in August that it will buy Broadway Stores in California. Sears is increasing same-store sales faster than many of its peers. At $33.88 and just seven times earnings, it is especially cheap. "The stores look terrific and more useful, and I expect they will be more of a destination in malls again," says Loeb (for more on Sears, see Companies). Loeb is looking for the three to expand earnings 14% to 15% a year for five years, ahead of the market.
For retailers, tobacco companies, and banks, the ingredients are in place to take the stocks to a market multiple. Cheap or chancy? Make no mistake: Some companies live in the basement because that's their natural habitat. Electric utilities, for example, have sold at a discount because their profits have been largely regulated. The coming deregulation is sure to knock down shareholder value even more. As for the three stock groups we've reviewed here, well, that's a better story.
If you have any last doubts about low P/E investing, consider this: The history of low P/E investing makes it clear that you stand to make money twice. First, you win when companies start to earn bigger profits and share them with you by way of fatter dividends and rising share prices. This will wake up all those investors who've been sleeping on the sidelines. They'll start buying, the multiple will increase, and presto!--you've won again.
http://money.cnn.com/magazines/fortune/fortune_archive/1995/10/16/206857/index.htm
By SUSAN KUHN REPORTER ASSOCIATE KIMBERLY SEALS MCDONALD
October 16, 1995
(FORTUNE Magazine) – EVERY SO OFTEN you've got to say the heck with all those brokerage reports, newsletters, and other materials that entire forests died for. Let's face it, there are only three sure ways to beat the stock market bogey:
One: Get your investment banker brother, or some other well-placed friend, to tip you off about the next big merger;
Two: Undergo a mind meld with stock picker extraordinaire Warren Buffett; or
Three: Be a pirate, and grab a fistful of shares for way less than they're worth.
This story is not about the felonious option No. 1 or the science-fictitious No. 2. But it is a map that will lead you to the X that marks the spot where treasure often lies buried.
The X is the P/E ratio, the price of stocks relative to earnings per share, of various companies. You'll find P/Es right in the newspaper. Your task is to identify the ones that fall short of the market average--it was a recent 16.5 for Standard & Poor's 500-stock index. The signal is clear: Dig here and odds are you'll get rich. Make that very rich. Over time, say numerous studies, a portfolio of these discounted stocks will do six times better--that's right, I said six times--than a portfolio made up of shares with the highest P/E ratio. Are all you technology investors listening?
And those startling numbers are just the averages. You can improve on that performance by finding low P/E stocks that are set to rise. But which ones are they? You've got many shares to choose from in the world of low P/Es, ranging from down-and-out commodity companies to the fallen angels of tech. Some dip into discount territory for a quarter or two while others are relegated to the basement for decades on end. Your job--and the purpose of this story--is to separate the living from the dead.
Few stock groups have spent as much time in low P/E country in recent years as banks, tobacco companies, and retailers, so if you are serious about low P/E investing, you've got to make a call on these. The average major regional bank now sells at a 36% discount to the S&P 500. Tobacco companies are taking a 25% haircut. Department stores trade at an average P/E that is 18% lower than the S&P's. These three groups have spent much of the past 25 years with low P/Es, and in recent years their discounts have grown ever steeper, so their potential looms large.
Even so, as any bargain hunter with muddy boots knows, there are reasons that stocks sink to a discount. Banks, for instance, have had an unerring tendency to sabotage their balance sheets periodically with bad loans that blow up like a Scud missile. And cigarettes? Well, the short of it is that they can kill you. As for putting money into a big department store chain, why invest in an outfit that has lost so many big spenders to specialty stores?
But try to think of these well-known problems as opportunities--not only for companies to turn around but also for you to get in on the change. Still not convinced? Here's a broader perspective: Take a low P/E stock and turn the multiple upside down (that is, divide earnings per share by the stock's price). What you'll get is something called the earnings yield, which tells you how much you'll earn on your money if you buy the stock at that price. Compare this with the interest the same money would earn elsewhere, and you'll see just how bountiful these cheap stocks can be. At 16.5 times earnings, stocks in the S&P 500 earn an average 6% a year, only a very slight edge over the 5.4% paid by most money market funds and well shy of the 7% you'd get on 30-year bonds. On the other hand, regional banks sell for 10.5 times earnings, equal to a juicy earnings yield of 10%. Of course, you get only part of that 10% return mailed to you as a dividend. The rest is plowed back into the company and should boost the stock price by adding value to the company.
Buying discounted shares doesn't always end happily, but it often does. Consider the story of Nike. Beginning in the mid-Eighties, when Wall Street thought the company's days were numbered, the stock sold at six to nine times earnings, at a 50% to 70% discount to the market. From 1983 through 1990, despite some difficult years, the company managed to increase earnings fourfold as it transformed itself into a global marketing giant. This upward earnings trend continued over the next five years, and the market finally awarded the stock a higher P/E multiple. Nike shares increased 230% in value, half that gain coming from better earnings and the other half from a rise in the P/E multiple. Its shares are now trading at $92.50, 17 times earnings, a 3% premium to the market.
Nike investors who bought shares early never had any guarantees that this treasure hunt would end up the way it has, of course. Similarly, it's impossible to be certain that every bank, tobacco company, and department store will transform itself into gold. Nevertheless, if earnings gains keep improving, so should the P/E. And if those gains are as good as or better than the market's average rate of profit growth--11.8% annually over the next five years, according to a forecast by the Institutional Brokers Estimate System--then the P/E multiple should eventually be as good as or better than the overall market's. As long as these wheels are turning, the only thing you need is patience. Explains Robert Rodriguez of First Pacific Advisors in Los Angeles about this potential double-dip payoff: "If I buy a company that is cheap relative to its assets, I let the market worry, not me. If I am right about improvements, then I'll get profitability squared. Rising profits and a rising P/E multiple equals a financial home run."
This twofold kick is something pricey shares can't match. A stock like Microsoft, way out there at some 40 times earnings, must get its earnings to sprint ahead every year just to keep the stock from tumbling. Bill Gates may be able to meet this challenge, but over time the more expensive companies tend to falter. Earnings gains eventually lose speed, the P/E multiples inevitably contract, stock prices fall--and investors lose money.
The technology crowd may not wish to be reminded of this, but their chances of scoring in stocks are actually lower with the high P/E titans of tech than they are with the downtrodden shares of unloved industries. Ken French and Eugene Fama, professors at the Yale school of management and the University of Chicago, respectively, recently pounded this point home with a study of high and low P/E stocks. They measured the performance of shares on the New York Stock Exchange from July 1963 through 1993 and found that the 10% of those with the lowest P/E multiples outperformed the 10% with the highest multiples by an average of 7.6% a year. Over 30 years, every dollar invested in the low P/E group returned at least $100 more to investors--a lot of money by any account (see chart).
LOW P/E stocks don't just do more on the upside; they behave better when the market is falling. David Dreman, chairman of the Kemper-Dreman mutual fund firm in Jersey City, recently compared the total return of 1,200 stocks over a 20-year period ending in 1993 and found that when the market fell, the 20% of stocks with the lowest P/Es outperformed the 20% with the highest P/Es. The difference in quarterly losses averaged a huge 41%.
Of course, you can't make money in stocks just by citing some uplifting academic studies. Eventually you've got to put down some money, and that brings us back to the three industries mentioned above--banks, tobacco, and retailers, which have all been in the market's cellar for years. The last time that banks sold at a premium, John Kennedy was President. Once-fat premiums for tobacco companies petered out in 1953, blipped again in the 1970s, and collapsed once more in the early 1980s as health- related lawsuits scared an increasing number of Wall Streeters. Retailers have had some days in the sun over the years, but there haven't been many. From 1946 to 1953, department stores in S&P's universe, which includes May and Federated, sold at a premium to the market. From 1951 to 1963, "mail-order and general chains" like Sears Roebuck became the investor's darlings. Department stores were back in Wall Street's affections until the 1980s, when specialty stores like the Gap displaced them.
The investor's call now is to decide whether these groups can stage yet another comeback, or whether they are on the slow train to oblivion.
