One of the things I find fascinating about markets and the economy is the tendency towards mean reversion. Rather than taking a random-walk, markets seem to shuffle back in forth, contained within a tight range of possibilities. One of the places you see this is with the stock market averages. In Jeremy Siegel's book, "Stocks for the Long Run", he shows a plot (need a link) of the stock market average from 1830 to the present. Amazingly, it is nearly a straight line (on a log-axis) when corrected for inflation which indicates a steady 6.9% return over long periods of 30 years or so. In the shorter term, there are "wiggles" like the great crash of 1929 and the great bull market of the 1990s but over long periods you see it return to the trend. Other investments like bonds or real estate or gold do not show any kind of regularity. Stocks do not behave as a random walk, where the next move is simply random. Even though the country has changed dramatically from a agricultural economy to an industrial economy and then finally a service economy, the stock market returns have not changed a bit. Over 30 year periods, you simply get a 6.9% real return just like you always have.
Well, this isn't a history class. What does this mean for investors? There are a number of useful things to take away from this. Lets stick with the stock market averages for now. For one, it means that the current prices of stocks are not really the best predictor of where they will likely be in the future. This contradicts the Efficient Market Hypothesis (EMH) which says that the current price of stocks is really the best predictor: the price tells you everything and the trend tells you nothing. Mean reversion says the best predictor is really the trend itself. If your below trend, then your most likely to move upward back to the trend. If your above the trend then the opposite is more likely to happen. The long term data clearly indicates that mean reversion and not random walks is a better description of the stock market averages. In other words, in times like 1980 when stocks were well below the trend, we should have known better and simply loaded up on stocks. It should have been a no brainer and of course it is in hindsight. We were way below trend and they were practically giving stocks away. Of course most people hated stocks then. Business Week had their famous "Death of Equities" cover. In the opposite extreme was 1929 and 1999 when we were way above trend but crazy about equities. Using the insight of mean reversion should have convinced people to pull out and ignore stocks for a while. Of course we know what happened. The bubble bursted and we heading back to the trend. Surprise, surprise.
Other places that you see mean reversion is with whole industries. Banking for example goes through periods of high profits and periods of low profits. Same with insurance companies. Real estate also has these cycles. By understanding that these cycles are temporary and actually acting on this insight, you can out-perform the indices. Of course, not everyone can do this anymore than everyone can be taller than average. There seems to be some principle that keeps the average person at a 6.9% return. The goal of the stock picker to be better than average. But clearly only a few of us can do this. Others need to underperform and most will simply cling to the average by buying index funds.
The value investor is someone who tries to appreciate this principle of mean reversion. They seek to buy things that are out of favor and probably performing below average. The hope is that, as usual, things will change and this company's fortunes will change for the better. If the company is selling for a cheap enough price, then it will appreciate quickly when things begin to change. In my opinion, the best places to do this are with older companies that have survived many such cycles. For example, buy high quality and conservative insurance companies when profits are lower than usual. This is usually when there is a soft market and many companies are jumping into insurance and fighting for market share and so lowering prices. This eventaully will change when there is a crisis and these new companies become unprofitable and start to pull their capital from the insurance business. This allows prices to rise and the old stalwart insurance company becomes more profitable again. Other examples. Buy home builders during a housing crash (like now). Buy industrials during a recession.
The key is that you may have to wait a a while to get good returns. It is very difficult to forcast accurately when things will change. In fact it is probably almost useless to try to guess since the Market is a great discounting machine that is trying to determine this before you do. Marty Whitman has said that you should try to buy at the point of maximum fear. Of course you never know that you have reached this point. Buffett has said to "be feraful when others are greedy and greedy when others are fearful". However getting the timing right is difficult at best. Buffett has made the point that what you really do is simply try to figure out how much the company is worth as the total discounted cash flow (DCF) over its lifetime. This is the long view and to do this you need to assume that things will revert to the mean. You should not simply extrapolate the present situation because that is what the Market does. To beat the market, you should use the principle of mean reversion.
Why do things revert to the mean? That is the great mystery and we will leave that one to the philosophers and the social scientists. What an investor needs to know is that for whatever reason it is simply a proprerty of the markets. To beat the market averages you should work it into your investment scheme. If everyone did this and we had a market of DCF robots then maybe this wouldn't work. But Markets are controlled by people and people are afraid to lose money and get more afraid as security prices drop. This makes them ignore mean reversion and miss opportunities that value investors take advantage of. This is unlikely to change anytime soon as it appears to be simply a part if human nature. If we can resist these human emotions and invest more objectively, we have a chance at above average returns.
Thursday, February 15, 2007
Saturday, January 27, 2007
Friday, December 22, 2006
Two value strategies
I believe that all good investing involves buying something below it real value. Up until now I have been concentrating on what may be called a Buffett strategy. This is essentially investing in good business at prices below their value. For example you can buy companies with high return on equity (ROE) and low P/E. You can make guesses about their probable future growth and so estimate their fair value P/E and buy if the market P/E is below that.
There is another way where you buy companies at low price to book value, P/B, regardless of whether they are good or bad. These strategies are connected because of the identity
P/B = P/E * ROE
This is true simply because ROE = E/B. So you can't really have low P/E , low P/B AND high ROE. You need to choose whether you want to go with high ROE and low P/E or low ROE and low P/B. With good companies like Coke or Walmart your going to get stable and predictable earnings, high ROE and high P/B. Generally you care about getting them at low P/E.
The other strategy is buying companies with low P/B. In the extreme you want to get things where the Current Assets - Liabilities is less than the market cap. This is tangible book value and is what you would get (hopefully) if the company was liquidated right away.
The main difference is that for the growth companies, you are valuing the companies based on the earnings that will come in the future. For the low P/B companies you are simply looking at what is there already. In some ways these low P/B companies are a more conservative bet. You don't need to project far in the future. You just look at what is there. The trick for these is to figure out whether your actually going to be able to extract that value.
Things can go wrong. The management can piss away stockholder value by trying to save the company with hair-brained schemes or outright fraud. When tangible book value is substantially more than market cap, the stockholders would usually be happy if the company simply liquidated and paid out a final dividend. However often this doesn't happen. If the CEO is getting a high salary he is often happy bleeding the company for years and simply collecting salary. He need to look for management with interests alligned with shareholders. You also need to look out for other liabilities that may arise such as pending lawsuits or other fishy things on the balance sheet or 10Qs.
