- The Washington Times - Friday, July 24, 2009

OPINION/ANALYSIS:

As earnings season associated with the recently completed June quarter heats up, the stock market, as measured by the S&P 500, has rebounded sharply since its early March lows. Even so, the market is down 25 percent compared to year-ago levels.

Looking at the rebound in the last few months and the position versus a year ago, more than a few people are likely beginning to wonder - is it time to get back in the market? It’s a great question and while I’ve talked about ways to diversify and play certain strategies via exchange-traded funds (ETFs) and other vehicles, one of the more basic sets of tools is looking at an individual stock to ascertain whether it’s a good company and a good investment. By good investment, I mean: is there sufficient upside in the share price to offset potential risks that could drive the stock lower?

There are many companies that are good, solid companies that potential investors may like but their valuations may suggest their stocks are fully valued.

“Valuation”? Yep, “valuation.” It’s not some secret code or arcane methodology but rather a framework used to determine the value of a stock (and other securities as well) using several tools in our investment arsenal. For the most part, these tools rely on pretty basic math that you can do with a calculator, paper, and if you’re like me, a pencil rather than a pen.

Examples of these tools include price-to-earnings (P/E) ratios on both a historical and relative basis, discounted cash flows, dividend yield, enterprise value (EV) to revenue or EV to earnings before interest tax, depreciation and amortization (EBITDA) multiples. To keep things simple, I’ll focus on P/E ratios. For those looking to understand these other tools and metrics, I’d recommend perusing either “Investment Valuation” by Aswath Damodaran or “Valuation: Measuring and Managing the Value of Companies,” by Tom Copeland, Tim Koller and Jack Murrin.

A P/E ratio is calculated by dividing a company’s share price by its earnings per share (EPS) on either a trailing basis or forward expectations. My preference is to use the forward earnings per share, which can be found in a number of places. One of the more convenient is at finance.yahoo.com. For example, as I write this, the S&P 500 is at 954 and forward earnings per share forecasts are $54.19 for 2009 and $68.48 for 2010 compared to $65.47 in 2008. After some quick calculations, we see the corresponding P/E ratios are 17.6x for 2009 and 13.9x for 2010. While we have the pencil and paper at the ready, I’d point out the earnings growth in 2010 over 2009 is 26.4 percent.

Now, as I have pointed out in prior columns, we need more than one piece of data in order to have context and understanding. That is what the P/E ratio for the S&P 500 gives us - a benchmark for the overall stock market. As such, we can analyze other companies’ P/E ratios and earnings growth rates relative to the market. In a perfect world, we would want to look at companies that have faster earnings growth than the overall market and P/E ratios that are below those for the market. For example, a company that is expected to generate 30 percent earnings growth in 2010 and is trading at 15x 2010 earnings per share is one that we should potentially put under the microscope.

Uncovering these opportunities is not always easy. Sometimes when we do find potential opportunities, we have to be wary of any potential pitfalls. Pitfalls could be issues on the balance sheet or the discontinuation of a product or customer loss. This is where the homework begins and often means reading up on a company including its press releases, financial filings over at www.sec.gov, and pretty much whatever you can get your hands on.

Once we have compared the chosen company to the market, we next have to compare it to other companies that serve the same end markets and/or offer similar products. This gives rise to what we call a relative P/E valuation using a peer group or group of comparable companies. After all, it makes little sense to compare a supplier of mobile phone semiconductors with a company that offers underwear and lingerie.

There are several ways to identify a company’s competitors that we would use to build this peer valuation, from finance.yahoo.com to finance.google.com to the competition section in a company’s 10K filings with the SEC and other services like Hoover’s. Once we’ve calculated each company’s P/E ratios and earnings growth rates, we want to see how the company we are analyzing and interested in potentially buying shares of is doing relative to average metrics for the assembled peer group. Again, in a perfect world we would prefer to be scrutinizing companies with faster earnings growth and cheaper ratios, but we need to be wary for those pitfalls here as well.

This is hardly the complete methodology for using P/E ratios to look at stocks, and I have to say I am far more a fan of using several valuation tools to triangulate the upside as well as the downside in a company’s share price to better determine the potential reward and risk. Perhaps, more for future columns?

That said, one example is a company I have been writing about lately - InterDigital, a licensing and technology company that serves the mobile phone market. The company is expected to deliver EPS of $1.57 in 2009 growing 54 percent to $2.42. With the company stock at 27.59, its respective P/E ratios for 2009 and 2010 are 17.8x and 11.4x, respectively. InterDigital has a solid balance sheet characterized by a strong net cash position and its business has it benefiting from the shift toward smartphones and 3G wireless technology. Its peer group is trading at 18.8x and 20.2x 2009 and 2010 earnings, respectively. In my view, the company’s stock warrants a much closer look.

If any of you have suggestions for future topics, I can be reached at the e-mail address below.

Chris Versace is the director of research at Think 20/20 LLC, an independent research and corporate access firm based in Reston. He can be reached at cversace@washingtontimes.com. At the time of publication, Mr. Versace had no positions in companies mentioned. However, positions can change.

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