Spotting Value Stocks and Using ROE as a Measure of Growth

A look at the basic value indicators, and a warning about using return on equity to find hot momentum plays.
Author:
Publish date:

As the year comes to a close, I've been struggling to clear the backlog of Fundamental Questions that seem to be piling up on the server like unread magazines on a kitchen table. Unfortunately, my best intentions have largely been bowled over by the demands of the holiday season.

As such, this week's Q&A is essentially a random grab into the mailbag of both old and new. If you've sent a question to the forum that remains painfully unanswered, fear not. I'll be making a valiant effort to get back to you over the next few weeks, either here or in a personal reply. And, please, keep those fresh questions coming in.

The Beauty of Value

Andrew, How do I find great value stocks to invest in? What are the criteria that need to be satisfied before a stock can be called a value stock? Rani Misra

Rani:

Like beauty, value is often in the eye of the beholder. Coming up with one set of hard and fast criteria for all investors is like applying

Henry Ford's

manufacturing model to investing decisions (you can have a car in any color you want as long as it's black).

In general, though, pursuing a "value" orientation means buying something at a market price lower than what you've determined to be the "intrinsic value" of the object. The idea is that the market is not always efficient in the short run but generally returns to its senses over time. So, the market price of your purchase eventually should gravitate toward its "true" value, yielding you an above-average return in the process. (See the original

5-part TSC Series for more on this.)

So how exactly do you determine the "intrinsic value" of a stock? Nobody knows for sure, but plenty of pundits have put together their own formulas as varied as the chorus of worldwide religious denominations. (One of these recipes, by

Ben Graham

, is detailed in a

previous column.)

But just like religion, many investment doctrines share common roots in the form of some basic value indicators. As a starting point, many value adherents stick to some combination of low price to earnings (P/E), low price to book, high return on equity, and some kind of threshold debt-to-equity ratio. Just which combination is right for you might require some additional research and experimentation. I'd suggest revisiting the

TSC

Schoolhouse and Fundamental Questions Archive for starters.

Fishing for Growth With ROE

Please discuss ROE use as a screen for undervalued growth stocks. Viren Balsara, MD.

Dr. V:

Undervalued growth stocks? Sounds like a new member of the oxymoron club. I'll just file it next to "jumbo shrimp" and "efficient government."

Return on equity is basically the net income of a company divided by the average shareholder equity for the period. (See the balance sheet and income statement pieces for a more detailed definition of these concepts.) Some analysts argue that the resulting figure, expressed as a percentage, represents the maximum sustainable growth rate of the firm given sunny skies, a straight, dry road, and otherwise ideal conditions (kind of like the MPG rating on your car). By that logic, then, the higher the ROE, the better the investment, right?

Well, not necessarily. ROE is actually more of a backward-looking measure of just how much wealth management has generated for shareholders in the past than some kind of indicator of future stock price performance -- at least in the short term. ROE is also greatly dependent on the firm's individual leverage policy.

A barely profitable firm like

General Motors

(GM) - Get Report

can show an ROE equivalent to a highly profitable firm like

Cisco Systems

(CSCO) - Get Report

by simply by taking on additional debt to leverage its equity (at least until it runs out of lenders). So while GM seems tapped out on future growth potential with heavy long-term liabilities, Cisco can easily take on additional debt -- and it has -- to finance its explosive growth if it needs to. As a result, this function of leverage policy makes one-to-one comparisons across industries generally ill advised.

That said, some studies show that ROE does correlate well with stock price over five to 10 years or longer. One explanation is that a good management team consistently creating value for shareholders will eventually be reflected in the stock price regardless of short-term market fluctuations.

Bottom line: I would give ROE a cautious thumbs-up as a long-term indicator of management competence. If you're using the figure to screen for a hot momentum play, however, you had better think again.

Fire Sales, and Expense

When a company with substantial long-term debt is losing or has lost its profitability and is having difficulty paying its quarterly interest payments, are asset sales continually allowed in which the proceeds simply are consumed, enabling short-term survival while depleting the balance sheet and bondholders' collateral? Barry Tranckino

Barry:

As far as I know, it can and does happen. Selling off assets to service debt, however, is sure to draw the attention of stock analysts and bond-rating services. Expect stock and bond prices to both plummet on the discovery.

Often, though, the company will already be in bankruptcy by the time things get to the liquidation stage. Consequently, the bondholders will essentially be running the show anyway to salvage what they can from the wreckage.

Often, bondholders write in covenants to their contract at the time of a debt issue (especially in cases of high-yield -- read junk -- offerings) requiring management to maintain certain policies and coverage ratios under severe penalty. As long as the firm sticks to the covenants, they're free to manage the biz as they see fit. Break the deal, however, and bondholders will be pounding down the door faster than you can say Chapter 11.

Committed for the Long Term

I have been invested in the "four pillars" of the Nasdaq (Microsoft (MSFT) - Get Report, Intel (INTC) - Get Report, Cisco (CSCO) - Get Report and Dell (DELL) - Get Report) for many years. I am used to and accept their volatility and so far have never been scared out of these stocks, even when they undergo 40% price declines. I know this is a "high-risk" strategy of concentrating all of your portfolio in one sector and just four stocks, but it has worked extremely well for me over the years. What does worry me, however, is when the P/Es on these stocks get to the 60s while their earnings growth rates are half of that or less. Conventional wisdom says the stock price is ahead of the company and the stock is overvalued. My question is so what? Should a long-term investor sell under this scenario and one, experience a huge taxable capital gain, and two, be out of a very fine company that is growing much faster than the vast majority of companies? I've never been able to bring myself to sell just because of a high P/E. Can you explain why it makes sense to get out of these great companies because they are overvalued? Don't you run a huge risk of reinvesting your profits in companies that will not do nearly as well as these great companies in the long term? Thanks, Bob Lindinger

Bob:

Frankly, I can't explain why you should sell these stocks (at least in your case, as you've described it to me). I could give you the whole broker spiel, grounded in theoretical doctrine a la Ben Graham, about selling overvalued stocks and buying them back on dips. Unfortunately, I'd also be ignoring several real-world complications like taxes, imperfect information, and transaction costs, simply to generate a few year-end commission dollars.

To me, it sounds like (a) you fully understand and are comfortable with the risks inherent with concentrating your wealth in a handful of tech stocks, and (b) you're truly committed for the long term.

Just ask yourself this: If you won the Publisher's Clearinghouse Sweepstakes tomorrow, would you be willing to buy more shares of these stocks at their current prices? If the answer is yes, then let 'em ride! Who cares about near-term valuations if you're looking to cash in five to 10 years down the road or longer?

Nasdaq Changes

Would someone on the staff please calculate the P/E ratio of the Nasdaq 100 now that AMZN has been added to the index and report the results to your subscribers. Thanks Larry Kimble

Larry:

While I could certainly spend a few hours running the numbers, I was hoping that one of our readers could provide a more elegant solution. (I can tell you, however, that the P/E will be roughly the same as before

Amazon.com

(AMZN) - Get Report

was added since its weight is only about a quarter of a percent of the total.) So if anyone knows where we can look up the average P/E ratio for various indexes, including the Nasdaq 100, please

e-mail

me here. Next time, I'll post the results along with a technical explanation of the "New" Nasdaq 100 index that went live on Dec. 18, along with the latest additions to the portfolio.

Andrew Greta is a business student and onetime stockbroker who lives in West Lafayette, Ind.