Combining these two strategies is probably a good idea since they should be uncorrelated. In fact the low P/B stocks themselves should have practically no correlation and so is good for diversification. The diversification thing is more than just reducing volatility. Value investors shouldn't fear that. It has more to do with the fact that some of these companies will blow up and could cost you everything you put in. However most will return above book value. Some of these will more than triple in a few years and should make up for the occasional loss. It is not short term volatility that matters but rather volatility of long term portfolio growth. If you lose it all your done. This relates to the Kelly formula from gambling theory. Never bet your whole payroll on one bet. Figure out the right amount to bet on each based in your edge and the odds your getting.
Also with these low P/B companies you have low expectations of earnings growth. Generally you just want them to quit losing money, stablize their business and generate postive earnings with below average ROE. Then they return to above book value and you sell them. This could be considered more conservative than expecting an already good company to get even better and grow even faster. It is these low expectations that make them a reasonably good investment.
There is another way where you buy companies at low price to book value, P/B, regardless of whether they are good or bad. These strategies are connected because of the identity
P/B = P/E * ROE
This is true simply because ROE = E/B. So you can't really have low P/E , low P/B AND high ROE. You need to choose whether you want to go with high ROE and low P/E or low ROE and low P/B. With good companies like Coke or Walmart your going to get stable and predictable earnings, high ROE and high P/B. Generally you care about getting them at low P/E.
The other strategy is buying companies with low P/B. In the extreme you want to get things where the Current Assets - Liabilities is less than the market cap. This is tangible book value and is what you would get (hopefully) if the company was liquidated right away.
The main difference is that for the growth companies, you are valuing the companies based on the earnings that will come in the future. For the low P/B companies you are simply looking at what is there already. In some ways these low P/B companies are a more conservative bet. You don't need to project far in the future. You just look at what is there. The trick for these is to figure out whether your actually going to be able to extract that value.
Things can go wrong. The management can piss away stockholder value by trying to save the company with hair-brained schemes or outright fraud. When tangible book value is substantially more than market cap, the stockholders would usually be happy if the company simply liquidated and paid out a final dividend. However often this doesn't happen. If the CEO is getting a high salary he is often happy bleeding the company for years and simply collecting salary. He need to look for management with interests alligned with shareholders. You also need to look out for other liabilities that may arise such as pending lawsuits or other fishy things on the balance sheet or 10Qs.
Combining these two strategies is probably a good idea since they should be uncorrelated. In fact the low P/B stocks themselves should have practically no correlation and so is good for diversification. The diversification thing is more than just reducing volatility. Value investors shouldn't fear that. It has more to do with the fact that some of these companies will blow up and could cost you everything you put in. However most will return above book value. Some of these will more than triple in a few years and should make up for the occasional loss. It is not short term volatility that matters but rather volatility of long term portfolio growth. If you lose it all your done. This relates to the Kelly formula from gambling theory. Never bet your whole payroll on one bet. Figure out the right amount to bet on each based in your edge and the odds your getting.
Also with these low P/B companies you have low expectations of earnings growth. Generally you just want them to quit losing money, stablize their business and generate postive earnings with below average ROE. Then they return to above book value and you sell them. This could be considered more conservative than expecting an already good company to get even better and grow even faster. It is these low expectations that make them a reasonably good investment.
Thursday, December 21, 2006
Concord Camera (LENS)
This company is terrible. Their stock is abysmal. I just bought $2K of shares. Basically they sell single use cameras, traditional 35mm cameras and digital cameras. They are losing money not gaining it. However what makes them a buy is that they have little debt and lots of cash and they are selling for less than the cash on the books. Somewhere around half the tangible book value.
A company like this should be liquidated for its assets. Unfortunately that isn't going to happen. They may get bought out but probably will attempt to return to profitability. That might happen. I am just hoping that they will stop burning cash and stabilize so that the market starts to value them at something close to book value.
I think there is a decent chance of that happening. They are ditching the digital camera sales which is good because they had negative gross margins. They also must have required more R&D to keep up with the trends. They will be left with one time use cameras and traditionals which should be fairly easy to produce for a profit. Lets hope. I don't need to large profit to make me a profit. I just need them to stop bleeding cash. I think that is happening now. Last quarter they had break even cash flow.
Another positive is that the terrible CEO is buying shares. He seems like a greedy bastard but at least I can count on him to look out for himself. If he is buying he probably sees good times ahead or at least sees the company as being undervalued. With all of their assets, that is not hard to believe.
Then there is their new product, the OnGuard Kids Safety Watches.
http://www.onguardkids.com/
Basically they are watches for which kids can set off an alarm if they are grabbed by a stranger. These will sell for $39 and probably will make a decent gross margin. Sounds rediculous but then again so are paranoid american mothers. I think these will augment the operating margins and so I see this as a good thing.
If all goes well this company may double within the year. If all goes to hell, I think the major holders will force the company to liquidate while it still has assets. I don't think the downside is so bad and it has quite a bit of upside. Overall I think this is a good bet.
A company like this should be liquidated for its assets. Unfortunately that isn't going to happen. They may get bought out but probably will attempt to return to profitability. That might happen. I am just hoping that they will stop burning cash and stabilize so that the market starts to value them at something close to book value.
I think there is a decent chance of that happening. They are ditching the digital camera sales which is good because they had negative gross margins. They also must have required more R&D to keep up with the trends. They will be left with one time use cameras and traditionals which should be fairly easy to produce for a profit. Lets hope. I don't need to large profit to make me a profit. I just need them to stop bleeding cash. I think that is happening now. Last quarter they had break even cash flow.
Another positive is that the terrible CEO is buying shares. He seems like a greedy bastard but at least I can count on him to look out for himself. If he is buying he probably sees good times ahead or at least sees the company as being undervalued. With all of their assets, that is not hard to believe.
Then there is their new product, the OnGuard Kids Safety Watches.
http://www.onguardkids.com/
Basically they are watches for which kids can set off an alarm if they are grabbed by a stranger. These will sell for $39 and probably will make a decent gross margin. Sounds rediculous but then again so are paranoid american mothers. I think these will augment the operating margins and so I see this as a good thing.
If all goes well this company may double within the year. If all goes to hell, I think the major holders will force the company to liquidate while it still has assets. I don't think the downside is so bad and it has quite a bit of upside. Overall I think this is a good bet.
Thursday, December 14, 2006
The psychology of investing
Picking stocks can be a very frustrating experience. I think different people have different psychological problems when it comes to investing. Some example are
1) Getting caught up in a bull market
When stock are going up you feel your getting left behind. If you don't buy now, you might not get the chance to buy at all.
This is a dangerous one. I have learned to look out for it. My first experience was gold as it started to accelerate to $700/oz. Naturally I rushed into this one and bought at the top and then panicked when it crashed and sold at the bottom. I only lost $100 or so but enough to learn a lesson. The lesson there was mostly to avoid speculation. Gold is always a speculation. I can value stock fairly well but commodies? I am going to leave that one to other people and concentrate on what I can do well. I don't think I will get too caught up in this in the future but will be on the outlook.
