Forum Archive Index - January 2001

["Ben Dutton" <bendutton@sharechat.co.nz>]

Some people may be interested in reading the following article from
Bloomberg.com on calculating a company's "enterrpise value" - a ratio that
the writer believes gives a fuller picture of a company's fortunes.

Enjoy

Ben Dutton

http://quote.bloomberg.com/fgcgi.cgi?T=money_fstory.ht&s=AOmSthQuPT25lIFN1&r
efer=moneyfront1

One Sure Way to Avoid Value Traps

There's a ratio that gives a fuller picture of a company's fortunes than the
P/E

By Chuck Carlson Bloomberg Personal Finance January/February 2001

I'll bet this sounds familiar: After doing vast amounts of research, you
come across a stock that appears too good to be true. Strong market
position. Rising profits and sales. And best of all, a price-to-earnings
ratio so low you get the bends just looking at it. I mean, really, really
low, like about one-third the P/E ratio of the Standard & Poor's 500 Stock
Index.

Your two concerns are that the company has a fair amount of long- term debt
and is involved in a business that is extremely sensitive to the economic
cycle. But the cycle still seems to be in the industry's favor. The stock
has already come down about 25 percent from its high, so you know you're not
buying at the top. And remember, it has that low P/E ratio, so the share
price is already discounting a lot of concerns, right? So you buy. And you
buy more when the stock goes down another 20 percent because, after all,
it's got that microscopic P/E. But the stock keeps falling...and
falling...and falling. Welcome to the ``value trap.'' I don't know too many
investors who haven't lost money in the market betting on ``cheap'' stocks
that just got cheaper and cheaper and cheaper. The problem? These shares
weren't as cheap as their low P/E ratios indicated.

Don't get me wrong. P/E ratios--obtained by dividing a stock's per- share
price by either trailing or forecasted 12-month per-share earnings--have
their place in evaluating many prospects. But they may not tell the whole
story in terms of risk. Indeed, P/E ratios, as well as another popular
valuation tool, book value, look solely at a company's equity value.
Although these measures work fine in many cases, they don't work so well for
companies that have a lot of debt and/or cash on their balance sheets.

A better way to value a company while still remaining within the P/E
framework is to replace its equity number in the equation with its
enterprise value. Enterprise value is a corporation's total
capitalization--equity plus debt. Computing a company's enterprise value is
easy. Take the stock's market capitalization (which is the stock price
multiplied by the number of shares outstanding), add long-term debt, and
then subtract the value of assets peripheral to the core businesses (that
is, cash). To compute a per-share number, divide the enterprise value by the
number of outstanding common shares. Why include debt? Simple. An important
component in your evaluation of a company is the risk of owning the stock.
Unfortunately, traditional P/E ratios don't accurately reflect the hazard
connected with large amounts of debt, because this factor is ignored in the
original computation. To be sure, debt is not always a bad thing. Companies
may find it better to issue debt rather than additional shares of stock in
order to fund their businesses, especially given the tax advantages.
Nevertheless, high debt levels elevate risk.

For example, a company with a highly leveraged financial position may lack
the flexibility to weather industry slowdowns. Companies with large debt
loads must also pay interest on it, which reduces their ability to reinvest
in their businesses. The upshot is that lots of debt increases the potential
volatility of the earnings stream. And volatile earnings make for chancy
stocks. Using a company's enterprise value per share instead of the stock
price in computing an enterprise value-to-earnings ratio may provide a
different perspective on a stock's relative ``cheapness.''

Caterpillar, a leader in the heavy equipment sector, is viewed by many value
investors as a cheap stock. It trades at a P/E ratio of 11 (based on 2001
per-share earnings estimates), and compared with the Dow Jones Industrials's
P/E ratio of 20, Caterpillar is clearly a bargain, right? Not so fast. The
company has a fair amount of long-term debt on its balance sheet--$11
billion at the end of the third quarter. That amount--which accounts for a
hefty 55 percent of total capital--coupled with the cyclical nature of
Caterpillar's markets, boosts the risk of owning the stock. When you plug
Caterpillar's enterprise value per share into the traditional P/E ratio, the
new value is 20--almost double the normal P/E of 11.

The table at the left shows a number of so-called value stocks sporting P/Es
well below that of the Dow. What's significant, however, is that when you
substitute enterprise value per share in the ratio, these stocks don't look
like such great deals. Praxair is a manufacturer of industrial gases. Its
per-share profits have moved higher in each of the last three years, and
record returns are expected this year. Yet, despite the seemingly strong
profit performance and appealing P/E ratio, its shares have underperformed
the market dramatically over the last year. You might wonder why until you
see that its multiple, when using enterprise value per share, is 16 times
2001 earnings estimates.

Cooper Tire & Rubber, a manufacturer of tires, and CSX, a leading railroad
concern, also look dramatically different from a value standpoint when using
enterprise value per share: Cooper Tire's multiple expands from 5 to 12
times 2001 earnings estimates; CSX's from 12 to 24.

Like many of the indicators I've talked about in this column, I like to use
enterprise value to compare companies within the same industry. The table
also lists three retailing stocks. Looking at P/Es to evaluate the relative
value of these shares, you would be led to believe that Dillard's, for
example, is a much better value than Wal-Mart Stores. However, when
comparing multiples based on enterprise value per share, this value gap
shrinks rather dramatically.

Perhaps the most interesting stock in this group is J.C. Penney. During the
last two years, this retailer has been one of those ``value traps'' for
investors. The stock has plummeted from nearly $79 in 1998 to a 52-week low
of $8. Nonetheless, Penney has gotten a lot of play from value investors
over the last year or so primarily because of its low P/E ratio. Currently,
the stock is trading at just 13 times earnings estimates (ending in January
2002), down from a P/E of 25 in 1999.

Is J.C. Penney a cheap stock at these depressed prices? Perhaps. But as an
investor, you don't want to buy cheap stocks. You want to buy stocks
cheaply. Despite the decline in these shares and the modest P/E ratio, I'm
not convinced Penney is a stock that meets this requirement. One reason is
that Penney trades at 34 times its 2002 per-share earnings estimate if you
substitute enterprise value per share for its stock price. To put that
figure in perspective, it's a multiple exceeding that of Wal-Mart Stores. In
fact, Penney's enterprise value multiple is higher than Intel's (which is
21) and slightly higher than Microsoft's.

Perhaps Penney's current stock price is a value that will manifest in huge
gains over the next 12 months. I wouldn't bet on it, though. The company has
had trouble sustaining growth in both its department store and drugstore
operations. Competition remains fierce in the retailing sector, which will
not help Penney's cause. Finally, the company has been experiencing these
problems during arguably one of the best environments for retailers ever
(record-low unemployment and vigorous consumer spending). Now that retailing
conditions appear to be less favorable, it is difficult to see Penney
bucking the sector slowdown. At some point, Penney may get cheap enough to
attract bargain hunters. But it's not there yet.

Chuck Carlson, CFA, is chief executive officer of Horizon Management
Services and author of the recently published Eight Steps to Seven Figures
(Doubleday). David Wright provided research assistance for this article. Mr.
Carlson, his firm, and/or his clients may own or trade investments mentioned
here. -0- (BN ) Jan/16/2001 20:22 GMT 



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