# 3 Short And 4 Long Ideas Based On Fair Value Estimates

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by: Efsinvestment

There are several ways to estimate the fair value of a company. From a financial engineering perspective, investors expect the investment project to provide substantial profits for the future. By purchasing a stock of the company, investors are entitled a share of the future profits. However, time has a value itself. Therefore one needs to discount the future profits by using appropriate discount rate. As Professor Donald F. Kuratko from Indiana University, Kelley School of Business, describes this model as:

This model attempts to establish future earning power in current dollars. Projects future earnings (five years), calculates the present value using a then discounted rate based on projected “timing” of future income.

Besides the future earnings, the company already has some assets that you are entitled a portion of. Adding these assets to the present value of future earnings gives us the FED+ Model:

Future Earnings Discounted Plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own due diligence. So far I’ve analyzed the fair values of several stocks. Here is a brief analysis of 3 stocks trading above their fair value and 4 stocks trading within and below their fair-value:

 Stock Average P/E EPS Growth Estimate Closing Price Fair Value Range O-Metrix Score Baidu (BIDU) 48.17 48.00% \$140 \$140 - \$145 4.99 Amazon (AMZN) 77.69 26.42% \$210 \$74 - \$91 1.70 Netflix (NFLX) 42.28 31.38% \$213 \$167 - \$173 3.71 SiriusXM (SIRI) 35.22 30.00% \$1.72 \$1.76 - \$1.88 4.29 Apple (AAPL) 13.24 20.85% \$374 \$363 - \$430 7.84 Cisco (CSCO) 10.71 10.65% \$15.41 \$15 - \$23 5.70 Intel (INTC) 8.55 10.69% \$19.64 \$26 - \$34 8.75

Short Ideas

Baidu, a Jim Cramer favorite, is trading at the lower end of its fair value range. However, the stock is trading at P/B ratio of 28. It has a book value of \$5.01 per share. As the largest internet information provider in China, Baidu’s trailing twelve month revenues were equal to \$1.65 billion. Thus, the stock is trading at 29.63 times its revenues. The stock is trading with a sky-high P/E ratio of 63.84, and a forward P/E ratio of 32.51. In the last five years annualized EPS growth was 136%. However, with a market cap of \$51.8 billion, I do not expect the growth to keep its pace. Even if it does, this has already been priced by the market. The stock returned 45% since January. I think it is a good time to realize the profits. (Full analysis, here)

Amazon.com is the world’s leading international online retailer. Seattle-based Amazon was founded by Jeffry P. Bezos from his garage. Initially started as an online book-store, the company offers almost anything that customers want to buy. As of September 3rd, Amazon was trading at a price of \$210. I like Amazon as a company. Its website allows me to get real good deals for products that I can easily find. I see great growth potential, as well. However, the market already priced this potential. The current price of \$210 indicates the stock is dangerously overvalued. Based on my FED+ fair value estimate, Amazon is more than 100% more expensive than my fair-value range. The stock has to fall by 60% to be fairly-priced. (Full analysis, here)

Netflix is trading 30% lower, but 60% higher than its 52-week high. It seems like Wall Street has extremely divided opinion on the stock. Wedbush has an underperform rating with a target price of \$100, whereas Oppenheimer has an outperform rating with a target price of \$360. My FED+ Fair value range for Netflix is \$167 - \$173. Even with an EPS growth estimate of 31.38%, Netflix has a below average O-Metrix score of 3.71.

Long Ideas

I was on the bearish side of Sirius XM until the company reported decent earnings. Sirius XM is one of the most highly-speculated and manipulated stocks in the market. The stock lost 11.34% in the last month, while returning 70.30% in a year. It was a good short 3 months ago with no reported profits and a price of \$2.2. Surely, Sirius XM has some serious debt issues. Debt/Equity ratio of 6.12 is a strong red signal. However, it recently reported some good profits and is trading 30% below its 52-week high, which makes it a fairly-valued stock. If the analysts’ estimates of 30% EPS growth hold, Sirius XM could be an outperformer. (Full analysis, here)

Apple is among my favorite stocks. I was also on the bearish side of Apple when it was trading around \$400 with a P/E ratio of above 20. However, Apple reported surprisingly good earnings in the last quarter. The stock is priced for a value-type of company, whereas analysts estimate around 20% EPS growth for the next 5 years. As I stated here, when Apple was trading at \$330, the stock has a strong resistance at \$330 level. Do not expect the 40% annualized returns of the last 5 years, but a moderate annualized return of 20% - 25% is enough to beat the market. (Full analysis, here)

Cisco and Intel are both in the list of fallen angels. They were the most popular stocks of the techno bubble show. At one point Cisco reached \$500 billion market cap.

Cisco might never reach its market cap again, but it is offering a good value to patient investors. It is trading with a low trailing P/E ratio of 13.28 and a forward P/E ratio of 8.15. P/B value of 1.79 is among the lowest ratios in technology sector. Based on 10.65% EPS growth estimate, Cisco has an O-Metrix score of 5.70. (Full analysis, here)

Intel, the glorious winner of the microchip battle, is trading with a single digit P/E ratio of 9.01. It has a nifty yield of 4.28%, which rarely happens for a company of Intel’s size. There is no debt issue and PEG ratio of 0.84 is below the norm of 1. My fair value estimate range for Intel is \$26 - \$34. I think there is no downside potential left for Intel. (Full analysis, here)