2) Indecision on when to buy
This is always hard. Do I buy now or wait for it to go down further. I need to develop some kind of method for making this decision. This can be stressful since you tend to go back and forth everyday depending on how you feel about the economy and which article/webpage you happen to have read last.
3) Which to choose from?
Usually I can boil things down to a few candidates. For example right now some candidates on my list are JNJ, Walmart, K-Swiss, Meritage Homes, Home Depot. All are clearly undervalued but by how much? There is also the timeliness issue. Even if K-Swiss is undervalued, it is going to go down in a hurry if we have a consumer pull back. So maybe I should wait on those kind of stocks and buy stocks like JNJ which I only expect to go up. Of course you can be dead wrong on the short term direction of the stocks. I could always just buy all of them. The problem there is that I don't want to have a portfolio of 50 stocks since I don't have the time to cover all of them. If I am going to start buying so many stocks I might as well just buy the Dow. I want to keep my portfolio focused but feel afraid of missing a good opportunity.
4) Fear in a falling market
I haven't really experienced this too much except (as mentioned) with gold. I think if you have enough confidence in your stocks, you can avoid this. The trick is knowing your companies and knowing how much they are worth. Only then can you be confident that the market is wrong and you are right.
1) Getting caught up in a bull market
When stock are going up you feel your getting left behind. If you don't buy now, you might not get the chance to buy at all.
This is a dangerous one. I have learned to look out for it. My first experience was gold as it started to accelerate to $700/oz. Naturally I rushed into this one and bought at the top and then panicked when it crashed and sold at the bottom. I only lost $100 or so but enough to learn a lesson. The lesson there was mostly to avoid speculation. Gold is always a speculation. I can value stock fairly well but commodies? I am going to leave that one to other people and concentrate on what I can do well. I don't think I will get too caught up in this in the future but will be on the outlook.
2) Indecision on when to buy
This is always hard. Do I buy now or wait for it to go down further. I need to develop some kind of method for making this decision. This can be stressful since you tend to go back and forth everyday depending on how you feel about the economy and which article/webpage you happen to have read last.
3) Which to choose from?
Usually I can boil things down to a few candidates. For example right now some candidates on my list are JNJ, Walmart, K-Swiss, Meritage Homes, Home Depot. All are clearly undervalued but by how much? There is also the timeliness issue. Even if K-Swiss is undervalued, it is going to go down in a hurry if we have a consumer pull back. So maybe I should wait on those kind of stocks and buy stocks like JNJ which I only expect to go up. Of course you can be dead wrong on the short term direction of the stocks. I could always just buy all of them. The problem there is that I don't want to have a portfolio of 50 stocks since I don't have the time to cover all of them. If I am going to start buying so many stocks I might as well just buy the Dow. I want to keep my portfolio focused but feel afraid of missing a good opportunity.
4) Fear in a falling market
I haven't really experienced this too much except (as mentioned) with gold. I think if you have enough confidence in your stocks, you can avoid this. The trick is knowing your companies and knowing how much they are worth. Only then can you be confident that the market is wrong and you are right.
Monday, December 11, 2006
CRFT - How a drop in the dollar can kill it
I like this little company Craftmade International INC (CRFT) which makes ceiling fans and outdoor lighting accesories. They make good returns on equity (fairly steady ROE= 25%). They have been growing earnings at about 20% over the last 10 years. They are still tiny (market cap $96M) so have plenty of room to grow.
I even called around and and asked all kinds of people about their fans. Apparantly they are top notch. Based on the usual valuations they are quite cheap EBIT/EV = 17%. They even have an 8% Free cash flow yield (on EV). On top of that thet have a dividend yield of 2.6%.
So what is wrong with this company? Two things.
First of all they sell half of their product to the new home market. Housing starts are down 20% and will probably fall another 20%. So they may see a 20% revenue drop from that. But that is simply a cyclical phenomenon, not a problem with the business. Starts will rise again someday and the market will improve.
What will kill their business? A dollar decline could. To see this, we need to understand how this business works. Basically they are very light on assets. They design the fans, outsource manufacturing to China and Taiwan and sell them to US new home builders and home refurbishers. This company has fairly steady 6% net margins. This means that any change in their cost of goods and sales (CG&S) is magnified by a factor of 100/6=16.7 in net income.
They are very up front about this in their annual report
http://www.sec.gov/Archives/edgar/data/856250/000095013406017675/d39626e10vk.htm
They say that a 1% drop in the dollar will decrease annual net income by $1.15M. Net income is $7.1M so this is 16.2% which agrees with my 1/(Net Margin) calculation for the degree of magnification. In other words a 6.2% decline in the dollar versus these currencies will result in the entire loss of income. In fact a 26.3% decline in the dollar wipes out all $30.3M of stockholder equity.
Here is the dollar versus the Taiwanese dollar and the Yuan.
http://finance.yahoo.com/q/bc?s=USDTWD=X&t=2y&l=on&z=m&q=l&c=usdcny=x
The USD to TWD has lots of flucuation but has declined about 3% in a two months (this is Dec 11 2006). The dollar has been falling versus the Yuan since they unpegged it a little over a year ago. It is down almost 6%. If this continues then CRFT is history. It's entire business model is based cheap goods and sales from Asia and sold to the insatiable US consumer. How could it survive? It would have to raise prices to compensate. Can CRFT raise prices on ceiling fans amid a severe housing contraction? No way. In fact their will probably be a supply glut and prices will probably fall. CRFT may in fact be a good short opportunity.
I think this is an excellent micro example of a larger macro phenomenon. Most people think that if the dollar declines by 5% it means that their trip to Europe becomes 5% more expensive. They wouldn't think about a company going bankrupt because of it. The concept of leverage is clearly displayed here. However the dollar might not decline. Maybe globalization has created so much foreign labor that companies like CRFT will be able to keep lowering labor prices by shopping around. In fact I think this is why they have been moving away from Taiwan to China. Maybe they will be OK after all? Or maybe not. I think they began this move before the Yuan was unpegged and before the Secretary of the Treasury was going around asking the Chinese to lower their currency.
The moral of the story is (I think) to stick to companies with much higher net profit margins like JNJ (20%), KO (21%) and MSFT (28.5%) and stay away from little speculative companies that are highly leveraged to things like exchange rates. This is another reason to prefer old companies who have survived many such currency/economic cycles.
