Good Investment Indicator for Uncovering Bargain Stocks
Companies / Investing 2009 Oct 02, 2009 - 02:39 PM GMTBy: Money_Morning
Keith Fitz-Gerald writes: For investors who fear that the markets have soared too far too fast, the thought that some stocks may still be cheap is hard to imagine - especially when it comes to China.
Here's one way to separate the cash from the trash.
I call it the "good-deal number," or the "good-deal indicator." And for a very good reason: By running this simple equation, I can determine whether a stock I'm interested in is a "good deal" - and worth buying.
Intuitively, investors know that it's best to buy at the bottom and sell at the top. And history bears this out.
For instance, investors who bought at or near such market peaks as 1928, 1969, 1999, or 2007 tended to overpay. And they doomed themselves to sub-par returns, as a result.
On the other hand, investors who had the courage to wade in when the days were darkest - think 1932, 1942, 1982 and 2003 - were typically rewarded with above-average results. Over time, such moves can translate into life-changing wealth.
Unfortunately, reality is never that simple. Markets usually aren't operating at peak or trough levels. And even when they are, how can an investor to tell for sure?
Nor is that the only challenge that investors have to face, Pat Dorsey, director of equity research for Morningstar Inc. (Nasdaq: MORN), wrote in a recent Money magazine column. Although investors endure a daily barrage of stock prices, Dorsey said there's no "ticker tape" that tells us whether those prices represent actual values.
In other words, just because a stock is cheap doesn't mean it's a bargain.
That's why I like my "good-deal indicator" so much. Although it can be used when the markets have reached extremes, it's just as useful when the markets are in between extremes - as they are right now.
But best of all, it's simple to calculate and easy to use. I can run the number in my head or on the back of a napkin - without resorting to fancy spreadsheets or computer modeling. You can develop a good feel for how a company will perform over a longer stretch - so you won't get fooled by one or two periods of dramatic movement.
Let's walk through a real-world example drawn from a meeting I held in China regarding a fast-growing energy-and-biofuels company that I'm studying right now.
To start, you need two key numbers: the company's earnings per share (EPS) and its Price/Earnings (P/E) Ratio.
Since 2007, this company's annual per-share earnings have ranged between 22 cents and 72 cents, according to MSNMoney.com. For purposes of making a reasonable, middle ground estimate, let's say the company's EPS number is 47 cents.
During the period in question, the company's P/E ratio has ranged from a low of 5.0 to a high of 43. So using the same middle-ground approach, let's call it a P/E of 24. Now we multiply the EPS of 47 cents by the P/E of 24 (0.47 x 24) and we get a rough "value per share" of $11.28. That's roughly 1.69 times higher than the stock's recent market price of $6.65, suggesting that this particular stock is a "good deal." Here's the calculation shown below:
[EPS of 47 x P/E of 24 = Estimated Value of $11.28/Market Price of $6.65 = "Good Deal Number" of 1.69. Conclusion: Stock appears to be undervalued - and a "good deal" - at this price.]
Now for some caveats.
This company is growing rapidly and its actual current P/E ratio (as of this writing) is 11.4, which is much more conservative than our simple estimate of 24. It also tells us that the company is maturing, which suggests to me that we ought to try creating a range of values using even more conservative calculations.
Re-running the formula using a P/E of 11.4 gives us a potentially more realistic estimated value of $5.36 per share, which is slightly less than the current stock price of $6.65. Our "good deal indicator" in this example would seem to show that the company is fairly valued.
[EPS of 0.47 x P/E of 11.4 = Estimated Value of $5.36/Market Price of $6.65 = "Good Deal Number" of 0.81. Conclusion: Stock appears to be reasonably valued at its current price.]
So what do we do now? We have one value that suggests a theoretical price that's far higher than the current trading price. And we have a second one that gives us an estimated value that's actually a bit less than the current stock price. It's in the general ballpark, however.
I suggest we dig deeper. Again, we're not trying to come up with an absolute valuation. We're trying to develop a simple-to-calculate - but still useful - measuring stick that we can use to compare a company's current market price with its potential value.
If we dig a little deeper, we see that the company's current P/E (11.4) is actually lower than the industry average of 13.9 and well below the Standard & Poor's 500 Index P/E of 32.6.
So let's put a checkmark in the "undervalued" column.
We also know that the company has been reporting year-over-year top-line (sales) growth of 11.70%. Industry peers have actually experienced a year-over-year sales decline of 36.7%. Over a five-year period, the company we're studying has watched its sales advance by an aggregate 127.5%. That compares very favorably with the industry's five-year aggregate growth of 27.6%. And it is 9.7 times the average S&P 500 firm, which has experienced total growth of only 13.14%.
The upshot?
While there are conflicting good deal numbers, there's other data suggesting that this company may be undervalued yet is experiencing sales and earnings growth above that of its peers and other investment choices. So I'm inclined to believe this stock is a good deal - even with our revised estimated value of $5.36 - but then again, I'm a conservative guy.
Before we wrap up, there's one other point to consider - and it's a big one. The good deal number is not a proxy for wishful thinking, nor should it be confused with an assumption that the markets will move higher.
And it's limited to the "Buy" discipline only, which means you can't simply plunk down your money and then just ignore (or, even worse, forget about) the stock. So make sure you have trailing stops and an exit plan in place at all times.
When it comes to investing, it pays to play it smart - even in high-growth-potential markets such as China.
[Editor's Note: If you've been thinking about investing in China, this short note could represent the wealth-building opportunity of a lifetime. When it comes to China investments, Money Morning Investment Director Keith Fitz-Gerald may well be the dean. He's lived and worked and lived in Asia for two decades - including numerous sojourns into China, where he's seen how market-focused changes are creating fortunes for the entrepreneurs who are making everything happen.
And rest-assured, Fitz-Gerald has some ideas of his own. In fact, he is scheduled to return from his most recent trip to China today (Tuesday), and figures to have much to say about where investors should be looking next.
As the editor of The New China Trader service, Fitz-Gerald can now make those market insights available to you. Fitz-Gerald has not only chronicled the many changes that have taken place in China over the past several years - in many cases, he's actually predicted them. Subscribing to The New China Trader is akin to hiring a guide to help you navigate, and profit from, a market that's perhaps the most complex in the world - and that promises to be the most profitable for decades to come.
So if you've been looking for a way to invest in China for the first time - or you've been investing there, but aren't satisfied with your results - now may be the time to act. For more information on how to sign up for Fitz-Gerald's latest on-the-ground research, please click here.]
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