Yesterday an interesting point was made in the comment section on my last article. What does it mean for a stock to be undervalued? The commenter stated that many analysts touted that Apple (NASDAQ:AAPL) was an undervalued stock yet it crashed after disappointing earnings. I'd like to clarify, at least in my opinion what the difference is between a value stock and a growth stock.
A value stock is a stock that is currently priced less than what it is fundamentally worth. I, as well as many others utilize the formula known as the Graham Number. As I have said before this is a very simple calculation that can be typed into a spreadsheet. As you look at a stock simply punch in the EPS and Book Value to get the Graham Number. It is of course up to the individual investor to decide their personal tolerance of how far they are willing to deviate from this number when picking a stock. Again the formula is:
Square Root of (22.5 x EPS x BVPS)
Let's take a look at AAPL. The Graham Number for AAPL is $366.88. On Wednesday AAPL closed at $466.59. As we can see it is way over the Graham Number, 27% over in fact. This tells me AAPL is not undervalued.
A growth stock is a stock that is under its "Fair Market Price" based on its PEG ratio. This is also an easy formula to calculate; most financial websites post the PEG ratio. This is the Price to Earnings to Growth ratio. Basically a percentage of its growth, under 1 means the stock is underpriced, over 1 the stock is overpriced. Again, it is up to the individual investor to decide their tolerance for how far they are willing to deviate from this number.
The formula can also be placed into a spreadsheet and simply enter the numbers and get your ratio. Here is the formula:
(Price / EPS / Growth rate for next five years)
Currently AAPL's PEG is .70. This means that Apple's "Fair Market Price" is $666.56. The problem with growth is that it is an estimate. Because it is an estimate analysts are free to change it whenever they want without notice and with total impunity.
Yes, I talked about personal tolerance. What I mean by this is there are other things to take into consideration other than simply the Graham Number and PEG ratio. Here are a couple things to also take into consideration and decide if the stock is right for you.
Dividend - Does the stock have one? How long has it had it? Does the payout increase every year?
Stock Buy Back - Does the company repurchase its own stock? This is something that is hard to value as you do not know how much the company will buy its own stock back for. Obviously the cheaper the stock the more it can buy back and therefore increase the shareholder's portion of the company.
Management - Not only does it need to have a good management team. How are they being paid? This is another issue with AAPL. The Board of Directors receives huge stock options. This means that they are giving themselves a part of the company at the cost of the other stockholders, not good.
The Graham Number and PEG are great ways to filter through stocks. If you find one you like, other filters must be in place to make a selection. If there is a stock you like but it does not meet your tolerance levels at that time for the Graham Number or PEG simply keep tabs on it and be patient. Come back to the stock every quarter and rerun the numbers.
If a company pays its Directors and staff with stock options, the portion of the company for other stockholders will decrease. Then eventually the company has to buy back the shares to prevent a saturation of the outstanding shares. This ultimately lowers the dividend as more shares need to see a payout. It also makes a buyback extremely inefficient.
Instead we want to see little or no options. The CEO and Directors are employees of the shareholders. We also want to see a stable and consistent buyback program removing shares from the market lowering the outstanding shares on a regular basis. This then leads to dividend increases as there are fewer shares to payout to. The best example of this is Coca-Cola (NYSE:KO). Because of this program KO has raised its dividend 8% a year for the past 50 years. When was the last time you got an 8% raise for one year, let alone 50?
When someone says a stock is undervalued I want to see the numbers and I want to know how the writer came to that conclusion. If the writer cannot show you how he or she came to the conclusion then I would simply ignore that person and move on.