DELL

The list of most actively traded stocks in the S&P 500 seems to attract the most attention amongst the investment community and always create a good amount of “Buzz”. We decided to take the list of the most actively traded stocks over the last 50 trading days (excluding financials) and run them through The Applied Finance Group’s (AFG’s) meat grinder to see which are worthy of the hype and are attractive investment opportunities and which you should probably stay away from.

AFG uses a set of criteria in its stock selection process that has proven successful at identifying winners and losers in the market including its proprietary measure of corporate performance (Economic Margin), valuation, management quality and earnings quality among other criteria. Of the companies listed that are heavily traded, AFG believes the companies with expected improvement in Economic Margins, attractive valuations, and a wealth creating management team are the companies that will be the most likely to outperform the market and their sector peers. (register now to receive exclusive buy ideas- it's fast and free!)

The rankings above were provided using AFG’s research product AFGView.com and are ranked based on AFG’s overall investment opportunity signal, valuation signal and expected changes in Economic Margins. The companies must rank as attractive or unattractive in all 3 categories or the firm is listed as neutral.

Below is a brief description of those variables with informative links.

Source: EconomicMargin.com

AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.

Management Quality – Assesses management’s ability to make wealth creating decisions.

+View our List of Value Expepectations Recommended Articles

AFG Recommendation Performance
9/1998 – 5/2009
Annualized Returns

Source: AFGView client databases from 9/1998 – 5/2009
Universe size: 4,000 to 5,500 firms

Much like earnings results, when a company delivers 20% revenue growth, how does one determine whether that is a good or bad? It really depends on what expectations are priced into the stock that allows an investor to determine whether or not the company has delivered. But understanding the expectations priced into a stock in not an easy task, that is, unless you use The Applied Finance Group’s (AFG) Value Expectations (VE) interface.

AFG’s Value Expectations interface provides clients a platform to better understand economic profitability, and at the same time understand the performance a company must deliver to justify its current stock price. By understanding the embedded expectations a company must deliver to justify their current trading price, clients can develop a “hurdle rate” to quickly determine if the company’s expectations are rich or low. Take, for example, the typical company during the tech bubble: the expectations that were priced into the average tech stock far exceeded what it could realistically deliver. For this reason, AFG identified the technology sector as overvalued, as well as potential torpedos such as Cisco, whose expectations were unrealistically high.

After determining if a company is a valid investment opportunity, users have the flexibility to adjust expectations based on their own research, build out pro-forma financial scenarios, and arrive at an NPV target price.

In addition, the VE interface has all the key theoretically components of a well-thought-out valuation model, which takes into consideration the appropriate risk, with a market derived discount rate (MDDR) that is adjusted for size and leverage. Competition and perpetuity issues are also taken into account, using company specific Competitive Advantage Periods (CAP).

By gaining a better understanding of the embedded expectations built in to security prices, relative to what a company has delivered historically, can provide insight into the Sales Growth, EBITDA Margin, and Asset Turnover a company must deliver in the future to justify its current trading price. In many circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued.

Our recent analysis of Dell’s acquisition of Perot Systems is a good example of how we have recently used the VE interface to determine the value of one company (PER), to get an understanding of what the acquiring company is paying for.

Our analysis revealed that Dell would acquire Perot Systems for $30 a share, a 68% premium over where PER closed last Friday. The sales growth required to justify the $30 a share price Dell has agreed to pay was quite lofty relative to PER’s historical performance. Using realistic, if not generous, expectations for EBITDA Margins of 11% and asset turns of 1.4, we concluded that PER will need to deliver an astounding 26% sales growth each year over the next 4 years to justify a $30 share price! This compares to the 13% average annual sales growth PER has delivered over the past 5 years, the 6.4% sales growth it delivered in 2008, and the expected but rather certain decline of 9% in sales in 2009. Overpaying for such growth destroys rather than creates shareholder value. Therefore, the real losers in this situation are the company’s existing shareholders who paid for the excessive acquisition premium by losing $1.4 Billion of market value Monday.

This is just one example of how Value Expectations can be a powerful tool to help investors understand the embedded expectations in security prices, with the added flexibility of building your own set of expectations for a company.   As you enter your own set of expectations (proforma), this will recalculate your inputs and translate them into an intrinsic value.

