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Category Archives: Valuation

When To Look At Operating Cash Flow

Posted on by Posted in Investing, Ratios, Valuation 1 Comment

Revenues and earnings are nice numbers to quote, but often free cash flow (FCF) is a more valuable number for investors when evaluating a business.  FCF can be a very powerful tool when evaluating a business.  One area where FCF can hamper one’s investment analysis is when a business engages in a major capital project.  The capital expenditures will be taken from the FCF value and could possibly drop FCF significantly quarter from a previous quarter.

To work around this weakness of FCF evaluation, it is sometimes more applicable to look at a company’s operating cash flow (OCF).  OCF does not take into account capital expenditures and thus will provide a clearer picture of any changes in cash from actual operations.

When a company is growing capital expenditures can be very high.  Such activity will drive down FCF.  Under the assumption that the capital expenditure are being spent wisely, you would not want to hold such actions against a company.  Therefore, focus on OCF when you know new capital intensive projects are going on.

A History of Rising Dividends Is Indicative of Company Success

Posted on by Posted in Dividends, Investing, Ratios, Strategy, Valuation Leave a comment

A couple weeks ago I wrote about the significance of the dividend growth rate for long-term investors.  Since that time I’ve given more thought to the subject.  It should not be forgotten that companies that are able to consistently raise their dividend distribution are demonstrating, through tangible actions, that their company is a success.

One area that new and experienced investors worry about is earnings.  First, investors worry about positive earnings because we all want to be part of a company that is alive and not moving towards death.  Second, we want to believe that the earnings we’re being told about are legitimate.  Yes, the number looks great, but is it an accounting scheme or is this some oddity that we’re not aware of?  No one wants to be deceived.

A company that has a history of growing its dividend yield has demonstrated growth and earnings legitimacy.  If you’re looking at historical data to evaluate a company, a growing dividend is a very strong sign that the company has a business model that has been proven successful.

In my previous example I looked at Pepsi, which had an extensive track record of dividend increases.  When a company is able to year over year boost its dividend distribution, it’s showing real performance.  Sure dividend payments can be maintained and even grown for a short period, if a company has a large cash holding, but after a few years reality will set in.  In such cases you may have a company with an enormous dividend yield based on its current offering price.  Why would this be the case?  It would be the case because its payout ratio indicates that the dividend it’s paying is unsustainable!  Unsustainable dividends do not increase the demand for a stock.

Look at the World Wrestling Entertainment Company (WWE). The company’s payout ratio has for over a year has been astronomically high (near 300%).  The earnings of the company have not been sufficient to cover the quarterly dividend distribution paid out (.36 per share).  To continue the dividend payout the company’s founders reduced the dividend amount paid to their class B shares and reallocated the dividend funds to the class A shares.  This worked out great for a while, but when you’re not bringing in enough money, eventually the cosmetics ware off.  The most recent quarterly dividend payment from the WWE declined from .36 per share to .12 per share.

What is stated above may sound confusing, yet it’s not.  When earnings come out you will typically see in a press release a figure quoted saying something like, “…in the 3rd Quarter X company earned .xx cents per share.”  Okay, great information.  Now, go and look at what they have historically paid per quarter as a dividend.  Is the amount paid per quarter as a dividend more or less than the earnings per share?  If the earnings are less than the dividend a red flag should go up.

I know a lot a investors have a fear about the legitimacy of companies for sale on the public market.  To a certain extent this fear is healthy.  One way to help negate such fear is to fish in the waters of companies that have a track record of increasing their dividend payments.  The longer the track record typically the better, but if I was pushed to say, I’d go with 5 years or more of annual increases to feel pretty comfortable with the legitimacy of a company’s dividend growth.

The simplest answer I could give someone if I was asked, “How do you know X company is legitimate?” would be to say “X company has increased its dividend distribution for Y years now.”  Certainly there are other things that need to be evaluated when considering buying a company, but if you want something quick and dirty; look at the dividend track record and determine where it shows growth or not.

Note: If you’re looking at companies that do not pay dividends this obviously will not work.

Disclosure: No Position

Thinking about investing in a fund? Look at its index.

Posted on by Posted in Dividends, Funds, Investing, Valuation 1 Comment

I typically invest in individual stocks, but I do hold a couple ETFs.  Instant diversification has its pluses, especially when you’re looking at a more passive investing approach.  With that said, if you are going to invest in a fund whether it be a mutual fund, exchange traded fund (ETF), closed-end fund (CEF) or some other variety of fund, it is very important that you look at the fund’s performance against the index it is attempting to match or beat.

If you’re investing in a managed fund, like a mutual fund or a CEF, you’re going to pay a fee for a team of fund managers to trade and/or use a variety of financial instruments for you.  The goal is to use the team’s expertise and skill to bring you superior market returns.  To hear more about this visit a previous blog entry here.

