DETERMINING A FAIR PRICE

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DETERMINING A FAIR PRICE Disclaimer: All stock references are meant to be used for educational purposes.

Ken Kavula President Mid-Michigan Chapter Ann Cuneaz Education Program Manager BetterInvesting This presentation

2 Let s Review Selecting the Best Companies Complete Quality Worksheets for Stryker Buffalo Wild Wings Walgreens

1 DETERMINING A FAIR PRICE Disclaimer: All stock references are meant to be used for educational purposes. No recommendation for purchase or sale is intended or implied. Ken Kavula President Mid-Michigan Chapter Ann Cuneaz Education Program Manager BetterInvesting This presentation is being recorded for future use! 2 Let s Review Selecting the Best Companies Complete Quality Worksheets for Stryker Buffalo Wild Wings Walgreens Costco (using the Online SSG) Answer key has been posted in My Classes with session 1 materials The Stock Selection Guide (SSG) Helps Answer Two Basic Questions 1. Is the company a quality growth company? 2. Is it currently selling at a fair price? 3 4 1

Our Goals Today Begin to learn how the BetterInvesting SSG

purchased at the current 5 We ll begin this class by

We want to know what it is and what it can tell us about a

6 P/E Is a Ratio Think FRACTION (Numerator over

2 Our Goals Today Begin to learn how the BetterInvesting SSG helps us decide if a company stock is currently at a fair price. Evaluate the expected annualized return if stock is purchased at the current price. 5 We ll begin this class by revisiting the Price to Earnings Ratio (P/E). We want to know what it is and what it can tell us about a company. 6 P/E Is a Ratio Think FRACTION (Numerator over Denominator) Miles per hour Calories per slice FRACTION? Dollars per karat Cats per household Price per pound Which is more expensive? $1.35 $ oz. 8 oz. $.09 / oz. $.10 / oz

The P/E ratio is the current price of a stock divided by four consecutive quarters of earnings per share (EPS). P/E Ratio = Current Price EPS Why Do We Use P/E?

9 10 Understanding P/E P/E ratio represents the price we are willing to pay for $1 of earnings per share (EPS). A P/E of 16 means we are willing to pay $16 for every $1 of EPS.

3 The P/E ratio is the current price of a stock divided by four consecutive quarters of earnings per share (EPS). P/E Ratio = Current Price EPS Why Do We Use P/E? P/E is one way to measure how investors value a stock, regardless of share price. It allows us to compare the value of one stock priced at $30 to another stock priced at $ Understanding P/E P/E ratio represents the price we are willing to pay for $1 of earnings per share (EPS). A P/E of 16 means we are willing to pay $16 for every $1 of EPS. If that company earned $2.00 per share, how much would we be willing to pay for one share? $32 11 Let s Compare Stock A sells at $20 with $1.00 EPS Stock B sells at $100 with $10.00 EPS Which is more expensive? 12 3

Stock Price Does Not Answer Our Question Stock A: P/E = $ 20 $1 = 20 Stock B: P/E = $100 $10 = 10 With Stock A, we would pay much more for one dollar of EPS. P/E can tell us if a stock is expensive.

4 Stock Price Does Not Answer Our Question Stock A: P/E = $ 20 $1 = 20 Stock B: P/E = $100 $10 = 10 With Stock A, we would pay much more for one dollar of EPS. P/E can tell us if a stock is expensive. Current P/E The Current P/E is calculated using the Current Price and the Current Earnings per Share. The current EPS is the sum of the EPS from the most recent 4 quarters (also known as TTM). Be aware that some P/E ratios may use periods other than the most recent four quarters of EPS. Current P/E = Current Price EPS (TTM) SSG Section 3 Reports Historical P/Es Historical High P/Es High Price in the Fiscal Year EPS in the Fiscal Year For 2011, $34.22 $1.93 = High P/E

Historical Low P/Es Historical High P/E Low Price in the Fiscal Year EPS in the Fiscal Year For 2010, $18.56 $1.65 = 11.

