We all occasionally have the planned or accidental amount of spare cash to invest, dry powder to enable us to continue seeking alpha, the incremental return from astute investing. This article will help you make sound decisions and select the right opportunities for you, today.
This article makes several assumptions concerning your current situation. It assumes that you own a number of Dividend Growth Stocks and that you have portfolio rules in place. These guidelines would include the standards that you apply to new purchases, such as yield, and include limits on the size of each holding or amount of concentration or emphasis in each sector or industry.
Your guidelines would include a minimum yield, which could be from 2.75% up to 4.00%. Other hurdles might include a debt level or payout ratio. A standard for valuation might include determining a low enough valuation to allow a margin of safety. If you have a $300,000 DG portfolio of 40 stocks, you might open positions at $5,000, have an average position of $7,500 and a limit of $10,000.
I propose that the best candidates for today's purchase are stocks that you currently own, and which are undervalued. By virtue being in your portfolio now, you have researched them in the past, and lived with them for some time. This should cut the amount of time you have to spend in doing your due diligence on them to add to your positions to a minimum. You have also experienced owning them, which gives a level of understanding unavailable to one who had not. There is less unknown risk with the familiar. Indeed, this article could be titled, "The Devil You Know Is Better Than The Devil You Don't Know."
Making a List
I'm making a list and checking it twice. Not just to see if my stocks have been naughty or nice, but to determine if they currently meet my investing guidelines including yield and investment size. Importantly, those that do must also meet valuation standards before I add to them. Here is what this list looks like in real life, which is in my little home in Florida. I got a good start on this project with a blank piece of paper with some lines drawn on it with ballpoint.
I use one of three methods to determine the valuation of a stock. If it is ambiguous, I check two or all three methods and see if that makes things clearer. By valuation, what I mean is the true worth, the real value, the intrinsic value of a stock. One way of doing this, the root and precursor of many methods, is by doing a Discounted Cash Flow study. This is based on the theory that a company is worth the discounted value of its future cash flows. This takes the time values of money into account, that is, a dollar today is worth more than it will be tomorrow. If the meaning behind the acronym MPT is important to you, you might start be figuring the WACC. Otherwise, you can use a simple software implementation of a formula that is posted online by moneychimp, leaving 11% in the discount rate input area. Simply input the last twelve months' earnings per share, EPS, in dollars, and projected annual 5-year average EPS increase, into the live screen. Here is what it looks like online for Intel Corporation (NASDAQ:INTC).
DCF - The Discounted Cash Flow Calculator
You could also figure this out with our basic toolkit, the ballpoint or pencil and a piece of paper. Here is the formula:
P = E1Q + E2Q2 + ... + ENQN + ENQN x Q/(1 - Q) , where E2 is the earnings in year 2 (or whatever) and Q is the so-called "discount factor" 1/(1 + R).
This graph, also from moneychimp's site, illustrates the matter.
We are basing our formula on the sum of the first 5 green bars. However, to do so, we still need to estimate or find a number to use for the future 5-year annual estimated EPS growth rate. Security analysts estimate this number, and usually a reported figure is the consensus of these. The number I used for 5 year annual estimated growth rate was from FinViz, 11%; I do not know their source and have emailed them inquiring about it. S&P Capital IQ's number is 11.5% and Thomson-Reuters First Call reports a rate of 16.1, according to Yahoo Finance. Because there is a great difference between 11% and 16.1% we should look at other sources because there obviously is some confusion here. Intel Corporation closed today at $23.74. Is $26.21 close to its actual real value? If so, it is fairly priced or slightly underpriced.
Morningstar provides a couple of estimates of value for the stocks it covers. The first one, and the most used, is the Star rating system, which is available to all. Morningstar gives this stock a rating or 3 Stars, which means that in general it is fairly priced. A rating of 4 Stars or 5 would mean that it is more likely to be a bargain. Morningstar, for its Star Ratings and other estimates, uses a proprietary modified DCF model. The company also provides a Fair Value price to its Premium Subscribers. In this case, the Fair Value is $25, very close to our DCF value of $26.21. Does that settle it?
Another way to estimate the value of any stock is to compare its P/E to the P/E of the market, usually the S&P 500 or to other similar firms in its industry. A very relevant method compares its own average historic P/E to its current P/E. Again, this can be done by looking up historic prices and earnings, and doing the calculation with paper and pencil.
But, once again, in this age of electronic miracles, you can use sophisticated but easy to use software that you can access on your desktop computer. This program will do the computations and present the results in graphic form. That software is F.A.S.T Graphs, developed by Seeking Alpha contributor Chuck Carnevale, of the Tampa Bay area of Florida. This powerful software offers a visual presentation as its primary output. The most basic indication of value is simply this - if the black price line is under the orange earnings justified value line, the stock is underpriced. The orange line is based on a little more than P/E but we will not go into that here.
What we will do, however, is show you a more typical presentation of the same FAST Graphs chart, which includes the above information and much more. The blue line shows the normal P/E, the pink line the dividend payments.
We first observe that the black line is, as before, below the orange line in the green area. When we place our cursor on the end of the black line, it indicates today's price. The intrinsic value of the stock based on earnings may be interpolated on the orange line, but since we are near the end of the year, we can simply use the value that appears when we place our cursor on the caret on the orange line for the year end, the last one on the right. That comes up at $28.05. That number is less than 10% away from our DCF value of $26.21 as was Morningstar's lower value of $25. That gives me a high degree of confidence that the fair value of INTC today is within plus or minus 10% of $26.21.
