How to bottom-fish for stocks
Here are some calculations to help you decide when the risk of buying a stock is worth it. If you'd rather not attempt the math, don't worry -- I'll do some of it for you.
By Jim Jubak
Tired of trying to figure out if the Jan. 22 low was the bottom for stocks? Whether the recent rally will hold or turn into a massive bear trap? Whether to buy now or wait until, well, until who knows when?
Today, I'm going to put you out of your misery and tell you when it's time to buy.
No, I'm not going to call a bottom for the stock market as a whole. (Cue the boo birds.) I don't think anyone is in a position to do that. What I'm going to do instead is show you how to calculate a fair-value price for an individual stock and how to use that to figure out when to buy. This method won't tell you when a stock has hit its absolute bottom, but it will tell you when the price is low enough and the potential return high enough to justify the risk of getting in too early.
It's not about calling a bottom but learning how to bottom-fish.
As guinea pigs, I'm going to use the stocks I picked in my Jan. 29 column, "10 stocks to buy after the bloodbath." And don't worry if you see this column veering toward the dreaded land of Math. I'll do all the hard work and give you fair-value prices for each of these 10 stocks at the end of the column without any heavy lifting on your part.
2 key numbers
The simplest method for figuring out a fair value for a stock starts with the company's projected earnings for the next year and some estimate of a company's appropriate price-to-earnings, or P/E, ratio. Multiply the two and you've got what the stock should be worth in a year.
For example, Wall Street analysts, on average, expect Chevron (CVX, news, msgs), one of my 10 stocks for after the bloodbath, to earn $9.33 a share in 2008. Using the Feb. 15 P/E ratio of 9.4, a fair value for Chevron shares is $87.70. That's above the Feb. 15 close of $83.60 but only about 5% above that price. Holding for the rest of 2008 to make 5% (plus dividends), which is by no means guaranteed in a risky stock market and a slowing economy, isn't my idea of a great investment.
· A bad market? You ain't seen nothin'
(A target price is different from fair value, in my opinion, because a target price takes into account market conditions, including investor sentiment and momentum. So a target price can be, for periods of a year or less, above or below fair value. You can make money, for example, buying above a fair-value price if the stock market is in a strong bull rally.)
Resting on assumptions
Of course, this method is only as good as the two data points that go into it. The Wall Street earnings consensus can be wrong. In my example, though the average of the analyst estimates is $9.33 a share, the high is $10.75, and the low is $7.85. Somebody's wrong.
Or maybe the P/E ratio is out of line. Chevron trades at a P/E ratio of 9.4 now, but over the past 10 years it has traded at a P/E ratio as low as 7.8 and as high as 76.6.
Narrowing it down
That range is too broad to be very useful. To turn it into a number that means something, I'll need more-exact numbers for 2008 earnings and an end-of-the-year P/E ratio. At this point, I'd say the current P/E ratio for Chevron is too low. It lags the industry average multiple (or P/E ratio) because the company has had difficulty in getting new production on line. That looks ready to move up to the industry average of 11.1 by 2009.
For 2008, a transitional year, I'd use a P/E ratio halfway between the current 9.4 multiple and the future 11.1, which would be 10.25. I'd also say that, even with a global slowdown, oil prices will average at least $80 a barrel in 2008. Because the global slowdown will take some profit from the company's refining and gasoline-retailing businesses, however, I'd put my earnings estimate at, say, $9.40 a share.
You can use my simple Excel tool to fine-tune this target price. Plugging in those values gives me a price of $96.35, a 15.25% gain from the Feb. 15 closing price.
The reason it's so important to make these two numbers as accurate as possible is because they're the only inputs, so your final price calculation depends on the accuracy of these two numbers. For example, if Chevron's production plans slip and some of the new oil production that was supposed to take place in 2008 actually winds up in 2009, that will have a huge effect on the value generated by this calculation.
Looking further into the future
As I result, I'd say it's a good back-of-the-envelope calculation for a year ahead or less, but it doesn't really give you a value for a stock that reflects its long-term prospects.
To calculate the long-term fair value of a stock, you've got to put time back into the equation and include more than just one year's results. The standard method for doing this is called discounted cash flow, abbreviated to "DCF" in the formula below.
Here's the math:
CF = cash flow
CF1 = first-year cash flow
r = discount rate
(For cash flow in this calculation, use free cash flow, which is operating cash flow minus capital expenditures. For the discount rate, use the company's weighted average cost of capital, an average of the cost of equity and debt capital. A good default value today is about 10%, which is the yield on the 10-year Treasury note, about 4% now, plus a 6% risk premium).
Less risky companies show a lower discount rate. Johnson & Johnson (JNJ, news, msgs), for example, I'd peg around 7.7%. Waters (WAT, news, msgs), a smaller and riskier company, I'd put at 9.5%.
