Sometimes we try to make valuing stocks too difficult. If we like a company, and that is always a prerequisite, how do we know whether we are getting a margin of safety with our purchase? A lot of models generated by Wall Street research firms put painstaking effort into coming up with an exact earnings number. However, as investors, we should be comfortable with a range of outcomes because the value of our stock holdings will often deviate significantly from that company's particular earnings power. One example, which I own shares in, is Aflac (NYSE:AFL). We'll return to that later.
I want to introduce the idea to those unfamiliar with it the notion of a perpetuity. A perpetuity is a constant stream of identical cash flows with no end. The formula for determining the present value of a perpetuity is as follows:
Basically, a perpetuity assumes an asset will generate the same earnings every year forever. So, to give an easy example, assume an asset generates $1 in earnings every year in perpetuity and as an investor you demand a 10% return. What is this asset worth to you? The answer should be $10, because $1/0.10 equals $10. So, let's use the perpetuity formula on a couple of examples of stocks which I feel are undervalued today, and back out what rates of return we can expect from these stocks at current market prices.
Let's return to AFL. According to Nadaq.com, AFL earned $6.11 last year. Aflac currently trades at ~$50. So, what rate of return could we expect if Aflac generated $6.11 in perpetuity (forever)? The answer is $6.11/.1225 = $49.88, approximately equal to Aflac's current price. This means that we can expect a 12.25% (.1225) return from Aflac if it just keeps its earning constant for the foreseeable future. Many who have followed Aflac are aware it has demonstrated significantly higher than 0% earnings growth historically, and with even relatively conservative long-term growth rates factored in, Aflac should be worth much more in a few years than it is today.
Another company trading at low multiples with a good track record of growth is Cisco Systems (NASDAQ:CSCO). According to Nadaq.com, its LTM EPS is $1.74 and trades for $20.96. Again, the expected rate of return is $1.74/.0825 = $21.09, approximately equal to its current trading price. This means that we can expect a 8.25% (.0825) return from Cisco if it just keeps its earning constant for the foreseeable future.
To provide some contrast, let's look at a company I love to eat at, and which I believe will eventually become a strong dividend payer like McDonald's (NYSE:MCD). That company is Chipotle Mexican Grill (NYSE:CMG). According to Nadaq.com, its LTM EPS is $8.75 and trades for $331.90. Again, the expected rate of return is $8.75/.026 = $336.53, approximately equal to its current trading price. This means that we can expect a 2.6%% (.026) return from Chipotle if it just keeps its earning constant for the foreseeable future.
Now, this case requires a caveat because Chipotle is growing so fast. Chipotle will certainly not have 0% earnings growth over the next 10-20 years, but what this number does tell us is that a significant portion of Chipotle's "value" in the eyes of the market comes from its expected future growth. With companies growing as quickly as Chipotle, guessing what rate of growth makes sense is not a game I want to play.
I am content to look for companies similar to Cisco and Aflac, rather than Chipotle.