I even called around and and asked all kinds of people about their fans. Apparantly they are top notch. Based on the usual valuations they are quite cheap EBIT/EV = 17%. They even have an 8% Free cash flow yield (on EV). On top of that thet have a dividend yield of 2.6%.
So what is wrong with this company? Two things.
First of all they sell half of their product to the new home market. Housing starts are down 20% and will probably fall another 20%. So they may see a 20% revenue drop from that. But that is simply a cyclical phenomenon, not a problem with the business. Starts will rise again someday and the market will improve.
What will kill their business? A dollar decline could. To see this, we need to understand how this business works. Basically they are very light on assets. They design the fans, outsource manufacturing to China and Taiwan and sell them to US new home builders and home refurbishers. This company has fairly steady 6% net margins. This means that any change in their cost of goods and sales (CG&S) is magnified by a factor of 100/6=16.7 in net income.
They are very up front about this in their annual report
http://www.sec.gov/Archives/edgar/data/856250/000095013406017675/d39626e10vk.htm
They say that a 1% drop in the dollar will decrease annual net income by $1.15M. Net income is $7.1M so this is 16.2% which agrees with my 1/(Net Margin) calculation for the degree of magnification. In other words a 6.2% decline in the dollar versus these currencies will result in the entire loss of income. In fact a 26.3% decline in the dollar wipes out all $30.3M of stockholder equity.
Here is the dollar versus the Taiwanese dollar and the Yuan.
http://finance.yahoo.com/q/bc?s=USDTWD=X&t=2y&l=on&z=m&q=l&c=usdcny=x
The USD to TWD has lots of flucuation but has declined about 3% in a two months (this is Dec 11 2006). The dollar has been falling versus the Yuan since they unpegged it a little over a year ago. It is down almost 6%. If this continues then CRFT is history. It's entire business model is based cheap goods and sales from Asia and sold to the insatiable US consumer. How could it survive? It would have to raise prices to compensate. Can CRFT raise prices on ceiling fans amid a severe housing contraction? No way. In fact their will probably be a supply glut and prices will probably fall. CRFT may in fact be a good short opportunity.
I think this is an excellent micro example of a larger macro phenomenon. Most people think that if the dollar declines by 5% it means that their trip to Europe becomes 5% more expensive. They wouldn't think about a company going bankrupt because of it. The concept of leverage is clearly displayed here. However the dollar might not decline. Maybe globalization has created so much foreign labor that companies like CRFT will be able to keep lowering labor prices by shopping around. In fact I think this is why they have been moving away from Taiwan to China. Maybe they will be OK after all? Or maybe not. I think they began this move before the Yuan was unpegged and before the Secretary of the Treasury was going around asking the Chinese to lower their currency.
The moral of the story is (I think) to stick to companies with much higher net profit margins like JNJ (20%), KO (21%) and MSFT (28.5%) and stay away from little speculative companies that are highly leveraged to things like exchange rates. This is another reason to prefer old companies who have survived many such currency/economic cycles.
Saturday, December 9, 2006
The other vaulation method - EGM
There is another way to value stocks besides DCF that isn't too bad. I don't know what its name is but we can call it the explicit growth method (EGM).
It is fairly well based in reality. How do you make money on a stock? You buy it, hold it for some time and then sell it. The profit (or loss) is the dividends that you have collected plus the capital gains (or loss).
So lets assume that we have an initial valuation metric P/E. One could use any of them such as P/B or P/D P/CF etc.
Lets ignore dividends first off. If the stock grows at G for N years then the earnings will be E_0 * (1+G)^N. If the valuation P/E stays the same you will have obtained a anulaized return of G. That pretty easy. If the valuation changes then the price of the stock will be P=(P/E) * E_0 * (1+G)^N
Your anualized return will be R=[r^(1/N)*(1+G)] -1 where r is the ratio of the final valuation to the initial. Example. The stock grows earnings at 10% for 5 years. The P/E goes down from 20 to 15 so that r=0.75. That is a 4% return. If the vaulation went the other way from 15 to 20 it would be a 16.5% return. If the valuation stays the same it is a 10% return.
You also have to add in dividends. We want to assume that the dividend payout ratio stays the same so that the dividend grows with earnings. With no change in valuation this is simple. You just add the dividend yield (which stays constant) to the annualized return from capital gains. So for example if G=10% and the yeield Y=2% then the return is R=12%.
But what if the valuation changes? This now depends on when and how the valuation changes and whether or not you reinvest the dividends or whether you invest them somewhere else at some other rate (ie the discount rate). Lets assume a constant change in valuation (linear in time) and reinvested dividends. In this case the dividends help more in the beginning if the stock valuation rises and help more in the end if the valuation drops. Thus, dividends have been called a bear market protection device. If Altria groups has a 4% dividend yield and the P/E drops by 50% you may have lost in capital gains but are now getting a dividend yield of 8% as long as they keep the dividend at the same rate. Not bad.
I believe you can just take the geometric mean of 1+Y which means that the average number of shares that you gain each years is AY = Y* (1 + (1-r)/2)
So your annulized return R is (keeping first oder in yield)
1+ R = r^(1/n) * (1 + G + AY) with the adjusted yield, AY = Y* (1 + (1-r)/2)
Example r=0.75 as before, Y=0.02 G=0.1 you get R =0.06. A 6% gain is not bad for a stock that declines in P/E by 25%.
The trick is that you need to reinvest those dividens when it declines and not sell out low. ideally you want to benefit from all three things. Growth in earnings, growth in valuations and also reinvesting dividends.
Lets look at a plot. We are going to run a Monte Carlo simulation and make a random distribution of P/E expansion factor r. Lets assume this is log-normally distributed and has a mean of 1 and sigma(log)= 0.15. We want to generate the distribution of returns for the two cases when we have only growth and when we have growth and a dividend yield. We will assume in eaither case that the sum of growth and yield are equal. For example in the middle panel we have Y= 3% so that black is G=10% Y=3% and the red is for only growth G=13%. The lower panel is for a higher Y=6%. One can see that the mean return is the same. The effect of having a dividend yield is that it reduced the variance of return. However this reduction is not very large even for rather large yields of 6%. This is for 10 years periods. The variance reduction is even smaller for shorter periods where capital gains becomes more important. I think this makes the case fairly well that dividends don't really protect you much in bear markets. However it could well be the case that stock which pay a dividend will not fluctuate as much. That is probably true and so you should expect less variation in returns due to this. However you do much better in reducing volitility just by buying another few uncorrleated stocks. I don't think one should discriminate against non-dividend paying stocks. It seems that adding the dividend yield to the growth rate is a pretty good estimate of return as long as you expect the valuation to stay about the same.
