This chapter discusses value investing strategies and techniques for identifying undervalued stocks. It defines value investing as buying stocks that are temporarily undervalued or unpopular for various reasons. Key points include: - Computing a stock's fundamental value using models like the present value or Gordon growth model and comparing it to the current price. - Common valuation metrics like price-to-book, price-to-earnings, and price-to-cash flow that value investors use to find underpriced stocks. - The teachings of value investing pioneers like Benjamin Graham and Warren Buffett, emphasizing buying good companies at fair prices and focusing on margins of safety. - Other criteria value investors employ in stock screening

1. Investments: Analysis
and Behavior
Chapter 11- Value Stock
Investing
©2008 McGraw-Hill/Irwin

2. 11-2
Learning Objectives
 Learn the characteristics of a value investing strategy.
 Be able to compute fundamental value.
 Identify undervalued stocks.
 Learn the value of dividends.
 Implement computer stock screens.

3. 11-3
Value Investing
 Finding securities considered to be
temporarily undervalued or unpopular for
various reasons.
 Determine Economic Value of the firm
 Sometimes called Fundamental Value
 Compare to current price
 Value investing is a contrarian philosophy
 Not following the herd…
 Why might a stock be selling below its
economic value?

4. 11-4
Finding Fundamental Value
 Present Value Model
The value today, of receiving a dividend and
next year’s price, is:
 k is the risk-adjusted discount rate.
But what is next year’s price?
So,
k
1
P
D
P 1
1
0



k
1
P
D
P 2
2
1



 2
2
2
1
0
k
1
P
D
k
1
D
P






5. 11-5
Continuing the substitution, leads to the
general present value equation:
How is Pn estimated?
 One method is to use the P/E ratio. Note that:
   n
n
n
2
2
1
0
k
1
P
D
k
1
D
k
1
D
P







 
 
   n
n
n
n
n
g
E
E
P
E
E
P
P






1
0

6. 11-6
 EXAMPLE: According to information obtained from Yahoo! Finance, Freddie Mac
(FRE) has a current price of $64 per share, an expected dividend per share of
$1.40, an EPS of $7.50, expected EPS growth of 6% per year, and a typical P/E
ratio of 12.
 According to the Present Value Model, what is the present value of FRE using a
discount rate of 14% and a five years analysis period? Is it undervalued or
overvalued?
 Solution
 Estimated price in five years:
 Future dividends are:
 Present Value is:
    44
.
120
$
06
.
1
50
.
7
$
12
1 5
5
0
5
5 






 g
E
E
P
P
57
.
1
)
06
.
0
1
(
2
3 


 D
D
40
.
1
1 
D 48
.
1
)
06
.
0
1
(
1
2 


 D
D
67
.
1
)
06
.
0
1
(
3
4 


 D
D
77
.
1
)
06
.
0
1
(
4
5 


 D
D
       
89
.
67
$
47
.
63
99
.
0
06
.
1
14
.
1
23
.
1
14
.
0
1
44
.
120
77
.
1
14
.
0
1
67
.
1
14
.
0
1
57
.
1
14
.
0
1
48
.
1
14
.
0
1
40
.
1
5
4
3
2
0

















P

7. 11-7
 Note that the model depends on growth rates of
the profits and dividends.
 Constant Growth Model
 Also called the Gordon Growth Model
 If you can assume that the future growth of the
company is constant, then the equation becomes:
 Only works for k > g
 
g
k
D
g
k
g
1
D
P 1
0
0






8. 11-8
 A company paid a $0.75 per share dividend this year and
it is expected to grow at 5%. If the required rate of return
for this firm is 10%, what is its fundamental value?
 If the stock is a preferred stock (pays a constant
dividend), then g=0%.
 Notice how much more valuable a growing firm is!
    75
.
15
$
05
.
0
10
.
0
05
.
0
1
75
.
0
$
1
0
0 







g
k
g
D
P
  50
.
7
$
10
.
0
75
.
0
$
0
0
1
0
0 




k
D
P

9. 11-9
What is the appropriate discount rate?
 Various methods
CAPM return
 Requires company beta, market return, risk free
rate
Average historical return of the firm
From the constant growth model:
Gain
Capital
Yield
Dividend
g
P
D
k
0
1





