1. Investments Vicentiu Covrig 1 Value Stock Investing (chapter 11)

2. Investments Vicentiu Covrig 2 Value Investing Finding securities considered to be temporarily undervalued or unpopular for various reasons. - Determine Economic Value of the firm  Sometimes called Fundamental Value - Compare to current price Value investing is a contrarian philosophy - Not following the herd…

3. Investments Vicentiu Covrig 3 Characteristics of Value Firms Measures - Price to Book: Firms with low P/B (or high B/M) are value stocks - Price to Earnings ratio: Firms with low P/E are considered value stocks.  Earnings could be negative or vary because of extraordinary items.

4. Investments Vicentiu Covrig 4 Finding Fundamental Value Present Value Model - The value today, of receiving a dividend and next year’s price, is:  k is the risk-adjusted discount rate. - But what is next year’s price? - So,

5. Investments Vicentiu Covrig 5 - Continuing the substitution, leads to the general present value equation: - How is P n estimated?  One method is to use the P/E ratio. Note that:

6. Investments Vicentiu Covrig 6 EXAMPLE: According to information obtained from Yahoo! Finance, Freddie Mac (FRE) has a current price of $64 per share, an expected dividend per share of $1.40, an EPS of $7.50, expected EPS growth of 6% per year, and a typical P/E ratio of 12. According to the Present Value Model, what is the present value of FRE using a discount rate of 14% and a five years analysis period? Is it undervalued or overvalued? Solution Estimated price in five years: Future dividends are: Present Value is:

7. Investments Vicentiu Covrig 7 Note that the model depends on growth rates of the profits and dividends. Constant Growth Model - Also called the Gordon Growth Model - If you can assume that the future growth of the company is constant, then the equation becomes: - Only works for k > g

8. Investments Vicentiu Covrig 8 A company paid a $0.75 per share dividend this year and it is expected to grow at 5%. If the required rate of return for this firm is 10%, what is its fundamental value? If the stock is a preferred stock (pays a constant dividend), then g=0%. Notice how much more valuable a growing firm is!

9. Investments Vicentiu Covrig 9 What is the appropriate discount rate? Various methods - CAPM  Requires company beta, market return, risk free rate - From the constant growth model:

10. Investments Vicentiu Covrig 10 Graham & Dodd Approach Coauthors of Security Analysis— value investor’s bible - Graham lost fortune in 1929 crash. - Learned that true measure of stock values come from earnings, dividends, future prospects, and asset values, NOT price movements Graham teamed up with professor Dodd to write the book, 1934

11. Investments Vicentiu Covrig 11 Most important idea: margin of safety—positive difference between price and value Degree of “bargain-ness” Enlightened stock analysis—price vs. true intrinsic or real economic value - Liked firms that sell below liquidation value

12. Investments Vicentiu Covrig 12 Warren Buffett: Current leader of the value investing strategy 10 lessons from Warren Buffett 1. Better to buy a wonderful company at a fair price then a fair company at a wonderful price. 2. When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that survives. 3. Management does better by avoiding dragons, not slaying them. 4. Like Newton’s law of motion, an institution will resist any change in its current direction. 5. Corporate projects will materialize to soak up available funds.

13. Investments Vicentiu Covrig 13 6. Cravings of the leader, however foolish, will be quickly supported by detailed studies prepared by the troops. 7. The behavior of peer companies will be mindlessly imitated. 8. It is not a sin to miss a business opportunity outside one’s area of expertise. 9. If your actions are sensible, you are certain to get good results. 10. Do not join with managers who lack admirable qualities, no matter how attractive the prospects of their business.

14. Investments Vicentiu Covrig 14 Dividends: An Important Part of Total Return from Value Firms Dividends mitigate risks—bird in hand theory Dividend growth - Dividends give more stable income streams than bonds. - Dividends grow faster than inflation over time. - Dividend yields have decreased over the last two decades. Valuable indicator of corporate health

15. Investments Vicentiu Covrig 15 Quality at a Reasonable Price value of ROE, or VRE - VRE = return on equity divided by the P/E ratio - If VRE ≥ 1, the stock may be worthy of investment attention and possible purchase. - If VRE ≥ 2, the stock is definitely worthy of investment attention and may represent a very attractive investment. - If VRE ≥ 3, the stock is apt to represent an extraordinarily attractive investment opportunity.

16. Investments Vicentiu Covrig 16 Use the value of ROE to determine the worthiness of the stock to a value investor for the following stocks: CompanyROEP/E Intel19.6%20.0 Ford Motor 24.1%6.3 Procter & Gamble40.2%20.9 Solution: Compute the value of ROE: CompanyVRE Intel19.6% / 20.0 = 0.98 Ford Motor 24.1% / 6.3 = 3.83 Procter & Gamble40.2% / 20.9 = 1.92 With a VRE = 0.98, Intel is not a candidate for a quality-at-a-reasonable- price stock. Procter & Gamble may be worthy of further investigation. Since Ford Motor’s VRE is greater than 3, it represents a very attractive possibility for a value investor.

17. Investments Vicentiu Covrig 17 Finding Value Stocks Common Criteria for Value Stocks Ample cash reserves (cash > 10% of market cap). Ample free cash flow to fund necessary investment (EBIDTA > capital spending). Conservative dividend payout policy (dividend < 75% of EPS). Conservative financial structure (debt < 50% of market cap). Conservative issuance of common stock to managers and other employees (constant or falling number of shares outstanding). Low price-book ratio relative to the market and a company's own history (P/B < 75% of S&P 500 average). Low price-cash flow ratio relative to the market and a company's own history (P/CF < 75% of S&P 500 average). Low price-earnings ratio relative to the market and a company's own history (P/E < 75% of S&P 500 average). Negative investor sentiment as reflected in poor financial ratings (S&P rating of B- or worse). Significant dividend income (yield > 150% of S&P 500 average).

18. Investments Vicentiu Covrig 18 Stock Screener at Yahoo! Finance

19. Investments Vicentiu Covrig 19 Careful stock selection should limit downside risk Difficulty obtaining reliable and relevant information Not necessarily a buy-and-hold strategy—constant recycling of stocks through portfolio; constant research and vigilance Popular rules-of-thumb already factored into market? Value Investing Advantages & Limitations

20. Investments Vicentiu Covrig 20 Learning objectives Discuss the characteristics of value investing Know how to apply the value model using discounted dividends Know the constant growth model Know the use of P/E ration calculate the intrinsic value (slide 6) Know the two formulas to calculate the cost of equity/ discount rate Discuss the main investment ideas behind the Graham and Dodd approach to value investing Discuss five investment ideas behind Warren Buffett approach to value investing Discuss the concept of Quality at a reasonable price Discuss the Contrarian investment philosophy Discuss the role of dividends and value investing (text pages 340 to 343) End of chapter questions 11.1,11.2, 11.4, 11.5, 11.6; Problem 11.2; CFA problem 11.2