Clearly you do not want to pay a management fee to a company that under-performs against their index.  If they can’t meet their benchmark, then you might as well buy the index or a low cost ETF that simply looks to match the index.  How do you know whether or not a fund is performing well against its index?

In today’ investment world you’ll be told a million different things.  You may see a variety of Lipper Leader scores, which are supposed to guide you to making the best investment decision or you may read a variety of literature that attempts to sell you how the fund is made for success.  Don’t get confused by this wall of information.  It doesn’t take a finance degree to figure out if you’re looking at a fund with a good track record.

I’m going to use the Dow 30 Enhanced Premium & Income Fund (DPO) for this example.  It’s a Closed-End fund, which means it trades like a stock.

Here I am individual investor looking at DPO…should I invest in it?  Well where do I start?

First, what exactly is this?  It’s a fund that holds the 30 stocks that compose the DOW, plus the managers are using financial instruments like options to gain some additional exposure and hopefully come out further ahead than if it was just the DOW 30.  Okay, so they’re going to invest in the Dow Jones Index and use some fancy finance tools to leverage and hopefully beat the market.

Second, how much is this going to cost me?  I understand the trading fee, which I would pay for any other stock, so I don’t concern myself much with that.  What does concern me are the management fees.  What am I going to incur to simply hold this investment annually? I look at fund data and see that annual management expenses will be .88% and other expenses will be .21%.  Therefore, I’m going to be out 1.09% of my initial investment annually, if I invest in DPO.

Third, before I look to compare performance of the fund to performance of its benchmark index I’ll look at its dividend payout and see what the current yield is.  It turns out that DPO has a yield of 8.57%.  On face value that catches my attention.  I like high yields so I’m interested, but also a little cautious.  I’ll look at the index DPO is up against (The Dow) and see that the Dow is paying about 2.33% in dividend yield.  Therefore, DPO is about 6.24% higher.

Fourth, I’ll glance at the Net Asset Value figure to see whether or not this fund is trading at a premium or discount to its actual value of investment holdings.  DPO is currently showing a 3.03% premium.  (I like it best when the company selling the fund actually provides a chart to show NAV in terms of history.  Then I can see whether or not this premium or discount is high or low in historical terms).

Lastly, now I’m ready to see how this fund has stacked up against its index, the Dow Jones Industrial Average.  I’ll compare DPO against ^DJI and look at multiple years (FYI…You can do this very fast and easily through the Interactive chart feature on Yahoo! Finance).

Here is what I see in terms of DPO’s performance compared to the Dow in terms of stock price appreciation.

2011 YTD: +8%

2010-YTD: -5%

2009-YTD: -6%

2008-YTD: -15%

From the start of 2011 until today the DPO fund has been handily outperforming the Dow Index.  It is not only beating it in terms of price appreciation, but its yield is vastly superior.  From 2010 to present and from 2009 to present the fund underperformed in price against the DOW, but it would have made up that ground with its superior dividend yield.  We’ll call ’09 and ’10 a wash.  In 2008 the fund go creamed.  My guess is that the managers were hammered hard when the market took a steep down-turn in the latter part of the year and the leverage that they were using came back on top of them.

In summary this is what I see: A fund that seems to be able to match or beat the market in normal market conditions and a fund that will take additional trauma if markets move south fast.  The dividend yield of DPO has a positive variance of 6.24% compared to the dividend yield you would earn if you just held a Dow Index fund, but in reality you need to subtract the 1.09% management fees, too.  With the management fees your positive variance is 5.15%.

Should you buy this fund or buy a low-cost fund that is designed to mirror the Dow?  I would say that it really depends on your needs.

Again, there are many more funds and indices than the 2 considered here, but think about it in terms of what’s going to benefit you most.  If you hold that both these funds are going to bring comparable returns in the future, then do you need a quarterly distribution or not?  DPO is going to beat the regular index all day long in terms of distribution, but what are you going to use that for?  If you don’t have any need, then maybe your quest for a high-yield is misguided in this situation.  Maybe it’s the index that’s going to be better positioned for you as an investment in the long-run.

(Note – Information about DPO was mainly found via the fund’s website…I’d recommend doing the same for other specific fund research.)

Momentum Play? Mobile & Social Gaming

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I’d like to say that “We live in interesting times,” but I’m pretty sure almost everyone throughout history has made such a statement.  Either way, the strength of investor sentiment towards anything tied into social media is an interesting phenomena.  Is the social/mobile revolution going to live up to the hype?

Based on LinkedIn’s valuation, it appears that many in the market believe that we are yet to grasp the full implications of social media.  Maybe they’re right or maybe they’re wrong.  Either way, the general sentiment/momentum of the market currently is toward the darlings of the social/mobile revolution.