Below is a view from within the Value Expectations interface :

As you will note, we have solved for expectations on the $30 a share price Dell paid to acquire PER.

In this particular interface, users have the ability to stress test each input.  This is very handy for busy Portfolio Managers an analyst to them determine which stocks they need to reevaluate if it's a current holding.  If it's a new stock they are considering, they can quickly determine if it's worth their time to further investigate or to build a complete set of  proforma financials, using AFG's Proforma Builder.

Once a scenario is generated, there are many charts and options to present the data.  The Visual we selected below, does a nice job at comparing PER's lofty expectations with its historical performance. 

Value Expectations Interface allows investors to:

• Understand the performance expectations embedded into today’s stock prices.

• Build out Different Pro forma Financial Scenarios

• Determine NPV target price based on the users assumptions.

• Quickly determine if a company is over/under valued

• Benchmark valuation attractiveness against peer groups

• Efficiently Identify investment opportunities or potential torpedo’s

• Help clients outperform!

Components within the Value Expectations Interface:

Target

• The NPV target price.

• Based off forecasted cash flows and Economic Margin (EM) levels.

Upside

• The percent premium or discount to the market price.

• The “Percent to Target” or percentage up/down side

CAP – Competitive Advantage Period

• Defines the terminal value period

• A number of years over which EMs decays to zero.

• Force companies to be a “break even business” over time

• A four-factor regression analysis based on a company’s profitability, variability, EM trend, & size.

Cost of Capital

• Market Derived Discount Rate (MDDR).

• Adjusted for Size and Leverage on company specific basis.

• Expressed as a nominal rate

Tools

• Calculate- After new data has been entered in the Sales Growth, EBITDA%, Asset Turns, Price, CAP or COC select Calculate in this menu or click on the calculator to have the model reflect the changes and calculate a new target price.

• Solve- Select either Sales Growth or EBITDA% to see what percentage is required to keep the stock priced at the current price assuming that all other variables (sales growth, EBIDA% and asset turns) remain constant. The same results can be achieved by clicking the solve buttons next to Sales Growth and EBITDA%.

• Pro-forma Stages- Choose a pro forma stage from one to five to view Sales Growth, EBITDA Margins, Asset Turns and EPS for the number of years selected.

• Publish- Publish saved Value Expectations™ models to make them available to other members of your investment team

• Reset- Changes data in the Value Expectations™ model to the default values; clicking on the reset button in the header will also do this.

Charts

• Utilize value driver charts to benchmark and track your forecasts

• Benchmark forecasts vs. peers Data

• Multiple VE modules allow various starting points for your forecasts

• 1 Year Median

• 3 Year Median

• 5 Year Median

• Analyst (Default Forecast)

Value Drivers

• Sales Growth - Annual % increase or decrease in sales.

• EBITDA -Operating Income + DD&A

• Asset Turns - Total Sales/Total Assets

Smooth

• Use to straight-line up/downward trends.

EPS

• In the Analyst mode, this represents the consensus street estimate for forecast years 1 and 2

• Calculated as operating earnings, free of the impacts of financial manipulation

Stages

• Forecast 5 years out explicitly. Collapse the model down to forecast average or Long Term (LT) figures.

Price – Last night’s closing price

CAP and COC in greater detail:

CAP – The CAP field represents the Competitive Advantage Period calculated by AFG. The CAP value represents an exponential decay expressed in number of years. The decay range is between 7 and 39, with the average company having a 17-year CAP period. For each company, AFG performs a four-factor regression on historic Economic Margin (EM) levels to determine how attractive the company’s line of business is to competition. The four factors consist of profitability, variability, trend, and invested capital. For example, a company with very high historical Economic Margins (EMs) indicates that the company is highly profitable. Highly profitable firms attract competition; thus, the model will decay the levels of Economic Margin (EM) much faster than a company with lower Economic Margins (EMs)—or vice versa. A company with very volatile historical Economic Margin (EM) levels will have a shorter CAP period than a company with more consistent historical levels of Economic Margin (EM). If a company’s historical levels of Economic Margin (EM) are on an upward trend, the CAP period will be extended; or conversely, on the way down (slippery slope) the CAP period will be shortened. In terms of invested capital, the model assumes that is more difficult to erode profits from a larger more established company; thus, extending the CAP period for larger companies, and shortening it for smaller companies.