One could argue that this isn't really a fundamental valuation method since you have just postponed the question of what the correct valuation should be. That is true and DCF is probably better in this way. However this method has its merits. It is actually better related to how one actually makes money in stocks. Your not going to hold a stock forever. Valuations are affected by demand as well as supply and demographics have an effect on valuations. This can be input into this model but not really in DCF (unless you raise the discount rate). It seems a better way of treating dividends. We have a long historical record of what the market has been willing to pay for earnings. The average P/E of the market is about 15. I would say that for most mature companies, the P/E should be somewhere in the range 10-20 depending on their profitability and other factors.
It is fairly well based in reality. How do you make money on a stock? You buy it, hold it for some time and then sell it. The profit (or loss) is the dividends that you have collected plus the capital gains (or loss).
So lets assume that we have an initial valuation metric P/E. One could use any of them such as P/B or P/D P/CF etc.
Lets ignore dividends first off. If the stock grows at G for N years then the earnings will be E_0 * (1+G)^N. If the valuation P/E stays the same you will have obtained a anulaized return of G. That pretty easy. If the valuation changes then the price of the stock will be P=(P/E) * E_0 * (1+G)^N
Your anualized return will be R=[r^(1/N)*(1+G)] -1 where r is the ratio of the final valuation to the initial. Example. The stock grows earnings at 10% for 5 years. The P/E goes down from 20 to 15 so that r=0.75. That is a 4% return. If the vaulation went the other way from 15 to 20 it would be a 16.5% return. If the valuation stays the same it is a 10% return.
You also have to add in dividends. We want to assume that the dividend payout ratio stays the same so that the dividend grows with earnings. With no change in valuation this is simple. You just add the dividend yield (which stays constant) to the annualized return from capital gains. So for example if G=10% and the yeield Y=2% then the return is R=12%.
But what if the valuation changes? This now depends on when and how the valuation changes and whether or not you reinvest the dividends or whether you invest them somewhere else at some other rate (ie the discount rate). Lets assume a constant change in valuation (linear in time) and reinvested dividends. In this case the dividends help more in the beginning if the stock valuation rises and help more in the end if the valuation drops. Thus, dividends have been called a bear market protection device. If Altria groups has a 4% dividend yield and the P/E drops by 50% you may have lost in capital gains but are now getting a dividend yield of 8% as long as they keep the dividend at the same rate. Not bad.
I believe you can just take the geometric mean of 1+Y which means that the average number of shares that you gain each years is AY = Y* (1 + (1-r)/2)
So your annulized return R is (keeping first oder in yield)
1+ R = r^(1/n) * (1 + G + AY) with the adjusted yield, AY = Y* (1 + (1-r)/2)
Example r=0.75 as before, Y=0.02 G=0.1 you get R =0.06. A 6% gain is not bad for a stock that declines in P/E by 25%.
The trick is that you need to reinvest those dividens when it declines and not sell out low. ideally you want to benefit from all three things. Growth in earnings, growth in valuations and also reinvesting dividends.
Lets look at a plot. We are going to run a Monte Carlo simulation and make a random distribution of P/E expansion factor r. Lets assume this is log-normally distributed and has a mean of 1 and sigma(log)= 0.15. We want to generate the distribution of returns for the two cases when we have only growth and when we have growth and a dividend yield. We will assume in eaither case that the sum of growth and yield are equal. For example in the middle panel we have Y= 3% so that black is G=10% Y=3% and the red is for only growth G=13%. The lower panel is for a higher Y=6%. One can see that the mean return is the same. The effect of having a dividend yield is that it reduced the variance of return. However this reduction is not very large even for rather large yields of 6%. This is for 10 years periods. The variance reduction is even smaller for shorter periods where capital gains becomes more important. I think this makes the case fairly well that dividends don't really protect you much in bear markets. However it could well be the case that stock which pay a dividend will not fluctuate as much. That is probably true and so you should expect less variation in returns due to this. However you do much better in reducing volitility just by buying another few uncorrleated stocks. I don't think one should discriminate against non-dividend paying stocks. It seems that adding the dividend yield to the growth rate is a pretty good estimate of return as long as you expect the valuation to stay about the same.
One could argue that this isn't really a fundamental valuation method since you have just postponed the question of what the correct valuation should be. That is true and DCF is probably better in this way. However this method has its merits. It is actually better related to how one actually makes money in stocks. Your not going to hold a stock forever. Valuations are affected by demand as well as supply and demographics have an effect on valuations. This can be input into this model but not really in DCF (unless you raise the discount rate). It seems a better way of treating dividends. We have a long historical record of what the market has been willing to pay for earnings. The average P/E of the market is about 15. I would say that for most mature companies, the P/E should be somewhere in the range 10-20 depending on their profitability and other factors.
PEG is a rediculous valuation metric
I have never understood why people use PEG (PE ratio divided by the growth rate) as a valuation metric. It really makes no sense. Here are a few reasons.
First of all, if you knew what the future earnings were going to be, you could value the company with discounted cash flow (DCF). That's the real way to value stocks. Lets give a few examples. We will assume a discount rate of 10% and assume that earnings are to be thought of as free cash flow.
First example. G=30% for 10 years followed by 20 years of 4% growth. The correct DCF PE is 90 and so the correct PEG is 3.
Now if instead we had only 5 years of 30% growth followed by 25 years of 4% growth the correct PE is 38.6 and so the correct PEG is 1.3. Finally lets consider two years of 30%, 8 years of 10% and then 20 years of 4%. That gives PE = 30.1 and so PEG=1.
So obviously the right PEG has everything to do with how long the company will grow its earnings at that initial rate. In most cases the recommendation of buying stocks with PEG < 1 is actually too conservative. In retrospect buying Walmart with PE=100 would have been a very profitable thing to do since it grew quickly for 2 decades.
But there are other things wrong with PEG. It ignores things like return on equity (ROE) and quality of earnings. Maybe companies can grow earnings but will never develop into very profitable companies. Maybe they are growing earnings so quickly only because their initial earnings are so tiny (compared to say invested capital or total assets). For companies that have positive equity and fast growing earnings but very low ROE, it is useless to look at PEG. You should instead analyse the business model and figure out what ROE they will eventually obtain and how long it will take to get there.
Another reason to hate PEG. For slow growth companies, it makes no sense either. Perpetually slow growing companies can be valued with P/E = 1/(DR-G) where DR is the discount rate and G the perpetual growth rate. This requires G < DR.
inverting this E/P = DR -G or DR = E/P + G
Your expected return will be the discount rate DR = E/P + G. So you can see that what matters is E/P + G not PEG=(P/E)/G. You could choose to write this DR = E/P * (1+ G/(E/P)) for your expected return. Now you see that what matters is the
valuation E/P and the ratio of growth to E/P not its inverse P/E. In other words the right PEG is 1/(G*(DR-G)) which still obviously depends on G and DR.
