STOCK INVESTOR PRO > April 2012

Estimating a Stock’s Fair Value Using Valuations

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Common sense dictates that investors should buy stocks when they are cheap and sell when they are rich. However, while this may be a simple principle, determining a company’s fair market price or intrinsic value is far from easy. Stock Investor Pro includes a tab in the Stock Notebook devoted to valuations to help users gauge the market’s assumptions that are built into a company’s stock price.

In this issue, we walk you through the numbers and calculations presented on the Valuations tab and discuss their use and interpretation.

The Valuations tab for Microsoft Corp. (MSFT) shows data as of March 16, 2012. The Valuations tab uses popular multiples such as the price-earnings ratio (P/E) coupled with historical and projected growth rates to determine benchmark price valuations.

Valuations are meaningful for a wide range of company situations and can help determine which primary factors are influencing a company’s stock price. The Valuations tab provides figures for earnings, dividend, cash flow, free cash flow and sales.

CALCULATIONS

Stock Investor Pro 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.

A simple projection of per share earnings, dividends, cash flow, free cash flow, and sales is calculated in the Trend row. The Latest Reported row (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, Microsoft’s trailing 12-month earnings per share was $2.79 as of its latest quarter ending December 31, 2011. Increasing the earnings by the five-year growth rate of 17.7% leads to a one-year projected earnings figure (Trend) of $3.28: [2.79 × (1 + 0.177) = 3.28].

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) row 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 row 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 $38.75 earnings valuation (EPS) for Microsoft is determined by multiplying the $3.28 earnings trend figure by the current multiple (price-earnings ratio) of 11.8 (manual calculation differs slightly from Stock Investor Pro due to rounding of 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.

Comparing current multiples against industry and historical norms helps to indicate if the stock valuation is out of kilter. Microsoft’s current price-earnings ratio of 11.8 is cheap when compared to both the average of 18.9 for the technology sector and when compared to the software and programming industry’s average of 25.1. The market sees weaker growth potential for Microsoft when compared to its industry and sector, making it an “out-of-favor,” or value, stock. As an investor, you must decide if the market’s assumptions are reasonable.

Below the Current Multiple row on the Valuations tab is the Five-Year Average Multiple (AM) row. 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. Microsoft’s current price-earnings multiple of 11.8 is also much lower than its historical average of 14.8. Multiplying this average multiple (AM) by the projected income statement variable (Trend) forms the basis for the second valuation (the Average Valuation row). Microsoft’s average valuation is $48.60, almost 50% greater than the March 16, 2012, closing price of $32.60.

Two additional valuations provided under the EPS column use I/B/E/S earnings estimates found under the Estimates tab in place of the simple trend-generated estimates. These valuations are calculated by multiplying the consensus estimate for the company’s current fiscal year (EE) by the current multiple (CM) and the average multiple (AM), respectively. The $2.69 consensus earnings estimate represents the projection for the fiscal year ending June 2012. As seen in the Valuations tab this estimate is below the simple projected trend of $3.28 (T). Using the consensus estimate of $2.69 leads to a $31.72 valuation based on the current multiple ($2.69 × 11.8) and a $39.78 valuation based on the average multiple ($2.69 × 14.8).

The Valuations page provides a quick look at a stock’s appeal. However, the merit of the Valuations tab does not rest within the calculated fair market values, but rather in getting a feel for the assumptions built into the company’s stock price. Extraordinary gains come when you place a bet against the general consensus and are correct.