COC – The COC field represents the Cost of Capital calculated by AFG. AFG calculates COC by taking a subset of companies (2200 industrial, 150 utility, or 300 financial) meeting certain qualitative criteria. For each individual company in those subsets we solve for the discount rate that makes them fairly valued today. We then rank order those discount rates and select the median discount rate to represent a typical firm’s COC in the marketplace. Each company is then adjusted from the market-derived discount rate for its size and leverage characteristics. Thus, the largest most levered firms have the smallest COC; and the smallest most highly levered firms have the highest COC. For a complete review of AFG’s COC please see the Advanced Learning section of our home page.

Dell (NASDAQ:DELL) announced that it would acquire Perot Systems (NYSE:PER) for $30 a share, a 68% premium over where PER closed on Friday. What input did Dell’s Board of Directors offer on this deal? While the equity dollar amount of the deal is only “$3.5 Billion”, relative to Dell’s $12 Billion cash coffer and market capitalization of $32.5 Billion, it is still a bet of more than 10% of the company’s value.

While paying a 68% premium for a company is not by definition silly, it is usually not very smart – in this case it will likely lead to significant wealth destruction. The market seems to agree.

Dell lost approximately 4% of its market value (net of market returns) yesterday when the deal was announced, representing approximately $1.4 Billion dollars. That loss basically represents the entire premium Dell anted up for PER! In other words, the market is saying the benefit given to PER owners has to come completely from the hide of existing DELL owners. The market clearly does not perceive this as a “win win” type of acquisition. Instead this seems to be a typical “winner’s curse” deal where management overpays to ensure it “wins”.

Is the market always right? Of course not, but unfortunately management teams listening to Investment Bankers trying to drive deals tend to be right less often. How can one tell when the market is likely to be wrong, and thus reap potentially lucrative rewards? The answer is easy: when one can affirmatively say that the price paid for an acquisition reflects reasonable future corporate performance expectations. With that in mind, let us deconstruct the PER deal.

While growing earnings and sales is nice, it is woefully insufficient to ensure shareholder value creation. Understanding value requires a fundamental grasp of: Profits, Investment, Growth, Risk, and Competition. We will utilize AFG’s Value Expectations™ framework and focus on the profit, investment and growth side of the value equation to decompose this deal.

The 3 charts below highlight PER’s value drivers – Sales Growth, EBITDA Margin, and Asset Turnover. In order to frame whether the transaction makes sense or not, we will back into an answer that describes the sales growth Dell must achieve from PER in order to make this deal work out for existing Dell Shareholders. We will first begin by determining a reasonable estimate of PER’s sustainable EBITDA margin and then estimate how much capital PER needs to sustain its sales model. Lastly we will impute the sales growth required to justify the $30 a share price Dell has agreed to pay.

Beginning with PER’s historic profit margins, what can Dell expect from the unit going forward? Looking at the EBITDA Margins in the chart below from 2000 through 2008, PER delivered EBITDA margins ranging from a low of 2.8% to a high of 11.8%. For our analysis, we will use what seems to be a reasonable figure of 11% to represent PER’s normalized long-term EBITDA Margin. In fact, given the volatility of PER’s margin historically, many can argue that 11% is a generous assessment. That said, let us use 11% nonetheless. Next, review the chart depicting PER’s Asset Turn Over ratio, which tracks how much a company must invest in its balance sheet to support a dollar of sales. For PER the figure recently was about 1.4x, or for every $1.40 of sales the company generates, it must invest $1.00 in assets to support those sales. Though PER has been much more efficient historically, its trend has been towards requiring more and more capital to support a dollar of sales. By using the most recent figure, we will assume it will minimally arrest that slide.

So what sales growth PER needs to generate to justify a $30 share price? An astounding 26% each year over the next 4 years! This compares the to the 13% annual growth PER has delivered over the past 5 years, the 6.4% it delivered in 2008, and an expected but rather certain decline of 10% in 2009.