So PEG makes no sense for slow growers and for fast growers it depends critically on how long the fast growth will continue. So why it is used at all?
First of all, if you knew what the future earnings were going to be, you could value the company with discounted cash flow (DCF). That's the real way to value stocks. Lets give a few examples. We will assume a discount rate of 10% and assume that earnings are to be thought of as free cash flow.
First example. G=30% for 10 years followed by 20 years of 4% growth. The correct DCF PE is 90 and so the correct PEG is 3.
Now if instead we had only 5 years of 30% growth followed by 25 years of 4% growth the correct PE is 38.6 and so the correct PEG is 1.3. Finally lets consider two years of 30%, 8 years of 10% and then 20 years of 4%. That gives PE = 30.1 and so PEG=1.
So obviously the right PEG has everything to do with how long the company will grow its earnings at that initial rate. In most cases the recommendation of buying stocks with PEG < 1 is actually too conservative. In retrospect buying Walmart with PE=100 would have been a very profitable thing to do since it grew quickly for 2 decades.
But there are other things wrong with PEG. It ignores things like return on equity (ROE) and quality of earnings. Maybe companies can grow earnings but will never develop into very profitable companies. Maybe they are growing earnings so quickly only because their initial earnings are so tiny (compared to say invested capital or total assets). For companies that have positive equity and fast growing earnings but very low ROE, it is useless to look at PEG. You should instead analyse the business model and figure out what ROE they will eventually obtain and how long it will take to get there.
Another reason to hate PEG. For slow growth companies, it makes no sense either. Perpetually slow growing companies can be valued with P/E = 1/(DR-G) where DR is the discount rate and G the perpetual growth rate. This requires G < DR.
inverting this E/P = DR -G or DR = E/P + G
Your expected return will be the discount rate DR = E/P + G. So you can see that what matters is E/P + G not PEG=(P/E)/G. You could choose to write this DR = E/P * (1+ G/(E/P)) for your expected return. Now you see that what matters is the
valuation E/P and the ratio of growth to E/P not its inverse P/E. In other words the right PEG is 1/(G*(DR-G)) which still obviously depends on G and DR.
So PEG makes no sense for slow growers and for fast growers it depends critically on how long the fast growth will continue. So why it is used at all?
Monday, November 27, 2006
Best 50-year stocks
From Jeremy Siegels "The Future for Investors"
These are the best survivor firms from the past 50 years. Top 10 with annual return.
Note that all are either consumer brand names or pharmaceutical with the exception of Royal Dutch Shell and Crane. There are no tech stocks with the exception of Crane (industrial products). None of these obtained a 20% return by themself. If you wanted to beat Buffett's 22% you needed to buy and sell.
These are the best survivor firms from the past 50 years. Top 10 with annual return.
| Stock | Annual Return |
| Phillip Morris | 19.75% |
| Abbot Labs | 16.51% |
| Bristol Myers | 16.36% |
| Tootsie Roll | 16.11% |
| Pfizer | 16.03% |
| Coca Cola | 16.02% |
| Merk | 15.90% |
| PepsiCo | 15.54% |
| Colgate Palmolive | 15.22% |
| Crane | 15.14% |
| Heinz | 14.78% |
| Wrigley | 14.65% |
| Fortune Brands | 14.55% |
| Kroger | 14.41% |
| Schering-Plough | 14.36% |
| Proctor & Gamble | 14.26% |
| Hershey Foods | 14.22% |
| Wyeth | 13.99% |
| Royal Dutch Shell | 13.64% |
| General Mills | 13.58% |
Note that all are either consumer brand names or pharmaceutical with the exception of Royal Dutch Shell and Crane. There are no tech stocks with the exception of Crane (industrial products). None of these obtained a 20% return by themself. If you wanted to beat Buffett's 22% you needed to buy and sell.
Stock Valuation
I have been trying to figure out a good method for stock valuation. There are of course many models for valuation mostly based on discounted cash flow models DCF. The idea is that a company is worth the sum of all future cash flows to the owners between now and infinity, discounted by some discount rate. This discounting is because money now is worth more than money in the future. If I had money now I could invest it and get about 10% per year so that in 7 years it will double. The discounting of future cash flows accounts for this simple fact.
Here is a good link to an overload of information on variations of DCF.
However for stock picking I think these complex models are not required. If you knew the inputs precisely (i.e. growth rates etc) then it might be good to include all of these details such as changes in working capital and changes in payout ratio. However you don't. I am looking for a good proxy to use for the whole class of stock that I like to invest in. I want a generally useful tool: a jacknife of sorts that I can quickly use to compare all stocks.
So a simple N-stage DCF model should suffice. I have written one in the IDL computer laguage. Of course, you need to pick a discount rate. This is always difficult. They way I figure it, you you simply fix the discount rate and keep it constant for all stocks. This is possible because I am only going to invest in one kind of company: companies with stable earnings and somewhat predictable growth rates. I don't need a variable risk premium, I don't need to work out the correct WACC etc.
I just use 10%. This of course specifies the relative weight I give to earnings now versus earnings in the future. However 10% seems reasonable because it is approximately the average stock return, is not far from the average bond rate (plus a constant risk premium). It is also the number of fingers that I have. This gives a fair value P/E of 10 for a perpetually zero growth company and a fair P/E of 20 for a perpetual growth rate of 4.8% which is about the long term bond rate. The way I figure one most needs a discount rate to decide whether to buy stock at all. Once you have chosen one, just use DCF to decide between stocks. Buy the cheapest relative to the DCF value with a few caveats.
Next choice: which earnings to use. Some just use accounting earnings. The Usual E. Others use DCF with the dividend D in which case P/E becomes P/D or inverse of dividend yield. There is the handy formula for the dividend discount model for constant growth.
Y= D/P = DR-G
where Y is dividend yield (D/P) and DR is the discount rate and G is the dividend growth. This is called the Gordon Growth Model and is easy to derive (it is just a geometric series). This only works for DR > G so that you don't get infinite value D/P = 0. I find this equation useful in that it tells you what the correct discount rate should be. DR= Y + G. If you buy the stock and sell in the future, after dividends and earnings have grown by G, and the valuation D/P stays the same then your anualized return will be R=Y+G which is the discount rate. In other words, the discount rate is your expected return. You want to buy things that give you a rate equal to or better than you expected return. This is somewhat circular but really gives you an idea of what the discount rate should be. 10% is not so bad of a return. Naturally I would like a higher return so if I use DR=10% in my N-stage DCF and find things that are selling for a significant discount to this rate, then I will buy them.
