Your goal is not to identify the profitability and growth stars of tomorrow.

Your goal is to have a good handle on a company’s true profitability and growth potential so that you value it correctly. You should even be willing to buy a low-profitability and low-growth company as long as the price is right.

Profitability

Table 1 shows Company A’s return on equity (ROE). The table reveals a dramatic improvement in Year 3 as compared to the previous two years. What do you make of this newfound prosperity? You need to answer this question before proceeding with the valuation.

Table 1. DuPont Analysis for Company A

A DuPont ratio analysis is useful for answering this question. It allows you to break down Company A’s return on equity into three components as:

ROE = NPM × TAT × EM

Where,

• ROE is return on equity,
• NPM is the net profit margin,
• TAT is the total asset turnover, and
• EM is the equity multiplier.

The net profit margin shows a very strong improvement in Year 3 as compared to the two earlier years. Company A operates in a commodity industry, therefore I would say that future margins will decline from the Year 3 level.

The total asset turnover shows a very healthy trend over the last three years, increasing from $0.60 of revenue for every dollar of assets to $0.77. To the extent that this improvement is the direct result of a price increase in Year 3, this higher total asset turnover may not be sustainable in the future. However, there does seem to be some good news here since the total asset turnover improved from Year 1 to Year 2 prior to the Year 3 price increases.

The final component of the DuPont analysis is the equity multiplier (EM). This measures the impact of Company A’s use of debt financing on profitability. Using debt per se cannot make a firm profitable. Instead, debt, with its fixed interest payments, amplifies the return to shareholders. If net profit margin is negative, then the return to shareholders is even more negative because the interest payments have to be made to debt holders. On the other hand, if net profit margin is positive, the return to shareholders is even better.

This latter case is much like the situation you face as a homeowner with a large mortgage when housing prices increase and as a result your equity in the house increases several-fold. For example, if you have taken out a 90% mortgage on a $300,000 house and prices go up by 10%, your equity doubles from $30,000 to $60,000—a 100% increase. Note that in this case your equity multiplier is 10 ($300,000 ÷ $30,000) and the house appreciation of 10% has been amplified by 10 (10% to 100%). The equity multiplier plays the same amplifying role in the ROE equation for the company.

Company A’s equity multiplier, as shown in Table 1, has declined about 10% over the last three years. This means that the company has decreased its use of debt relative to equity financing and thus its financial structure has become more conservative. Most investors would view this as a positive trend. This makes the company less vulnerable to an economic downturn.

Putting this all together, you can see that Company A’s profitability has improved over the last three years. All three of the components of return on equity have moved in the right direction over this time period. The one major concern is whether the company will be able to maintain the high Year 3 net profit margin.

Growth

I now turn to the second important value determinate: the company’s growth potential. As a starting point, I focus on the actual and projected growth rates for Company A, as presented in Table 2. I have arranged the rates in this particular order because it provides additional insight into the growth profile of the company. The projected growth rates can be obtained from various information services, or you may want to produce your own estimates.

Table 2. Past and Projected Growth Rates for Company A   

How does a company grow? First it retains earnings for reinvestment in the company. This retention shows up as growth in shareholder’s equity, the first item shown in Table 2.

The company then invests the retained earnings in assets, both physical and human, ultimately producing more revenues. This is the second item in Table 2. From revenue growth comes earnings growth, which is the third item. Finally, it is from earnings that dividends are paid. Thus, Table 2 presents a growth chronology for Company A.

The past five years show mixed results. Shareholder’s equity has grown an average of 6% annually, but revenues have expanded at a mere 2.5%, while earnings per share (EPS) actually declined over the period. Dividends per share (DPS) grew at the same rate as shareholder’s equity. The three-to-five year projections are a bit more positive, with earnings per share growing much faster than shareholder’s equity. But these are only projections, so you have to remember that they are subject to error.

What would be an ideal growth profile? In general, you would expect revenues to grow faster than shareholder equity and in turn earnings per share to grow faster than revenues. Both of these faster growth rates would be the result of productivity gains in the company: more revenue per dollar of assets and more profit per dollar of revenue. For a typical company, you should observe revenues growing 1% to 2% faster than shareholder equity and earnings per share growing 1% to 2% faster than revenues. You should not be as concerned about the dividends per share unless it exceeds earnings per share growth, as this is obviously not sustainable over the long run. On the other hand, dividends per share growing more slowly than earnings per share means that the company’s ability to pay future dividends is improving, which is very much a positive turn of events.

