ESV

Traditional Discounted Cash Flow (DCF) models have been been underutilized in equity analysis over the years primarily because of the assumptions one has to sign off on. We will concentrate on just two of the major issues we have with traditional DCF models, the lack of ability to deal with competition and the perpetuity assumption embedded in a DCF model. These assumptions lead to irrational calculations of intrinsic value and force analysts to make compromising decisions in their model building efforts.

AFG uses a modified DCF model that accurately addresses the competitive nature of the business while also dealing with the perpetuity issue through our Economic Margin decay or competitive advantage period.

The four factors that affect AFG’s Competitive Advantage Period (CAP) are;

Profitability – High Profit leads to increased competition and a higher decay rate
Variability – Higher volatility leads to less predictability and a higher decay rate
Trend – AFG gives the benefit of the doubt to an upward trend which leads to a lower decay rate
Invested Capital – Large Invested Capital creates barriers to entry and leads to lower decay rate

The Decay Rate is the rate at which the Economic Margins™ will diminish over time due to competition, market conditions and limited investment opportunities. Higher decay rates translate into shorter competitive advantage periods, while lower decay rates translate into longer competitive advantage periods.

The Decay Rate profile is downward sloping to the right, which means that Economic Margins™ over time diminish to zero. This does not mean that the company will not have earnings, but instead the company will have an Economic Margin™ of zero, which indicates there are no excess profits after the investors are paid and the depreciating assets are replaced.When selecting securities, companies that are maintaining a high level of economic profitability or growing their profits rapidly are attractive from an investment standpoint. However, the more profitable a firm is the more likely other companies will attempt compete away excess returns.

To illustrate this, one has to look no further than Dell Computer. Dell Computer had Economic Margins™ hovering around 40% (top 5% of all companies) in 1997 and 1998, but soon every major firm was announcing that they were going to build computers to order. Why? Because they saw the huge profits that Dell was making. The result is that Dell's Economic Margin™ for 1999 was around 25%, a decline of 37.5% in just one year. The remaining factors are relatively straight-forward, in that volatile returns are worth less than consistent returns, companies with an increasing Economic Margins™ are worth more than a company in decline, and large companies have a natural barrier to entry, thus a lower decay rate.

Theory: Excess return gets competed away

Fact: In 1997, the median top decile Economic Margin (EM) firm = 17.4%. 10 years later, that same group of companies had a median EM of 6.5%. On the other hand, the bottom decile had an EM of -12.2%, 10 years later that same group had a median EM of -1.0%.

Current Top Decile Economic Margin Companies (S&P 500 ex. financials)

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Here are the 10 best and 10 worst performing stocks in the S&P 500 for the month of May excluding financials. We have provided the returns achieved by each firm during the month of May (5-1-09 to 5-28-09) along with a look at the valuation attractiveness of each of these firms going forward.

May Biggest Movers In S&P 500 (Ex. Financials)

AFG's default valuation is a great place to start when looking for potential equity investments as our valuation techniques have proven successful through time at identifying mispriced securities and helping our clients identify investment opportunities resulting in outperforming their chosen benchmark.

AFG's Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers. AFG's Value Score - A score which represents the ranked percent to target (deviation between stock’s current trading price and AFG’s current default target price) or attractiveness (upside) relative to the universe. A Value Score of 100 is the most undervalued and 0 is the most overvalued company in the universe.

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The Halloween Indicator in the stock market sometimes defined as “sell in May and go away” is a strategy that is based on the difference in the performance of the market during May to October vs. November to April. The strategy is to invest in the S&P 500 during “the best 6 months” and switch to bonds during “the worst 6 months” to avoid the summer doldrums of small to negative returns. Since January of 1950 the average returns for November to April “good months” is 7.9% compared to the 2.5% average return delivered from May to October ‘bad months”.

Although there is a significant spread in returns between the good and bad months, does this mean you should convert to bonds and go on a vacation until September? There are several views for and against market timing but we feel it is too difficult to identify when to be out and when to be in the market. If you dig deeper into the market performance since 1950, you will find that 20 good and 20 bad months make up a significant part of the market performance. For more information read the following market timing strategy filled with pitfalls.

The market has been up in those worst 6 months 60% of the time since 1989, not as profitable as the best 6 months but still positive. I believe 2009 is a good lesson for many, with all of the inefficiencies and irregularities in today’s market, the mixed macro economic reports, and the belief we are headed toward a recovery, jumping out of the market could mean missing out on making up for some of the losses the market handed us in 2008

However, being invested isn’t enough, identifying quality companies and a good value will put you in an even better position to outpace the general market. Listed below are companies that should be considered as potential investment opportunities. These companies all have a valuation attractiveness near the top of their sector in addition to expected improvement of profitability (Economic Margin) above their sector, and do not follow a wealth destroying strategy defined by AFG’s management quality score.

Attractive companies to consider in each sector instead of selling in may and going away

A brief description of AFG's buy criteria variables is below:
• Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.• Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers.• Management Quality – Assess management’s ability to make wealth creating decisions.

