Stock Valuation Discussion

[Robandcindy2]

With some time to kill before the Brady-Manning show today I thought I'd get a discussion going on stock valuation. Specifically, how you determine a stocks "buy price".

I've read about several formulas and theories yet have never quite wrapped my arms around one that I felt was consistent. Graham Formula? Piotroski? DCF? Lots to choose from.

Recently I "blew a financial gasket" over KMB. KMB had been on my radar for a long time. First waiting to have the cash set aside and then waiting for the price to drop.

The only newsletter I subscribe to is Morningstar Dividend Investor run by Josh Peters. Josh had a KMB fair value price of $92. I'm finally ready to go for it and had a limit order in at $91.99 at Vanguard.

Thanks to Congress the price started coming down. Now I admit I wasn't watching things to closely and KMB bottomed at $92 and change I believe in September. It has since topped $106. So close....sooo close...

Discussion:
What do you use to determine a stocks fair value or buy price (not that they are necessarily the same thing)?

Is "value investing" necessary for the DG investor?

Thoughts on investing in companies which are historically priced above fair value (KMB, GPC, to name two)?

Enjoy the games today!

Rob

Go Pats!

[EricL]

(01-19-2014, 08:42 AM)Robandcindy2 Wrote: With some time to kill before the Brady-Manning show today I thought I'd get a discussion going on stock valuation. Specifically, how you determine a stocks "buy price".

I've read about several formulas and theories yet have never quite wrapped my arms around one that I felt was consistent. Graham Formula? Piotroski? DCF? Lots to choose from.

Recently I "blew a financial gasket" over KMB. KMB had been on my radar for a long time. First waiting to have the cash set aside and then waiting for the price to drop.

The only newsletter I subscribe to is Morningstar Dividend Investor run by Josh Peters. Josh had a KMB fair value price of $92. I'm finally ready to go for it and had a limit order in at $91.99 at Vanguard.

Thanks to Congress the price started coming down. Now I admit I wasn't watching things to closely and KMB bottomed at $92 and change I believe in September. It has since topped $106. So close....sooo close...

Discussion:
What do you use to determine a stocks fair value or buy price (not that they are necessarily the same thing)?

Is "value investing" necessary for the DG investor?

Thoughts on investing in companies which are historically priced above fair value (KMB, GPC, to name two)?

Enjoy the games today!

Rob

Go Pats!

I think value investing is still very important in DGI. I suppose it could be less important if you are entering retirement and relying solely on dividend income with no further worries about capital appreciation, but in my mind why not have your cake and eat it too?

I have a pretty simple process when looking for prospective companies. First I look at Fastgraphs to see how it is trading in respect to historical valuations over a few different time frames. I'll look at 20 year, 10 year and 5 year charts to see how they all compare. Sometimes as a company matures and growth slows what appears to be a value at current PE is actually fairly priced due to slower EPS growth rates than in the past.

If the stock passes the first test then I will look at the key statistics information on Yahoo Finance to see ROE, debt levels, cash on hand and free cash flow generation. I love companies with low debt and great cash flow.

Finally, if it still looks interesting I will go to the company website and look for investment presentations. I will read a few of these from the past year and see if I like the business model and growth prospects.

If everything looks good I put the stock on my watch list or try to find room for it in my portfolio. Once I do make a decision to buy I put a limit order in near the current price and make a buy. At this point I don't nickle and dime things. If I've determined its near fair value I buy it, I don't want to lose out on something because I was too stubborn to raise my limit order $1.

As for KMB and GPC, I agree they are both a bit overvalued right now and I personally wouldn't buy either here. I own GPC at about $72.

I'm sure if you bought either and held for 10 years you'd probably do okay with 5-7% annual returns and reliable dividend growth. As a 35 year old looking to build my portfolio I'm looking for better capital gains than that.

[Kerim]

Great topic, Rob.

Valuation is a tough one for me. I think it is incredibly important, and yet so vague and amorphous and nearly impossible to nail down. "Intrinsic value" is an important concept, but it is important to recognize that there is no formula that can reliably provide it. In fact, it is crucial to recognize that there IS no such thing as the "right" value for a stock -- if there were, there would be no trading at all, because nobody would pay more or accept less than that price. Disagreement about the right valuation is the only reason that we can have a market at all.

That said, I apply different standards to different companies. For cream of the crop dividend growth companies, I am comfortable buying "great companies at good prices." That is, for a JNJ or a KO, I am happy to buy when the price dips a little below its historical average P/E or yield, but I am not just waiting for a screaming bargain. I trust these companies to grow earnings over the long haul, and hence dividends, and so I don'y worry that I need a huge margin of safety to make the investment pay off in the long term.

But for companies with a few more question marks -- companies that are not top tier DG companies -- I need a lot more of a bargain to be comfortable taking a position. For example, I don't think I'd have F or LMT in my portfolio at all if I didn't feel like they were really undervalued at the time I bought them.

