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The Applied Finance Group’s (AFG’s) suite of investment tools and research is designed to help investors make more informed investment decisions by helping them understand the performance a company must deliver to justify its current stock price in addition to calculating the firm's intrinsic value. By understanding the embedded expectations a company must deliver to justify its current trading price, clients can develop a “hurdle rate” to quickly determine if the company’s expectations are too rich or too low.

Last week, AFG released its monthly stock market review which discussed the embedded expectations of the entire S&P 500 using the Value Expectations Interface. We concluded that the overall index is slightly undervalued, but trading pretty close to fairly valued.

Using AFG’s Value Expectations Interface and Intrinsic Value Chart, we will provide a company example of each of the following scenarios: A) a company with an unattractive default intrinsic value and high expectations for sales growth B) a company with an attractive default intrinsic value and low expectations for sales growth.

The company we will use as example A, Apple Inc. (NASDAQ:AAPL), is a great company but not necessarily a great investment as it has an unattractive default valuation rank and high expectations for sales growth to justify its current price of $215. Assuming EBITDA margins and Asset Turns remain constant AAPL would have to grow sales by over 20% ($36 billion to $92 billion) each year for the next 5 years to justify its current price.


VE Insight
Assuming EBITDA margins and Asset Turns remain constant
AAPL would have to grow annual sales from $36 billion to $92 billion
over the next 5 years to justify current price


Company B is Hewlett-Packard Co. (NYSE:HPQ), a company that looks attractive from a valuation standpoint as it is currently trading below its default AFG intrinsic value and appears to have very realistic sales growth expectations embedded into its current stock price. HPQ has 1.8% sales growth currently priced-in to its current share price meaning it must grow sales from $114 billion to $125 billion over the next 5 years to justify its $52 share price, assuming EBITDA margins and Asset Turns remain constant.

VE Insight
Assuming EBITDA margins and Asset Turns remain constant
HPQ would have to grow annual sales from $114 billion to $125 billion
over the next 5 years to justify current price

The question investors must ask themselves is which of these 2 risk/return scenarios are you willing to take on in their client’s portfolio.

AFG’s valuation techniques and understanding of expectations “built-in” to stock prices are just a couple ways that AFG helps investors make more informed stock selection decisions. If you are a professional investor and would like to see if you qualify for a free trial of AFG’s research and suite of investment tools click here and an AFG Representative will contact you.

AFG’s Intrinsic Value Chart:

• Identifies entry/exit points

• Shows how well AFG has tracked the company (accuracy)

• Displays the trading range of the company each year through time (blue bars)

• Displays the end of year closing price (dash on blue bar)

• Displays AFG’s default intrinsic value (red dotted line)

How to Read this chart:

• The Blue Bars represent the high and low trading range for a stock for each calendar year.

• The red dotted line represents Applied Finance Group’s (AFG’s) historical Intrinsic Value through time.

• When the red line (Intrinsic Value) is above the blue bars (trading range) the company looks to be undervalued.

• When the red line (Intrinsic Value) is below the blue bars (trading range) the company looks to be overvalued.


What Is The Value Expectations Interface?

AFG’s Value Expectations interface provides clients a platform to better understand economic profitability, and at the same time understand the performance a company must deliver to justify its current stock price. By understanding the embedded expectations a company must deliver to justify their current trading price, clients can develop a “hurdle rate” to quickly determine if the company’s expectations are rich or low. Take, for example, the typical company during the tech bubble: the expectations that were priced into the average tech stock far exceeded what it could realistically deliver. For this reason, AFG identified the technology sector as overvalued, as well as potential torpedoes such as Cisco (CSCO), whose expectations were unrealistically high.

After determining if a company is a valid investment opportunity, users have the flexibility to adjust expectations based on their own research, build out pro-forma financial scenarios, and arrive at an NPV target price.

In addition, the VE interface has all the key theoretical components of a well-thought-out valuation model, which takes into consideration the appropriate risk, with a market derived discount rate (MDDR) that is adjusted for size and leverage. Competition and perpetuity issues are also taken into account, using company specific Competitive Advantage Periods (CAP).

By gaining a better understanding of the embedded expectations built in to security prices, relative to what a company has delivered historically, can provide insight into the Sales Growth, EBITDA Margin, and Asset Turnover a company must deliver in the future to justify its current trading price. In many circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued.

Value Expectations Interface allows investors to:

• Understand the performance expectations embedded into today’s stock prices.

• Build out Different Pro forma Financial Scenarios

• Determine NPV target price based on the users assumptions.

• Quickly determine if a company is over/under valued

• Benchmark valuation attractiveness against peer groups

• Efficiently Identify investment opportunities or potential torpedo’s

To stay updated on companies AFG believes are attractive investment opportunities register here.

Disclosure: none

Source: Apple: A Great Company, Not Necessarily a Great Investment