 

By using The Applied Finance Group’s (AFG's) Risk Analysis, we have identified the top and bottom two firms in each sector (excluding the Financial sector) according to an overall risk score based on 9 variables (see more detail below). In addition to the risk analysis variables we also added another layer of analysis by evaluating the companies’ Earnings Quality (based on the concept of Accruals) and Altman Z-Score (identifies firms that are at risk of going bankrupt in the next 2 years).

Applied Finance Group’s Risk Analysis is designed to systematically calculate a stock’s risk score based on fundamental relationships between the Quarterly Income Statements and Balance Sheets. The template measures 9 factors to determine Risk: Changes in A/R, Changes in Inventories, Cash Flow vs. Operating Cash Flow, Fixed Payments vs. Pre-Tax Cash Flow, Leverage, Intangibles, Write-offs, Management Quality, and Valuation. Companies with lower scores have less risk. Companies in the Financial Sector were excluded due to their differences in financial statement structure.
 

1. Receivables to Sales - Delta – takes the difference in the median A/R to Sales ratio over the last 4 quarters vs. median 4 quarters before that.

2. Inventories to Sales - Delta – takes the difference in the median Inventories to Sales ratio over the last 4 quarters vs. median 4 quarters before that.

3. AFG’s Cash Flow-Oper. vs. Operating Cash Flow - AFG's Cash Flow-Oper. for a company is net cash that is generated by the continuing and discontinuing operations of the firm. We compare it to the company's Operating Cash Flow to assess its ability to pay its debt.

4. Fixed Payments vs. Pre-tax Payments Cash Flow – This ratio assesses the company’s ability to cover long-term obligations. If the fixed pmts are greater than 50% of the pre-tax payments cash flow, there is chance that this company may not be able to meet its obligations. Obligations less than 30% of cash flow are considered safe.

5. Leverage – Book leverage and Market leverage are analyzed to give us information about the company’s leverage position. Best score is given to the companies with Book Leverage lower than 60%, and negative score to these with Book Leverage higher than 60% and Market Leverage greater than 0.9*Book Leverage.

6. Intangibles as a Percentage of Total Assets – With this score we try to filter through and reward the companies that have grown organically, rather than through acquisitions. Our research has shown that on average companies tend to overpay for acquisitions and thus are rarely a profitable investment. Companies with Intangibles less than 20% of Total Assets get the best score.

7. Write-offs – Shows the number of years with significant write-offs over the last 5 years.

8. Management Quality – Measures a company’s EM+1 and LFY Asset Growth and there is empirical evidence that companies with positive EMs that are able to grow their business tend to outperform companies with negative EMs who continue to invest into unprofitable business.

9. Value Score – Measures a company’s attractiveness from valuation perspective.

Most/Least Risky Firms By Sector S&P 500 (excluding financials)

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In our March Monthly Market Review we released a series of graphs representing the valuation attractiveness of each sector relative to its historical norms and to the entire AFG universe. Below is a graph representing the Capital Goods sector which is attractively priced when you compare against its historical trading ranges (red line) and when comparing against the overall AFG Universe (represented by the value of 1). Only in 1998 has the sector looked more attractive since our valuation tracking started in 1996. Listed are 10 companies in the Capital Goods sector that meet AFG’s Buy Criteria and look attractive from a valuation standpoint. Also listed below the graphs are an explanation of AFG’s Buy Criteria and AFG’s Percent to Target Charts.

Capital Goods Relative Valuation Chart

10 Capital Goods Companies (S&P 500) With Attractive Valuations

Percent to Target Chart -This graph shows the Percent to Target Current (Valuation Attractiveness) for a universe relative to the overall market. Values greater than 1 indicate the universe is more undervalued than the market, while values less than 1 indicate the opposite. The red line identifies the historical median value to provide a basis to understand valuation levels relative to historic norms. This example illustrates that the median Large Cap company is undervalued relative to the market currently and has been trading at a discount to its historic relative valuation, indicating a potentially attractive opportunity.

A brief description of The Applied Finance Group's Buy Criteria variables is below:

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.

Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers.

Management Quality – Assess management’s ability to make wealth creating decisions.

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Earlier in the week we highlighted the most attractive style and sector universes from our Monthly Market Review. As a follow up to that article we are providing a list of the 10 most undervalued stocks in the S&P500. All companies listed met The Applied Finance Group's (AFG's) Buy screen (criteria explained below) and are in the bottom half of their sector in Market Value/Invested Capital (MV/IC) which by definition qualifies the companies as part of the AFG Value Universe.

 10 Most Undervalued Stocks In The S&P500

When identifying buy ideas AFG looks for companies with the most valuation upside compared to their sector peers, above sector median expected Economic Margin change, and a management quality score that reflects a management team following a wealth creating strategy.

A brief description of AFG'sbuy criteria variables is below:

Economic Margin - A corporate performance measurement that addresses the gaps in GAAP, eliminating distortions caused by accounting policies to measure what a company is truly earning above or below their cost of capital.

Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to it's peers.

Management Quality – Assess management’s ability to make wealth creating decisions.

Value Universe: Companies in the AFG universe, which have MVIC at the bottom 50% of the
universe and have EPS estimates.

