This week’s decision by Australia’s Reserve Bank to keep the cash rate on hold at 4.1% underlines that the period of central bank rate rises in high income economies are close to the end, which is potentially good news for equities markets. Remember that the cash rate was close to zero only 12 months ago. It must be remembered that the absolute level of interest rates is higher than had been anticipated at any time in the past decade. This will be good for some equities, but not all. If a company’s profitability or growth is still at least three years out, investors are not going to give the stock any credit. Needless to say, stock picking is paramount.

In theory, if you take away the fear of interest rate rises, that allows you to value with more confidence, businesses that are making money today. This leads to a re-rating upwards of stocks that have been neglected, but which make money and just as important, return some of that to shareholders, while maintaining growth.

What we’re not going to see, is a return to the go-go days of ultra-low interest rates, where investors paid for growth at any price. Now we are back to growth at a reasonable price, and a return to investment rewards based firmly on fundamentals, namely, growing earnings, or at least a line of sight to earnings, positive cash flow and a strong balance sheet that ensures equity capital raisings are only for growth.

Our value based philosophy of investing in such companies, subject to their price, is well suited to this environment. Last week (Issue 132) we delivered six practical tips on utilising the Blue Chip Value Portfolio. To remind, these were: note sector weightings; look closely at valuations; be proactive and act on signals; note our value bias and what that means; take account of volatility; and use Blue Chips for income and Small Caps for growth.

This issue, we focus on the value aspect of the equation and how we come up with our price targets. This enables you to understand the basis upon which we are making our calls. We don’t always get them right, but utilising a diversified approach of owning more than 12 stocks, combined with a focus on fundamentals, ensures that you can sleep at night, while your portfolio is being put to work.

If you are interested in learning more about Blue Chip Stocks and how to invest in this area, read more here.

BLUE CHIP PRICE TARGETS ARE BASED ON TWO MODELS

The Blue Chip Value methodology uses two models:
1. Dividend discount model
2. Earnings discount model

Both utilises a company’s fundamentals and consensus forecasts for future earnings and dividend payments. They are based on long-standing and validated valuation theory principles.

THE MODELS EXPLAINED

The first one, the dividend discount model is the one upon which all equity discount models are based. This is because historically when investors buy stocks they are most often purchasing a stream of expected future dividends, as well as the price they sell it for at the end of a period.

THE DIVIDEND DISCOUNT MODEL

This is simply the valuation of those expected dividends, plus an expected price at the end of the holding period. Since the expected price is determined by future dividends, the value of the stock in the present value of the dividends into perpetuity.

INPUTS

The model uses the consensus estimates for those forecast dividends. Because these stocks are covered by many analysts (unlike Small Caps) these consensus estimates are a reliable guide. The model also uses an estimate for long-term growth in dividends, in order to reach the stock value (also known as the terminal value).

VALUING THE FUTURE

A present value of the future dividends is derived using a discount rate, which reflects the riskiness of the cashflows being discounted. This discount is also known as the required rate of return. If you were investing in a medical technology start-up, your return requirements would be greater than if were investing in a bank.

The discount is based on the 10 year bond rate plus a premium for investing in a stock times the riskiness of that stock compared to the overall market.

THE EQUITY DISCOUNT MODEL

This uses the same principles of discount rates but it substitutes earnings for dividends. It uses estimated forecast earnings and long-term growth rates for the projection of those earnings.

WHERE DOES THE PE AND OTHER EARNINGS MULTIPLES FIT IN?

In fact, commonly used multiples including the Price Earnings Ratio, the Enterprise Value to EBITDA and the Price to Book value multiples are all based on the principles underlying the earnings discount model. These valuation multiples are often preferred because they require less effort and can be calculated quickly.

All are looking at the current price of a stock versus its future earnings estimates. The EDM model adds long-term forecasts onto this, as well as an estimate for the discount rate. Again, these concepts are based on valuation theory.

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DDM WORKS FOR SOME STOCKS WHILE EDM WORKS FOR OTHERS

For some high dividend paying stocks like Transurban (TCL) and Sydney Airport (SYD), the dividend discount model is a better reflection of their valuation. While for others, like Flight Centre (FLT) and Macquarie Group (MQG) it is the earnings discount model.

WE CHOOSE THE CLOSEST TO THE CURRENT PRICE

The Blue Chip Value model generates two prices targets for each stock, then calculates the expected capital gain or loss. Then it chooses the one where there is the smallest price discrepancy. For example, based on the earnings discount model, TCL is 80% overvalued, while based on the dividend discount model it’s less than 10% overvalued. In this case we would choose the dividend discount model for our valuation.

IMPORTANT TO RECOGNISE THE MODEL’S LIMITATIONS

At times we don’t agree with the output of the model, whether it’s the DDM or the EDM. In these cases we will explain why when we cover it.

CASE STUDY

A good example is the wealth management group AMP Limited, which we covered last issue (Issue 132) rating it a buy at $1.14. Yet this price is only just below our $1.16 price target. What’s going on?

The answer is that we like the group’s intangible brand, which has existed for over 150 years. As we stay in our note, “great stocks can emerge from old companies and this might be one of them”. This hidden value that our analysts has seen is not included in the discounted cash flow based valuation.

THREE ATTRIBUTES BLUE CHIP VALUE LOOKS FOR IN A COMPANY

1. The company is not expensive on a Price to Book ratio. You are simply looking at the share price divided by the net assets per share. This methodology comes up with the same result as the simple PE or price earnings ratio, but is preferred because it is more easily comparable across industries. This involves some work because you are stripping out a lot of accounting related non-cash profits and expenses.

2. Strong operating profitability. Under the Radar focuses on cash flow return on assets because it’s similar to Return on Assets but is more focussed on cash flow. Once again we are stripping out the non-cash accounting related effects to get back to what a company is really getting as a return from its past investments.

3. At the big end of town Under the Radar avoids companies that are heavily reinvesting excess cash flow or free cash flow back into the business. We don’t like big “capex humps” coming up where a company is set to spend huge amounts on assets.

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