Common sense dictates that investors should attempt to buy stocks when they are cheap and sell when they are dear. However, while this may be a simple principle, determining a company’s fair market price or intrinsic value is far from easy. Stock Investor includes a tab on the Stock Notebook devoted to valuations to help users gauge the market’s assumptions that are built into a company’s stock price:
The screenshot above displays the Valuations tab for Johnson & Johnson (JNJ) with data as of April 3, 2009. The Valuations tab uses popular multiples such as the price-earnings (P/E) ratio, coupled with historical and projected growth rates to determine benchmark price valuations.
The valuations are based upon a range of items, including earnings, dividends, cash flow, free cash flow, and sales. Valuations are then meaningful for a wide range of company situations and help determine which primary factors are influencing a company’s stock price.
Stock Investor includes four valuations based upon earnings and two valuations each for dividends, cash flow, free cash flow, and sales. The formulas used in the calculations are displayed on the Valuations tab of the Stock Notebook in the far-right column, and also appear when Valuations are included in the Company Summary report. However, going through the actual calculations may prove helpful.
The five columns of numbers provide a simple projection of per share earnings, dividends, cash flow, free cash flow, and sales. The latest reported line (represented by the “L” in the Formulas column on the far right of the Valuations tab) uses per share figures for the last four fiscal quarters (trailing 12 months), which are projected out one year (T) using the historical five-year annual growth rate (AGR). For example, Johnson & Johnson's trailing 12-month earnings per share is $4.62. Increasing the earnings by the five-year growth rate of 13.8% leads to a one-year projected earnings figure (T or Trend) of $5.26: [4.62 × (1 + 0.138) = $5.26].
There are numerous assumptions underlying this simple projection, notably the latest figure must be representative of a normal period and the growth must continue in a stable and predictable manner. Normally, dividends will expand in a consistent pattern, but earnings, cash flow, and even sales can be quite variable from period to period. Investors must take seasonal, cyclical, and product life-cycle patterns into account when judging the reasonableness of the trend estimates.
The current multiple (CM) provides an indication of the expectations embedded into the stock price. Companies with higher expectations will trade with higher multiples to earnings, dividends, cash flow, and sales. As expectations increase, multiples expand, raising the stock price supported for the given level of earnings, dividends, cash flow, or sales. At times, the market gets ahead of itself—leading to overvaluation. When reality catches up with overzealous expectations, downward adjustments are made to multiples and prices, even if on the surface, factors such as earnings increase.
The first valuation multiplies the current multiple (CM) by the projected “trend” variable (T) to calculate the fair market price. Valuations are calculated only for companies with positive figures for the latest reported items and a five-year growth rate (positive or negative). The $59.94 earnings valuation (EPS) for Home Depot is determined by multiplying the $5.26 earnings trend figure by the current price-earnings ratio of 11.4 (manual calculation may not agree; Stock Investor rounds underlying figures). Beyond assuming that earnings will continue to grow over the next year at the same rate that they have over the past five years, this valuation assumes that the relationship between price and earnings will stay constant.
Below the current multiple on the Valuations tab is the five-year average multiple (AM). The five-year average multiple serves as a base to help determine whether the current price has deviated too far from its past relationship to sales, earnings, cash flow, free cash, and dividends. Johnson & Johnson's current price-earnings multiple of 11.4 is also much lower than its historical average of 17.7. Multiplying this average multiple (AM) by the projected income statement variable (Trend) forms the basis for the second valuation (average valuation). Johnson & Johnson's average valuation value of $93.06 is almost 80% greater than JNJ's current price of $52.15.
Two additional valuations provided under the EPS column use I/B/E/S earnings estimates in place of the simple trend-generated estimates. These valuations rely on the estimate for the company’s current fiscal year (EE) times either the current multiple (CM) or the average multiple (AM). The $1.57 earnings estimate represents the projection for the fiscal year ending January 2003. As seen in Figure 1, this estimate is below the simple projected increase of $1.73 (T). Using the estimated $1.57 figure leads to a $41.76 valuation using the current multiple ($1.57 × 26.6) and a $64.06 valuation using the average multiple ($1.57 × 40.8).
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