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  • How To Determine if it's a value trap instead of a value stock 3 comments
    Jul 7, 2009 9:28 PM

     Investors often underperform their expected returns. In particular, this is common among so called "value investors". Whatever method they used to determine the value (Relative valuation, discounted-cash flow, p/e, pe/g.pb, etc) may prove worthless if the company does conduct efficient operations. There are two key measures which any "value investor" should employ against those in the industry and the market as a whole.

     1) Earnings Yield- Many people familiar with this but don't employ it correctly. The quality of earnings is the first step, in other words remove any one time items and either remove reoccurring income from other sources or normalize it. In essence this will reveal the quality of earnings from operations which are more likely to exist in the future. The adjustment is determining the earnings yield by dividing enterprise value to Eps (EV/EPS). EV = Current share price * shares outstanding - cash and marketable securities + debt.  After you compute this ratio you merely take the reciprocal.. 1/(EV/EPS). A quick example: Company A earned 40 million from operations. It has 120 million in debt and 15million in cash. They have 75 million shares outstanding and the current price is 4$/share.EV=4*75million+120million-15million = 405 million.  Earnings Yield: 405/40= 9.87%Using the reciprocal of the Pe would give an artificially high EY = 300/40= 13.33% 

    2) Measuring the efficiency of a company's operation: This is done by taking Pre-tax Return on capital. There multiple firms who look like a deal but have low return on capital. This is very easy to calculate: EBT/Net PPE+ Depreciation (from the statement of cash flows because of GAAP accounting which you are forced to depreciate certain assets over a fixed time frame).

     Conclusion:   When comparing what you determine "values" put the earnings yield in one column and return on capital in another. Do this for other players in the industry or other equities. Obviously there are exceptions. But you can negate some of this by using forward measures of these going out as long as you think you can accurately project growth. Joel Greenblatt wrote about this is a very small book with a bad title but it is very telling. When you have a group of equities pick the one which is relatively high in both categories as opposed to high in one and poor in another. 

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  • manuel
    , contributor
    Comments (299) | Send Message
    sorry but you speak about earnings per share and their quality, it would be enough if you use ebit or gross margin instead of eps, on your calculation you are not removing one time items you just add debt to market cap
    8 Jul 2009, 09:35 AM Reply Like
  • Hyperinflation
    , contributor
    Comments (810) | Send Message
    Author’s reply » If you read it again, in my example I said "earnings from operations" not simply net income. No enterprise value is the current market cap less cash plus debt, which is used to figure out earnings yield. A lower market price = lower market cap = lower enterprise value. what does one time items have to do with market cap
    9 Jul 2009, 03:10 AM Reply Like
  • manuel
    , contributor
    Comments (299) | Send Message
    ok sorry so your 40$ earnings are earnings from operations, anyway I think it is better to use market price to determine the yield not some ev you determine, market price finally determines your real yield


    most of the definitions of earnings yield i read are simply E/P


    9 Jul 2009, 06:48 AM Reply Like
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