Wednesday, April 6, 2011

Valuing a Stock II

Just buying stocks at low valuations in terms of P/E, CF/P, P/BV or dividend yield was David Dreman's way of buying stock at the right price. The Canadian Share Owner Association has developed a very solid method for buying stocks at the right price as well. Their website is:

The association has long advocated a systematic way of valuing stocks. Their long time track record based on this method speaks for itself. The Share Owner Association has created an extensive database of 'cleaned up' quarterly and annual corporate financial data to ensure that one compares apples with apples and not with oranges. Annual subscription to access the data or get it send to you quarterly on CD is around $250, there is also a membership fee of $90 or so per year. The membership fees entitle you to access on-line webinars that discuss specific case histories of companies based on the association's methodology, subscription to an on-line brokerage magazine and participation in a small investor brokerage service. The latter is a great starting point for small or novice investors. You can open an investment account with just a few hundred dollars and practice for the big world. Commissions are quite reasonable.

Without becoming a member, you can learn the details of the Share Owner Association for free on their website. If this way of investing makes sense to you, then become a member or try to use it on your own. The association's method is based on traditional value investment and fundamental methods. It considers predictable, easily to extrapolate earnings an hallmark for a great company. A picture is worth a thousand words, so here is the final screen of the association's software that helps you interpret the database data for companies you may be interested in (Fig 1.). We'll be using Microsoft as an example – no particular reason other than that I just like this company. But even if the company is great and profitable, can we buy the shares at the right price?

The Blue line depicts revenue over the last 10 years since 2000. You can see that Microsoft's revenue has grown steadily in spite of the wild gyrations of its share price. The green line shows that not only revenue has grown at nearly 11.3% per year but also the company's profits have grown. Not only that, the earnings have not been diluted but excessive new share issues. The green line represents not just profits but the profits earned per share. In 2000 Microsoft earned $0.85 and in 2011 it earned $2.10. Profit grew at 11.8% per year, so its profit margin/share increases every year as well (earnings growth 11.8% versus revenue growth of 11.3%). This is partially the result of extensive share buy-back programs.
Microsoft increases its earnings and revenue as steady as a train without breaks running down a slope. It seems unstoppable. On top of that dividends are paid to shareholders. In 2003, Microsoft started to pay dividends of $0.08 per share while today its dividend has grown to $0.52, that is a dividend yield of 2.5 per cent! GICs anyone? In 2005 it had so much cash on hand; the company paid a special dividend of $3.32 per share. Right now, Microsoft holds again a lot of cash – nearly $48 billion. With 8.5 billion shares that is around $5.5 per share in cash. You may say that at its current share price of $25 dollars, you buy $5.5 cash and $19.5 assets or you earn $2.10 with $19.5 dollars in assets, i.e. a P/E of 19.5/2.1 = 9.3. Now that is cheap! Compare that to Google!

On the graph, below the green line, you see blue boxes representing the price range that the stock traded at. You can see that although earnings have steadily increased, the stock price hasn't. In other words, the stock has become cheaper and cheaper. Just like there seem to be a lot of people who don't like Stephen Harper, there are a lot of people who just don't like Microsoft. It is purely emotional. One day those people will wake up and recognize what a terrific company Microsoft is and then they want to buy, buy and buy. Driving up the stock like crazy! Who are they buying it from? Well, you and me of course (if they pay enough)!

In the meantime, we will be collecting ever increasing dividends and if lucky, from time to time we collect a special dividend as well. Based on the range of P/Es that Microsoft has traded at in the past, the association's software (called Stock Study Guide) shows that prices could go up as high as $110 per share in about five years and based on extrapolated earnings that may climb as high as $3.66 per share (P/E of around 30 (as Microsoft traded at in 2004).

Will we ever reach those earnings and prices? Who knows, no one knows the future, but if the past is any guide, it sure seems possible considering its solid profit growth and revenue growth over the past 10 years.
Both Dreman's method and that of the Canadian Share Owner Association illustrate how you can value stocks and how to determine when the price is right. No market hysteria or emotions – just plain the facts ma 'me!

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