Source (The Applied Finance Group)

Bottom line, Dell’s management team believes it will double PER’s growth rates over the next four years relative to what PER achieved during the past economic boom, while maintaining historically aggressive profit margins. While it is not impossible, it seems very unlikely. In fact, Dell executives did not give any targets for revenue, saying more details would come after the deal closes. They did touch upon expected opportunities for cost savings, saying the two companies spend a combined $4 Billion in the areas they plan to integrate, and its sees cost savings of about 6-8% in 2 years. If Dell hits those synergies, which justifiably the market rarely pays for, the new Perot would likely have profit margins approaching that of Accenture, arguably the best in class provider of these services. Again, while such an outcome is possible, it is much like betting on the expectation of hitting an inside straight – generally not a very good strategy.

Ultimately, that is the essence of an investment decision – How likely is a company to deliver on the expectations embedded in its share price. During the Tech Boom of 2000, the answer was “not very likely” as stock prices reflected absurdly optimistic future expectations. In March of this year, the answer was “very likely” as so much pessimism reigned, that stock prices reflected absurdly negative future expectations. (See this report for our analysis of the Tech Boom and 2008/2009 Panic).

Dell justifies the deal on the basis of “strategic fit”, as this acquisition should enable Dell to expand into higher margin IT services (increasing its revenues from Services from the current $5.5 billion to $8 billion) and to secure a more stable and recurring revenue stream as computer hardware becomes more and more commoditized. However, any strategically sound growth strategy must have a sound price tag. Overpaying for assets may allow the current management team to claim future revenue and profit growth, and depending on their compensation plans achieve nice bonus payouts. But overpaying for such growth destroys rather than creates shareholder value. Therefore, the real losers are the company’s existing shareholders who paid for the excessive acquisition premium by losing $1.4 Billion of market value yesterday.

Dell’s Board should do what every PC user does when its machine acts up – reboot. In this same tech spirit, Dell’s Board should reboot this deal until it creates value for existing shareholders.

Other articles that Include AFG’s Value Expectations™ framework:

In yesterdays article we provided an update of the performance of our annual HOT STOCK LIST:

We also provided an update of the performance of the Toreador Large Cap Fund, TORLX which uses AFG’s Economic Margin Framework as part of its investment philosophy.

As you may note, both have done very well!

Today we decided to provide a Buy/Sell list to VE’s registered visitors applying some of these same investment principles: Economic Margin, Management Quality, and a company's Percent to Target (the deviation between a stock's current trading price and its current default target price according to AFG).

Below is a preview of the list which includes a Buy/Sell Recommendation on each Stock. The complete list, accessible to Value Expectations registered users, contains around 500 Stocks.

Source: The Applied FInance Group

To download the complete list click here.

Traditional Discounted Cash Flow (DCF) models have been been underutilized in equity analysis over the years primarily because of the assumptions one has to sign off on. We will concentrate on just two of the major issues we have with traditional DCF models, the lack of ability to deal with competition and the perpetuity assumption embedded in a DCF model. These assumptions lead to irrational calculations of intrinsic value and force analysts to make compromising decisions in their model building efforts.

AFG uses a modified DCF model that accurately addresses the competitive nature of the business while also dealing with the perpetuity issue through our Economic Margin decay or competitive advantage period.

The four factors that affect AFG’s Competitive Advantage Period (CAP) are;

Profitability – High Profit leads to increased competition and a higher decay rate
Variability – Higher volatility leads to less predictability and a higher decay rate
Trend – AFG gives the benefit of the doubt to an upward trend which leads to a lower decay rate
Invested Capital – Large Invested Capital creates barriers to entry and leads to lower decay rate

The Decay Rate is the rate at which the Economic Margins™ will diminish over time due to competition, market conditions and limited investment opportunities. Higher decay rates translate into shorter competitive advantage periods, while lower decay rates translate into longer competitive advantage periods.

The Decay Rate profile is downward sloping to the right, which means that Economic Margins™ over time diminish to zero. This does not mean that the company will not have earnings, but instead the company will have an Economic Margin™ of zero, which indicates there are no excess profits after the investors are paid and the depreciating assets are replaced.When selecting securities, companies that are maintaining a high level of economic profitability or growing their profits rapidly are attractive from an investment standpoint. However, the more profitable a firm is the more likely other companies will attempt compete away excess returns.