But how do I know? Again, I'm not sure any of us can "know," and my approach is hardly scientific. I do the usual light diligence -- looking at the main ratios (P/E, yield), especially as compared to the company's own historical averages. But usually it is a case of "I know it when I see it" and not a case of math.

For example, I started my dividend growth portfolio during the 2008-2009 financial crisis. I knew a lot less about stocks and valuation back then, but I knew the world was not going to stop spinning and that people were not going to keep smoking. MO was yielding 7 to 8 percent at the time. So I bought some. I should have bought a lot more. Summers of 2011 and 2012 saw major market downdrafts that provided above-average entry points on some great names.

I'd love more opportunities like that now, but with the market up, up, and up, it is harder now. But, as DG'ers hear all the time, it is a market of stocks, not a stock market. Right now I'm focused on companies that haven't really participated in the recent rally, but still have excellent prospects. TGT and PM are perfect examples. Great stocks have years where they languish and years where they surge ahead. I am happy to accumulate shares while they languish. I liked TGT at $70, and for various reasons it has been beaten down to almost $60 now. Is is irresponsible of me to accumulate more shares without doing DCF or other valuation formulas? Well, the Target near me is still packed, and I have no real concerns that they'll get their issues sorted out eventually. It is a well-managed company with a long streak of dividend increases and a safe payout ratio. And they have a plan to grow revenue and earnings. I think they will continue to pay and increase the dividend, despite the recent issues. Could I be wrong? Sure. But I'm happy to buy the shares on sale.

Sorry for the rambling answer -- I'm just coming back up for air after a grueling stretch at work.

Oh -- and I'm looking forward to this afternoon's matchup as well. Should be a great game!

[Dividend Watcher]

Rob, that IS a great question. I still wrestle with it all the time.

First off, to answer your dilemma, I don't think you can come up with a consistent method of valuing where you should buy and/or sell. Just as there are growth, value and cyclical companies (and hence the stock), there are different ways of valuing a company. Chuck Carnevale alluded to this with his method of fixing a "True Worth" line in FAST Graphs. Simplistically, for slower growers, he uses a P/E of 15; faster growers get a PEG for True Worth, etc. There's a reason he calls it a "tool to think with".

Then there's the actual P/E line of what investors were willing to pay in the past. That is where I usually shoot for but even that is not set in stone. Since I don't subscribe to any pay newsletters or tools, I use what's available to me.

I use the S&P stock sheet from TDA to come up with a 10 year average P/E. To that I add a DCF calculation from moneychimp.com. I also use the modified Graham formula for instrinsic value (the one using long-term bond rates). I also look at the stats such as the Chowder Number in the CCC spreadsheet.

Of course, the Discounted Cash Flow and Dividend Discount Models are very sensitive to the assumptions you use and seem to vary all over the place with with a small change in the input. I just don't trust them as much.

Then I look at the financials. Of course I'm looking for low debt, steady (and preferably higher) growth, a good dividend that grows, etc. but there's an exception to every rule. Look at CLX and LMT. They have very high debt yet they keep pumping out the earnings and dividends. GIS hasn't had a current ratio above 1 for years yet they keep paying their bills and hasn't ever cut its dividend for almost 100 years.

I also look at some of the analysts reports -- S&P, Credit Suisse, Ford. They have someone who's followed the business for a while and know what events are significant for the company. I can't be an expert in every field. I do a search on SA because sometimes a non-professional's views bring out something I could key on. KO is a prime example. David Crosetti has mentioned several times he was never sure what KO should be selling at but whenever the yield got to 3%, it was a good time to buy. I bought it for my wife's portfolio blindly when it last dipped to bring the yield to 2.92% and the P/E was somewhere between 19.99 and 20.02 (I can't remember exactly). I was counting on this next dividend increase to bump the yield to over 3%.

As to dividend growth rate, I like it to be somewhat consistent. At least not a steady decline in most cases. For example, 1Y DGR=3%, 3Y=5%, 5Y=8% and 10Y=12% won't do it for me without the company radically changing its business model within the last few years. However, a 1Y=6%, 3Y=8%, 5Y=12% and 10Y=17% would work. If you look at Robert Allen Schwartz's web site, dividend growth rates over 6-8% over the long term are very hard to sustain. But, you never know. Look at MMM's last dividend increase ... over 30%. Yowza! Talk about kicking yourself in the arse after selling it at breakeven (about $78) in the Great Recession. Yield and growth had gotten too low for me. This was one of my pre-DGI purchases (the old me) and let emotions get the best of me.

Lastly, I look at a price chart just to see if there's a trend over the last few months. If there's that characteristic exponential curve going up without a corresponding exponential increase in earnings or a big jump, I tend to stay away. Nothing stands out in my mind specfically but look at GOOG (P/E over 30 right now) over the last couple years or the gold (not that I'm a gold bug) curve a few years ago.