Therefore, I would invest some of my surplus cash in Intel Corporation, up to the portfolio limit, if there were no other opportunities of greater value or which better served my portfolio needs. INTC offers a fair price with a slim margin of safety.
We continue our valuation analysis of the remaining 12 possible opportunities for investment within the portfolio rules, and created the below table to summarize the results.
Note, I have my portfolio loaded into FAST Graphs. One quick way to screen for valuation is to simply click through the graphs and observe if the black line is above or below the orange line. I can also use Morningstar to review value information and can simply observe the number of Stars for each stock. Since I subscribe to Morningstar Premium, I can customize a screen of my portfolio, which provides me with the relevant data in report form. I included yield and DGR on this, and could add a debt measurement. The way I designed it shows, to the far right, the ratio of Price to Fair Value. That is, a relative measure of how much the stock is undervalued or overvalued by their computational method..
This indicates the Star Rating, based on DCF calculation with other factors, such as economic moat. It is quickly apparent that our best buys are potentially BBL, MCD, PG, PPL, SO and TU. Let us look at our list and discern which of those are not too near our portfolio limits, or have other factors, which would prevent us from further investment at this time.
Above is our updated list. Three Morningstar 4 Star stocks are on this list, McDonald's (NYSE:MCD), Procter & Gamble (NYSE:PG) and Southern Company (NYSE:SO). Four other stocks are rated 3 Stars and a total of seven have Price/Fair Value ratios under 0.99. However, only five of these seven stocks are confirmed by FAST Graphs. That is, the black price line is not below the orange earnings justified line. Is FAST Graphs wrong in these cases? FAST Graphs knows no right or wrong. It simply presents data in a uniform and consistent manner, for the users' interpretation. It does not flash a big red warning on the screen that says, "DO NOT BUY" or a flashing green light that says, "BUY."
What I see on MCD's Fast Graph is a blue chip stock, which sold at a premium to its Earnings Justified Price much of the time until 2008. This was based in part, I am sure, because of the impressive record of growth. Even now at a market cap of nearly $100 billion, it has operating earnings growth of over 10%. It has a dividend of 3.1% and a dividend growth rate of 14%. The fast graph shows it rising away from its lower market valuation in 2008 through 2011. It bumped up against the Normal P/E ratio, the blue line at the end of 2011 and again more recently this year. It has since dipped in price. In addition, I offer the current FinVis chart below.
Being a belt and suspenders person I also ran a DCF using the same process as illustrated above. Using $5.46 as the Earnings Per Share for the ttm, 8.4% as the expected annual future growth rate and the 11% discount rate, the DCF calculator produces a price of $69.63. I was anticipating something nearer to $80 than $70. However, the EPS Growth Rate for the past 5 years was much higher at 22.7% than the expected future rate. Growth is slowing with increased size, as is to be expected. The analysts' consensus recommendation is 2.40. I call that a weak buy.
I will defer further investment at this time, and seek further insights.
Procter & Gamble
Procter & Gamble rates 4 Stars by Morningstar but that buying opportunity valuation is not confirmed by the FAST Graphs chart either.
In some respects, this chart looks similar to McDonald's. From the year 2000 until 2008, the stock traded at the level of the blue line, the normal P/E line on the chart. Then it dropped to below the orange line, offering a great buying opportunity in 2009, and after several years of tracking the Earnings Justified Orange line it is now back to its former level at the blue line. What does this mean? Is this the new normal? Is it fairly priced at $80? Is it worth $87 as determined by Morningstar or is it worth only $63 as the FAST Graph might be interpreted? The DCF comes up with a valuation of $48.48. The analysts' consensus is 2.20, a buy but not a strong buy. While I think PG is a great company, I'm not going to purchase it at or near $80.
From my core portfolio of 23 stocks, 22 of them met the portfolio requirements for inclusion as a new or additional investment. Of those 22, the portfolio-position-limit-size would allow additional investment of at least $1,000 in 13 of them. Of these 13 stocks, 7 passed my initial value screen in which I used the Morningstar Fair Value amount and the calculated Price/Fair Value ratio of under 99% as a limit. Of these 7, 5 passed the next value screen, FAST Graphs. Of those 5, only two seemed to have an adequate margin of safety. That is a phrase coined by legendary investor Benjamin Graham to describe the amount below the intrinsic value that one should pay to assure a more certain outcome. The remaining two stocks do not have an ideal margin of safety, but they will further my goals. I am going to place a buy order for $2,000 of AstraZeneca (NYSE:AZN) and $1,000 of Westpac Bank (NYSE:WBK).
- Those orders were placed and were executed on 9/19/2013 just before the close. They were AZN for 38 shares at 51.85 and WBK for 32 shares at 31.14.
I will seek more information on McDonald's. I will watch the other undervalued stocks, which do not have a large margin of safety, and consider buying them at a better price.
I am certain there are other methods to determine the best use of investable cash. However, I believe I have demonstrated a logical way to decide how to invest intelligently in your existing portfolio. I believe it is a good place to look for opportunities. You do not add the complexity of a new holding to your existing ones. You do not need to do the degree of due diligence required of a new holding. You build stronger and larger positions in your best holdings by adding an incremental investment, probably a smaller one than you would use to open a new position. By doing a valuation study, whether like this one, by solely reviewing the FAST Graphs charts on your holdings, or solely looking at the Morningstar Fair Value, you put your money to its optimum use. This will move you toward being a superior investor with superior returns.
I wish you tremendous good fortune as you continue seeking outsized returns on your investments.
Disclosure: I am long MCD, PG, AZN, WBK, SO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.