BANKS. Among all the low P/E stock groups, none holds as much opportunity for gains as the banks. No doubt, they are in their best shape in years. "It's banking heaven," says CS First Boston analyst Thomas Hanley. Since the dog days of 1990, when earnings and capital reserves had been pummeled to the ground after a disastrous decade of bad real estate loans and defaults on loans to Third World countries, banks have been shaping up their act. Their balance sheets look so fine that the FDIC recently voted to halve the rates banks must pay for deposit insurance. Well capitalized and healthy, many banks are looking to take some of the volatility out of their earnings by developing fee-based businesses. Selling mutual funds, for example, generates a steadier flow of profits than high-risk lending. Helping matters along, the steadily expanding economy and low inflation have been good for business.
Another trend likely to buoy the banks' P/Es: Legislation allowing interstate banking nationwide goes into effect next year, which will allow strong banks to pick up more retail customers. Even more important to investors, the wave of mergers should lead to higher stock prices in this sector as investors accord bank stocks the prices that more closely reflect their potential value as takeovers.
Sound balance sheets, a favorable economy, interstate banking, and consolidation could combine to drive bank stocks to much better valuations. "Before we are finished," says Hanley, "both money center and regional banks will be at or near a market multiple." He predicts this will happen "by the middle or end of 1996." There, in a blink, is a 36% gain in your pocket, as the discount fades away.
Make no mistake, banking as an industry is going through a take-no-prisoners sea change. Some institutions will drown and others triumph in the storm that's already raging in the erosion of interstate banking restrictions and the Glass-Steagall act, which separated the banking and securities business. The latter extends investor opportunities to brokerage firms, which Smith Barney notes carry an average discount of 16%, and to life insurers, 18%.
Clearly, winning banks will pick specialties that suit them, or a breadth of services that sets them apart from competitors--or both. In Minneapolis, for example, Norwest bank has moved smartly into new businesses but continues to lend money very well. As Larry Puglia, co-manager of the T. Rowe Price Blue Chip Growth fund, puts it, "The most important reason to own Norwest is that the credit culture is very strong there, and that's a fancy way of saying that they tend to get repaid when they lend money." (For more, see box.)
Or consider Citicorp. At $67.50, it sells for nine times earnings, a sizable 45% discount to the market. Fans include Richard Dahlberg, director of U.S. equities for Salomon Asset Management, who says, "I think there is a definite potential for financials to break out of their bands. Citicorp is a case in point. They stayed in the international area and strengthened their position in the hard times, and now that's providing an accelerating growth rate. That will be taken into consideration when you look at the multiple on the stock. That kind of company may be held in esteem instead of disrepute."
Banks may be transforming, but like Dorothy on the road to the Wiz, they're not there yet. Final destinations could turn them into one-stop financial-services centers like Charles Schwab, an outfit that offers free checking accounts and ATM cards as well as software that enables investors to use their home PCs to trade stocks, mutual funds, and money market accounts. That wouldn't be the worst fate to befall banks--at a recent $26.75 per share, Schwab commands a P/E of 33.3, or nearly three times the average bank multiple.
Investors looking for banks that might be headed for higher ground should also consider Wachovia and Mellon, which tied for first place in a "1997 cream of the crop" list put together by First Boston's Hanley. He ranked contenders on criteria such as expected return on assets, expense ratios, the mix of interest-rate-sensitive and other earnings, and dividends. Mellon, with its recent Dreyfus acquisition, has been aggressively diversifying into fee-based business, and if it can digest the purchase (see "A Bitter Lesson for Banks," August 21), its earnings may be as predictable as a clock. Wachovia, on the other hand, has stuck with its basic banking business, but the quality of its assets, tight controls on expenses, and strong generation of equity capital are exceptional. Though profits should be plentiful in the years ahead, stock prices are still cheap relative to expected earnings this year. At $45 a share, Mellon trades at 11 times 1995 earnings. At $41 a share, Wachovia carries a P/E multiple of 12.
TOBACCO. Tobacco companies could easily teach everybody a lesson or two about generating profits. For decades the industry has generated margins in the smokin' 20% range and up, vs. a 5% median for the Fortune 500. In earlier days, this meant the tobacco stocks sold at a stiff premium. Not anymore. The Food and Drug Administration's push to regulate tobacco has whacked stock prices, and so too have a host of class-action lawsuits brought by, or on behalf of, smokers who contracted lung cancer and other diseases they say were caused by smoking. The biggest threat: a class-action lawsuit named for Dianne Castano, the widow of a smoker who died of cancer. It would permit all who are or who have been addicted to nicotine, a potential horde of 80 million people, to seek damages as a group. A district court backed the suit. The industry, which wants to make every plaintiff sue individually, is appealing. With so much bad news looming, it's hard to imagine how much lower tobacco stocks could be priced. The industry had its biggest defeat in late August, when a smoker who had sued Lorillard and its filter manufacturer for an asbestos-related disease won $2 million. But the stock of Loews, Lorillard's owner, actually rose when the news hit. That could be a sign that prices for the industry have bottomed out. Says Paine Webber analyst Emanuel Goldman: "These stocks absolutely have the potential for expansion. Say the Fifth Circuit decertifies Castano. It would take 22 seconds to be reflected in higher stock prices." At a recent price of $74.75, industry leader Philip Morris trades at 12.5 times earnings, well below the S&P 500. How high could the multiple go? "If Philip Morris goes to a market multiple today, the stock goes to $110," says he. "Probably more, because it implies the external issues have been pushed to a back burner."
That kind of gain is not puffery. Neither is Philip Morris's financial picture. In the past ten years, sales and earnings have increased at a compound rate of 18.5% per year, dividends have gone up 22% on average annually, and book value has tripled. It bought General Foods in 1985; in 1988 it added Kraft. Food now accounts for over half of revenues and more than a third of operating profits, and is worth plenty. David Dreman has done a dead-or-alive analysis, assuming Philip Morris made no money on its domestic cigarette business. The 40% left was still growing at a 15% clip. If the stock price merely matches the company's annual earnings growth rate of 15% or more, investors will do nicely. Add on a 5.4% dividend, and total returns leap above 20%.
That's not a bad bet for investors willing to wait for multiple expansion. And wait they might. Tony Hitschler, a value manager with Brandywine Asset Management in Wilmington, Delaware, is not as confident as Goldman that multiples will expand right away. Says he: "With tobaccos, I believe the perceived risks and the actual risks are in line. Though the industry has been incredibly successful, the mores of our society are so much against them. I would like to see a significant price correction on bad news, which could be more liabilities, or limits on their markets." Nonetheless, even he cannot resist some of the values in the group. He's choosing RJR Nabisco, which trades at 4.6 times cash flow, half of Philip Morris's price-to-cash-flow multiple, though RJR also has more debt. The stock is now $28.38 a share. Sanford C. Bernstein, a New York City investment management company that specializes in value investing, believes Philip Morris, RJR Nabisco, Loews, and especially UST are all attractively valued, even in light of litigation and regulation risks.
RETAILERS. If you really want to go shopping for bargains, check out department store stocks. After years of watching customers leave for fancier fare, some of the best stores have finally stepped back into fashion. Says Walter Loeb, a longtime retailing-industry analyst at Morgan Stanley who now has his own firm in New York City: "Today, as I see it, there is a resurgent interest in Sears, Federated, even May. I expect there will be multiple expansion in these stocks, to a market multiple or better."
At specialty stores, the big retailers' competition, troubles are rising faster than hemlines. Sales from women's apparel have dropped dramatically, and some former star performers are losing their edge the most. Earnings at the Limited are off 11% in the first half of their fiscal year, ending in January. The Gap's profits have declined 23% compared with the same period a year ago. Their P/E multiples are also falling. The Gap's stock was selling as high as 59 times earnings in 1992. At $33 a share, the multiple is down to 16.3. The Limited's multiple peaked the same year at 32.9 times earnings and is now 15.6.
Yes, there are too many department stores fighting for the customers coming back, particularly given still-weak spending patterns. The big winners will be so-called destination stores, places that seem to hold the biggest drawing power. When you go to a mall in the future, Macy's and every other retailer around want to make sure you go there first.
Nordstrom is the rare diamond that shows what dominance can do. The Northwest-oriented retailer is consistently known for superior customer service, great-looking stores, and nice clothes, all translating to strong profits. Over the past ten years, its P/E on Merrill Lynch's earnings estimates one year out has averaged a high 32% premium relative to the S&P 500. Most department stores sell at discounts. May, for example, has a ten-year average discount of 16% relative to the market.