To illustrate this, one has to look no further than Dell Computer. Dell Computer had Economic Margins™ hovering around 40% (top 5% of all companies) in 1997 and 1998, but soon every major firm was announcing that they were going to build computers to order. Why? Because they saw the huge profits that Dell was making. The result is that Dell's Economic Margin™ for 1999 was around 25%, a decline of 37.5% in just one year. The remaining factors are relatively straight-forward, in that volatile returns are worth less than consistent returns, companies with an increasing Economic Margins™ are worth more than a company in decline, and large companies have a natural barrier to entry, thus a lower decay rate.

Theory: Excess return gets competed away

Fact: In 1997, the median top decile Economic Margin (EM) firm = 17.4%. 10 years later, that same group of companies had a median EM of 6.5%. On the other hand, the bottom decile had an EM of -12.2%, 10 years later that same group had a median EM of -1.0%.

Current Top Decile Economic Margin Companies (S&P 500 ex. financials)

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By using The Applied Finance Group’s (AFG's) Risk Analysis, we have identified the top and bottom two firms in each sector (excluding the Financial sector) according to an overall risk score based on 9 variables (see more detail below). In addition to the risk analysis variables we also added another layer of analysis by evaluating the companies’ Earnings Quality (based on the concept of Accruals) and Altman Z-Score (identifies firms that are at risk of going bankrupt in the next 2 years).

Applied Finance Group’s Risk Analysis is designed to systematically calculate a stock’s risk score based on fundamental relationships between the Quarterly Income Statements and Balance Sheets. The template measures 9 factors to determine Risk: Changes in A/R, Changes in Inventories, Cash Flow vs. Operating Cash Flow, Fixed Payments vs. Pre-Tax Cash Flow, Leverage, Intangibles, Write-offs, Management Quality, and Valuation. Companies with lower scores have less risk. Companies in the Financial Sector were excluded due to their differences in financial statement structure.
 

1. Receivables to Sales - Delta – takes the difference in the median A/R to Sales ratio over the last 4 quarters vs. median 4 quarters before that.

2. Inventories to Sales - Delta – takes the difference in the median Inventories to Sales ratio over the last 4 quarters vs. median 4 quarters before that.

3. AFG’s Cash Flow-Oper. vs. Operating Cash Flow - AFG's Cash Flow-Oper. for a company is net cash that is generated by the continuing and discontinuing operations of the firm. We compare it to the company's Operating Cash Flow to assess its ability to pay its debt.

4. Fixed Payments vs. Pre-tax Payments Cash Flow – This ratio assesses the company’s ability to cover long-term obligations. If the fixed pmts are greater than 50% of the pre-tax payments cash flow, there is chance that this company may not be able to meet its obligations. Obligations less than 30% of cash flow are considered safe.

5. Leverage – Book leverage and Market leverage are analyzed to give us information about the company’s leverage position. Best score is given to the companies with Book Leverage lower than 60%, and negative score to these with Book Leverage higher than 60% and Market Leverage greater than 0.9*Book Leverage.

6. Intangibles as a Percentage of Total Assets – With this score we try to filter through and reward the companies that have grown organically, rather than through acquisitions. Our research has shown that on average companies tend to overpay for acquisitions and thus are rarely a profitable investment. Companies with Intangibles less than 20% of Total Assets get the best score.

7. Write-offs – Shows the number of years with significant write-offs over the last 5 years.

8. Management Quality – Measures a company’s EM+1 and LFY Asset Growth and there is empirical evidence that companies with positive EMs that are able to grow their business tend to outperform companies with negative EMs who continue to invest into unprofitable business.

9. Value Score – Measures a company’s attractiveness from valuation perspective.

Most/Least Risky Firms By Sector S&P 500 (excluding financials)

If you are a professional investor and would like to learn more about this analysis as well as other useful valuation tools click here for a free trial subscription to The Applied Finance Group's research.

