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Measures of Value

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In previous posts I’ve shown you a measure of market valuation, the Shiller P/E, that indicates the stock market is at the upper end of the valuation range. I don’t want to beat that horse again, so I thought it might be interesting for you to look at some companies that are undervalued based upon two of my favorite measures.

The image above is a partial list of companies sorted by the ratio of Price-to-Book multiplied by its Forward P/E ratio, sorted from lowest to highest. This ratio is one of the rules of thumb that the father of Value Investing, Benjamin Graham, used to identify companies that were undervalued. In essence, Graham liked to buy companies when the product of these two ratios equaled less than 22.5.

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My other favorite measure of value is the ratio of a company’s Enterprise Value divided by its EBITDA. This ratio is a good measure of a company’s attractiveness for a takeover because it tells you how many years a company’s cashflow will take to breakeven on the overall market cap of a company in a takeover. If the ratio is below 7, then an acquirer knows that it should be reimbursed for the purchase of a target company within seven years through that acquisition candidates own cashflow.

The chart above sorts a partial list of companies by this ratio, from lowest to highest. The two companies that have that ratio blocked with a black box show should be ignored from this calculation.

When I am researching companies for a value investment (researching growth companies is a completely different exercise, one we’ve discussed here in the distant past), these two ratios are key components for me to look at. It is rare that you find a company that has both ratios under their threshold levels.

However, these ratios are just a starting point – there can be excellent reasons for a company to have a low ratio that should keep you from owning it. Value investing is an exercise in finding companies that other investors are shunning and buying them because you see some catalyst that will drive the valuation higher once other investors see it. If you can buy a company for less than its book value, you are buying it for less than the value of the sum of its assets – and if its competitors are selling for some value above book value, you only need to move to parity with its competitors valuations in order to make money.

The complete list above contains 104 companies out of our research database of 6,000 companies. Many of these 104 would not be candidates for us to buy for various reasons – too small, too illiquid, too much debt, too little cashflow, etc. However, I thought you’d like to see a sample of those 104 in case you wanted to use it as a starting point for some research of your own.

We have discussed several examples of this over the years – I believe that Dell Computer was the most recent one where we purchased it for about $8 per share (because we saw significant cashflow generation and a price well below book value) then sold it after the take-over was announced at $13.50.

Today, in client portfolios, we have several other companies in similar positions, selling below book value with either current cashflow being significant or some catalyst in place that we believe will cause cashflow to increase in coming quarters.

If you were to review the complete list of 104 companies, you would see the following companies that we already own in various client portfolio: Statoil, Marathon Oil, Hewlette Packard, Royal Dutch Shell, Apache, Wells Fargo, Tesoro, Agrium, Vale, and Xerox. We have different equity strategies based upon the different goals/objective/needs of our clients – Growth, Core, Blue Chip, Dividend Income, and Fully Diversified. These companies appear in one or more of those strategies depending upon their specific investment characteristics.

Let’s take a look at one of those companies that we hold: Xerox. This graph is the price chart from our initial purchase in May 2012 through today. We have a couple of purchases of this company at an average price of $7.12 compared to today’s price of $9.63, for an average gain of a bit over 35% – individual accounts may vary a few percentage depending upon the price they individually paid.


You can see that yesterday, Xerox reported earnings that were below expectations and it dropped 10%. One of the issues you have when buying companies based upon value fundamentals is you have no idea when the catalyst you identify will be recognized by the broader market, nor how long that catalyst might last. The higher the price goes, the more investors jump onto the bandwagon – ones that might not be in it for the same thesis you have and who are less willing to live through earnings misses that are inevitable in a turnaround.

In looking at the graph, you can see that after we made our purchases, investors still were punishing the company driving the price to about $1 below our average cost basis. However, based upon the cashflow Xerox was generating based upon its turnaround strategy of moving from a copier company to a business process company we believed that ultimately our return would be big and that we could not get hurt by buying the company under the book value of its assets as long as it was generating a significant amount of cash from its operations.

Finally, about six months after we purchased our shares, the stock price bottomed and investors began to realize the value in this company based upon the significant and reliable cashflow it was generating compared to its price below the book value of its assets. We have seen steady growth in the stock price, with a return of 43% year-to-date compared to 19% for the broader S&P 500.

However, not all value investments work out as well or as quickly as Dell and Xerox. Sometimes, that catalyst you see (like the turnaround/business transformation strategy at Xerox) takes a long time to make an impact and you may give up holding onto the company thinking its dead money long before other investors begin to see the value in it and drive the stock price higher.

It is really a balancing act – clearly Xerox has been a good investment for our clients, but if you compare its return during that initial six months we owned it to the S&P 500 Index, you might question whether we were on the right track:


You can see that our Xerox investment was actually down 9% (the red line on the graph above) over the same period of time that the S&P 500 was up 5% (the green line on the graph above). This represents a 14% under-performance and honestly can shake your confidence in your investment thesis. However, the power of Xerox’s cashflow was convincing and we believed investors would spot it sooner rather than later – and fortunately that happened.

This is also a perfect example of why the monthly, quarterly, or annual comparison of a portfolio’s performance to the S&P 500 is specious at best. It is always more important to beat the market over the long-term than over short periods of time – and most well reasoned investment theses can take longer periods of time to play out in order to provide significant returns, in particular these deep value investments.