May, Federated, and Sears (now classified as a department store, having shed Dean Witter, Allstate, and other operations) look especially fit and in shape for investor plays. May and Federated, moreover, are themselves shopping for acquisitions. May, recently $42.50 a share and 14 times earnings, has bought a number of stores, including 13 Wanamaker outlets in Philadelphia. Federated, of course, has swallowed Macy's, and announced in August that it will buy Broadway Stores in California. Sears is increasing same-store sales faster than many of its peers. At $33.88 and just seven times earnings, it is especially cheap. "The stores look terrific and more useful, and I expect they will be more of a destination in malls again," says Loeb (for more on Sears, see Companies). Loeb is looking for the three to expand earnings 14% to 15% a year for five years, ahead of the market.
For retailers, tobacco companies, and banks, the ingredients are in place to take the stocks to a market multiple. Cheap or chancy? Make no mistake: Some companies live in the basement because that's their natural habitat. Electric utilities, for example, have sold at a discount because their profits have been largely regulated. The coming deregulation is sure to knock down shareholder value even more. As for the three stock groups we've reviewed here, well, that's a better story.
If you have any last doubts about low P/E investing, consider this: The history of low P/E investing makes it clear that you stand to make money twice. First, you win when companies start to earn bigger profits and share them with you by way of fatter dividends and rising share prices. This will wake up all those investors who've been sleeping on the sidelines. They'll start buying, the multiple will increase, and presto!--you've won again.
http://money.cnn.com/magazines/fortune/fortune_archive/1995/10/16/206857/index.htm
Business owners should always have an exit or succession plan, no matter what stage of their business' lifecycle.
Entrepreneurs establish and grow their business for essentially one reason - reward.
That reward can come in many forms whether it be fulfilling a passion, gaining respect or recognition or achieving a lifestyle. One common trait through all business owners is that they want to build value.
We have seen many business plans, long or short, simple and sophisticated. However, a consistent fault with many is that they do not reference their actions or strategies against what impact these may have on the business value - short or long-term. When asked why, a typical response is that they do not know how to realistically value the business - hence, have no measurement tool.
At another level, we continually try to give the message to business owners that they should always have an exit or succession plan, no matter what stage of their business' lifecycle. Whether it be via family succession, management buy-out, trade sale or IPO, the plan for exit will or should largely drive the actions and strategies of the business to increase value.
So, what is a business worth? In very simple terms, it is the best price you can get at a given time. The price issue is long-standing. The seller wants to get as much as possible, the buyer wants to pay as little as possible, and the value lies somewhere in between. However, this is not always reasonable. For example, at a given time, there may be no buyers or investors that have expressed an interest. You should not therefore conclude that the business is worth nothing. So how can you arrive at a reasonable valuation, or if you are selling, a realistic asking price?
http://www.mondaq.com/australia/article.asp?articleid=68178
That reward can come in many forms whether it be fulfilling a passion, gaining respect or recognition or achieving a lifestyle. One common trait through all business owners is that they want to build value.
We have seen many business plans, long or short, simple and sophisticated. However, a consistent fault with many is that they do not reference their actions or strategies against what impact these may have on the business value - short or long-term. When asked why, a typical response is that they do not know how to realistically value the business - hence, have no measurement tool.
At another level, we continually try to give the message to business owners that they should always have an exit or succession plan, no matter what stage of their business' lifecycle. Whether it be via family succession, management buy-out, trade sale or IPO, the plan for exit will or should largely drive the actions and strategies of the business to increase value.
So, what is a business worth? In very simple terms, it is the best price you can get at a given time. The price issue is long-standing. The seller wants to get as much as possible, the buyer wants to pay as little as possible, and the value lies somewhere in between. However, this is not always reasonable. For example, at a given time, there may be no buyers or investors that have expressed an interest. You should not therefore conclude that the business is worth nothing. So how can you arrive at a reasonable valuation, or if you are selling, a realistic asking price?
http://www.mondaq.com/australia/article.asp?articleid=68178
ABOUT EXPECTATIONS INVESTING
ABOUT EXPECTATIONS INVESTING
Expectations investing represents a fundamental shift from the way professional money managers and individual investors select stocks today. It recognizes that the key to achieving superior investment results is to begin by estimating the performance expectations embedded in the current stock price and then to correctly anticipate revisions in those expectations.
Conventional wisdom suggests that investors need a host of approaches to value different businesses. Expectations investors recognize that while various businesses have different characteristics, it is important to value all companies using the same economic approach.
TEN RULES FOR EXPECTATIONS INVESTING
Here are ten expectations investing rules to increase your odds of generating superior returns.
1. Follow the cash. Investor returns come from two sources of cash—dividends and changes in share prices. But a company cannot pay dividends unless it is able to produce positive cash flows. So without the prospect of future cash flows, a company commands no value. Stock prices therefore reflect transactions between investors willing to sell the present value of a company’s expected cash flows and buyers who are betting on higher cash flows in the future. Cash flow is how the market values stocks.
2. Forget earnings and price-earnings multiples. Savvy investors don’t rely on short-term metrics such as earnings and price-earnings multiples because they fail to capture the long-term cash-flow expectations implied by the stock price. Indeed, the most widely used valuation metric in the investment community, the price-earnings multiple, does not determine value but rather is a consequence of value. The price-earnings multiple is not an analytic shortcut. It is an economic cul-de-sac.
3. Read market expectations implied by stock price. Rather than forecast cash flows, expectations investing starts by reading the collective expectations that a company’s stock price implies. By reversing the conventional process, you not only bypass the difficult job of independently forecasting cash flows but you can also benchmark your own expectations against those of the market. You need to know what the market’s expectations are today before you begin to assess where they are likely to move in the future.
4, Look for potential causes of revisions in market expectations. The only way for an investor to achieve superior returns is to correctly anticipate meaningful differences between current and future expectations. Investors do not earn superior returns on stocks that are priced to fully reflect future performance. Where do you look for revisions? Changes in volume, selling prices, and sales mix trigger revisions in sales growth expectations. Revisions in operating profit margin expectations originate from changes in selling prices, sales mix, economies of scale, and cost efficiencies.
5. Concentrate analysis on the value trigger (sales, costs or investment) that has the greatest impact on the stock. Identifying the so-called turbo trigger enables investors to simplify their analysis and channel their analytical focus toward the changes with the highest payoffs.
6. Use competitive strategy analysis to help anticipate revisions in expectations. The surest way for investors to anticipate expectations revisions is to foresee shifts in a company’s competitive dynamics. For investors, competitive strategy analysis integrated with financial analysis is an essential tool in the expectations game.
7. Buy stocks that trade at sufficient discounts from expected value. The greater the discount from expected value, the higher the prospective excess return—and hence the more attractive a stock is for purchase. The sooner the stock price converges toward the higher expected value, the greater the excess return. The longer it takes, the lower the excess return.
8. Sell stocks that trade at sufficient premiums over expected value after accounting for taxes and transactions costs. The higher a stock price’s premium to its expected value, the more compelling the selling opportunity. Investors should sell a stock for three reasons: It has reached its expected value, better investment opportunities exist, or the investor revises expectations downward. But even these reasons may not be decisive after incorporating taxes and transactions costs into the analysis.
9. Don’t overlook other significant value determinants that don’t appear in the financial statements. For example, ignoring employee stock options can lead to a significant underestimation of costs and liabilities. Past grants are a genuine economic liability and future option grants are an indisputable cost of doing business. In contrast, real options, the right but not the obligation to make potentially value-creating investments, are often a meaningful source of value for start-ups and companies in fast-changing sectors.
10. Heed the signals sent when companies issue or purchase their own stock. An acquiring company’s choice of cash or stock often sends a powerful signal to investors. Under the right circumstances, buybacks provide expectations investors a signal to revise their expectations about a company’s prospects. Correctly reading these signals provides investors with an analytical edge.
http://www.expectationsinvesting.com/about.shtml
Expectations investing represents a fundamental shift from the way professional money managers and individual investors select stocks today. It recognizes that the key to achieving superior investment results is to begin by estimating the performance expectations embedded in the current stock price and then to correctly anticipate revisions in those expectations.
Conventional wisdom suggests that investors need a host of approaches to value different businesses. Expectations investors recognize that while various businesses have different characteristics, it is important to value all companies using the same economic approach.
TEN RULES FOR EXPECTATIONS INVESTING
Here are ten expectations investing rules to increase your odds of generating superior returns.