5 Historical Low P/Es Historical High P/E Low Price in the Fiscal Year EPS in the Fiscal Year For 2010, $18.56 $1.65 = Low P/E Once we compute the High and Low P/Es, we can calculate a five-year average. Historical Low P/E These averages can be used to help us determine what a reasonable High and Low P/E might be five years from now. How do we do that? How do I find an AVERAGE?

Average High P/E Average Low P/E Sum of High P/Es = 19.55 + 18.

9 Average High P/E 21 Sum of Low P/Es = 15.36 + 8.56 + 6.76 + 11.

6 Average High P/E Average Low P/E Sum of High P/Es = = = 16.9 Average High P/E 21 Sum of Low P/Es = = = 10.8 Average Low P/E 22 Let s use these numbers! USING P/E ON THE SSG

Everyone knows... Miles per hour X hours = total miles 60 MILES 1 HOUR X 3 HOURS = 180 MILES In a similar calculation... P/E X EPS = price $30 PRICE $1 EPS X $2 EPS = $60 PRICE Here s the KEY.

We will use 17 (average high P/E). 25 26 How do we get a reasonable earnings value? The SSG is based on your judgment! Our completed SSG for TJX projects earnings to grow at 8.

7 Everyone knows... Miles per hour X hours = total miles 60 MILES 1 HOUR X 3 HOURS = 180 MILES In a similar calculation... P/E X EPS = price $30 PRICE $1 EPS X $2 EPS = $60 PRICE Here s the KEY... A reasonable High P/E value multiplied by a reasonable High EPS gives us a reasonable HIGH price! What is a reasonable High P/E? The five year average High P/E (or less). We will use 17 (average high P/E) How do we get a reasonable earnings value? The SSG is based on your judgment! Our completed SSG for TJX projects earnings to grow at 8.0% for the next five years. LET S THINK ABOUT THAT! 27 If TJX grows 8.0% per year for 5 years, what will the EPS be in 5 years? We start with the most recent 4 quarters of EPS - $2.35. If $2.35 grows 8%, then EPS will be $2.54 one year from now. $2.35 x 1.08 = $ $2.54 7

45 29 30 Estimate the Future High Price To get a reasonable High Price five years from now, multiply the anticipated High P/E five years from now (17) by the

8 If TJX grows 8.0% per year for 5 years, what will the EPS be in 5 years? Repeat four more times and we will get the estimated EPS five years from now! It works out to $3.45. $2.35 x 1.08 = $2.54 $2.54 x 1.08 = $2.74 $2.74 x 1.08 = $2.96 $2.96 x 1.08 = $3.20 $3.20 x 1.08 = $3.45 HISTORY $ YEARS AHEAD $ Estimate the Future High Price To get a reasonable High Price five years from now, multiply the anticipated High P/E five years from now (17) by the anticipated EPS five years from now ($3.45). $17 PRICE $1 EPS X $3.45 EPS = $58.65 PRICE Based on the judgments used on this SSG, in five years TJX could trade as high as $

Estimate the Future Low Price Do a similar calculation for the Future LOW price.

most recent fiscal year (assumes no growth!) - $2.

85 PRICE Remember: P/E multiplied by EPS gives you a price! 33 34 Let s pause for some questions!

9 Estimate the Future Low Price Do a similar calculation for the Future LOW price... Reasonable Low P/E: The five year average Low P/E (or less) - 11 Reasonable Low EPS: The EPS from the most recent fiscal year (assumes no growth!) - $2.35 Estimate the Future Low Price Low P/E X Low EPS = Low Price $11 PRICE $1 EPS X $2.35 EPS = $25.85 PRICE Remember: P/E multiplied by EPS gives you a price! Let s pause for some questions! The HIGH price and the LOW price give us an estimated trading range for a stock over the next five years. Forecasted High Price Think of that as a distance that we will divide into four parts. Forecasted Low Price

Forecasted High Price Forecasted Low Price Zoning We ll name the top quarter SELL, the bottom quarter BUY and the middle two quarters HOLD. Buy, Hold or Sell?