The real question everyone should have on their minds right now, though, is whether the 10% pullback yesterday means Xerox should be purchased. So, lets take a peak at the Equity Review of Xerox I prepared this morning to help me answer that same question relative to several new accounts that we have opened recently – in other words, should I take new clients money and buy Xerox or has the Deep Value investment thesis based upon a turnaround/business transformation strategy played out, or is there still enough value there to justify an investment.

Below is page 1 of our internal Equity Review – my apology for the lack of clarity, I scanned my hard-copy and it is a bit fuzzy:

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This page provides me with a summary of the Operating Performance, Key Statistics, Ownership Data, Dividends, and various Valuations we perform based upon several recognized methodologies.

In the Operating Performance box you can see that earnings growth over the past 5-years has been negative, sales growth has been in mid single digits, and book value has grown just under 10%. You can also see that its Gross Margin , Return on Investment and Return on Assets is subpar (the numbers in red tell me they are below industry comps – whereas numbers in green are above industry comps). These are pretty common results for a company in a turnaround situation.

In the Key Statistics box you can see that the Free Cash Flow Yield is almost 19% (what I would expect based upon our thesis of buying this company when it had high cash flow but priced below book value) however, the Enterprise Value to EBITDA ratio has moved back above 7. Trailing 12-month earnings growth is below our 15% benchmark and the five-year forecasted earnings growth is below that of the S&P 500 (no surprise since we didn’t buy this stock under a growth thesis, but a value thesis).

In the Ownership Data box, you can see that something VERY important is happening: Insiders are buying the stock and make up nearly 1/3 of all buyers – this means the insiders believe in the company and its turnaround story and are committing their own money to it. It is a bad situation to own a company in a turnaround and the insiders do not believe in their own ability to affect change.

The valuation methodologies appear in the Price Data box. For a turnaround situation, the exact numbers are less important than seeing that the overall trend of the calculations are positive. In the case of Xerox, you can see that the analysts have a consensus target price 10% above the current market (which is actually pretty good for a turnaround stock) but the valuations we calculate – the various Discounted Cash Flows, the Dividend Discount, etc., all show significant upside.

The Dividend box also shows us that dividends are strong (2.39% is a higher yield than the S&P 500), that they are growing significantly each year (31.95% growth rate) and that the company has more than adequate ability to pay them (the payout ratio at 21% and the Coverage Ratio at more than 8X).

All-in-all, this page makes me pretty happy.

Let’s look at page 2 of our Equity Review:

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This page is a collection of third party ratings, valuation metrics and technical indicators. One important one near the top is the Consensus Rating among all the analysts that follow it. They rate it a moderate buy, which is OK – better than kissing your sister but not quite like the homecoming queen.

Standard & Poors rates it 2 stars out of 5, which is not really surprising. They use more of an earnings and balance sheet strength system, and since this is owned under a Turnaround thesis, it makes sense. However, you will note that they rate it 5 of 5 for Fair Value, meaning they recognize the value of this company is greater than the market is currently recognizing.

Morningstar, however, rates it 4 out of 5, which is also not surprising since they utilize a value methodology. You can see that they give it a fair value of $12 per share and on page 1, in the Price Data box they say you should consider selling it when it gets to $16.20. Its pretty clear that Xerox rates pretty high in their methodology which is a good sign for a deep value stock.

The yellow box in the middle of the page shows you how this company rates on our proprietary ratings system. Even though neither rating is really apples to apples for a turnaround company, it still rates above 70 on both measures – our threshold is set at 60, so we are above that.

Looking at the Valuation Metrics box you can see that all of our ratios are below the benchmarks (except EV/EBITDA – I prefer to buy a new deep value stock when that measure is below 6, but below 7 is very acceptable). There is still plenty of value in this investment compared to its industry, the broader market, or our internal benchmarks.

At the bottom of the page, you will see a pink box showing that the Price-to-Book X Fwd P/E Ratio is well below the 22.5 threshold, at 8.24.

There are several other pages to the review, but this post is getting long and I don’t want to bore you much more than I already have. So I will just sum it up: This is not the original deep value investment we bought 18 months ago, but the fact that our valuation methodologies show significant upside, insiders are strong buyers of the company’s stock, one of our Deep Value ratios is still in play and the other just misses the threshold, our cashflow is still strong, the company has a shareholder friendly dividend policy, and the company has a long way to go before it is valued in line with its industry, I am inclined to go ahead and add shares to new client portfolios.

I don’t expect we will get the explosive 40% price increase that we received over the past 18 months in the coming 18 months. But even if we can move up to Morningstar’s $12 fair value, that represents a greater than 20% increase above today’s price. With S&P 500 earnings expected to increase 5% over the next year, your risk/reward for owning this investment seems to more than justify allowing management to continue to execute their turnaround strategy. As long as they are believers in it, as evidenced by their buying shares in the company, I am a believer in it as well.

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As always, this is not in any manner to be consider a recommendation for you to go buy this company. Always do your own analysis and make sure that any investment fits with your personal risk profile and objectives.

Have a great weekend!