1. Follow the cash. Investor returns come from two sources of cash—dividends and changes in share prices. But a company cannot pay dividends unless it is able to produce positive cash flows. So without the prospect of future cash flows, a company commands no value. Stock prices therefore reflect transactions between investors willing to sell the present value of a company’s expected cash flows and buyers who are betting on higher cash flows in the future. Cash flow is how the market values stocks.
2. Forget earnings and price-earnings multiples. Savvy investors don’t rely on short-term metrics such as earnings and price-earnings multiples because they fail to capture the long-term cash-flow expectations implied by the stock price. Indeed, the most widely used valuation metric in the investment community, the price-earnings multiple, does not determine value but rather is a consequence of value. The price-earnings multiple is not an analytic shortcut. It is an economic cul-de-sac.
3. Read market expectations implied by stock price. Rather than forecast cash flows, expectations investing starts by reading the collective expectations that a company’s stock price implies. By reversing the conventional process, you not only bypass the difficult job of independently forecasting cash flows but you can also benchmark your own expectations against those of the market. You need to know what the market’s expectations are today before you begin to assess where they are likely to move in the future.
4, Look for potential causes of revisions in market expectations. The only way for an investor to achieve superior returns is to correctly anticipate meaningful differences between current and future expectations. Investors do not earn superior returns on stocks that are priced to fully reflect future performance. Where do you look for revisions? Changes in volume, selling prices, and sales mix trigger revisions in sales growth expectations. Revisions in operating profit margin expectations originate from changes in selling prices, sales mix, economies of scale, and cost efficiencies.
5. Concentrate analysis on the value trigger (sales, costs or investment) that has the greatest impact on the stock. Identifying the so-called turbo trigger enables investors to simplify their analysis and channel their analytical focus toward the changes with the highest payoffs.
6. Use competitive strategy analysis to help anticipate revisions in expectations. The surest way for investors to anticipate expectations revisions is to foresee shifts in a company’s competitive dynamics. For investors, competitive strategy analysis integrated with financial analysis is an essential tool in the expectations game.
7. Buy stocks that trade at sufficient discounts from expected value. The greater the discount from expected value, the higher the prospective excess return—and hence the more attractive a stock is for purchase. The sooner the stock price converges toward the higher expected value, the greater the excess return. The longer it takes, the lower the excess return.
8. Sell stocks that trade at sufficient premiums over expected value after accounting for taxes and transactions costs. The higher a stock price’s premium to its expected value, the more compelling the selling opportunity. Investors should sell a stock for three reasons: It has reached its expected value, better investment opportunities exist, or the investor revises expectations downward. But even these reasons may not be decisive after incorporating taxes and transactions costs into the analysis.
9. Don’t overlook other significant value determinants that don’t appear in the financial statements. For example, ignoring employee stock options can lead to a significant underestimation of costs and liabilities. Past grants are a genuine economic liability and future option grants are an indisputable cost of doing business. In contrast, real options, the right but not the obligation to make potentially value-creating investments, are often a meaningful source of value for start-ups and companies in fast-changing sectors.
10. Heed the signals sent when companies issue or purchase their own stock. An acquiring company’s choice of cash or stock often sends a powerful signal to investors. Under the right circumstances, buybacks provide expectations investors a signal to revise their expectations about a company’s prospects. Correctly reading these signals provides investors with an analytical edge.
http://www.expectationsinvesting.com/about.shtml
What is Expectations Investing about?
FREQUENTLY ASKED QUESTIONS
1. What is Expectations Investing about?
Stock prices are the clearest and most reliable signal of the market's expectations about a company's future performance. The key to successful investing is to estimate the level of expected performance embedded in the current stock price and then to assess the likelihood of a revision in expectations. Investors who properly read the market expectations and anticipate revisions increase their odds of achieving superior investment results. The expectations investing process allows you to identify the right expectations and effectively anticipate revisions in a company’s prospects. Expectations investing comprises the following three-step process:
Estimate Price-Implied Expectations. The expectations investor “reads” the expectations for cash flow embedded in a company's current stock price.
Identify Expectations Opportunities. The expectations investor then assesses those expectations, evaluates the company's competitive position, and considers the likelihood of upward or downward revisions in those expectations.
Buy, Sell, or Hold? The Expectations Investor makes a buy, sell, or hold decision, making sure that all investments have a clear-cut after-tax "margin of safety" between the stock's price today and the expected price tomorrow.
2. Do I need to be a financial guru to understand and apply the Expectations Investing approach?
If you feel comfortable reading The Wall Street Journal and other leading business and investment periodicals, you should easily grasp the basic concepts presented in the book.
To apply the expectations investing approach to selecting stocks, it helps to be familiar with spreadsheet software such as Microsoft Excel. We have made the spreadsheets presented in the book available for download at this web site, so don't worry; you won't need to create complex spreadsheets yourself!
3. Who should read this book?
This book brings the power of expectations investing to:
Institutional investors, security analysts, and investment advisors. Professional money managers who make investment decisions day-in and day-out, analysts who make stock recommendations, and investment advisors who often make buy and sell decisions for their clients will find that the Expectations Investing approach represents a fundamental shift from the way they evaluate stocks today.
Individual investors. Investment tools presented to the mass market are typically over-simplified so they can be easily understood, but as a consequence lack economic substance. Expectations investing is constructed on top of a solid economic foundation. Implementing expectations investing successfully, however, does require familiarity with the company and its competitive environment, finely honed insight, and dedication.
Corporate managers. We expect Expectations Investing to generate substantial interest in the corporate community. After all, both investors and managers accept stock prices as the "scorecard" for corporate performance. Companies seeking to outperform the Standard & Poor's 500 Index or an index of their peers can use expectations investing to establish the reasonableness of the goal.
Business students. All business schools offer finance courses that cover valuation and courses on competitive strategy. However, there are few courses that bridge competitive strategy and valuation. If you are eager to cross this chasm, Expectations Investing may be the book for you.
4. Can't I "read " market expectations using earnings per share (EPS) or price-to-earnings (P/E) multiples?
The answer is an emphatic "No"!
Investors who use EPS and P/E multiples may have their hearts in the right place, but their money on the wrong idea. Granted, the investment community undeniably fixates on EPS. Business publications amply cover quarterly earnings, EPS growth, and price-earnings multiples. This broad dissemination and the frequent market reactions to earnings announcements might lead some to believe that reported earnings strongly influence, if not totally determine stock prices.
Extensive empirical research finds that the market sets the prices of stocks just as it does any other financial asset. Specifically, the studies show two relationships. First, market prices respond to changes in a company’s cash-flow prospects. Second, market prices reflect long-term cash–flow prospects. Static measures such as reported EPS or estimates of next year’s EPS do not capture future performance, and ultimately they let investors down—especially in a global economy marked by spirited competition and disruptive technologies. Without assessing a company’s future cash-flow prospects, investors cannot reasonably conclude that a stock is undervalued or overvalued.
The investment community’s favorite valuation metric is the price-earnings (P/E) multiple. Presumably a stock’s value is the product of EPS and an “appropriate” P/E multiple. But since we know the EPS denominator of the P/E multiple, the only unknown is the appropriate share price, or P. We therefore are left with a useless tautology: To estimate value, we require an estimate of value.
This flawed logic underscores the fundamental point: The price-earnings multiple does not determine value; rather, it derives from value. Price-earnings analysis is not an analytic shortcut. It is an economic cul-de-sac.
5. Does Expectations Investing fall into the "growth" or "value" investing style?
Please don't associate us with either camp!
Most professional money managers classify their investing style as either “growth” or “value.” Growth managers seek companies that rapidly increase sales and profits and generally trade at high-price earnings multiples. Value managers seek stocks that trade at substantial discounts to their expected value and often have low price-earnings multiples. Significantly, fund industry consultants discourage money managers from drifting from their stated style, thus limiting their universe of acceptable stocks.
Expectations investing doesn’t distinguish between growth and value; managers simply pursue maximum long-term returns within a specified investment policy. As Warren Buffett convincingly argues, “Market commentators and investment managers who glibly refer to ‘growth’ and ‘value’ styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component—usually a plus, sometime a minus—in the value equation.”
6. Does Expectations Investing work for technology stocks?
Unquestionably!
Fundamental economic principles endure, and they are sufficiently robust to capture the dynamics of value creation across all types of companies and business models. The principles of value creation—which are central to the expectations investing process—are the ties that bind all companies.
While fundamental economic tenets apply to all companies, when analyzing technology stocks, we have to take into account their source of competitive advantage.
