Value Investing for Dummies

Last time we addressed value, we wrote about Penney. That’s a tough nut to crack, value-wise. Anything that’s losing money but will make money eventually is a tough valuation case.

This time, we’ll talk numbers, using a couple actual stocks that are much easier to value. We’re not going to get fancy here; we’re going to hit the high points, but be assured, this is the tip of the iceberg when it comes to actually valuing a company.

We’re going to start with IBM. This stock is selling at around 13 times its most recent earnings. That’s its PE (price divided by earnings). It means that we are paying $13 for every one dollar that the company has earned lately. In its history, IBM has typically sold at a PE between 11 and 20. Its recent history has been skewed to that 11 number because IBM has had earnings problems lately, but we do know IBM is capable of being valued by investors at a higher PE. Maybe it never gets to 20 ever again, but it might get to 17.

What happens if the company is valued at a higher PE and its earnings stay constant? Its price must rise. This is just a math equation: PofIBM/EofIBM = price/earningsIBM, so the way to make its P/E rise is to have something like (PofIBM+$10)/EofIBM.

If you have two things happen at once – slightly higher earnings and a higher PE, then the price rises more.

Aside from selling at a low PE relative to its history, IBM sells at a much lower PE than the rest of its competition, and the market as a whole. So it looks ‘cheap’ in this way, too.

So if we start with IBM selling near the lower end of its long term historical PE, and we are reasonably confident that IBM’s earnings can grow even very slightly, then the price of the stock will rise. Note! This is one of the beautiful things about value investing: you do not need for your company to perform miracles in order to get a return out of it. It doesn’t need to grow at 20% or 50% – of course if it does, you will have a bonanza. But since we are buying so cheap, all we need is for IBM to grow just a little tiny bit – not a big hurdle.

What about other measures? Well, IBM’s dividend yield is much higher than most stocks, at 3.5%. That’s even higher than the long term Treasury. It’s 160% of the rate of the average stock in the S&P 500. Its return on capital is about 20%. That’s really high. Anyone should be happy to garner a 20% return on his capital.

So we can conclude that IBM is cheap, and might be worth an investment.

Now we will look at Netflix. Its PE is 330. That means we are paying $330 for every $1 the company is earning. That is a lot more to pay than IBM’s shares would cost. Netflix has no dividend. Its return on capital is about 5%. None of these measures make Netflix look like a good value. In every way, investors are paying more for this stock.

Netflix may be a growth manager’s cup of tea, but it does not work for us. The mathematical expectation that is required to justify Netflix’ share price is unreasonable: growing into this PE means Netflix must grow much faster than it has in the past. The problem with requiring a higher growth rate to justify a stock price is that you cannot know this will pan out, and if it doesn’t, the stock will crater. This may be dawning on investors because the stock price today is selling at the same price that it was selling at back in August of 2015. It has gone nowhere since then – 16 months. Meanwhile, the market is up over 8% since then. Netflix is being left in the dust.

IBM, however, does not require a stretch of the imagination, mathematical unreasonableness, or any other contortion to see that its price will probably rise over time.