There are still other choices for earnings. I think using free cash flow (FCF) is probably the best. Buffett calls this Owner Earnings and in my code I use OE as FCF per share. This is cashflow-capital expenditure. The trick here is knowing whether the capital expenditure is really different from expenses and different from real investment. I don't have a good feel for this. Should I simply just trust the accounting line "Capital Expenditure" and subtract that off? If you do that you see that Home Depot has significant OE but Walmart does not. I doubt these two companies are that different so I am not sure if this is just differences in accounting.
So for a company reinvesting all of its money, use OE as earnings and look at growth in OE for the growth rates, G. For price I use enterprise value (EV). This is what you use if you were going to buy the whole company for market value and I think this is the right way to think about buying stocks. You get whatever cash and cash equivilents that the company owns and are stuck their debt as well. So EV = P - Debt + Cash. So now OE/EV is the measure of valuation that I estimate with DCF.
What about dividends? I still need to figure how to include these properly. I think you can simply augment the growth rate by
the dividend yield. This is because you can just buy more shares which is equivilent to having a faster growth rate. If a stock is growing OE at 12% with a dividend yield of 2% then use 14% for G. Not sure if this is entirely correct but will do for now.
The final question is how many stages. You clearly need at least two since most companies that I look at grow at something close to or greater than DR=10%. There is no point in getting carried away and having more than four. For a stable company like JNJ I use 2 or 3. Sometimes I get creative with stocks like homebuilders which should see a decline in earnings and then a turn around. You can still use DCF for this.
The hard part of DCF of course are the growth rates. Garbage In = garbage out as they say. Here, you don't want to over estimate growth or you could end up paying way too much. I think the best way to do this is to use the historic growth rates over 10 years. I get these from S&P though my scottrade account. I think a good thing to do is to take the ten year pattern and divide into 2 five-year segments and get the growth rate for each. Use the lower of thr two and take off 2 percent to be conservative. By doing this you aren't assuming it can grow any faster than it already has. Avoid new companies that have grown quickly because they had no earnings to begin with. Avoid cyclicals that have just come off a huge bull market. Don't ever input very high growth rates like G=40% since they are not sustainable. In fact I want to find companies with high ROE since this tells you the sustainable growth rate. G = ROE (1-p) where p is the payout ratio. That is I will avoid the Googles and the unproven internet stocks etc with huge growth rates and low ROE. I would rather buy a company with G=10% and low valuations since these kind of growth rates are likely to persist and getting the growth rate correct as well as the period of growth is less important.
Finally an example. Johnson & Johnson (JNJ). A perfect company for me (see "My rules for investing" post).
Annual growth in OE over the past 10 years is 13.4% (by exponential fitting) and 14.8% (point to point). The two five year periods are
G=13.5% (first) and G= 17.6% (most recent) as determined by exponential fitting. The lesser is 13.5%. The dividend yield is
Y=2.3%. So I will use G=13.5+2.3-2=13.8%. I will use a 3-stage model with
---------------
N Years | Growth
-------------
10 13.8%
10 8.0%
20 4.0%
In IDL I simply type:
IDL> dcf,[10,13.8,10,8.0,20,4]
Using default DR 10.0000
12.1112 12.7136 13.6629
total V/E = 38.4878
This reports that the Value to Earnings of 38.5. That pretty high but I think reasonable for a great company like JNJ. Over the next 40 years that predicts a growth in earnings (dividend adjusted) of 17 or 7.7 adjusted for 2% inflation. Taking out the dividends it says that the company must grow by a factor of 6 or so in 40 years which I think is very reasonable considering that the developing world is getting richer and will desire the same level of health care as the developed world and also the developed world is ageing rapidly. The key to trusting high valuations that come out of DCF is to ask whether the company is truely great and is likely to remain a strong company in the extreme distant future. I am fairly certain Coke, JNJ and Budweiser will be around in 100 years unless they are bought by another company. I have no idea what will happen to Google or Yahoo.
So how much does JNJ cost? Since we are working with owner earnings, it is EV/OE that we look at for valuation. The inverse of this I call free yield FY=OE/EV. JNJ has FY = 5.43% or OE/EV=18.41. This is not too different from the usual P/E which for JNJ is 17.29.
So according to DCF it is underpriced by 50%. Quite a steal!
What will my return be? Over the next 20 years this is a rise of about 7.75 in earnings. If valuation stays the same that is an 11% annulaized return. Not bad. However as I mentioned, I think the right valuation is twice as high. So if it takes 10 years to obtain the right valuation this will be a 13% return. If it takes 10 years it is 19%. If it only takes 3 years, it is a 37% annualized return although over a shorter period. I figure this is a sure thing to obtain a 10% annulized return over some future interval and possibly as high as 30% as long as I hold on through any ups and downs. I will buy now and sell whenever it becomes overpriced. I would probably sell if P/E > 35 but may sell after a year if there are even better opportunities.
Of course the growth rates could be wrong. Lets try a simple 2-stage with 10% initial growth.
IDL> dcf,[10,7,20,5],val,e,de
Using default DR 10.0000
8.61628 9.64537
total V/E = 18.2617
That comes closer to the price but requires 10 years of only 7% growth followed by 20 years of 5%. I don't see anyone could think that JNJ would see such terrible growth rates especially with the demographics that we have. JNJ is definitely underpriced. A definite BUY. The only question is whether there are better buys out there which is always the source of all my stress.
Here is a good link to an overload of information on variations of DCF.
However for stock picking I think these complex models are not required. If you knew the inputs precisely (i.e. growth rates etc) then it might be good to include all of these details such as changes in working capital and changes in payout ratio. However you don't. I am looking for a good proxy to use for the whole class of stock that I like to invest in. I want a generally useful tool: a jacknife of sorts that I can quickly use to compare all stocks.
So a simple N-stage DCF model should suffice. I have written one in the IDL computer laguage. Of course, you need to pick a discount rate. This is always difficult. They way I figure it, you you simply fix the discount rate and keep it constant for all stocks. This is possible because I am only going to invest in one kind of company: companies with stable earnings and somewhat predictable growth rates. I don't need a variable risk premium, I don't need to work out the correct WACC etc.
I just use 10%. This of course specifies the relative weight I give to earnings now versus earnings in the future. However 10% seems reasonable because it is approximately the average stock return, is not far from the average bond rate (plus a constant risk premium). It is also the number of fingers that I have. This gives a fair value P/E of 10 for a perpetually zero growth company and a fair P/E of 20 for a perpetual growth rate of 4.8% which is about the long term bond rate. The way I figure one most needs a discount rate to decide whether to buy stock at all. Once you have chosen one, just use DCF to decide between stocks. Buy the cheapest relative to the DCF value with a few caveats.