Most technology companies are essentially knowledge businesses that develop a competitive advantage by having their people develop an initial product that is then reproduced over and over again. This contrasts with physical businesses that leverage tangible assets to create a competitive advantage, and service businesses that rely on people as the main source of advantage and generally deliver their service on a one-to-one basis. We need to incorporate the primary characteristics of knowledge businesses into our analyses of technology companies:the importance of product obsolescence, high scalability, the production of "non-rival" goods such as software that can be used by many people at once, the difficulty of protecting intellectual capital, and the existence of demand-side economies of scale.
http://www.expectationsinvesting.com/faq.shtml
1. What is Expectations Investing about?
Stock prices are the clearest and most reliable signal of the market's expectations about a company's future performance. The key to successful investing is to estimate the level of expected performance embedded in the current stock price and then to assess the likelihood of a revision in expectations. Investors who properly read the market expectations and anticipate revisions increase their odds of achieving superior investment results. The expectations investing process allows you to identify the right expectations and effectively anticipate revisions in a company’s prospects. Expectations investing comprises the following three-step process:
Estimate Price-Implied Expectations. The expectations investor “reads” the expectations for cash flow embedded in a company's current stock price.
Identify Expectations Opportunities. The expectations investor then assesses those expectations, evaluates the company's competitive position, and considers the likelihood of upward or downward revisions in those expectations.
Buy, Sell, or Hold? The Expectations Investor makes a buy, sell, or hold decision, making sure that all investments have a clear-cut after-tax "margin of safety" between the stock's price today and the expected price tomorrow.
2. Do I need to be a financial guru to understand and apply the Expectations Investing approach?
If you feel comfortable reading The Wall Street Journal and other leading business and investment periodicals, you should easily grasp the basic concepts presented in the book.
To apply the expectations investing approach to selecting stocks, it helps to be familiar with spreadsheet software such as Microsoft Excel. We have made the spreadsheets presented in the book available for download at this web site, so don't worry; you won't need to create complex spreadsheets yourself!
3. Who should read this book?
This book brings the power of expectations investing to:
Institutional investors, security analysts, and investment advisors. Professional money managers who make investment decisions day-in and day-out, analysts who make stock recommendations, and investment advisors who often make buy and sell decisions for their clients will find that the Expectations Investing approach represents a fundamental shift from the way they evaluate stocks today.
Individual investors. Investment tools presented to the mass market are typically over-simplified so they can be easily understood, but as a consequence lack economic substance. Expectations investing is constructed on top of a solid economic foundation. Implementing expectations investing successfully, however, does require familiarity with the company and its competitive environment, finely honed insight, and dedication.
Corporate managers. We expect Expectations Investing to generate substantial interest in the corporate community. After all, both investors and managers accept stock prices as the "scorecard" for corporate performance. Companies seeking to outperform the Standard & Poor's 500 Index or an index of their peers can use expectations investing to establish the reasonableness of the goal.
Business students. All business schools offer finance courses that cover valuation and courses on competitive strategy. However, there are few courses that bridge competitive strategy and valuation. If you are eager to cross this chasm, Expectations Investing may be the book for you.
4. Can't I "read " market expectations using earnings per share (EPS) or price-to-earnings (P/E) multiples?
The answer is an emphatic "No"!
Investors who use EPS and P/E multiples may have their hearts in the right place, but their money on the wrong idea. Granted, the investment community undeniably fixates on EPS. Business publications amply cover quarterly earnings, EPS growth, and price-earnings multiples. This broad dissemination and the frequent market reactions to earnings announcements might lead some to believe that reported earnings strongly influence, if not totally determine stock prices.
Extensive empirical research finds that the market sets the prices of stocks just as it does any other financial asset. Specifically, the studies show two relationships. First, market prices respond to changes in a company’s cash-flow prospects. Second, market prices reflect long-term cash–flow prospects. Static measures such as reported EPS or estimates of next year’s EPS do not capture future performance, and ultimately they let investors down—especially in a global economy marked by spirited competition and disruptive technologies. Without assessing a company’s future cash-flow prospects, investors cannot reasonably conclude that a stock is undervalued or overvalued.
The investment community’s favorite valuation metric is the price-earnings (P/E) multiple. Presumably a stock’s value is the product of EPS and an “appropriate” P/E multiple. But since we know the EPS denominator of the P/E multiple, the only unknown is the appropriate share price, or P. We therefore are left with a useless tautology: To estimate value, we require an estimate of value.
This flawed logic underscores the fundamental point: The price-earnings multiple does not determine value; rather, it derives from value. Price-earnings analysis is not an analytic shortcut. It is an economic cul-de-sac.
5. Does Expectations Investing fall into the "growth" or "value" investing style?
Please don't associate us with either camp!
Most professional money managers classify their investing style as either “growth” or “value.” Growth managers seek companies that rapidly increase sales and profits and generally trade at high-price earnings multiples. Value managers seek stocks that trade at substantial discounts to their expected value and often have low price-earnings multiples. Significantly, fund industry consultants discourage money managers from drifting from their stated style, thus limiting their universe of acceptable stocks.
Expectations investing doesn’t distinguish between growth and value; managers simply pursue maximum long-term returns within a specified investment policy. As Warren Buffett convincingly argues, “Market commentators and investment managers who glibly refer to ‘growth’ and ‘value’ styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component—usually a plus, sometime a minus—in the value equation.”
6. Does Expectations Investing work for technology stocks?
Unquestionably!
Fundamental economic principles endure, and they are sufficiently robust to capture the dynamics of value creation across all types of companies and business models. The principles of value creation—which are central to the expectations investing process—are the ties that bind all companies.
While fundamental economic tenets apply to all companies, when analyzing technology stocks, we have to take into account their source of competitive advantage.
Most technology companies are essentially knowledge businesses that develop a competitive advantage by having their people develop an initial product that is then reproduced over and over again. This contrasts with physical businesses that leverage tangible assets to create a competitive advantage, and service businesses that rely on people as the main source of advantage and generally deliver their service on a one-to-one basis. We need to incorporate the primary characteristics of knowledge businesses into our analyses of technology companies:the importance of product obsolescence, high scalability, the production of "non-rival" goods such as software that can be used by many people at once, the difficulty of protecting intellectual capital, and the existence of demand-side economies of scale.
http://www.expectationsinvesting.com/faq.shtml
Do profits matter? It's a fine line to walk between generating profits and growing.
April 21, 2000 8:15 AM PDT
Patience-to-Earnings ratio wears thin for dot-coms
By Tiffany Kary
Staff Writer, CNET News
.With the Nasdaq well below its March 10 high of 5,048, investors are finally asking what the 'E' in the P/E, or price-to-earnings ratio, means.
Although profits suddenly mean something to dot-com investors, some analysts and executives maintain Net companies still need leeway to build out their businesses.
Do profits matter?
The profit tug-of-war will determine the direction of Net stocks for the foreseeable future, said investment experts. The tug-of-war is already underway -- shares of Excite@Home (Nasdaq: ATHM) fell Thursday after the company said it was foregoing near-term profits for long-term market share. The usually optimistic Merrill Lynch analyst Henry Blodget said he didn't 'see any positive catalysts for the stock.'
And in recent weeks, companies with no roadmap to earnings suffered the most (see chart). Shares of companies like CDNow (Nasdaq: CDNW), DrKoop.com (Nasdaq: KOOP) and Webvan (Nasdaq: WBVN) have been decimated.
As investors shun promising ideas for real results, dot-coms will have to generate cash instead of running back to the market for a quick-fix stock offering. To determine the long-term winners, investors will have to scrutinize business models and look for balance between growth and profitability.
Growth vs. profit
It's a fine line to walk between generating profits and growing. Excite@Home was panned by some analysts because it chose international expansion over immediate profits. The problem? Excite@Home has been profitable and has a track record. The market is more forgiving with promising newcomers.
'Companies that have been around for a while should have profits, but newcomers should be allowed time to build market share,' said Abhishek Gami, analyst for William Blair & Co.
Gami said he would allow business-to-consumer e-commerce companies about 12 to 18 months to become profitable. In the business-to-business space, a company should have as much as two to three years to turn a profit. In B2B, there are only a handful of competitors and a lot of market share to grab. With a portal, he wouldn't look at anything that didn't plan on earnings within 12 to 18 months.
About.com (Nasdaq: BOUT), which is far below its 52-week high of 105 13/16, is caught in the middle.