Economic Margin is a measure of economic profitability that identifies how much a company earns above or below its cost of capital. We analyzed all companies in the S&P500 Index based on their historical, current and forecasted Economic Margins to see which firms have the best average of past, present and future profitability. We identified the two most profitable and the two least profitable companies from each sector and have presented them in the table below. As a base of reference, the average firm in corporate America earns a 0 (zero) Economic Margin, or is a “break-even business”. Our research has shown that companies with consistently positive EMs that are also expected to increase their EMs in the future tend to outperfom firms with negative or declining EMs.
<!--[if gte mso 10]> Economic Margin is a corporate performance measure, which helps us identify well managed, wealth creating companies. Although not included in this post, we want to remind you that it is also important to understand the attractiveness of corporations' valuations to make sure we invest in great companies at great prices. (Here is an article by ValueExpectations.com explaining Applied Finance Group’s basic valuation concepts).

Note: Only companies in the S&P 500 were included.

S&P 500 Companies With The Best/Worst Average Profitability (Economic Margin)

Economic Margin (EM) Defined: A measure of corporate performance that captures off balance sheet items, by looking at how much a company is earning above or below their cost of capital. EM is expressed in a % or margin. The Economic Margin Framework™ is more than just a performance metric as it encompasses a valuation system that explicitly addresses the four main drivers of enterprise value: profitability, competition, growth and cost of capital. more EM details (PDF)

Economic Margin (EM) Defined - A measure of corporate performance that captures off balance sheet items, by looking at how much a company is earning above or below their cost of capital. EM is expressed in a % or margin. The Economic Margin Framework™ is more than just a performance metric as it encompasses a valuation system that explicitly addresses the four main drivers of enterprise value: profitability, competition, growth and cost of capital.

Here is a list of companies within the S&P 500 that have earned extraordinary Economic Margins (EM) over the last 7 years and are also expected to maintain high levels of EMs over the next two years. Companies expected to improve their EMs more than their peers have proven to be more likely to out-perform. High EM companies on the list below that have low expectations priced-in for sales growth and attractive valuations, are ones that may be worth a look as a potential investment.

S&P 500 Companies That Maintain High Economic Margins

*AFG’s Value Expectation allows us to understand the imbedded Sales Growth, EBITDA Margins, and Asset Turnovers a company has to deliver in the future to justify its current trading price. In theory and in normal circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued. The table displays the implied future sales growth of companies assuming their EBITDA margins and Asset turnovers stay at the 5 year median levels.

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Fidelity’s Low Priced Stock Fund, which launched in 1989 (18 Billion AUM) and is managed by Joel Tillinghast, follows a simple strategy… Only invest in stocks with a share price under $35. This strategy first started with Tillinghast only investing in stocks below $10 a share, but later he moved the limit up to $35 a share. He argues that share price alone is not important but that the small-cap universe contains the most frequently mispriced stocks and the least amount of analyst coverage.

Although his fund at best has been a market performer as of late, Tillinghast had taken advantage of such mispricing’s during the last 15 years, averaging an 11% annual return compared to the 6% return earned by the S&P 500 over the same period. The fund had been closed to investors since 2003, but was recently reopened in December. Fidelity says they reopened the fund to get more cash inflow to be able to take advantage of all of the investment opportunities they see in the market.

Below is a list of the top holdings in Fidelity’s Low Priced Stock Fund as well as stocks that AFG believes are attractively priced in three price brackets: under $10, $10 to $20, and $20 to $35. Compare the implied sales growth priced-in to justify the current trading price (VE Sales Growth) vs. what the company has delivered in sales growth the past 5 years (5 Year Median Sales Growth) to see if the expectations are realistic for the company to achieve. The more realistic the expectations are, compared to what has been delivered, the more likely the firm will be to out-perform.

The tech sector has been taking a pretty bad beating the past few months but according to Bill Luby of SeekingAlpha.com, The 4 Horsemen of Tech (RIMM, AAPL, GOOG, AMZN) will be the most likely companies in the sector to make the strongest comeback when the tech sector makes a comeback. Here is a list of many of the big names in tech and the implied sales growth expectations priced-in to justify their current price. The companies with low sales growth expectations priced-in (VE Sales Growth) compared to what they have been able to deliver in sales growth (5 Year Median Sales Growth) are the companies we believe have the best chance of making a strong comeback with the sector.