Market Value/Invested Capital - The firm's average total equity, debt and other obligations divided by net invested capital

*AFG’s Value Expectation allows us to understand the imbedded Sales Growth, EBITDA Margins, and Asset Turnovers a company has to deliver in the future to justify its current trading price. In theory and in normal circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued. The table displays the implied future sales growth of companies assuming their EBITDA margins and Asset turnovers stay at the 5 year median levels.

Recent Market Review:  Obama, the Budget and the “Un” Stimulus package

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There are many ways professional equity investors use to narrow their list of investment constituents; by size, value, growth, sales growth, earnings growth, etc. When ValueExpectations.com looks for investment opportunities or to avoid potential torpedoes, we start with a focus on accessing Valuation, Corporate Performance (Economic Margin), and Management Quality of companies. These variables have proven very successful in finding winners and avoiding losers in different market caps, different styles, and different economic sectors, helping professional investors make sound stock selections in the past 13 years. These and many other proprietary variables can be screened on Applied Finance Group’s (AFG’s) institutional product www.AFGView.com.

Enjoying an accomplished methodology and process of selecting stocks doesn’t prevent us from learning how other people are identifying their fishing pool. We recently came across SA Editor Eli Hoffman's recommended list of stocks based on a set of variables that , he believes benefit both growth and value investors as these companies contain characteristics both investors will find attractive. These stocks were identified by what the author calls “a powerful screen and helps find strong companies at great values”.

Eli Hoffman's screen includes the following criteria:

• Only companies identified as Buys by Zack’s
• Companies with the highest 5 year historical earnings growth rates (top 20% all Zack’s Buy Rec.)
• Lowest P/E ratio (bottom 20% all Zack’s Buy Rec.)
• Trading over $5 a share
• 10 day avg. share volume of 50,000 shares or more

As the AFG methodology has also proven effective in identifying attractive stocks regardless of their Growth or Value characteristics, we thought it would be interesting to check the valuation attractiveness of Mr Hoffman’s stocks via AFG’s Value Expectation application. AFG’s Value Expectation allows us to understand the imbedded Sales Growth, EBITDA Margins, and Asset Turnovers a company has to deliver in the future to justify its current trading price. In theory and in normal circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued. The following table displays the implied future sales growth of Mr Hoffman’s companies assuming their EBITDA margins and Asset turnovers stay at the 5 year median levels.

Companies recommended by Mr Hoffman appear to have pessimistic future sales growth implied by their current stock prices, when compared to their historical sales growth, and appear to be undervalued from AFG’s valuation perspective. Before making a wise investment decision, however, we also need to understand a company’s corporate performance (Economic Margin), management quality, competitive advantages and valuation attractiveness relative to its industry and sector peers. AFG’s institutional product helps investors to gain considerable insight regarding those aspects through its proprietary framework and we will provide a detailed tutorial of this process next week. 

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In life, the most attractive people are in shape and have good looks, just look at Hollywood. The same is true the majority of the time in investing. The most attractive stocks have healthy financial statements and look good from a valuation standpoint.

The Altman Z-score is a metric that gives insights into the likelihood of a firm going bankrupt in the next 2 years. The model was developed by Professor Edward I. Altman of the NYU’s Stern School of Business and first published in The Journal of FINANCE in September 1968. A common critique to this metric is that it was developed over 40 years ago and is no longer relevant.

In 2001, Professor Joseph D. Piotroski of The University of Chicago Graduate School of Business, published a paper called, Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers. Piotroski showed that value investors were rewarded by looking at a firm’s financial health and he showed that Z-score was a meaningful statistic.
More recently, on December 5, 2008, Dr. Altman was called to testify before a House of Representatives Committee on the condition of U.S. Automakers. In his testimony, he noted that Bloomberg, Inc. reported, “that approximately 1,000 users of their system per day access the Altman Z-Score model.”

The Altman Z-Score breaks down firms into 3 zones:
• >2.99 – Not Likely to Go Bankrupt
• 1.8 - 2.99 – Gray Area
• <1.8 – Likely to Go Bankrupt in the Next 2 Years

Using AFGView.com, we screened for firms that looked relatively attractive from a valuation perspective and had an Altman Z-Score above 2.99. Below is a list of those firms. Later we will look at firms that are expensive and have a Z-Score below 1.8.

Sales Expectations for Companies with an Attractive Valuation and Healthy Balance Sheet

BusinessWeek.com asked some fund managers which stocks they believe will rebound in 2009 and below is a list of those companies, their 2008 share performance along with the sales growth expectations priced-in in order to justify the current price. These companies were all severely punished and many overly-punished by the many negative things going on in the market/economy in 2008. Whether it be oil stocks suffering from the drastic drop in oil prices, share prices of coal stocks dropping due to fears of increased government regulations, industrial firms hurting from a huge worldwide slowdown in building or any other 2008 market over-reactions, many of the firms listed here could recover huge losses from 2008. If you think a firm on this list has been un-fairly punished by the market in 2008 and has low expectations for growing their sales compared to what they have delivered in sales growth the last 5 years, those are the firms that may be worthy of consideration as a possible investment opportunity.