Fool's Eye View

[ December 14, 2000 ]

Obvious and Immediate Value

By Maynard Paton (TMFMayn)

Carburton Street, London -- Have you lost money buying into tech stocks this year? Do you want to know why? Scant attention paid to "obvious and immediate value", probably.

There is a line of thinking that suggests investors are split into two groups – "value" or "growth". It's not true. All investors are (or should be) "value" investors. "Growth" is purely a factor in calculating that value. Here's an example of what I mean, using Baltimore Technologies (LSE: BLM).

Baltimore is a leading developer of Internet security software. Needless to say, Baltimore operates in a big growth market. With "investment value" in mind, the Foolish investor could take a conservative projection of the industry's growth, then estimate Baltimore's prospective market share, net margin and stock market rating to ultimately arrive at a potential valuation for the company.

Value anchor

The trouble with extrapolating the prospects for Baltimore, or any other company involved in an "industry of tomorrow", is that it's racked with uncertainty. Will the Internet security market growth live up to expectations? Will Baltimore gain that market share? Will Baltimore ever generate a suitable margin?

At the moment, Baltimore, a company that currently generates annualised revenues of £80m and losses of the same amount, is worth £2b. Does that offer value? I'm sure some investors will say today's £2b is cheap, given the explosive growth expected. But then again, some investors must have thought £4b was cheap, since the valuation rose to that level earlier in the year. But how on earth can the ordinary investor tell Baltimore is cheap or not?

Because the questions of potential are so difficult to answer, investors in "jam tomorrow" companies do tend to ignore the all-important point of investment value. In other words, it's a case of long-term buy and hope.

However, the investment danger is for all to see. Not having value as your investment anchor leaves you at the whim of an emotional stock market tide. It leads investors to jump aboard shares at any old price. But if the stock market subsequently sobers up and the shares then revert to fair value (as they always do eventually), those paying a much higher price will be left high and dry.

Get a grip on value

Rather than get embroiled in long-term projections to justify a share price, it usually pays ordinary investors to concentrate on companies that exhibit rather more obvious and immediate value.

The value of any equity investment should be compared to the risk-free opportunities elsewhere, for instance, those from government bonds and deposit accounts. But how do you compare the 6% deposit rate you can get from a bank to shares on the stock market? Enter the earnings yield.

A shareholder is a part-owner of a business and is entitled to a proportionate slice of the annual profits, referred to as the company's earnings per share (EPS). The earnings yield is expressed by dividing a company's EPS by its share price.

So, for a company with a share price of 100p and EPS of 8p, its earnings yield would be 8%. Now, imagine that company will increase its EPS by 25% next year, to 10p, and by 20% the year after, to 12p. Which would you prefer? The bank account that returns 6p for every £1 deposited, or the aforementioned company, which generates you 8p now, rising to 12p in two years' time, for every £1 share bought? You would choose the company every time, as it shows obvious and immediate value over the deposit account.

Dividends

But remember, the company will retain and reinvest part of its earnings to generate increased profits for the future. So shareholders won't get their hands on all of the company's initial 8p of EPS as they would the 6p interest payment from the deposit account. But what they should receive is a capital gain, as the company's share price moves upwards to reflect the prospect of the greater profits.

However, perhaps an even better guide to immediate and obvious value than the earnings yield is the dividend yield. Whilst there can be some question marks hanging over a company's retained earnings (will they be put to good use?), you can't really argue with the dividend element that is paid directly to your bank.

So, imagine another company with a share price of 100p and having an annual dividend payment of 7p. Then suppose this payout will increase to 8p next year and 9p the next. Again which would you prefer? The bank account that returns 6p for every £1 deposited, or this second company, which pays you 7p now, rising to 9p in two years time, for every £1 share bought? Again, you would choose the company every time, as it shows obvious and immediate value over the deposit account.

Margin of Safety

You only have to look at the chart of BATM Advanced Communications (LSE: BVC), the chart of Torotrak (LSE: TRK) or the chart of Future Network (LSE: FNET) to see the dangers of investing in highly-rated companies when trouble strikes and expectations have to be lowered.

For those who have been badly burnt by highly rated companies this year and are looking for an alternative investment strategy, it could pay to start looking at companies that show some obvious and immediate investment value. To help avoid those horrific share price plunges, what's needed is a margin of safety in your share purchase. In other words, ensure the earnings and dividend yields are as high as possible so to limit the investment downside. Remember, although the stock market may think so sometimes, companies never offer guaranteed growth prospects.

Where Next?

Read the Introduction to the Foolish Investment Strategies
Invest with obvious value in mind -- follow the Qualiport and Value Investing series.
Enrol at the Fool's School -- How to Value Shares