I spent the 1st day of this week’s forum discussing the front page of the SSG and the judgments that need to be made concerning future growth of the Co. Thus far, FDS looks like a quality Co. Now we go onto page 2 of the SSG and start by evaluating management.
Pre Tax Profit on Sales (PTM) is the 1st item. Immediately our eyes are drawn to the last 2 year’s figures compared to the last 5 year average; and the trend. The last 2 years are down compared to the last 5 year average and thus the trend is DOWN. This is not what we want to see, but I do not think it is toxic. The number for 2006 may be an outlier, and eliminating it results in an EVEN trend.
The same can be said for Return on Equity (ROE). The last 2 years are down compared to the last 5 year average. If I eliminate 2004, the trend is varying. (See slide 1)
With both of these trends, I think it is valid to compare FDS with the industry averages from VL. (See slide 2) We can see from the VL chart that FDS exceeds the industry averages making it a leader in this group.
There is much more information dealing with management in the ratio analyzer link at StockCentral and I suggest anyone studying a stock to purchase, review this data.
For FDS, because there is no debt that the Co. has acquired, the Liquidity ratios are very good. And because the Accounts Receivable are very small and it has no inventories, the Efficiency ratios also are very strong. Cash Flow ratios are showing some weakness in the most recent quarter, however, year end over year end, remain strong. (Check Reuters financial statements for FDS) Cash Flow for the most recent Qtr. increased 23% despite a larger Number of share options and bonuses given to employees as part of the Co.’s performance based compensation program. (Employees will receive a full bonus at the end of fiscal year 08 if subscription and earnings growth have risen by 20% in the past 2 fiscal years.) The Co. has been able to grow revenues, net income and cash flow at relatively equal rates. (See slide 3)
Profitability ratios remain strong with the exception of a 27% increase in the cost of sales. (This also relates to the CO. PBC program described above.) Asset and Inventory ratios also remain good.
From looking at the data relating to management, I believe the Co. executives are doing a good job and that FDS is a leader in it’s industry. I see no evidence of a “barbed wire fence”.
I believe that FDS is a quality Co. based on it’s strong, predictable and consistent growth of sales and earnings. (It went through a slower stretch during the last economic recession but fully rebounded.) It has a strong management team and leads the Information Services industry in ROE and Operating Margins. It’s financial statements are excellent and it is a small Co. with much potential growth. Our next task is to decide if the Co. offers enough value to purchase. If not, at what price will the stock of the Co. be of value?
We use section 3 and 4 of the SSG to answer these questions. When considering the purchase of shares of a growth Co., I initially look at the Price and Earnings tables-column A, B and C in section 3. The High and Low price and the EPS have all more than doubled in the past 5 years, confirming the Quality of the stock. The computer has averaged the past 5 year high and low PE figures. There are no obvious outliers noted with the exception of the low PE from 2003. (See slide 4) Rather than eliminating that figure as an outlier without any other thought, I think it is best to look at what happened to cause the PE to decrease. If I can not find any reason other than the normal fluctuation of the PE, I will eliminate that year and move on.
In most cases of a PE contraction, there is either a depression of the price of the stock (decreasing investor sentiment) or there is a spike in the earnings. Looking back at the 10 year history of earnings for FDS, I see that there was not an earnings spike. There was a decrease in the growth of sales (due to the recession at the time) which caused the price to fall, thus causing a fall in the PE. So I believe that the low PE from 2003 was due more to investor sentiment (probably related to a drop in sales growth) than to a spike in earnings. At the time, this was probably viewed as a negative change in the Co. fundamentals.
Looking at PERT B (See slide 5) we see that the low PE decreased in 2002 and 2003, again during the sales slowdown in the last economic recession. Could this happen again if the economy contracts? If you judge that the economy will not go into a recession, or you feel that the Co. is better positioned to grow in a recession, you may want to consider 2003 an outlier and use the 5 year PE averages with that year removed. Another judgment that needs to be made also comes from the PERT B data. In the 5 year average PE ratio chart, we see that the high PE is shrinking. It has fallen from 45.3 in 2002 to 31.6 in 2007. The question is “how low will it go?”