Sustainable Growth

Most companies, with the exception of rapidly growing small companies, do not issue new shares into the market. This is the case for Company A. Thus, for the vast majority of companies, the only way they can grow is to retain earnings, invest these into new company assets and manage these assets so that new revenues and earnings result. Sustainable growth, then, is the rate at which the company can grow through the retention of earnings without the issuance of new shares. This internally generated growth rate is given by:

Sustainable Growth = ROE × retention rate

Where,

• ROE is the return on equity, and
• Retention rate is the fraction of earnings retained.

I will not bore you with the details of how to derive this equation. I hope that the equation is intuitively appealing to you.

Company A’s sustainable growth rate is reported in Table 3 for Year 1, Year 2 and Year 3. The retention rate is calculated by subtracting the payout rate (dividends per share divided by earnings per share) from 1. For example, the payout rate for Year 1 was 76%, so the retention rate equals 0.24 (1 – 0.76). Multiplying return on equity by the retention rate yields an estimate for sustainable growth. Company A’s sustainable growth potential exploded upward in Year 3.

Table 3. Sustainable Growth Rate for Company A

Much of this improvement can be traced back to the very strong industry-wide prices during Year 3. Higher prices led to wider profit margins, which in turn produced stronger profitability and higher sustainable growth potential. Though you will be pleased to see the stronger growth potential, you need to keep in mind the potential difficulties Company A may have in maintaining a high net profit margin.

Dividend Growth

I am now ready to get to the heart of value investing: that is, the estimation of a value range for Company A stock. I estimate the first value range based on dividends being paid, incorporating much of what I have already done in the previous sections to help develop this value range.

The constant growth dividend valuation model is:

V = DPS ÷ (R – G)

Where,

• V is the current value of the stock,
• DPS is the dividends per share expected to be paid over the next 12 months,
• R is the required rate of return for this particular stock and
• G is the expected constant growth in dividends.

For Company A, I use the Year 4 projected dividends of $0.90 for dividends per share and a required return of 10%. The growth rate is the most difficult variable to estimate; I use some of the analysis presented in the previous section as a guide in selecting the right value for dividend growth.

The initial estimates for dividend growth are drawn from the actual and projected growth rates presented in Table 2. The appeal of this array of growth rates is that it captures growth at various stages in the production process and is both backward- and forward-looking. This latter point means that I am using a centered growth rate estimate. Again, the ultimate goal is the best estimate of Company A’s long-term dividend growth potential. My initial estimate is obtained by averaging the eight growth rates in Table 2 to yield 4.3%.

This approach may seem arbitrary, but I would respond by saying that estimating dividend growth is equal parts art and science and that the technique does have a plausible basis. Having said this, however, there are many ways that the growth rates in Table 2 can be combined to come up with an estimate for G. You should feel free to develop your own unique approach.

Putting these estimates together, the initial value estimate is:

V = $0.90 ÷ (0.10 – 0.043)
    = $16

This is less than the current share price of $28.

The next estimate is obtained by averaging just the four projected growth rates in Table 2 and using the resulting 7.4%.

V = $0.90 ÷ (0.10 – 0.074)
    = $35

This value estimate exceeds the current share price of $28. I am less confident in this estimate since it is based exclusively on projected growth rates.

Using the estimated sustainable growth rates of 1.3%, 1.6% and 9.8% presented in Table 3 result in value estimates of $10, $11 and $450, respectively. This is a very wide range indeed! Given the difficulties faced by Company A in maintaining those high margins, the $450 estimate is clearly unrealistic.

It should be obvious at this point that coming up with a growth rate estimate is a significant challenge. Let’s turn this question around and ask, what growth rate does the stock market expect from Company A? This question can be answered by substituting the current price for V in the constant growth dividend valuation equation and solving for GM, the stock market’s growth rate expectation.