10 Forecasted High Price Forecasted Low Price Zoning We ll name the top quarter SELL, the bottom quarter BUY and the middle two quarters HOLD. Buy, Hold or Sell? Once we determine where the current price falls on the chart, we can determine if it is a good purchase. Forecasted High Price ($58.65) CURRENT PRICE ($44.75) ($25.85) Forecasted Low Price CAUTION: Buying Quality Growth Stocks at too high a price is one of the biggest mistakes you can make as an investor! Forecasted High Price Current Price Potential Gain Measure Upside vs. Downside The difference between the current price and the estimated high price represents our Upside, or Potential Gain. 39 Forecasted Low Price 40 10

90 CURRENT PRICE ($44.75) DOWNSIDE is $18.90 ($25.85) Forecasted Low Price Upside Downside Ratio Compares the potential gain to the potential loss. TJX 13.9 to 18.9 or 0.

11 Forecasted High Price Current Price Potential Loss Forecasted Low Price Measure Upside vs. Downside The difference between the current price and the estimated LOW price represents our Downside, or Potential Loss. Forecasted High Price ($58.65) UPSIDE is $13.90 CURRENT PRICE ($44.75) DOWNSIDE is $18.90 ($25.85) Forecasted Low Price Upside Downside Ratio Compares the potential gain to the potential loss. TJX 13.9 to 18.9 or 0.74 to to 1 Upside Downside Ratio Guideline: 3 to 1 BetterInvesting recommends that a purchase be made when the upside potential gain is at least three times larger than the downside risk. In other words, only purchase in the BUY zone! Look for 3 to 1 or greater! 43 EVALUATING THE POTENTIAL RETURN 44 11

5-Year Potential Expected annualized return comes from the stock s potential price appreciation PLUS the dividend.

Total Return = Price Appreciation + Dividend REMINDER: Not all stocks pay a dividend!

This percentage is called the Payout Ratio. Payout Ratio A company that had EPS of $2.

12 5-Year Potential Expected annualized return comes from the stock s potential price appreciation PLUS the dividend. Total Price Appreciation is the increase in stock price over our 5-year time horizon. Total Return = Price Appreciation + Dividend REMINDER: Not all stocks pay a dividend! Dividends The total amount a company pays in dividends for each share is expressed as a percentage of its EPS. This percentage is called the Payout Ratio. Payout Ratio A company that had EPS of $2.00 in the last fiscal year and paid a $1.00 dividend per share has a payout ratio of 50%. Whole Pie = EPS Slice = Portion of the EPS paid out as Dividends $1.00 Dividend per share $2.00 EPS =.50 = 50%

50 Dividend Yield The dividend as a percentage of the stock price is called Dividend Yield.

13 Dividend History On average, TJX pays out 18.9% of EPS as dividends. 49 The historical payout ratio helps us determine how much of the future EPS can be expected to be paid as a dividend to shareholder owning that share. 50 Dividend Yield The dividend as a percentage of the stock price is called Dividend Yield. Compound Annual Return Compound Annual Return is computed by adding the expected annualized price appreciation and the average dividend yield. If a share of stock sells for $50.00 and pays a $2.50 dividend, then its current yield is 5%. $2.50 $50.00 =.05 = 5% 51 It s important to decide whether the expected compounded annual return meets the needs of your portfolio

Our Investment Goal BetterInvesting suggests that the goal for your portfolio be 15% compounded annual return!

