Now that we’ve gone through the first three steps of my stock analysis process our next job is to put the numbers together, compare & analyze the data and then determine a valuation that represents a fair value (per share) that as a shareholder we would be willing to pay.
On page 81 of IGM’s annual report I pointed to a ten-year summary of financial data. Remember that we’re keeping things simple in this exercise and as an investor you can choose how far back you want to go into the financial history of a company and what information you want to use in your analysis. For IGM I have data in a spreadsheet dating back as far as 1988, but right now I’ll simply share the past ten years for readers to get a reasonable sense of what we’re looking at.
To highlight the spreadsheet these are the 10 year averages for the following data:
ROE: 21.5%
Yield: 2.82%
Payout: 50.83%
P/E: 18.8x
P/B: 3.17
BV Growth: 10%
Div Growth: 18.8%
Now what I want to do is compare the historical numbers we’ve gathered to IGM’s current numbers to gain a sense of its relative value at today’s price (is it more expensive or cheaper than in the past). For sake of this exercise I’ll set the current share price at $38 which is the price I paid for more shares that I bought on July 14th, 2008.
Current Data:
ROE: 22%
Yield: 5.1%
Payout: 58.6%
P/E: <11x>
P/B: 2.4x
We can see that IGM is currently trading above its historical dividend yield of 2.82%, below its average P/E of 18.8x, the payout of dividends is slightly higher at 58.6% and P/B is well below the 10-year average of 3.17x.
What does this give us for a relative valuation? Is IGM is a buy, sell or hold? At what price would IGM be a good investment?
There are multiple ways to determine valuations on stocks and some investors simply buy good companies when they have the cash available. In your process of learning to invest you should practice a few techniques to give you a sense of what valuation method you find easiest to understand and implement. In my Value Portfolio for instance I use a combination of various techniques to contrast valuations on a stock to give me better insight into its fair value. As a value investor I look for a specific margin of safety in a stock price before I make a purchase in an attempt to minimize my exposure to potential losses.
If you haven’t read a post before on why I use a margin of safety (MoS), the basic principle behind the idea is to buffer your investment with a built in safety net. I can’t be right 100% of the time in my stock analysis and a MoS is the difference between the intrinsic value of an investment and the market price. Intrinsic value differs from book value in a big way and I’ll try to explain.
Intrinsic value is usually defined as either the present value of all net future cashflows of a company or the value of a business based on the underlying value of the company (both tangible and intangible assets). That means that I’m looking to calculate the future value of a businesses’ ability to generate future cash and earnings and its present value of operations with a discount built into my purchase price.
When we look at book value we’re determining the value of a company’s net assets, but intrinsic value looks at how much the entire operating business will be worth at some point in the future. If Company ABC has a book value of $5 per share for its net assets, calculating the intrinsic value helps you to get a sense of what the rest of the business is worth. In a company such as IGM their P/B is much higher than stocks in other sectors because their business doesn’t require a massive capital investment into assets to generate returns. The book value of the company might be worth $16, but the intrinsic value (the rest of the business and future cashflow/earnings) is worth much more and that’s how IGM trades at a higher P/B than other companies.
A margin of safety (MoS) is my attempt to mitigate risk in stock analysis and concentrate on one of my foremost objectives when investing: preservation of capital.
