I Can't Wait Mommy
There are lots and lots of discussion boards in Fooldom, discussion boards that if visited regularly will teach the reader a great deal about one investing style or another.
In addition to the numerous discussion boards, there are always lots and lots of articles, most written by ordinary folk just like you and me, that discuss a fairly wide variety of stocks and other related investing issues. On Friday for instance, there were about 60 articles posted on the Fool’s main page.
One of the topics of great discussion, not only in many of the articles posted, but also on many of the boards, is that stocks are cheap.
What I found interesting about quite a number of these articles and posts is that the authors never really define cheap. I mean to me, if a stock is cheap, it needs to be cheap relative to something else, like the stock’s reasonable value, or an investment in oil, or gold, or corporate bonds.
There was an article a couple of weeks ago where the author decided that stocks that were trading at six times or less EV/EBITDA should be considered cheap, and I’ve seen quite a few articles that have said stocks were cheap because they used to trade higher. But higher than what?
So here’s what I think. I think folks should try a little bit of common sense investing?
Why is a stock cheap just because it’s trading today at a price that’s 40% lower than it was three months ago? What was the relative value of the stock before it fell?
And why is a stock trading at six times or less EV/EBITDA cheap? Are folks aware that when they use Enterprise Value (EV) they are actually removing the company’s cash and replacing it with the company’s debt?
What is reasonable about determining the value of a stock by using debt? Doesn’t that mean the greater the company’s debt, the greater the company’s value?
As a common sense investor, I personally don’t see much valuable about a company that has lots of debt. Common sense tells me that it would be smarter to keep the cash and throw away the debt, thus using Equity Value (EqV) instead of Enterprise Value to value a stock.
As an aside, and I mean no disrespect, for those that may not know, a company’s Enterprise Value is their market cap, less their cash, plus their debt, while Equity Value is market cap, plus cash, less debt. The result is then divided by shares outstanding to determine the respective value on a per share basis.
One of the companies that comes to mind when I think of a company with quite a bit of debt is Abbott Laboratories (NYSE: ABT). According to their latest annual balance sheet, the company has $2.456 billion in cash, $2.726 billion in short term (due with in one year) debt, and $9.488 billion in long term debt, or a total of $12.213 billion of debt. The company has 1.560 billion shares outstanding, and had a recent close of $53.07.
If I wanted to apply an Enterprise Value calculation to Abbot Labs, I would take 1.560 billion shares times the recent close of $53.07, and get a market cap of $82.789 billion dollars. From this number I would subtract the cash of $2.456 billion and add the debt of $12.213 billion leaving me with an Enterprise Value of $92.546 billion dollars. If I divide that number, by the number of shares outstanding, I get an Enterprise Value of $59.32 per share.
Applying the same calculations but subtracting debt and adding cash, I get an Equity Value of $73.032 billion dollars, or $46.82 per share.
Common investing sense tells me that if I wanted to buy the company’s debt, I would buy the company’s corporate bonds. But since I want to buy a stake in the company’s future earnings, what’s important to me is protecting my investment capital. As a result, Equity Value would be my valuation of choice for the stock of Abbot Labs, with a valuation of $46.82 per share.
The question is, is $46.82 a share for this stock, cheap?
Remember the stock had a recent close of $53.07. Is a 13% premium above Equity Value cheap? Not to me it isn’t.
But what if I employed a margin of safety to my Equity Value calculation of say 50%. Were I to do that, I would end up with a stock that had a buy target of $23.41, a first sell target of $45.65, and a close target of $49.42.
Is $23.41 cheap relative to the Equity Value of the stock? Maybe not to some, but to me, it’s a darn bit better than $53.07!
Still, I need a little more to know that the stock is truly cheap. For that little extra, I use a common sense calculation called the risk/reward calculation. The idea behind this calculation is to end up with a reward that is at least five (5) times greater than the risk. Here’s how it works.
As I said, my close target for the stock was $49.42, so from that, I would deduct the current price of the stock, $53.07, giving me ($3.65).
Next, I would determine what 20% of my buy target was. In this case it would be 23.41 times 0.2, or $4.68.
I use 20% because when I buy a stock, I often times put a stop underneath the price that is 20% less than what I paid for the stock. So if I paid $20 for a stock, I would put a stop under the stock at $16. Should the price then fall to $16, the stop would automatically take me out of the stock, thus limiting my downside to 20% of the price I paid for the stock.
So now that I have my reward number and my risk number, the last step is to divide the reward number by the risk number, ($3.65) / 4.68, giving me a risk reward of (0.8) with a stock price of $53.07.
But what I’m looking for is a reward that is five times greater than my risk, and in order for that to happen, I need a stock price of $26.
So in the case of Abbott Labs, and using Equity Value as my value determination, I would start a position at $26 and add to that position on price pullbacks, ending up with a full position (3% of my portfolio) that had an average cost basis including sales charges of $23.41 per share.
The thing I hope you will take away from this is that cheap means different things to different people, just like lucky means different things to different people. Speaking of lucky, I remember the time Greta and I were at the drive-in movies, she was wearing these seriously tight…..