Upon today’s news release that popular social/mobile game developer Zynga is going to file paperwork for an IPO in the near future, Glu Mobile (GLUU) popped by over 21%.  (If you are unfamiliar with social/mobile game developer GLUU, I would recommend you visiting a post in which I recommended the stock back in January 2011.)

If the Zynga IPO behaves as the LinkedIn IPO did, doubling from its set IPO price on the first day, then GLUU will certainly feel the tailwinds of Zynga.  We saw from the news today how strong those tailwinds can be.

Secondly, last week when LinkedIn came charging out of the gates, QuePasa (QPSA) caught a nice tailwind from the LinkedIn IPO and ran up over 30% at one point on the day.  QPSA is a social networking companythat targets Spanish and Portuguese speaking countries.  What most people do not know is that they are also a social media game company.

QPSA’s primary social media game offering is titled Wonderful City and is available via www.QuePasa.com or www.Okut.com (a social media site owned by Google).  Based on current user figures, the game Wonderful City  has between .8-.9 million users/players between the two networks.  The game was released a few weeks ago.  Based on current growth rates, it should hit 1 million players by early next week.  The company also plans to offer the game to Facebook users in the near future.

If you’re an investor that is willing to take on a decent amount of risk, I would monitor news about the upcoming Zynga IPO filing and any press releases that tout game growth from either GLUU, QPSA or other social/mobile game companies.  Social media and online gaming have been very hot areas in the market since the beginning of the year.

Disclosure: Long QPSA

How Can You Tell If You’re Beating the Market?

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I’m a big fan of actually taking a look at a stock or portfolio of stocks and seeing how they’ve performed against a model that takes into account risk and expected return.  Jensen’s Alpha is a tool that will do that for us (one of many).  It will enable us to see if our portfolio has outperformed the market by specifically gauging the amount of risk we took on to get the return we’ve received.

To illustrate the practical application of Jensen’s Alpha, I’m going to look back at the first stock I recommended via this site.  In early July 2010 I wrote a post that first appeared on the Div-Net investment site arguing that Telefonica (TEF) was a buy.  (Note – Since the time of the post TEF has split, so the price quoted in the original post needs to be adjusted.)

For the sake of this example, let’s assume a year has passed and we’re doing an annual review of this investment.

The Jensen’s Alpha formual is as follows….

= Portfolio Return – [Risk-free return + (Market Return - Risk-free Return) * Beta]

= 34.47% – [1.0% + (32.15% - 1.0%) *.97]

= 34.47% – 31.22%

=3.25%

What the number above means if that holding TEF from 7/2/10 – 5/20/11 would have provided the investor with superior returns to the market (S&P 500).  Your investment would have outperformed the market in absolute terms with volatility factored into the measurement.

Here is how I received my inputs for the calculation above…

Risk Free Return = 1% (I’m using what I could expect to get from the best liquid savings account from a bank)

Market Return =1,333.27 (S&P on 5/20/11) – 1,022.58 (S&P on 7/2/10) = 310.69

  • 310.69/1,022.58 = 30.38%
  • (.602+.653+.553)/102.2 = 1.77% (I’m using the SPDR S&P 500 ETF as a proxy for the dividend yield calculation…3 dividend payments have been distributed since July 2nd)
  • Total return = 30.38% + 1.77% = 32.15%

Beta =.97 (This beta figure compares TEF’s volatility against the S&P 500 over the past 5 years (obtained from Yahoo Finance)…The .97 measurement means that over 5 years the stock’s price, on average, has moved almost in sync with the S&P.)

  • To properly do this calculation I should construct Beta on my own for the specific time period in question, but I’m too lazy.

Portfolio Return = 23.77 (Price on 5/20/11) – 19.15 (Price on 7/2/10) = +4.62

  • 4.62/19.15 = 24.13% (Return from the stock’s price appreciation)
  • (.8983 + 1.082)/19.15 = 10.34% (I’m adding the dividends paid on 11/3/10 and 5/3/10 to factor in Return on Investment based on dividend payments)
  • Total return = 24.13% + 10.34% = 34.47%

Successful by Association – Glu Mobile & LinkedIn

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All ships rise with the tide and close to the same is true when you are a company associated with a hot stock.  Today on CNBC mobile and social gaming company Glu Mobile (GLUU) was mentioned in a conversation about LinkedIn.  Guess what happened? GLUU moved from around $3.8 per share to over $4.20 a share in a matter of minutes.

On a side note…What the heck happened?  LinkedIn gets priced at $45 per share by the institutions and then opens up in the high $80’s?  Talk about mis-priced!  The company could have nearly doubled the amount of capital they received from their IPO.  That is the past though.

