In my last post, I focused on the companies that were likely to have the most sustainable competitive advantage by sorting a list of my favorite companies by return on equity. In this post, I will apply a few simple calculations to see which companies are likely to offer the best value and then create a short list for further analysis.
The calculated fields that I have added to my list include the 52-week low price to earnings ratio (P/E), the 52-week high P/E ratio, the current P/E ratio, the full price, and the current percent of full value. The price to earnings ratio is a fairly typical valuation metric. It’s quick, it’s easy, and it can be a little misleading at times. However, it’s a nice place to start.
One thing worth noting is the wide range between the 52-week lows and the 52-week highs and their respective P/E ratios. Does it really make sense that the range of prices for a company like Starbucks would range between $42 and $64 in a year with the respective P/E ratio fluctuating between 24 and 36? Disney is a fairly stable company, but it has traded between $86 and and $120 per share. As investors, we hope to exploit these opportunities to sell when the market misprices a stock on the high side and buy when there is a mispricing on the low side.
P/E ratios are fairly easy to understand, but I should probably explain what I mean by full price. Typically when I develop a valuation of a company, it ends up landing at two times the earnings growth rate. For example, a full valuation of Starbucks will likely land at two times their earnings growth rate of 18.7%. Two times this rate (and times 100) is 37.4. At a full valuation, Starbucks would trade at 37.4 times earnings, which would put the price at $66.57 per share. A lot of work has to be done to determine if Starbucks can really grow at 18.7%, but analysts are projecting growth in this range, and for now we are just looking to build a list for future research. Below is my list of companies sorted by the greatest discount to full price.
There are likely some anomalies here. The most obvious is Southwest Airlines. I don’t know that it will ever trade at 28 times earnings, especially at the market top. This is a cyclical company that would only likely trade at this strong of a P/E ratio at a market bottom with anticipation for a recovery. Now is not the time.
I tend to favor companies that have better earnings growth prospects. I am looking at Skechers appearing at the top of the list, and Marriott and TD Ameritrade surprise me as well. There are some strong companies trading at decent discounts.
The Short List
In creating my short list of stocks for further research, I want to take a close look at companies with high returns on equity that also are trading at a discount to what could be considered a full price. I am definitely interested in every company on the list that has favorable long-term growth prospects that also produces high returns on equity, but for now I want to prioritize them based on their valuation and work my way down the list.
Below is my unscientific list for further research. It contains the fields of return on equity, 5-year projected growth, and potential discount to full price.
I kept Southwest Airlines on here, though it probably won’t be the first one I look at. Skechers really jumps out at me, with the potential to be 37% of their full price. I’m really focused on the companies with double digit earnings growth and strong returns on equity. TD Ameritrade will also get my attention, though I have not taken a close look at their industry. Disney, Starbucks, and Google (Alphabet) are all solid companies. Marriott also surprises me and may be fairly easy to understand. I know they are in the midst of a very big acquisition that may be holding down their share price.
I look forward to digging in to some of these companies to determine what they are worth and if they will make good investments.
Disclosure: I already hold many of the stocks mentioned in this post.