I have established my strategy of buying the stock of good companies that for some reason are undervalued by the stock market. Now comes putting that simple strategy into action. The details are a bit harder than the basic strategy.
Returning to my milk analogy, milk has only one way in which it has value–that is, its ‘asset’ of milky goodness. Thus, we can either consume it or sell it off to someone else who would appreciate its milky goodness. Companies are different, though. They too have their asset value, which is the value of all the inventory, machinery, property, patents and other things that could be sold if we shut the company down. In addition to that, they also have earnings power, or the ability to make a profit. So in evaluating companies, we can judge them to be a good or bad value based either on their actual assets or on their future earnings power. We will start with the evaluation of value based on assets.
The father of value investing, Benjamin Graham, wrote a book that all of you should read, The Intelligent Investor. In his book, Graham asserted that a company would be a good buy if it were valued at less than about 2/3 of its total net tangible asset value. Graham excluded patents and other hard to value ‘assets’ from his calculations, so he only counted the ‘hard’ (tangible) assets. To get the net tangible asset value we take the value of all tangible assets and subtract any debt the company owes. This gives us the company’s net worth, which is just like the net worth of a person.
Why isn’t a company selling at 90% of its net tangible asset value a good deal? The reason is that Graham insisted upon having a margin of safety. In other words, some of those ‘assets’ may be overvalued. To avoid situations where the assets are worth little, we want to only buy companies that are selling for far less than we think they are worth.
You may think that this is unlikely, and recently, this has not been very common. However, during bear markets, this happens a lot. The Washington Post Co. was valued by the stock market at only about $80 million in 1973. However, its assets, including television stations, the magazine Newsweek, and the newspaper, could have easily been sold off for hundreds of millions of dollars.
At least one value investor realized the true value of the company, and he bought many shares of Washington Post. His name? Warren Buffet, the most successful investor in the world. Now the Washington Post Co. is valued at over $8 billion in the stock market, giving Buffett a return of over 100x his original investment.
What if the market never realizes the value of the assets of a company, and the company never sells them off? This is not a likely situation. Nowadays, there are many private equity firms that look for such easy money. These companies will buy a majority or large minority stake in a company and then either find better management or sell off the company’s assets for a profit.
In the current market, however, fairly few companies are valued significantly below their assets. That leads us to the second way of valuing companies, which is based on their earnings power. This is much the same way you would evaluate the relative value of a bond or a savings account.
With a bond or savings account, you receive an interest payment that is your payment for loaning your money. With stock ownership, you have a claim to a portion of the profits of the company. If a company has 10 million shares outstanding and makes a profit of $20 million, then the profit per share (also called the earnings per share or EPS) is $2.
So if you own 100 shares, you have ‘claim’ to $200 in profits. Now, companies almost never pay out all their earnings to their stockholders. Usually they will pay a portion of their earnings to shareholders as dividends. Some don’t pay dividends at all. The profits not paid out as dividends are reinvested in the company.
Presumably, those reinvested earnings benefit the stockholders too, in the sense that they will help grow the company and increase the earnings power of the company. The future value of the company will be greater because of the increased future earnings and the stockholder will be compensated with increased market value of his shares of stock.
Thus, we will treat all of the company’s earnings, even those that are reinvested in the company, as income to us, the shareholders. So, to determine the fair price of a stock, we compare its price to the earnings per share (EPS). We divide the price by EPS to get the Price to Earnings ratio or P/E ratio.
The higher a P/E ratio is, the less current earnings the company has for each dollar we invest. So if we were to invest in a company with a P/E of 20, for each dollar we spend to buy stock, we will only get half as much earnings as if the stock had a P/E of 10. Therefore, we want to find and buy portions of companies that have lower P/E ratios. But how high is too high? Here I will give a brief explanation, but see my post on P/E ratios for a more in-depth explanation.
When you are investing in stocks, you value the stocks based on the future income of the company. To find a fair value for those stocks, though, you need to compare that future income to the future income you could get by just sticking the money in a safe U.S. government bond. Since stocks are riskier than government bonds, the earnings yield on the stock (E/P, the inverse of the P/E ratio) should be higher than the yield on a medium term government bond (let’s say with a 5 year maturity).
Medium-term government bonds are yielding about 5% right now, so if we had a perfectly safe stock investment, we would not mind getting a 5% earnings yield (which translates into a P/E of 20). However, stocks are less safe than corporate bonds, which are less safe than government bonds. Therefore, we want to be paid a risk premium for owning stocks. A 2% risk premium is enough for us to consider a stock a good value.
Therefore, stocks that are neither increasing nor decreasing their profits should be a fair value at around a P/E of 14 (and an E/P of 7%). However, because we are value investors, we do not want to pay fair value. Rather, we want to pay below fair value. Therefore, it is a good rule of thumb to avoid companies without significant earnings growth with a P/E over 10. For companies with significant earnings growth, a P/E below 20 should be fine. But, as with buying anything, the cheaper we can buy a good product (in this case, a company), the better.
When we buy something at a price less than it is worth, we give ourselves a margin of safety. That way, we are protected from losing a lot of money should we err in our estimation of the quality of a company. If we were to invest in companies that seemed to be selling at a fair value, we would be at greater risk of losing money if our estimation of the company’s value turned out to be wrong.
Disclosure: I hold no shares of any companies mentioned herein. See the disclosure policy.