(This content was originally published as an Action Alerts PLUS Alert on May 25, 2016. Stock prices, shares held and portfolio positions may have changed.)
We recently received a question in the Forum on how we determine price targets and the timeframe used. Although we will be publishing a summary of our response in the Forum, we wanted to devote a more comprehensive bulletin to covering what is a frequently referenced, yet rarely discussed, topic.
First, our timeframe for setting price targets is generally eight to 12 months, minimum. From a fundamental level it is very difficult -- if not impossible -- to pinpoint how and where a stock will trade over a three-month timeframe, as market conditions, sector sentiment, and technical trends take center stage.
Since fundamental investors cannot predict when values of stocks will rise or fall, we think it is important to take a conservative and longer-term approach to analyzing, developing and setting our price targets. We do trade around our holdings from time to time, and discuss our shorter-term directional views on shares, when:
1. they approach our price target;
2. they fall sharply despite intact fundamentals, creating an attractive risk/reward ratio; or
3. fundamentals/facts have altered the underlying story for the worse, which in turn changes our investment thesis and lowers our valuation/price target.
We invest in stocks of companies that are trading at a discount to what we consider to be their fair value. We attempt to simplify fair value by using a price to earnings (P/E) multiple on projected earnings estimates. When we decide to buy a stock, the purchase price reflects what we are willing to pay for a share of the company's future earnings stream and, when applicable, dividend payments. Valuing a company is an art, not a science. Anyone who says otherwise is lying.
Instead of trying to pinpoint one number when we value a stock price, we come up with a range of values, which force us to consider the downside risk as well as upside opportunities. The factors that influence a stock's valuation include its expected growth rate, earnings visibility, dividend yield, and financial health.
Any attempt to calculate a company's future growth rate relies on assumptions. While past earnings growth can be useful as an indicator of future earnings, what ultimately matters is whether it will continue at the same rate. Studying the company, its industry, its competitive position, the nature of its business, the products it sells, the concentration of end markets (customers and regions) and so on, all shape our forward earnings and growth estimates.
Just because a company is growing -- and looks poised to continue growing -- at a fast clip, that doesn't mean that it deserves to trade at a wild premium. New, trendy, fast-growing companies with limited earnings histories often experience greater earnings volatility. Since this makes future-growth projections less reliable, the multiple an investor applies to its estimated future earnings stream should be lower than a company with a proven, strong and consistent track record.
Companies with a long earnings history that have operated through full economic cycles (boom and bust, expansion and contraction) provide a greater degree of future-earnings visibility.
Bottom line: if a new company with limited earnings history is expected to grow at the same rate as a company with a more established financial history, the "blue chip" company should trade at a higher valuation.
Companies that pay out dividends also deserve to trade at a premium to an identical company that does not. This is because dividends provide investors with a tangible return. Similar to projecting earnings, it is easier to project dividends with a high degree of visibility for companies with a consistent track record of paying out and increasing dividends each year. Companies that fit this mould -- think Procter & Gamble (PG) as a stalwart example -- deserve to trade at a relative premium, as they are effectively an "equity bond."
Finally, a company's financial profile comes into play when it relates to risk. Key metrics include high return on equity (and return on invested capital), strong margins, robust free-cash-flow generation, and low leverage. Companies that boast strong financial profiles should trade at a premium to an identical company (expected to grow at the same rate) with a riskier financial profile (i.e. lower rate of returns, weak margins, high debt/leverage and limited cash flow generation). The worse a company's financial health, the more susceptible it is to falling apart during a financial downturn.
Once we ascribe an intrinsic value (or "price target") to a stock, we set a margin of safety by applying a discount to our price target. Developing an intrinsic value is the starting point; determining what price to buy a stock requires another step. Since making a price determination is highly subjective, the margin of safety provides room for error in the underlying assumptions and analysis (i.e. a cushion against errors in calculation, judgment, or unforeseen events).
The margin of safety implies the practice of buying an investment below its underlying valuation. Companies with limited earnings visibility and weaker financial health require a higher margin of safety.
For instance, consider the example of two companies in the same industry. Our intrinsic value/price target on Company A is $100, while our intrinsic value on Company B is $80. Company A is growing at a faster rate of growth than Company B, but it has limited earnings history, does not pay out a dividend, and has weaker financial health. We assign a 30% margin of safety to Company A, and a 12% margin of safety to Company B. This means that we are willing to pay $70 a share for Company A ($100 x 30% discount) and $70 a share for Company B ($80 x 12% discount).
Therefore, although Company B may offer less upside (12%, or $10 a share), the risk/reward is more balanced and earnings more reliable, making us comfortable buying the stock at or below $70 a share. Meanwhile, Company A may be growing at a faster clip, but its earnings are subject to more volatility and its financial profile is riskier. Even though it may appear to provide upside to our intrinsic value ($100) at $80 or even $90, we are only comfortable buying the stock if shares fall at or below $70 -- to account for greater subjectivity and higher risk.
The long and short of it is this: Our price targets reflect our long-term view of fundamentals. The price at which we purchase shares reflects the price target less the margin of safety. We prefer to take the long view with the expectation that, over time, the market will recognize the inefficiency between where shares are trading now and what their intrinsic value implies.