$28 = $0.90 ÷ (0.10 – GM)

GM = 0.10 – ($0.90 ÷ $28)
       = 6.8%

Note that the market’s growth rate expectation is equal to Company A’s required return net of the dividend yield. I have taken the liberty of converting GM to a percentage figure.

Focusing on the market’s expectation for Company A provides a different perspective on the growth issue. Is the 6.8% growth rate expectation achievable by Company A? From one point of view, it is somewhat aggressive in that it is higher than the average growth rate for the typical NYSE stock.

Next, you might ask, what net profit margin is necessary in order to sustain this level of growth? If you tie together the first equation for return on equity and the second equation for sustainable growth, the net profit margin necessary to sustain the market’s growth rate expectation is:

NPM = 6.8% ÷ (TAT × EM × Retention Rate)
         = 6.8% ÷ (0.77 × 2.0 × 0.72)
         = 6.1%

That is, in order for Company A to sustain an average growth rate of 6.8%, it has to maintain a net profit margin of 6.1%. Company A’s average net profit margin over the last 11 years is 6.8%. Therefore, I conclude that the market’s current growth rate expectation for Company A is realistic and the stock is undervalued at the current price of $28, since its historical net profit margin of 6.8% exceeds the market’s expectation of 6.1% built into the current price.

The Value Range

I have generated a number of value estimates for Company A stock. How do I now go about creating a value range? I take my first estimate of $16 as the lower bound for the value range. Two of the estimates based on sustainable growth were lower, but I believe they are unrealistically low. I take as the upper bound the second estimate based on projected dividend growth of $35. The growth rate of 7.4%, upon which this estimate is based, is sustainable, assuming Company A is able to maintain its historical 6.8% net profit margin. The other higher estimate ($450) does not seem reasonable in light of the realities facing Company A. Therefore, my value range is $16 to $35, and I conclude that the stock is currently properly valued as it sits within this range, priced at $28.

Graham and Dodd Earnings Valuation

Benjamin Graham and David Dodd, along with Sidney Cottle, are referred to as the fathers of securities analysis. While I am not as conservative as this threesome, I have the utmost respect for their unique investment strategy.

A number of years ago, Graham and Dodd conducted some empirical tests to determine the relationship between a company’s growth rate and its price-earnings ratio (P/E). They determined that this relationship is:

P/E = 8.5 + 2G

That is, if there is no growth, the price-earnings ratio should be 8.5 and increase at double the growth rate if there is actual growth.

The problem with this equation is that in the time period over which the tests were run, there were few changes in interest rates. Of course, recent years have witnessed dramatic interest rate changes, so the equation has to be modified to capture these changes. A few years ago a modified Graham and Dodd equation was proposed as:

P/E = (8.5 + 2G) × (4.4% ÷ AAA)

Where,

• AAA is the current AAA Corporate Bond interest rate, and
• 4.4% was the average AAA corporate bond rate over the time period of Graham and Dodd’s study.

Plugging in a conservative 6% for growth and an AAA rate of 4.1%, the estimated price-earnings ratio is:

P/E = [8.5 + (2 × 6)] × (0.044 ÷ 0.041)
       = 22

and the resulting value is:

V = P/E × EPS
V = 22 × $2.80
   = $62

Given low current interest rates, Graham and Dodd would conclude that Company A is dramatically undervalued, providing the margin of safety they so prized when making investment decisions.

Is It Undervalued?

I have followed a long and torturous route in my value analysis of Company A. So what have I learned? A careful growth analysis reveals that Company A’s sustainable growth rate is sufficient to meet the market’s growth expectation implicit in the current price of $28. The value range based on dividends confirms this. Based on the value analysis, I conclude that Company A is correctly valued at $28 and does not represent an attractive investment at this time.

If I currently own this stock, should I sell it? A reasonable case can be made for selling the stock, particularly in light of the dividend valuation. But I also think it would be reasonable to hold on to the stock. There is not an overwhelming sell signal at this point.

A question you might have been asking yourself is, isn’t there a shortcut to value analysis? I did go through a very thorough analysis of Company A and it is obvious that a wide range of techniques are available in a value analysis. You may decide to employ all of these techniques as I did in this example. Or you may choose a parsimonious strategy involving a small number of these techniques, as I do in managing the Athena Pure portfolio. The choice is up to you.

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