According to historical valuations the tech sector appears to be trading at a discount compared to historical valuations such as the Tech Bubble.

Big Tech Companies and Sales Growth Expectations

According to Bespoke.com these S&P 500 stocks over $5 a share, are those that make the biggest advances/declines the day after reporting earnings since this bear market began in October 07’. Included in this table is the percentage of time these companies beat earnings and their average change on report day, along with their implied sales growth expectations. The implied sales growth measures what a company needs to grow sales at over the next 5 years to justify their current price. Comparing those expectations (VE Sales Growth) with what the company has delivered the past 5 years (5 year median sales growth) is a good way to tell if the current expectations are realistic for the company to meet or exceed. The lower the expectations relative to delivered sales growth, the more likely the company is to out-perform.

In life, the most attractive people are in shape and have good looks, just look at Hollywood. The same is true the majority of the time in investing. The most attractive stocks have healthy financial statements and look good from a valuation standpoint.

The Altman Z-score is a metric that gives insights into the likelihood of a firm going bankrupt in the next 2 years. The model was developed by Professor Edward I. Altman of the NYU’s Stern School of Business and first published in The Journal of FINANCE in September 1968. A common critique to this metric is that it was developed over 40 years ago and is no longer relevant.

In 2001, Professor Joseph D. Piotroski of The University of Chicago Graduate School of Business, published a paper called, Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers. Piotroski showed that value investors were rewarded by looking at a firm’s financial health and he showed that Z-score was a meaningful statistic.
More recently, on December 5, 2008, Dr. Altman was called to testify before a House of Representatives Committee on the condition of U.S. Automakers. In his testimony, he noted that Bloomberg, Inc. reported, “that approximately 1,000 users of their system per day access the Altman Z-Score model.”

The Altman Z-Score breaks down firms into 3 zones:
• >2.99 – Not Likely to Go Bankrupt
• 1.8 - 2.99 – Gray Area
• <1.8 – Likely to Go Bankrupt in the Next 2 Years

Using AFGView.com, we screened for firms that looked relatively attractive from a valuation perspective and had an Altman Z-Score above 2.99. Below is a list of those firms. Later we will look at firms that are expensive and have a Z-Score below 1.8.

Sales Expectations for Companies with an Attractive Valuation and Healthy Balance Sheet

In Joel Greenblatt’s 2006 book, The Little Blue Book that Beats the Market, he presented his “Magic Formula” used in his hedge fund, Gotham Capital. Mr Greenblatt tested his formula between 1988 and 2004. The results were incredible, with only one down year, the magic portfolio would have returned 30.8% a year, against a 12.4% annual return for the S&P 500.

Mr. Greenblatt was a student of both Ben Graham and Warren Buffet and tried to include valuable insights from each investor in his “Magic Formula.” His Magic Formula was a screen that percentile ranked two variables: Return on Invested Capital (quality) and Earnings Yield (valuation). The idea is simple, buy the best companies at the best price. He also recommends one year holding periods, so we thought this would be a great time to get this list out. The Little Blue Book recommends selecting the top 30 firms from the “Magic Formula.” That formula ranks each company by variable and then puts a 50% weight on each. Below is a definition of each variable.

Variable 1: Return on Invested Capital = EBIT / (Net Working Capital + Net Fixed assets)

Variable 2: Earnings Yield = EBIT/EV

The table below shows the top 30 firms with their market implied sales growth expectations. Enjoy!

According to MotleyFool.com, InvestorPlace.com, Jubak’s Journal, Cramer, and FortuneMagazine.com these are the most attractive stocks to own in 2009. Compare the sales growth priced-in to justify the current stock price (VE Sales Growth) to what the company has achieved in revenue growth over the last five years (5 Year Median Sales Growth) to see if what’s priced-in is a reasonable number for the company to meet or exceed expectations. Couple the expectation information with AFG’s ranking for a stock’s attractiveness relative to the universe (Value Score AFG) to find companies that we find attractive on a default basis that also have low expectations for growing sales compared to what they have delivered the past 5 years. Companies with High Value Score’s and low sales growth expectations will be the companies on this list that are more likely to out-perform.

Recommended Stocks for 2009

Related Article: EPS Increased.....Company Underperformed?

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