MDP

Understanding the true intrinsic value of a company is very important when attempting to identify and take advantage of mispriced securities. The Applied Finance Group (AFG) has proven to be successful at helping their clients find attractive investment opportunities and also help avoid potential torpedo stocks by utilizing their Economic Margin Framework. AFG’s Economic Margin (EM) is the measure of the true economic profitability a company is earning after several adjustments to eliminate distortions caused by traditional accounting practices. Understanding a company’s EM levels and expected changes in EMs is important as it has been proven through vigorous back-tests that a company’s expected change in EMs is highly correlated with the company’s future market performance. Companies expected to improve their EM’s have proven to be more likely to outperform than those companies with declining EMs.

Source (The Applied Finance Group)

When analysts and market pundits come on tv to talk about stock picks, they usually talk about the "P/E" ratio (Price to Earnings) being attractive.  However if you're investing in stocks and you only look at the "P/E" ratio, you might be walking into a "Value Trap".  Investors ignore half the valuation picture when investors only concentrate on P/E as investors also need to consider the growth potential of the company and what investments are needed to get the earnings.  The Applied Finance Group (AFG) has developed a process that incorporates these factors easily into the valuation framework.  Using AFG’s Valuation Metric, we have compiled a list of 20 companies with low P/E, 10 of which we consider attractive investments, and 10 of which we consider Value Traps.

By using AFG's Economic Margin framework instead of earnings alone, investors capture the true net cash flow the entire firm is generating. It is not uncommon for companies to grow P/E while having declining EM’s. This occurs when the cost for the investment required to yield the increasing P/E is more than the cash flow generated from the investment. By analyzing a company’s EMs through time, investors gain a more accurate account of levels and changes in a company’s current profitability and value.

If earnings are a true proxy for performance, there should be a correlation between a company growing earnings and its price to earnings ratio. As a surprise to many investors, there is actually little to no correlation between earnings growth and price to earnings ratios (see chart below).
 

P/E is determined by taking a stock’s price and dividing it by the last four quarter’s worth of earnings. P/E alone should not be used to value companies. P/E does not look at a company’s balance sheet thus we do not know what the costs of generating those earnings. While the P/E is determined by looking at a company’s past performance, EM bases a company’s value off its future projections. By using EM, an investor can know how their stocks are likely to perform, allowing them to clearly evaluate where to invest.

Successful companies measure results, make decisions and set strategy with the goal of creating value. A company’s performance measures must serve as a proxy for its market value creation. While important, S-T Earnings alone are a poor indicator of a company’s value, due to what they do not measure.
 

Economic Margin is a more complete performance measure for companies to use to guide performance and motivate employees. Executives consider Cash Flow, Investment, Competition & Risk when setting strategy. The above charts show that investors do the same.

AFG's Valuation Metric – Measures the percent to target (deviation between a stock’s current trading price and its AFG current default target price). To derive the intrinsic value of a firm, AFG uses its proprietary Valuation Model (modified discounted cash flow model).

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.

Investment Insights from your peers, Professional Investors - The Applied Finance Group would like to invite professional investors to join AFG’s Market Forecast Project so you can better understand what your peers currently think about the market and cultivate the “wisdom of Crowds” into actionable investment ideas and themes. 
Click here to learn more

Since March 9, 2009, the S&P 500 experienced quite a recovery, going from 676 to 813, or just over a 17% rebound. To put that into perspective, the market historically delivered 8% average annual returns. In the table below we provide a list of the top and bottom 10 performers since the March 9th rebound began, to give you an idea of who the new Bulls and Bears are. In the list you will find each company’s attractiveness from a valuation standpoint, as well as an analysis of sales growth expectations imbedded in these companies’ stock prices. Compare the expectations for sales growth to what they have delivered historically to see which stocks on this list are most likely to meet or exceed those expectations, and thus be more likely to out-perform. This list contains companies from the S&P 500 excluding all financial companies.

Top & Bottom Returns (S&P 500 excluding financials) Since March 9, 2009

*Scott Goto Arts

*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.

In Joel Greenblatt’s 2006 book, The Little Blue Book that Beats the Market, he presented his “Magic Formula” used in his hedge fund, Gotham Capital. Mr Greenblatt tested his formula between 1988 and 2004. The results were incredible, with only one down year, the magic portfolio would have returned 30.8% a year, against a 12.4% annual return for the S&P 500.

Mr. Greenblatt was a student of both Ben Graham and Warren Buffet and tried to include valuable insights from each investor in his “Magic Formula.” His Magic Formula was a screen that percentile ranked two variables: Return on Invested Capital (quality) and Earnings Yield (valuation). The idea is simple, buy the best companies at the best price. He also recommends one year holding periods, so we thought this would be a great time to get this list out. The Little Blue Book recommends selecting the top 30 firms from the “Magic Formula.” That formula ranks each company by variable and then puts a 50% weight on each. Below is a definition of each variable.

Variable 1: Return on Invested Capital = EBIT / (Net Working Capital + Net Fixed assets)

Variable 2: Earnings Yield = EBIT/EV

The table below shows the top 30 firms with their market implied sales growth expectations. Enjoy!