10. 11-10
Graham & Dodd Approach
 Coauthors of Security
Analysis—value investor’s bible
 Graham lost fortune in 1929 crash.
 Learned that true measure of stock
values come from earnings,
dividends, future prospects, and
asset values, NOT price
movements
 Graham teamed up with
professor Dodd to write the
book, 1934

11. 11-11
 Most important idea: margin of
safety—positive difference
between price and value
 Degree of “bargain-ness”
 Enlightened stock analysis—
price vs. true intrinsic or real
economic value
 Liked firms that sell below
liquidation value

12. 11-12
Characteristics of Value Firms
 Measures
 Price to Book: Firms with low P/B (or high B/M)
are value stocks
 Price to Earnings ratio: Firms with low P/E are
considered value stocks.
 Earnings could be negative or vary because of
extraordinary items.
 Price to Sales ratio: Firms with low P/S are
considered attractive because they may have
potential for large future price gains.
 Price to Cash flow: Low P/CF firms are value
firms.

13. 11-13

14. 11-14
Warren Buffett: Current leader of the
value investing strategy
10 lessons from Warren Buffett
1. Better to buy a wonderful company at a fair price then a fair
company at a wonderful price.
2. When a management with a reputation for brilliance tackles a
business with a reputation for bad economics, it is the
reputation of the business that survives.
3. Management does better by avoiding dragons, not slaying
them.
4. Like Newton’s law of motion, an institution will resist any
change in its current direction.
5. Corporate projects will materialize to soak up available funds.

15. 11-15
6. Cravings of the leader, however
foolish, will be quickly supported
by detailed studies prepared by
the troops.
7. The behavior of peer companies
will be mindlessly imitated.
8. It is not a sin to miss a business
opportunity outside one’s area of
expertise.
9. If your actions are sensible, you
are certain to get good results.
10. Do not join with managers who
lack admirable qualities, no
matter how attractive the
prospects of their business.

16. 11-16
Dividends: An Important Part of Total
Return from Value Firms
 Dividends mitigate risks—bird in hand theory
 Dividend growth
 Dividends give more stable income streams than
bonds.
 Dividends grow faster than inflation over time.
 Dividend yields have decreased over the last two
decades.
 Valuable indicator of corporate health

17. 11-17
S&P 500 Index
0
1
2
3
4
5
6
7
8
9
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
Dividend
Yield
(%)

18. 11-18
Figure 11.3 Reinvested Dividends Are a Big Part of Total Return for the S&P 500 (1976-present)
$10,000
$60,000
$110,000
$160,000
$210,000
$260,000
$310,000
$360,000
$410,000
1976 1980 1984 1988 1992 1996 2000 2004
Year
Investment
Value
Data Source: http:www.barra.com
Total Value
$364,642
Principal Growth
$138,640
Total Value of
Reinvested Dividends
$226,002

19. 11-19
Quality at a Reasonable Price
 value of ROE, or VRE
 VRE = return on equity divided by the P/E ratio
 If VRE ≥ 1, the stock may be worthy of investment
attention and possible purchase.
 If VRE ≥ 2, the stock is definitely worthy of investment
attention and may represent a very attractive
investment.
 If VRE ≥ 3, the stock is apt to represent an
extraordinarily attractive investment opportunity.

20. 11-20
Use the value of ROE to determine the worthiness of the stock to a
value investor for the following stocks:
Company ROE P/E
Intel 19.6% 20.0
Ford Motor 24.1% 6.3
Procter & Gamble 40.2% 20.9
Solution:
Compute the value of ROE:
Company VRE
Intel 19.6% / 20.0 = 0.98
Ford Motor 24.1% / 6.3 = 3.83
Procter & Gamble 40.2% / 20.9 = 1.92
With a VRE = 0.98, Intel is not a candidate for a quality-at-a-
reasonable-price stock. Procter & Gamble may be worthy of further
investigation. Since Ford Motor’s VRE is greater than 3, it
represents a very attractive possibility for a value investor.

21. 11-21
Above-normal profits range
Below-normal profits range
Above-normal
profits (+)
Below-normal
profits (-)
12%-14%
Entry or nonleading
firm growth
Bankruptcy or
exit
Profit rate
over time
Figure 11.3 Profit Rates and Stock Returns Display a Regression to the Mean Over Time
Over time, entry and nonleading firm growth causes above-normal profits to regress toward the mean. Similarly, bankruptcy or exit by weak competitors boosts
profits for depressed industries. As a result, firm profits and stock-market returns converge toward the long-term average of 12-14%.
Regression to the mean:
At any point in time, the rate of return on stockholder’s equity varies among
firms and industries. Over time, these profit rates tend to converge toward the
overall average of 12-14% per year.