'Investors are looking at the total market, not individual companies,' said About.com CEO Scott Kurnit. 'They are looking at stock charts, and bringing the company down to at least 50 percent below its 52-week high, without regard for when the company reached its peak, or why.'
Kurnit is hoping a path to profits and strong third and fourth quarters will give About.com a boost. But his company is still in danger: Kurnit said About.com won’t be profitable for another 20 months.
The profit club
About.com is on the outside looking into a club that includes Yahoo! Inc. (Nasdaq: YHOO), eBay (Nasdaq: EBAY), America Online (NYSE: AOL), RealNetworks (Nasdaq: RNWK), Lycos (Nasdaq: LCOS) and Go2Net (Nasdaq: GNET). Inktomi (Nasdaq: INKT) and CNet (Nasdaq: CNET) are the latest members to the profitable dot-com club.
'The end game is, everyone will ask about profitability for every Net stock,' said Go2Net president John Keister. 'In 1997, people were talking about investing in earnings multiples for 2000, and now its 2002. People keep pushing it out.
'Smart investors, and institutional investors may not be satisfied with this anymore. Everyone has to trade on a multiple of earnings and revenue growth,' said Keister.
Leadership counts too
Leadership also counts for a lot. Chuck Hill, director of research at earnings tracking firm First Call, noted that profitable companies such as Yahoo, Go2Net, RealNetworks, AOL and Lycos have held up better than others, but said it doesn't have much to do with earnings. Hill said those companies are seen as industry leaders, which will survive. 'Even these companies are selling at multiples that are questionable,' he added.
'When a new company comes along, it's valued as a concept. Then there's a correction, and those that survive go on to be a good growth stock,' Hill said.
http://news.cnet.com/Patience-to-Earnings-ratio-wears-thin-for-dot-coms/2100-12_3-262272.html
Patience-to-Earnings ratio wears thin for dot-coms
By Tiffany Kary
Staff Writer, CNET News
.With the Nasdaq well below its March 10 high of 5,048, investors are finally asking what the 'E' in the P/E, or price-to-earnings ratio, means.
Although profits suddenly mean something to dot-com investors, some analysts and executives maintain Net companies still need leeway to build out their businesses.
Do profits matter?
The profit tug-of-war will determine the direction of Net stocks for the foreseeable future, said investment experts. The tug-of-war is already underway -- shares of Excite@Home (Nasdaq: ATHM) fell Thursday after the company said it was foregoing near-term profits for long-term market share. The usually optimistic Merrill Lynch analyst Henry Blodget said he didn't 'see any positive catalysts for the stock.'
And in recent weeks, companies with no roadmap to earnings suffered the most (see chart). Shares of companies like CDNow (Nasdaq: CDNW), DrKoop.com (Nasdaq: KOOP) and Webvan (Nasdaq: WBVN) have been decimated.
As investors shun promising ideas for real results, dot-coms will have to generate cash instead of running back to the market for a quick-fix stock offering. To determine the long-term winners, investors will have to scrutinize business models and look for balance between growth and profitability.
Growth vs. profit
It's a fine line to walk between generating profits and growing. Excite@Home was panned by some analysts because it chose international expansion over immediate profits. The problem? Excite@Home has been profitable and has a track record. The market is more forgiving with promising newcomers.
'Companies that have been around for a while should have profits, but newcomers should be allowed time to build market share,' said Abhishek Gami, analyst for William Blair & Co.
Gami said he would allow business-to-consumer e-commerce companies about 12 to 18 months to become profitable. In the business-to-business space, a company should have as much as two to three years to turn a profit. In B2B, there are only a handful of competitors and a lot of market share to grab. With a portal, he wouldn't look at anything that didn't plan on earnings within 12 to 18 months.
About.com (Nasdaq: BOUT), which is far below its 52-week high of 105 13/16, is caught in the middle.
'Investors are looking at the total market, not individual companies,' said About.com CEO Scott Kurnit. 'They are looking at stock charts, and bringing the company down to at least 50 percent below its 52-week high, without regard for when the company reached its peak, or why.'
Kurnit is hoping a path to profits and strong third and fourth quarters will give About.com a boost. But his company is still in danger: Kurnit said About.com won’t be profitable for another 20 months.
The profit club
About.com is on the outside looking into a club that includes Yahoo! Inc. (Nasdaq: YHOO), eBay (Nasdaq: EBAY), America Online (NYSE: AOL), RealNetworks (Nasdaq: RNWK), Lycos (Nasdaq: LCOS) and Go2Net (Nasdaq: GNET). Inktomi (Nasdaq: INKT) and CNet (Nasdaq: CNET) are the latest members to the profitable dot-com club.
'The end game is, everyone will ask about profitability for every Net stock,' said Go2Net president John Keister. 'In 1997, people were talking about investing in earnings multiples for 2000, and now its 2002. People keep pushing it out.
'Smart investors, and institutional investors may not be satisfied with this anymore. Everyone has to trade on a multiple of earnings and revenue growth,' said Keister.
Leadership counts too
Leadership also counts for a lot. Chuck Hill, director of research at earnings tracking firm First Call, noted that profitable companies such as Yahoo, Go2Net, RealNetworks, AOL and Lycos have held up better than others, but said it doesn't have much to do with earnings. Hill said those companies are seen as industry leaders, which will survive. 'Even these companies are selling at multiples that are questionable,' he added.
'When a new company comes along, it's valued as a concept. Then there's a correction, and those that survive go on to be a good growth stock,' Hill said.
http://news.cnet.com/Patience-to-Earnings-ratio-wears-thin-for-dot-coms/2100-12_3-262272.html
Valuation Methodologies
Despite their widespread usage, only limited theory is available to guide the application of multiples. With a few exceptions, the finance and accounting literature contain inadequate support on how or why certain multiples or comparable firms should be chosen in specific contexts. Compared to the DCF and RIV approach, standard textbooks on valuation devote little space to discussing the multiples valuation method.
Valuation Methodologies
This note provides an overview of the wide range of methodologies employed by Davy analysts when valuing shares.
One approach used is to apply average valuation multiples derived over multi-year periods, primarily with a view to smoothing cyclical effects.
Share-based multiples include:
Historic and forward price/earnings (P/E) ratios, based on normalised earnings before goodwill amortisation
Historic and forward price/cash-earnings (pre-depreciation) ratios
Price to net asset value per share
Dividend yields
Enterprise-based valuation multiples include:
Historic and forward earnings before depreciation, interest, tax, depreciation or amortisation (EBITDA) ratios; EBITDAR ratios are used where rental/lease charges (R) are material
Historic and forward EBITA ratios
Historic and forward operating cash-flow ratios
Enterprise value (EV)/sales ratios
EV/invested capital ratios
As enterprise values include net financial liabilities and minority interests, these are then deducted to arrive at the residual equity value.
Cyclical considerations
In the case of average earnings multiples, cognisance is given to the stage of the relevant industry cycle, as it may not be appropriate to apply average multiples towards the peak or trough of a cycle. In such cases, earnings multiples prevailing at the corresponding stages of previous cycles may be used.
Asset-based valuations
In the case of asset-based valuations, reported net assets generally provide a floor to a company's valuation. In many cases, however, company accounts can understate the underlying economic value of a company's assets, and a ratio such as return on invested capital to weighted average cost of capital (ROIC/WACC) may provide a more appropriate indicator of the book value multiple.
Company comparisons
The ratings of similar companies may be taken into account in valuing shares, as indeed may average ratings for particular industry sectors. Such ratings are commonly used in analysts' sum-of-the-parts (SOTP) valuations.
Cash-flow based valuation
In discounted cash-flow (DCF) models a company's forecast future free cash-flows are discounted by its weighted WACC. Due to the uncertainties involved in forecasting long-term cash-flows, analysts use a number of different DCF models.
Other valuation techniques
In some instances, other valuation metrics may be used. For instance, enterprise value per tonne of installed capacity may be used in capital-intensive sectors or in the earlier stages of a company's development.
http://www.davy.ie/Generic?page=valuationmethodologies
Valuation Methodologies
This note provides an overview of the wide range of methodologies employed by Davy analysts when valuing shares.
One approach used is to apply average valuation multiples derived over multi-year periods, primarily with a view to smoothing cyclical effects.