Company EPS growth slows as company gets larger More stable Less volatile Each and every stock does not need a 15% compounded

53 54 Diversify by Size Your Portfolio Small Large Medium BetterInvesting suggests your portfolio include: 25% small companies

14 Our Investment Goal BetterInvesting suggests that the goal for your portfolio be 15% compounded annual return! Company Size and Expected Return Are Frequently Related Small Company Faster EPS growth More risk More volatility Large Company EPS growth slows as company gets larger More stable Less volatile Each and every stock does not need a 15% compounded annual return to meet the goal Diversify by Size Your Portfolio Small Large Medium BetterInvesting suggests your portfolio include: 25% small companies 50% medium companies 25% large companies Company size is defined by annual sales: Large company has greater than $5 billion Medium company has between $500 million & $5 billion Small company has less than $500 million 55 LET S PRACTICE 56 14

Let s Review Sections 3, 4 and 5 of the TJX SSG Section 3 Price Earnings History 57 Can you locate: Current P/E? Average Low P/E for the past five years? Percentage Payout for 2010?

15 Let s Review Sections 3, 4 and 5 of the TJX SSG Section 3 Price Earnings History 57 Can you locate: Current P/E? Average Low P/E for the past five years? Percentage Payout for 2010? High Price for 2008? EPS for 2011? 58 Section 3 Price Earnings History Section 4 Evaluating Risk and Reward P/E multiplied by EPS gives you a price! Can you Explain: 16.9 in box D7? Average Price Earnings Ratio? What %Payout in Column G means? Remember how we came up with the reasonable high and low EPS?

16 Section 4 Evaluating Risk and Reward Section 4 Evaluating Risk and Reward There are other low price selections on the SSG. We have two more decisions to make: 1) a reasonable Average High P/E for the next five years 2) a reasonable Average Low P/E for the next five years P/E multiplied by EPS gives you a price! For now, let s ignore choices b, c and d! Zoning Forecasted High Price $58.65 Zoning Current Price: $44.75 The present stock price falls in the HOLD zone. Forecasted Low Price $

FOCUS ON THE RETURN! 65 66 LET S REVIEW 67 What We Have Learned P/E helps us evaluate how a stock is valued by investors.

17 Can you interpret an Upside Downside Ratio of 0.74 to 1? Section 5: 5-Year Potential Combines price appreciation with dividend yield to get an estimate of total return. Is 31% appreciation acceptable? FOCUS ON THE RETURN! LET S REVIEW 67 What We Have Learned P/E helps us evaluate how a stock is valued by investors. High and low prices are estimated based on future expectations for EPS growth and P/Es. P/E x EPS = Price Your judgment is required to complete the SSG. Price zones and the upside downside ratio indicate when to buy, hold or sell. Total return consists of both price appreciation and dividend yield

18 Skill Check BetterInvesting recommends a gain vs. loss ratio of or better. 1. one to two 2. two to one 3. three to one 4. four to one Skill Check Your high price forecast (select all that apply) 1. is for a five year time horizon. 2. is your projected average high P/E times your EPS forecast. 3. has a 90% or better probability. 4. is more accurate when sales and earnings grow consistently Skill Check Which of the following is a component in the Compound Annual Return calculation? (select all that apply) 1. Present yield 2. Average projected yield 3. % payout 4. Annualized price appreciation Practice Complete the Valuation Worksheet for Ross Stores (ROST) Extra: Complete the Valuation Worksheet for one or more of the practice companies (completed SSGs provided) Materials are located in My Classes

Handouts are in My Classes Class Materials

Access My Classes from the Education Tab 73

kkavula1@comcast.net annc@betterinvesting.

19 Handouts are in My Classes Class Materials Available For 120 Days Expires: Check Your Date Access My Classes from the Education Tab 73 Visit My Classes to get handouts 74 and view recordings. Session 3 Estimating Future Growth kkavula1@comcast.net annc@betterinvesting.org Learn how to make reasonable, conservative projections of future sales and earnings growth rates

ESTIMATING FUTURE P/Es

ESTIMATING FUTURE P/Es Pat Donnelly PITTSBURGH CHAPTER DIRECTOR BETTERINVESTING VOLUNTEER ADVISORY BOARD Ken Kavula MID-MICHIGAN CHAPTER CHAIRMAN BETTERINVESTING VOLUNTEER ADVISORY BOARD March 22, 2011