Next choice: which earnings to use. Some just use accounting earnings. The Usual E. Others use DCF with the dividend D in which case P/E becomes P/D or inverse of dividend yield. There is the handy formula for the dividend discount model for constant growth.
Y= D/P = DR-G
where Y is dividend yield (D/P) and DR is the discount rate and G is the dividend growth. This is called the Gordon Growth Model and is easy to derive (it is just a geometric series). This only works for DR > G so that you don't get infinite value D/P = 0. I find this equation useful in that it tells you what the correct discount rate should be. DR= Y + G. If you buy the stock and sell in the future, after dividends and earnings have grown by G, and the valuation D/P stays the same then your anualized return will be R=Y+G which is the discount rate. In other words, the discount rate is your expected return. You want to buy things that give you a rate equal to or better than you expected return. This is somewhat circular but really gives you an idea of what the discount rate should be. 10% is not so bad of a return. Naturally I would like a higher return so if I use DR=10% in my N-stage DCF and find things that are selling for a significant discount to this rate, then I will buy them.
There are still other choices for earnings. I think using free cash flow (FCF) is probably the best. Buffett calls this Owner Earnings and in my code I use OE as FCF per share. This is cashflow-capital expenditure. The trick here is knowing whether the capital expenditure is really different from expenses and different from real investment. I don't have a good feel for this. Should I simply just trust the accounting line "Capital Expenditure" and subtract that off? If you do that you see that Home Depot has significant OE but Walmart does not. I doubt these two companies are that different so I am not sure if this is just differences in accounting.
So for a company reinvesting all of its money, use OE as earnings and look at growth in OE for the growth rates, G. For price I use enterprise value (EV). This is what you use if you were going to buy the whole company for market value and I think this is the right way to think about buying stocks. You get whatever cash and cash equivilents that the company owns and are stuck their debt as well. So EV = P - Debt + Cash. So now OE/EV is the measure of valuation that I estimate with DCF.
What about dividends? I still need to figure how to include these properly. I think you can simply augment the growth rate by
the dividend yield. This is because you can just buy more shares which is equivilent to having a faster growth rate. If a stock is growing OE at 12% with a dividend yield of 2% then use 14% for G. Not sure if this is entirely correct but will do for now.
The final question is how many stages. You clearly need at least two since most companies that I look at grow at something close to or greater than DR=10%. There is no point in getting carried away and having more than four. For a stable company like JNJ I use 2 or 3. Sometimes I get creative with stocks like homebuilders which should see a decline in earnings and then a turn around. You can still use DCF for this.
The hard part of DCF of course are the growth rates. Garbage In = garbage out as they say. Here, you don't want to over estimate growth or you could end up paying way too much. I think the best way to do this is to use the historic growth rates over 10 years. I get these from S&P though my scottrade account. I think a good thing to do is to take the ten year pattern and divide into 2 five-year segments and get the growth rate for each. Use the lower of thr two and take off 2 percent to be conservative. By doing this you aren't assuming it can grow any faster than it already has. Avoid new companies that have grown quickly because they had no earnings to begin with. Avoid cyclicals that have just come off a huge bull market. Don't ever input very high growth rates like G=40% since they are not sustainable. In fact I want to find companies with high ROE since this tells you the sustainable growth rate. G = ROE (1-p) where p is the payout ratio. That is I will avoid the Googles and the unproven internet stocks etc with huge growth rates and low ROE. I would rather buy a company with G=10% and low valuations since these kind of growth rates are likely to persist and getting the growth rate correct as well as the period of growth is less important.
Finally an example. Johnson & Johnson (JNJ). A perfect company for me (see "My rules for investing" post).
Annual growth in OE over the past 10 years is 13.4% (by exponential fitting) and 14.8% (point to point). The two five year periods are
G=13.5% (first) and G= 17.6% (most recent) as determined by exponential fitting. The lesser is 13.5%. The dividend yield is
Y=2.3%. So I will use G=13.5+2.3-2=13.8%. I will use a 3-stage model with
---------------
N Years | Growth
-------------
10 13.8%
10 8.0%
20 4.0%
In IDL I simply type:
IDL> dcf,[10,13.8,10,8.0,20,4]
Using default DR 10.0000
12.1112 12.7136 13.6629
total V/E = 38.4878
This reports that the Value to Earnings of 38.5. That pretty high but I think reasonable for a great company like JNJ. Over the next 40 years that predicts a growth in earnings (dividend adjusted) of 17 or 7.7 adjusted for 2% inflation. Taking out the dividends it says that the company must grow by a factor of 6 or so in 40 years which I think is very reasonable considering that the developing world is getting richer and will desire the same level of health care as the developed world and also the developed world is ageing rapidly. The key to trusting high valuations that come out of DCF is to ask whether the company is truely great and is likely to remain a strong company in the extreme distant future. I am fairly certain Coke, JNJ and Budweiser will be around in 100 years unless they are bought by another company. I have no idea what will happen to Google or Yahoo.
So how much does JNJ cost? Since we are working with owner earnings, it is EV/OE that we look at for valuation. The inverse of this I call free yield FY=OE/EV. JNJ has FY = 5.43% or OE/EV=18.41. This is not too different from the usual P/E which for JNJ is 17.29.
So according to DCF it is underpriced by 50%. Quite a steal!
What will my return be? Over the next 20 years this is a rise of about 7.75 in earnings. If valuation stays the same that is an 11% annulaized return. Not bad. However as I mentioned, I think the right valuation is twice as high. So if it takes 10 years to obtain the right valuation this will be a 13% return. If it takes 10 years it is 19%. If it only takes 3 years, it is a 37% annualized return although over a shorter period. I figure this is a sure thing to obtain a 10% annulized return over some future interval and possibly as high as 30% as long as I hold on through any ups and downs. I will buy now and sell whenever it becomes overpriced. I would probably sell if P/E > 35 but may sell after a year if there are even better opportunities.
Of course the growth rates could be wrong. Lets try a simple 2-stage with 10% initial growth.
IDL> dcf,[10,7,20,5],val,e,de
Using default DR 10.0000
8.61628 9.64537
total V/E = 18.2617
That comes closer to the price but requires 10 years of only 7% growth followed by 20 years of 5%. I don't see anyone could think that JNJ would see such terrible growth rates especially with the demographics that we have. JNJ is definitely underpriced. A definite BUY. The only question is whether there are better buys out there which is always the source of all my stress.
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