Share-based multiples include:
Historic and forward price/earnings (P/E) ratios, based on normalised earnings before goodwill amortisation
Historic and forward price/cash-earnings (pre-depreciation) ratios
Price to net asset value per share
Dividend yields
Enterprise-based valuation multiples include:
Historic and forward earnings before depreciation, interest, tax, depreciation or amortisation (EBITDA) ratios; EBITDAR ratios are used where rental/lease charges (R) are material
Historic and forward EBITA ratios
Historic and forward operating cash-flow ratios
Enterprise value (EV)/sales ratios
EV/invested capital ratios
As enterprise values include net financial liabilities and minority interests, these are then deducted to arrive at the residual equity value.
Cyclical considerations
In the case of average earnings multiples, cognisance is given to the stage of the relevant industry cycle, as it may not be appropriate to apply average multiples towards the peak or trough of a cycle. In such cases, earnings multiples prevailing at the corresponding stages of previous cycles may be used.
Asset-based valuations
In the case of asset-based valuations, reported net assets generally provide a floor to a company's valuation. In many cases, however, company accounts can understate the underlying economic value of a company's assets, and a ratio such as return on invested capital to weighted average cost of capital (ROIC/WACC) may provide a more appropriate indicator of the book value multiple.
Company comparisons
The ratings of similar companies may be taken into account in valuing shares, as indeed may average ratings for particular industry sectors. Such ratings are commonly used in analysts' sum-of-the-parts (SOTP) valuations.
Cash-flow based valuation
In discounted cash-flow (DCF) models a company's forecast future free cash-flows are discounted by its weighted WACC. Due to the uncertainties involved in forecasting long-term cash-flows, analysts use a number of different DCF models.
Other valuation techniques
In some instances, other valuation metrics may be used. For instance, enterprise value per tonne of installed capacity may be used in capital-intensive sectors or in the earlier stages of a company's development.
http://www.davy.ie/Generic?page=valuationmethodologies
Fair market valuation of a business
Fair market valuation of a business
Table of earnings multiples for groups of industries
(choose the earnings multiple for the industry closest to the one you are valuing)
Very narrow profit variation - 10 times average earnings
Cosmetics; Food; Tobacco; Utilities
Moderately narrow profit variation - 9 times average earnings
Amusement; Beverages; Chemical; Container; Drug; Meat Packing; Oil; Paper / Paper Products; Retail Trade; Sugar; Textile
Moderately wide profit variation - 7 times average earnings
Advertising; Agricultural Impt.; Aviation; Boots and Shoes; Coal; Electrical Equipment; Household Products; Financial; Leather; Office Equipment; Printing; Publishing; Radio; Railroad; Rubber; Shipping; Ship Building
Very wide profit variation - 6 times average earnings
Automobiles; Automobile Accessories; Construction; Machinery; Non-Ferrous Met.; R.R. Equipment; Steel
http://www.investordesktop.com/calcs/calcs/busins_fmvb_tbl.htm
Table of earnings multiples for groups of industries
(choose the earnings multiple for the industry closest to the one you are valuing)
Very narrow profit variation - 10 times average earnings
Cosmetics; Food; Tobacco; Utilities
Moderately narrow profit variation - 9 times average earnings
Amusement; Beverages; Chemical; Container; Drug; Meat Packing; Oil; Paper / Paper Products; Retail Trade; Sugar; Textile
Moderately wide profit variation - 7 times average earnings
Advertising; Agricultural Impt.; Aviation; Boots and Shoes; Coal; Electrical Equipment; Household Products; Financial; Leather; Office Equipment; Printing; Publishing; Radio; Railroad; Rubber; Shipping; Ship Building
Very wide profit variation - 6 times average earnings
Automobiles; Automobile Accessories; Construction; Machinery; Non-Ferrous Met.; R.R. Equipment; Steel
http://www.investordesktop.com/calcs/calcs/busins_fmvb_tbl.htm
Price to earnings ratio (P/E ratio) explained
Price to earnings ratio (P/E ratio) explained
by Kenneth W. McCarty
Price to earnings ratio (P/E ratio sometimes referred to as the multiple) is the current price per share divided by a years worth of earnings per share (EPS) for a particular stock. It is an important indicator of perceived value for a stock. Often it is used to compare two different stocks in the same sector (or two sectors in a given market) in an effort to find the better "deal". It sounds simple enough, but in practice it is a bit more complicated.
Not all publicly traded companies have earnings (they can have losses instead), yet these stocks clearly have value. P/E in such circumstance cannot be relied upon when it is negative or undefined. Much more important for estimating the current value of this type of equity are such things as cash on hand and other tangible assets. Some investors may anticipate that the stock will eventually have real earnings and add perceived value to the stock based on this assumption.
A backwards or "trailing" P/E takes into account only the earnings for the past year. In a "Bull Market", this form of P/E can be considered an indicator for the floor of a stock's share price. Instead of estimates, the earnings stated in the last 4 quarterly reports are publicly known and are generally not subject to change at a whim (except when future reports become current or the company is forced to make restatements by the SEC or an unfavorable audit).
Many investors prefer to use a forward P/E instead. This speculative potential of the stock's perceived worth that may or may not be added into the price anticipates and uses earnings over the next 12 months. Market forces determine how reliable such calculated predictions are and adjust prices accordingly. Company track records and economic influences are used by traders to judge the reliability of those numbers.
The difference between the two values that forward and backward P/E represent helps create volatility in the price of the stock as traders try to forecast earnings. Different stocks trade over different ranges of multiples for a variety of reasons. Many stocks in mature industries historically tend to trade between multiples of 10 and 20. Technology stocks that have real earnings often trade between multiples of 20 and 40. A company that has significant revenue growth may deserve a much higher multiple than this because the implication is that notable future earnings growth will continue to occur. When track records for 10Q quarterly reports are consistently positive, investors tend to follow the idea that solid companies under good management will continue to notify the market of future earnings growth. Investors like to trade on trends because "the trend is your friend".
When traders and investors on the market either become extremely pessimistic or optimistic, historical range standards for P/Es generally do not hold true over the short-term. During the height of the stock bubble of 1999 and 2000, too many stocks traded with ratios over 500! Such imbalances are eventually corrected and that is what happened. Knowing the historical standards gives us insight into why those stock prices eventually crashed so abruptly and steeply. The trend could no longer continue.
In contrast, currently there is a dramatic pessimism depressing prices in the stock market (since November of 2007). I've seen a number of technology stocks trade with a backward P/E of 10 or lower. Certainly in this financial environment a P/E of around 15 seems common for even a technology stock! Some might even consider the trend justified because of the implications inherent from a failing sub-prime loan market. Yet these P/E ratios are far below the historic average even in the worst of times.
Even more unusual is that some of those same stocks are experiencing record breaking increased earnings with projected significant earnings growth - despite the continued horrendous condition of the financial sector. Some of these stock's earnings performance over the last 6 to 9 months have even been better than the most optimistic expectations. Yet a few of these top performers have had their price cut nearly in half with little to no recovery! Clearly there are forces other than just P/E ratios and growth potential at work when the market determines the worth of a given stock at any given time. Part of my job as a trader is to ask why this is happening at this particular time and respond appropriately. Keep in mind that history tells us a significant correction to the upside is inevitable once investors recognize the "good deals" available.
http://www.helium.com/items/1082973-what-is-pe-ratio
by Kenneth W. McCarty
Price to earnings ratio (P/E ratio sometimes referred to as the multiple) is the current price per share divided by a years worth of earnings per share (EPS) for a particular stock. It is an important indicator of perceived value for a stock. Often it is used to compare two different stocks in the same sector (or two sectors in a given market) in an effort to find the better "deal". It sounds simple enough, but in practice it is a bit more complicated.
Not all publicly traded companies have earnings (they can have losses instead), yet these stocks clearly have value. P/E in such circumstance cannot be relied upon when it is negative or undefined. Much more important for estimating the current value of this type of equity are such things as cash on hand and other tangible assets. Some investors may anticipate that the stock will eventually have real earnings and add perceived value to the stock based on this assumption.
A backwards or "trailing" P/E takes into account only the earnings for the past year. In a "Bull Market", this form of P/E can be considered an indicator for the floor of a stock's share price. Instead of estimates, the earnings stated in the last 4 quarterly reports are publicly known and are generally not subject to change at a whim (except when future reports become current or the company is forced to make restatements by the SEC or an unfavorable audit).
