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Finding The Right Price

Summary

B&H prepared a list of 26 stocks that are potential Buy-N-Forget Stocks.

Based on what I have learnt about DGI, and mostly following others on SA, I explain and list down the ways to select the right price of each selected stock.

I thank the SA contributors esp. BuynHold2012 (BnH), Regarded Solutions (RS), and David Crosetti (DC) for making me a better investor than ever was.

Thanks to B&H, RS, DC and a few others, this is what I have learnt:

1. Pick a great company/business first. Do not worry about the stock price. Dividend Aristocrats is a good place to start, or even better this list of 26 stocks is a better place. Remember, that this list was prepared keeping in mind the "qualitative" aspects, not for their "value" or "price" today. It includes:

- Their "moat" (as Buffett calls it)
- Their ability to stay in business and grow their business long term (hence buy and "forget"
- Their ability to pay dividends and grow that dividend long term
- Their "simple to understand" business. For e.g. SHW makes paint that you and I use to get our homes pained. So, you can look around you easily, as to how their "products" are used.

2. Now that you have picked a "great" business, now analyse if they are trading at an "attractive" price. The metrics or quantitative or "valuation". Before we get into Financial metrics, think for a moment - If you had a company A, how would you know how good it is performing? You started with $10000 (Initial Capital), you took a loan from a bank for $5000 (Debt), and you started making a "product" P, with this initial $15000. You had assets (machines etc. referred to as PP&E), and you had liabilities (interest on loan etc). Basically, you had expenses, and then you had net income(NYSE:NI) (or loss).

Start from here:

1. Shareholders Equity or Book Value = Assets - Liabilities.
(better be positive)

2. EPS = NI/#outstanding shares. For e.g. if company A has NI of $5000, and initially floated 1500 shares at $10 each. Its EPS = $5000/1500 = $3.34. What does it tell me? Nothing but the fact that the company is making profits, and not loss.

3. Price of a share is deemed overvalued, or undervalued based on what its making today plus what its projected to make in future (subjective, but lets keep it simple, and go with the flow).

4. P/E ratio i.e. Price of a share/EPS; If company A trades for $10/share, and earns $3.34/share, its P/E = $10/3.34 = 3x (i.e. multiple of 3). What does this tell me? It tell me that if I buy this share at $10/share today, it will earn 33% (pretty high). For e.g. SPY currently trades at 23+ x multiple. It also helps me compare 2 different companies in the same industry. For e.g. Utilities stocks do not have higher multiples, as no growth is expected vs. Tech stocks (more on future growth later).

As a rule of thumb, B&H says its best to pick a price (not the company, remember you already picked the companies based on moat etc earlier), when its TTM (Trailing Twelve Months) and Forward (next year's projected) P/E is no more than 20.

Benjamin Graham liked prices at P/E of 15. But he also mentioned that P/E times P/BV < 22.5 i.e. if P/BV is less than 1.5 then P/E could be higher than 15.

5. Now probably the most important ration: the PEG ratio, because it looks at future.

PEG ratio = P/E divided by Projected EPS growth rate (typically next 5 years).

For company A, if its current EPS of $3.34 is projected to grow by 10%, and with current P/E of 3x, its PEG ratio = 3/10 = 0.3

Now see, how this one ratio has brought together both the current earnings, the price you pay for these earnings (P/E), and future EPS growth rate - all rolled into one.

B&H recommends to buy companies when their PEG ratio < 2.

So, for e.g. a company with P/E of 20, must have projected EPS growth of 10% to have PEG of 2.0; same as company with current P/E of 10 with projected EPS growth of 5%.

If AMZN is the penultimate growth stock, then its high P/E of even 100x (i.e. it makes only $1 for each share price of $100) is acceptable, if its projected to grow at least 50% per annum in next 5 years (PEG = 2). This is not the case. Hence overvalued.

So, a P/E not more 20, and PEG not more than 2 - implies do not even look at companies which are not growing at 10%. How much has SPY grown in last 5 years? in 10 years? in 20 years? If you want to beat SPY, look for companies that beat SPY in growth, and choose your own P/E and PEG. 20 and 2 are upper limits.

6. Now that we have dealt with Share price, earnings, future earnings, Book value; what if a company is achieving great results with a lot of "debt" ? Look at GM.

This brings us to Debt/Equity ratio. Equity is same as Shareholder's equity as pointed out in #1. It should be low. It cannot be 217% as it is for GM, hence the stock appears cheaper. Remember, debt has been cheap for a while now. Hence the rise of leveraged CEFs (Closed Ended Funds), but we are at the beginning of a "transition" phase with rising rates.

I will not get into Return on Equity (ROE) for now.

HTH.