All that being said, I do have a few "rules":

1. Never buy a stock with a P/E over 20 although I prefer under 18. Despite temptation at times, I've been able to stick to this pretty much.

2. Yield should be over 2.5% at time of purchase. The lower the yield, the higher the dividend growth rate.

3. Has to be on the CCC list because I do want the dividend growth.

4. Shoot for a P/E at or below the 10 year average P/E.

Sometimes I want a stock that's a hair over my limits as in your KMB case. In those circumstances, I'll purchase a small position (1/4 or so) just as a placeholder in the portfolio and to get the dividend compounding ball rolling. This forces me to watch the stock closer and, when I think it's a real value, buy a bunch more.

Clear as mud, I know. If you thought Kerim's answer was rambling, I don't know what you call this.

[CritMass]

So what's better? Invest when the shares are above the averages and are considered high and start receiving the dividend right away? Or hold off for a period of time ( a quarter or three or longer) before purchasing and miss out on dividends? Further, does the answer matter if you are 35 years old or 55 years old or 65 years old?

[EricL]

(01-19-2014, 09:35 PM)CritMass Wrote: So what's better? Invest when the shares are above the averages and are considered high and start receiving the dividend right away? Or hold off for a period of time ( a quarter or three or longer) before purchasing and miss out on dividends? Further, does the answer matter if you are 35 years old or 55 years old or 65 years old?

I wouldn't recommend starting a position in anything that is grossly overvalued but I think if something you want to own is within range its good to get in and get the compounding machine working. I suppose it depends if you are planning on investing all in one lump sum or if you have continuous contributions being added to the portfolio.

In the case of my retirement account I currently hold 50 positions and have new money coming in every month which allows for a new purchase about every other month. Some of the stocks I bought were slightly overvalued (CHD, GPC, CLX) but I liked the companies and wanted to start a position. Since then I've been adding to other positions (DE, DLR, PM, IBM of late) as contributions to the account allow for new purchases. If CHD or CLX ever drop and provide a good opportunity I will add to them down the road. In the meantime I am reinvesting dividends in the companies that pay them which also gives me some dollar cost averaging on the stocks I own.

[CritMass]

Eric, in slowly transitioning my portfolio into more of a DGI model, I cashed out three Vanguard mutual funds a year ago and started small positions in about 20 companies, so I just jumped in at once. In about six months, upon retirement and being able to access two retirement accounts without tax consequences, I can add to each of the 20 or so positions. I also want to increase my portfolio by another 10 or so companies by next Fall. I still have 4 Vg funds that I plan to keep for awhile.

[rnsmth]

I also subscribe to Morningstar's DividendInvestor newsletter. I tend to use their fair value estimate for companies in their portfolio or their Income Bellwethers list. I also subscribe to FAST Graphs and take a look at it also.

I do not mind paying fair value for strong companies. I have moved to 34 companies during the past 18 months or so. Some are deep value, so are fairly valued and some have become overvalued. I use automatic reinvestment of dividends with all the positions.

As chowder is fond of saying, often times the strong get stronger.

[CritMass]

I'm familiar with FAST Graphs from reading SA, but not so much with Morningstar's newsletter. Thanks for the resources. I guess if I'm taking the plunge I should probably go all in and subscribe to some resources ( sorry for mixing metaphors).

[EricL]

(01-20-2014, 11:57 AM)CritMass Wrote: Eric, in slowly transitioning my portfolio into more of a DGI model, I cashed out three Vanguard mutual funds a year ago and started small positions in about 20 companies, so I just jumped in at once. In about six months, upon retirement and being able to access two retirement accounts without tax consequences, I can add to each of the 20 or so positions. I also want to increase my portfolio by another 10 or so companies by next Fall. I still have 4 Vg funds that I plan to keep for awhile.

Sounds like you will be having money come available periodically over the course of the next year or so. Why not just keep doing your research and if your goal is 20 positions just buy one or two a week until you get all of them filled. Create a watch list of 30-40 stocks and buy them when the opportunity presents itself.

Retail, REIT's, oil companies and some utilities are at pretty good prices right now. Could start there to begin and then keep on the lookout for the consumer staples to correct and give you a better entry point.

[Robandcindy2]

(01-20-2014, 07:23 PM)CritMass Wrote: I'm familiar with FAST Graphs from reading SA, but not so much with Morningstar's newsletter. Thanks for the resources. I guess if I'm taking the plunge I should probably go all in and subscribe to some resources ( sorry for mixing metaphors).

You can usually download a free issue. I also believe M* has a money back guarantee for the issues you haven't received.

FastGraphs is also a month to month subscription, cancel anytime.

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These are excellent points....

Let's keep this discussion going...