Many investors prefer to use a forward P/E instead. This speculative potential of the stock's perceived worth that may or may not be added into the price anticipates and uses earnings over the next 12 months. Market forces determine how reliable such calculated predictions are and adjust prices accordingly. Company track records and economic influences are used by traders to judge the reliability of those numbers.
The difference between the two values that forward and backward P/E represent helps create volatility in the price of the stock as traders try to forecast earnings. Different stocks trade over different ranges of multiples for a variety of reasons. Many stocks in mature industries historically tend to trade between multiples of 10 and 20. Technology stocks that have real earnings often trade between multiples of 20 and 40. A company that has significant revenue growth may deserve a much higher multiple than this because the implication is that notable future earnings growth will continue to occur. When track records for 10Q quarterly reports are consistently positive, investors tend to follow the idea that solid companies under good management will continue to notify the market of future earnings growth. Investors like to trade on trends because "the trend is your friend".
When traders and investors on the market either become extremely pessimistic or optimistic, historical range standards for P/Es generally do not hold true over the short-term. During the height of the stock bubble of 1999 and 2000, too many stocks traded with ratios over 500! Such imbalances are eventually corrected and that is what happened. Knowing the historical standards gives us insight into why those stock prices eventually crashed so abruptly and steeply. The trend could no longer continue.
In contrast, currently there is a dramatic pessimism depressing prices in the stock market (since November of 2007). I've seen a number of technology stocks trade with a backward P/E of 10 or lower. Certainly in this financial environment a P/E of around 15 seems common for even a technology stock! Some might even consider the trend justified because of the implications inherent from a failing sub-prime loan market. Yet these P/E ratios are far below the historic average even in the worst of times.
Even more unusual is that some of those same stocks are experiencing record breaking increased earnings with projected significant earnings growth - despite the continued horrendous condition of the financial sector. Some of these stock's earnings performance over the last 6 to 9 months have even been better than the most optimistic expectations. Yet a few of these top performers have had their price cut nearly in half with little to no recovery! Clearly there are forces other than just P/E ratios and growth potential at work when the market determines the worth of a given stock at any given time. Part of my job as a trader is to ask why this is happening at this particular time and respond appropriately. Keep in mind that history tells us a significant correction to the upside is inevitable once investors recognize the "good deals" available.
http://www.helium.com/items/1082973-what-is-pe-ratio
When to start investing for retirement
When to start investing for retirement
by Janet Grischy
The best time to prepare for your retirement is when it seems much too far off to worry about. People in their twenties and early thirties know they have years before retirement, but they may not know how quickly those years will pass. Money put into a retirement vehicle in your youth is worth ten times or more what the same amount will be worth if socked away at age 59. That's because of compounding.
Compounding is the magic ingredient in retirement investing. It can turn a pile of small investments into millions, given time. The longer an investment has to grow, the more likely you'll retire as a billionaire. This is because as the years pass you get a return on your investment, and then a return on the return, and then a return on the return on the return, and so on.
Many people start investing for retirement when they get their first "real" job, when their company or union makes a payroll deduction plan available to them. That way, money is taken out of their pay before they ever see it, and preparing for the future is easy, because it's automated. Americans who are self-employed, or who change jobs often, need to start their own investment plan, making it a habit to consistently put money in an IRA or Keogh each pay period.
Money in an IRA or Keogh avoids taxes, either when it's put in or when it is taken out, and it's all quite legal! Without the drag of taxes to slow you down, you can invest more, faster. It will grow much faster too. Your investing also helps your country, by adding to the stock of capital available to business and industry.
Another good time to invest is in your thirties and forties. Now you are mature, and acquainted with the financial realities of life. You have a clear idea of the kind of retirement you want, and can make a plan to go after it. You'll have to save a bit more than you would have if you'd started sooner, but you may be making more than you did then, too.
Even the fifties and sixties are a good time to start investing for retirement. The government knows that you have to make up for the investments you neglected to make earlier, so it permits larger contributions to your IRA at this age. The sense of urgency you feel will also help guide you when you make decisions that will affect your finances.
When is the best time to prepare for your future by investing for retirement? There's a simple answer to that question. Now.
http://www.helium.com/items/1248480-when-to-start-investing-for-retirement
by Janet Grischy
The best time to prepare for your retirement is when it seems much too far off to worry about. People in their twenties and early thirties know they have years before retirement, but they may not know how quickly those years will pass. Money put into a retirement vehicle in your youth is worth ten times or more what the same amount will be worth if socked away at age 59. That's because of compounding.
Compounding is the magic ingredient in retirement investing. It can turn a pile of small investments into millions, given time. The longer an investment has to grow, the more likely you'll retire as a billionaire. This is because as the years pass you get a return on your investment, and then a return on the return, and then a return on the return on the return, and so on.
Many people start investing for retirement when they get their first "real" job, when their company or union makes a payroll deduction plan available to them. That way, money is taken out of their pay before they ever see it, and preparing for the future is easy, because it's automated. Americans who are self-employed, or who change jobs often, need to start their own investment plan, making it a habit to consistently put money in an IRA or Keogh each pay period.
Money in an IRA or Keogh avoids taxes, either when it's put in or when it is taken out, and it's all quite legal! Without the drag of taxes to slow you down, you can invest more, faster. It will grow much faster too. Your investing also helps your country, by adding to the stock of capital available to business and industry.
Another good time to invest is in your thirties and forties. Now you are mature, and acquainted with the financial realities of life. You have a clear idea of the kind of retirement you want, and can make a plan to go after it. You'll have to save a bit more than you would have if you'd started sooner, but you may be making more than you did then, too.
Even the fifties and sixties are a good time to start investing for retirement. The government knows that you have to make up for the investments you neglected to make earlier, so it permits larger contributions to your IRA at this age. The sense of urgency you feel will also help guide you when you make decisions that will affect your finances.
When is the best time to prepare for your future by investing for retirement? There's a simple answer to that question. Now.
http://www.helium.com/items/1248480-when-to-start-investing-for-retirement
WHAT DOES PE RATIO TELL YOU?
WHAT DOES IT TELL YOU?
The P/E ratio gives us an idea of how much the investors are willing to pay for the company's earnings. The higher the P/E, more the chances of good earnings in the future and the higher premium investors are ready to pay for that anticipated growth. A lower ratio on the other hand means just the opposite; that the market has ruled out the company.
But just because the ratio is very high or very low cannot help investors to make a decision. A high P/E can also be an overpriced stock. Also if one stock has double the P/E of another stock in the same industry, but with the same rate of earnings growth, it is not seen to be a wise investment as more money has to be shelled out. A low P/E ratio may be a market that was overlooked. The investors who discover the true worth of such stocks make big fortunes overnight.
There are various interpretations for the P/E value and this is just one of them:
*N/A: A company with no earnings has an undefined P/E ratio. Companies with losses or negative earnings also fall under this category.
*0-10: This means that the company's earnings are declining. It could also mean an overlooked stock.
*10-17: This is the average healthy value
*17-25: This means that the stock is either overvalued or its earnings are increasing.
*25+: Such companies are expected to have high future growth in earnings.
It is important that investors note avoid basing a decision on this measure alone. The ratio is dependent on share price which can fluctuate according to changes in the market.
http://www.helium.com/items/1059698-price-to-earnings-ratio-pe-ratio-explained
The P/E ratio gives us an idea of how much the investors are willing to pay for the company's earnings. The higher the P/E, more the chances of good earnings in the future and the higher premium investors are ready to pay for that anticipated growth. A lower ratio on the other hand means just the opposite; that the market has ruled out the company.
But just because the ratio is very high or very low cannot help investors to make a decision. A high P/E can also be an overpriced stock. Also if one stock has double the P/E of another stock in the same industry, but with the same rate of earnings growth, it is not seen to be a wise investment as more money has to be shelled out. A low P/E ratio may be a market that was overlooked. The investors who discover the true worth of such stocks make big fortunes overnight.
There are various interpretations for the P/E value and this is just one of them:
*N/A: A company with no earnings has an undefined P/E ratio. Companies with losses or negative earnings also fall under this category.
*0-10: This means that the company's earnings are declining. It could also mean an overlooked stock.
*10-17: This is the average healthy value
*17-25: This means that the stock is either overvalued or its earnings are increasing.
*25+: Such companies are expected to have high future growth in earnings.
It is important that investors note avoid basing a decision on this measure alone. The ratio is dependent on share price which can fluctuate according to changes in the market.
http://www.helium.com/items/1059698-price-to-earnings-ratio-pe-ratio-explained
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