What I would keep in mind about the LinkedIn IPO…It’s going to be interesting to see how strong the hype is with the social networking business concept and investors.  We’re being told it’s very strong and that this is a relapse of the Internet bubble of over a decade ago.

In the coming days and weeks investors that were able to buy LinkedIn at the $45 IPO price and investors that gained positions within the company prior to the company going public are going to have a strong incentive to sell.  The ROI is high.  Will this selling dampen the price?  Or will the social media hype outweigh that force and push the stock’s price up?

One thing we learned today is that the market’s hunger for these social media darlings of the Internet is very real and very strong.  The question for long-term investors is can these companies live up to the hype?

How to Find Attractive Value Stocks

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1) I browse the pages of the Value Line Investment Survey, particularly its weekly listings of stocks selling at the widest discounts from book value.

2) I troll the news for companies experiencing troubles that may pass.

3) I poach from the picks of some of the better bargain-hunting mutual fund managers.

READ MORE.

Regression Toward the Mean & Investing

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When one speaks of “regression toward the mean” (average) they are speaking of the the phenomenon where an extreme measurement tends to move closer to the average upon successive measurements. As an investor, why should this concept interest you?  How can it help you to be a better investor?

Doing justice to this concept within this blog post is not possible.  Therefore, I seek to only drive home the most important points that will benefit investors.  Regression towards the mean deals with extremes and how extremes are hard to maintain – especially to perpetuity.  Tall parents may lead to taller children, but throughout successive generations limits are realized.  If this wasn’t the case, we’d have 11′ tall people walking around.  The same can be applied to investments.  While many investments will rise or fall, they will have a more difficult time maintaining such a direction in the long-term.

Stocks that continue to rise and rise some more will meet greater and greater resistance as they move forward, all else being equal.  If no ground breaking news, good or bad, is to break, the stock will eventually move back to the mean.  Think of industries for a moment.  Industries will be over-hyped or beaten down from time to time, but that does not mean that is their permanent home.  Far from it.  An industry that is overvalued or undervalued will have a difficult time maintaining such a position, unless something actually changes to cause their valuation to change (where the mean resides).  If the mean (average) moves then the notion of ‘extreme’ moves.

As an investor this concept should make you think more about those industries and/or specific stocks that trade at/near a 52 week high or at/near a 52 week low.  Why are they trading at such levels?  Is such a price movement an extreme reaction by the market?  Or has new information changed the reality for that industry/stock so that its current price is not really at an extreme?  If the situation aligns with the former (truly extreme), then consider the regression to the mean phenomenon.  In the long-run you’ll be rewarded.

Two industries I see today that might be in the process of regressing back to the mean are the shipping and natural gas industries.  Almost across the board, shipping has been beaten down since the recession started in 2008.  The market’s perception of shipping is filled with bears, but are they overly bearish?  Are things as bad as they are perceived by the whole?  I tend to think the pendulum has swung too far to the negative side.  Secondly, regarding natural gas, the resource has not seen the upswing in prices that other natural energy resources have, such as oil.  Thinking long-term , are investors bullish enough today on natural gas given what we currently know and its implications for the coming years?

Regression towards the mean is a powerful concept for investors.  Though it is powerful, it is not necessarily the golden ticket to a successful investing strategy.  It is only one piece of the puzzle, but an important piece that should be considered every time you are sizing up an investment.

GelTech As An Investment For The Summer

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In a previous blog titled, “Speculative Stocks – A Strategy for Lowering Risk,” I mentioned the company GelTech (GLTC.OB) as a small cap stock with a pivotal point in their company’s history that was soon to arrive.  That point was their ability to become one of the listed companies that the U.S. Forrest Service is contracted to do business with.  Their particular product, FireIce, was under evaluation and passed the necessary tests to be one of select products the Forrest Service has at its disposal to fight fires.

The stock moved from around $1 to over $1.80 in the days/weeks after the news broke.  Yes, a significant increase in the company’s value has occurred, but does the company still have room to run?  I cannot tell you for certain, but I do have one argument for the potential of higher valuations.  The advice is based on our current winter season in the Western half of the country.

As you may or may not know, the Sierra Nevada mountains in California (from Northern to Southern) have experienced abnormally high snow falls this year.  If you assume we have our regular hot summer, then we’re in for a few major forest fires.  Typically these fires occur in August and toward the latter part of the summer and early fall in southern California.  The fires may or may not occur, but if they do, extra new vegetation will be ready to add to the blaze.

Whether we have fires in Sierras, Rockies or other areas of the heavily forested Western region, investors will catch wind of the companies that are going to benefit from fire fighting services.  One company that will have a big target on their back in such a situation will be GelTech.

If I were looking to establish a position in this company, I’d look for some market weakness to drive the price down and then enter.

Disclosure: No Position