22. 11-22
Table 11.5 S&P 500 Operating Earnings Growth by Economic Sector as of 1/19/2006
2002 2003 % Chg 2004 % Chg 2005 % Chg
S&P 500 46.04 54.69 18.80% 67.67 23.7% 76.56 13.1%
Consumer Discretionary 9.53 10.53 10.56% 13.63 29.5% 13.03 -4.4%
Consumer Staples 11.91 11.79 -0.96% 12.82 8.8% 13.18 2.8%
Energy 9.87 16.32 65.34% 24.29 48.9% 34.97 44.0%
Financials 21.03 26.76 27.22% 30.88 15.4% 32.79 6.2%
Health Care 14.89 14.63 -1.73% 17.20 17.5% 18.61 8.2%
Industrials 10.53 10.88 3.27% 13.13 20.7% 16.18 23.2%
Information Technology 3.36 8.04 139.23% 12.60 56.7% 14.83 17.7%
Materials 4.48 5.32 18.66% 10.10 90.0% 11.77 16.5%
Telecommunication
Services 6.86 6.81 -0.66% 6.86 0.8% 7.52 9.6%
Utilities 9.69 8.77 -9.42% 8.63 -1.6% 9.50 10.1%
Source: Standard & Poor's

23. 11-23
Finding Value Stocks
Common Criteria for Value Stocks
 Ample cash reserves (cash > 10% of market cap).
 Ample free cash flow to fund necessary investment (EBIDTA > capital
spending).
 Conservative dividend payout policy (dividend < 75% of EPS).
 Conservative financial structure (debt < 50% of market cap).
 Conservative issuance of common stock to managers and other
employees (constant or falling number of shares outstanding).
 Low price-book ratio relative to the market and a company's own history
(P/B < 75% of S&P 500 average).
 Low price-cash flow ratio relative to the market and a company's own
history (P/CF < 75% of S&P 500 average).
 Low price-earnings ratio relative to the market and a company's own
history (P/E < 75% of S&P 500 average).
 Negative investor sentiment as reflected in poor financial ratings (S&P
rating of B- or worse).
 Significant dividend income (yield > 150% of S&P 500 average).

24. 11-24
Stock Screener at Yahoo! Finance

25. 11-25
Table 11.7 Stock Screens Can Help Turn Up Stock-market Bargains
Minimum stock screen criteria: ROE 15%, 5-year EPS Growth rate average 10%, EPS Growth Next 5 Years 10%
(analyst estimate). Maximum stock screen criteria: Current P/E Ratio 14, Debt to Equity Ratio 0.5.
Ticker Company Name Price
Mkt
Cap P/E
Earnings
Growth
Est Next
5y
Return On
Equity
Earnings
Growth
Past 5
Year
Total
Debt/Equity
GPS GAP INC 17.17 14.931B 13.6 12 21.6 22.8 0.09
PH PARKER HANNIFIN C 73.98 8.860B 13.5 11 17.1 11.6 0.27
AEOS AMER EAGLE OUTFIT 24.87 3.718B 13.6 14.5 31.1 12 0.00
NOVL NOVELL INC 8.99 3.489B 10.2 10 31.6 27.9 0.43
NX QUANEX CP 60.26 1.535B 9.9 15 30.6 33.6 0.21
OFIX ORTHOFIX INTL NV 41.28 660.8M 8.9 14 23.5 15.3 0.15
ASFI ASTA FUNDING INC 29.75 404.4M 13.9 15 23.9 17.4 0.20
WSTL WESTELL TECH CL A 4.12 287.5M 7.9 20 31.1 44.5 0.00
CRMT AMERICA'S CAR-MAR 18.40 218.2M 13.3 18 15.9 23 0.35
Source: Yahoo! Finance stock screener

26. 11-26
• Careful stock selection
should limit downside risk
• Difficulty obtaining reliable and
relevant information
• Not necessarily a buy-and-
hold strategy—constant
recycling of stocks through
portfolio; constant research
and vigilance
• Popular rules-of-thumb already
factored into market?
Value Investing
Advantages & Limitations