To help answer these questions, I often seek another opinion from other sources. I will start with VL. VL report gives future PE ratios. By dividing the future high and low prices by the future EPS you have VL’s predicted high and low PE. (See slide 6) The average VL PE is also offered and can be useful when looking at Relative Value and PAR value. (See slide 7)
Online Take Stock (available at StockCentral) offers historical PE values. The program averages, from the last 10 years of data, the 5 lowest high PE’s and uses that number as the high PE. In other words, it eliminates the high “outliers”. It does the same for the low PE: it averages, from the last 10 years of data, the 5 lowest low PE’s. (See slide 8) The program also will not allow a high PE above 30, or a low PE above 20. Doing this, the program keeps the PE ratios down, hoping to prevent the user from overestimating the future and overpaying for the stock. (Please refer to the Users Guide for Take Stock at StockCentral for a more complete description.)
So we have some choices concerning future PE ratios. If you feel that the Co. is heading for a slow down due to Economic contraction, you may want to lower your PE’s, especially the low PE. Otherwise, the 5 year average, Take Stock’s PE or VL’s future PE can be used. (See slide 9) Because of the risk of an economic contraction, and the fact that the 5 year average PEs have been going down, in my SSG, I used a high PE of 26 and a low of 16. (These are close to VL’s predicted future values.) The stocks recent low PE came on 3-17-08 when the price was $43.04 and the PE was 19.2.
Because I have chosen a growth rate that is low, the PEG will be very high. This is rather subjective, and done because I fear that the Co. sales and earnings will fall in the near future. In this scenario, I do not place a lot of value on the PEG because it is very subjective and looks bad due to my skittish outlook. (If I increased my growth judgment to 18% from 14%, the PEG would look much better.) I prefer to look at the PE RV. It is not subject to the same growth forecasts. The current PE and average PE are not affected by the forecast growth numbers. I agree with a prior presenter that a stock needs to be able to grow the EPS as well as the PE for really good gains in the price of the stock. Notice also that the current PE is higher than the average PE after judgment; it is below the 5 year average before judgment. (See slide 10) Also notice just to the right of the RV value, there is ACE4Q. The program is set to calculate the RV with future earnings growth from ACE rather than from my judgments. I usually use my judgments rather than those of ACE. My feeling is that ACE is more optimistic than my own judgments. (See slide 11) This can be done by going to the options tab and clicking “preferences” and SSG analysis
You may want to wait on purchase of shares until the current PE is at the level of, or below, the average PE. If you do that, your shares will likely grow at the same rate or better than the earnings of the Co. If you purchase shares of the Co. at a higher PE, and the PE decreases with time, your shares will not grow as fast as the Co. earnings. (Obviously, if investor sentiment increases, the PE will also and you will do better.) But if sentiment stays at the current level, PE will stay at the current level, and your shares will only grow as fast as earnings. It is for this reason that some investors prefer buying shares when the relative value of the PE is below or at 100. That way, the investor has a better chance for greater returns by growth of the earnings and the PE.
Another way to look at the RV is to consider the current and 5 year future price of the stock. Because we want the share price to double in 5 years, we compare the current price with the future price. Look at the PE with these numbers: if the purchase price is $52, we want it to climb to $104 in 5 years. Our future EPS is $4.22. If the Co. earns $4.22, for the price to get to $104, the PE will have to rise to 25. If the PE stays at the Co average (which I have chosen as 21 for the future) the price will go to $88.62. Here are the returns in the scenerio where the PE is 21 in 5 years: Price increase of $36.52 or 70%; Earnings increase of $1.98 or 88%. So the earnings went up 88% while the stock price only went up 70%. This is the risk of buying stock above the PE RV of 100.
Thus far, we have identified a quality Co. with good managers. I have applied conservative future estimates of growth as well as conservative future PE levels. In our next session, we will go through the zoning and risk and reward. |