Use access key #2 to skip to page content.

I Can't Wait Mommy

Recs

11

March 31, 2008 – Comments (7) | RELATED TICKERS: ABT

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…..

 

Wax

 

7 Comments – Post Your Own

#1) On March 31, 2008 at 10:07 AM, FourthAxis (< 20) wrote:

"the authors never really define cheap."....and suddenly you realize economics no longer matters as you encounter its fringe with psychology.

Cheap!  Yay!  Buy!

Report this comment
#2) On March 31, 2008 at 12:38 PM, wax (97.61) wrote:

Fourth;

I wish everyone understood these words as you seem to...

"and suddenly you realize economics no longer matters as you encounter its fringe with psychology.

Thanx for the comment.

Wax

Report this comment
#3) On March 31, 2008 at 1:05 PM, madcowmonkey (< 20) wrote:

FourthAxis did a nice little piece/statement about cheap a while back, when he mentioned stocks trading at 52 week lows and around 5-10 dollars. His explanation was to the point and I liked it.  I think your write-up puts all the cheap people in check and helps them understand cheap instead of cheapskateinvesting. I tend to use the word in a mocking way, but it is cheating/not working over the net since nobody hears the tone/sarcasm. 

.......do you mean tight as in fitting tight or stylish tight slang use. Either way, Greta sounds fun. 

Report this comment
#4) On March 31, 2008 at 3:23 PM, schuured (96.60) wrote:

Wax-

I appreciate your interest in how we each define cheap.  Certainly many "value" style investors would have a difficult time believing that a "growth" stock with a P/E of 50 is considered cheap.  But an investor with different criteria for evaluating a stock might find that same company very attractive.  Much like beauty, cheap is in the eye of the beholder.

I'm also interested in your explaination of how you might select buy/sell/close points.  I've gone back and reviewed several of your picks and it looks like many of them were made at a time when the Equity Value is very small and perhaps even negative.  Examples include Accuride and MoneyGram.  I'd be interested in knowing more about how EqV fits into your analysis of these corporations.

Being a simple minded sort of fellow (at least according to my wife), it would be good for me to stick with a common sense approach toward stock research.  EqV makes more sense to me than EV. 

Still learning, Ed.

Report this comment
#5) On March 31, 2008 at 6:00 PM, wax (97.61) wrote:

Madcow;

As to Greta...either one is fine.

Wax 

 

Report this comment
#6) On March 31, 2008 at 6:21 PM, wax (97.61) wrote:

Ed;

To be honest, I don't use Equity Value or Enterprise Value for my picks. I used them in my post just as an illustration that cheap needs to be relative to something else. And since over the years many posts have been made regarding Enterprise Value it just seemed an easy way to highlight my comments.

For my personal picks, I use free cash flow, of which I use three basic types, free cash flow to operations, free cash flow to the firm, and free cash flow to equity. Each one is calculated differently as they are all used differently and mean different things to different parts of a business.

There may in fact by other forms of free cash flow, but for my uses, these three work just fine.

Once I have determined what is a reasonable value for a stock, again based mainly by not solely on free cash flow, I then divide by 2 and that becomes my buy target.

To determine my first sell target I take my buy target times 1.95. It's at this point in the process that I would normally sell around half of my shares. The 1.95 is not etched in stone, it's just a price at which I would start to take some money off of the table.

My close target is my reasonable value estimate times 1.055. I use this number as an approximation, a point at which I would start to close my postion in a stock. The percentage seems strange but if you do the math it works out pretty close to giving me a double in a stock as well as allowing me to recover all of my sales costs.

The important thing to remember is what works for me may not fit your particular risk tolerance and so may not work for you.

You also need to know that all of my valuation work comes back to earnings, and as you have seen of late, changes in earnings can change stock valuation. Which is why it's important to determine an earnings percentage averaged over 10 years or so and to use a margin of safety when you buy.

Hope this helps.

Wax

Report this comment
#7) On March 31, 2008 at 8:55 PM, schuured (96.60) wrote:

Wax-

Very helpful, thank you.

Say Hi to Greta for me.  I think I met her sister once...

Ed 

Report this comment

Featured Broker Partners


Advertisement