By Roy Ward
Let’s talk about making money. One of the best ways to make money is to ensure that you don’t lose money, or at the least, you don’t lose your shirt. When I recommend a stock to buy, I always make sure the company is solid. A couple of quick ways to test the quality of a company are to check the company’s ability to pay dividends and to check its balance sheet. Today I’ll look at balance sheets–I’ll save the lesson on dividends for another time.
I am not an accounting professor by any means, so I’ll keep this simple. Every public company issues a balance sheet whenever sales and earnings are reported, which in the U.S. is always quarterly. Every balance sheet is divided into two sections: (1) Assets and (2) Liabilities and Shareholders’ Equity. One of the best ways to ascertain a company’s quality is to compare the book value per share to the stock’s current price.
I find that a lot of investors are unfamiliar with book value and book value per share, so, let’s at least become familiar with these terms. Book value is shareholder’s equity or retained earnings, which is a number found near the bottom of a company’s balance sheet. Book value per share is simply the shareholder’s equity or retained earnings divided by the number of common shares outstanding. (Price-to-book value can also indicate whether a stock is undervalued.)
Is book value per share important? By itself, no. But when compared to the company’s stock price, it’s enormously important. In short, quality companies with low price-to-book value per share ratios (P/BV) have outperformed companies with high ratios for the past three-, five- and 10-year periods. I recently scoured my databases to find the best companies with low P/BV ratios. I used several criteria to make my selections, narrowing the list of companies by also requiring: Value Line Financial Strength ratings of B++ or better, low price-to-earnings (P/E) ratios, dividend yields of 1.0% or higher and good earnings prospects for the next 12-month and five-year periods.
My search turned up investment choices quite different from companies appearing in most other investment advisories. I discovered six solid companies with low price-to-book value ratios selling at bargain prices, two of which are discussed below. You can find my analysis for the remaining four companies in the latest issue of my Cabot Benjamin Graham Value Letter.
Abbott Laboratories (ABT) is a very solid company with a reasonable stock price and an above average dividend. The company is performing quite well with the help of strong sales in emerging markets and recent acquisitions. Sales will increase 6% and earnings will likely increase 10% during the next 12 months. Abbott’s price-to-earnings ratio, based on next 12-month earnings per share, is 10.7, which is quite reasonable. Earnings will continue to increase at a 10% pace in future years.
Abbott has paid dividends in every quarter since 1924 and increased its dividend every year since 1971–an amazing record indeed. The dividend yield is now 3.6%. Abbott’s price-to-book value ratio is 2.79, which seems high, but is fair for a leading company in the health care industry.
And there’s more. Abbott will split into two separate companies before the end of 2012. I believe the two companies will be worth more than the current company, and investors who wait will be justly rewarded!
Drug stocks, in general, have lagged the stock market in 2011, but lately investors are beginning to notice the low price-to-earnings ratios, high yields and steady earnings growth. I recommend buying ABT at or below 52.97, and selling when its stock price increases to 72.97.
Fred’s Inc. ‘A’ (FRED), founded in 1947 in Memphis, sells discount merchandise from 678 stores in 15 states in the Southeast and Midwest. Stores offer household goods, pharmacy items, food, pet supplies, clothing and linens. Average store size is modest, about 14,400 square feet.
Fred’s offers a large selection of generic drugs, which are in high demand and highly profitable. I expect sales to increase 5% and earnings to rise 12% during the next 12 months. The retailer has added pharmacies to half of its stores and is working to add pharmacies to most of its remaining stores.
FRED shares are undervalued at 12.8 times forward earnings per share and at 0.92 times book value. The dividend yield of 2.0% is decent. I expect the strong demand for merchandise offered at low prices to continue during the next several years. I advise buying FRED at or below 13.00 and selling when the stock price hits 19.61.
I will continue to follow stocks offering investors good value in my Cabot Benjamin Graham Value Letter. My next issue, coming soon, will focus on undervalued stocks with low P/E to growth (PEG) ratios. I hope you won’t miss it.