The math looks daunting, I'd agree. But don't worry if it's all Greek to you: I'll give the fair values I calculated for the "after the bloodbath 10" at the end of this column, so you don't need to do any of this math yourself.
First, the concepts
But I think it is important that you understand the concepts behind this formula. It's actually common sense.
Companies that can generate more cash flow in the future are more valuable today. Take a company -- or any other investment -- that will generate $100 in cash flow per share a year from now (CF1) in my formula. How much would you be willing to pay today for that future cash flow? The formula says that for a company that generated $100 in cash flow at the end of one year and where it cost the company 10% to raise its capital, the present value of that investment would be $100/(1+0.1), or $90.90. That's how much you'd be willing to pay today for that cash flow at the end of a year.
Raise the per-share cash flow in my example to $120, and the present value becomes $109. Companies that pay less for their capital, either because they're less risky or because interest rates in general are lower, are also more valuable. Lower the cost of capital to 6% from 10% in my example, and the present value goes up to $94.34 from $90.90. The company with $120 in cash flow is worth $113.21 instead of $109.
Wimpy's hamburger finances
Wimpy's discounted cash-flow analysis: "I'll gladly pay you Tuesday for a hamburger today."
Of course, any company you invest in will produce cash flows for more than just one year. (At least you hope so.) So the formula includes cash flow from those years (CF2, CF3, etc.), too, but since they're further away, it gives those future cash flows a lower present value. (Popeye's friend Wimpy used a discounted cash-flow analysis when he said, "I'll gladly pay you Tuesday for a hamburger today.")
To use this formula, it's usually sufficient to use five years of cash flows and then calculate some perpetuity return for the years beyond that.
If you want to do the math yourself, you can use the NPV (net present value) function in Excel and the data on the "financial results" of our stocks page and in standard data sources such as the Standard & Poor's stock reports offered by most online brokerage companies. (S&P includes a weighted average cost of capital in the valuation section for most of the stocks it covers.)
Calculations for 10 stocks
If you don't want to do the math, now or ever, here are my calculated fair-value estimates for each of the "after the bloodbath 10." I've included the stock's closing price on Feb. 15 and the difference between this fair value and the current stock price.
| | |||
| Stock | Fair value | Feb. 15 price | % below fair value |
| | | | |
| $98 | $89.11 | 9.1% | |
| $93 | $83.60 | 10.1% | |
| $44 | $31.06 | 29.4% | |
| $238 | $219.39 | 7.8% | |
| $110 | $96.17 | 12.6% | |
| $80 | $58.23 | 27.2% | |
| $123 | $115.35 | 6.2% | |
| $152 | $147.98 | 2.6% | |
| $105 | $84.08 | 19.9% | |
| $76 | $60.37 | 20.6% | |
Which are buys?
It depends on your read of the risk of the individual stock and of the stock market as a whole at the time of the purchase. The size of the discount you want from any stock will depend on your assessment of the risk in the shares, in the economy and in the stock market. And that's still subjective.
So, no, this exercise hasn't given you some absolute buy or sell signal for any stock. But it does help you know when it might be worth taking the risk and pulling the trigger.
I've started two new threads on my MSN Money message board. "Are these prices insane?" asks for comments on my analysis of these 10 stocks, and "Got gas?" publishes fair values for the five natural-gas stocks I wrote about in my Feb. 15 column
So, no, this exercise hasn't given you some absolute buy or sell signal for any stock. But it does help you know when it might be worth taking the risk and pulling the trigger.
I've started two new threads on my MSN Money message board. "Are these prices insane?" asks for comments on my analysis of these 10 stocks, and "Got gas?" publishes fair values for the five natural-gas stocks I wrote about in my Feb. 15 column
"Profit when oil have-nots crash": On Feb. 6, Devon Energy (DVN, news, msgs) reported that fourth-quarter earnings had grown by 35% from the fourth quarter of 2006. That more than reversed the 5% drop in the third quarter of 2007 from the corresponding quarter of 2006.
But with Devon Energy the story is ultimately about production and the rate at which the company can develop its new finds. And there, too, the story was good. Total production increased 10% last quarter over the fourth quarter of 2006, largely on increased volumes of natural gas from the company's holdings in the Barnett and Woodford shale regions of Texas.
The big increase in production, however, will come from new finds in the Gulf of Mexico and in the deep waters off Brazil. Total drilling prospects there are 5 billion to 11 billion barrels of oil equivalent. Exploratory drilling is set to ramp up in those areas, which means rising costs. Capital spending rose to $6.5 billion in 2007, but operating cash flow climbed 21% to a record $7.3 billion. The company's net debt-to-capital ratio climbed to a still low 23%.
As of Feb. 19, I'm raising my target price on Devon Energy to $108 by December 2008 from my prior target of $102 by December 2007. (Full disclosure: I own shares of Devon Energy in my personal portfolio.)
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