Introduction to the
fair value series
Its been my intention
for some time to do a 'fair value' series for a wide variety of
stocks. Yes, there are the crazy over-priced ones that many traders
are fully aware of, but I also aim to get around to looking
at...(wait for it)...under-priced stocks! Yes, even a permabear
should look for under-valued (but high quality) stocks to purchase.
This first posting for
the fair value series will be longer than subsequent ones, so that I
can hopefully convey the underlying philosophy. Taken together, I
believe fundamental + technical analysis are important for any
trader. Clearly, this is just the start, and with more posts,
hopefully the standard will develop to become something worthwhile.
Fair Value theory
verses an ocean of lunatic and misguided analysts
Fair value is a concept
I've been touting massively for a few years now. It has almost become
a long time joke where if someone touted one of the momentum (momo)
stocks (like NFLX, GMCR, AMZN), I'd just say 'divide by 10', and then
give my 'fair value' price.
Dividing by 10 is
admittedly overly harsh for even some of the very worse momo stocks,
but the point stands, most of them were – and still are, grossly
What is fair value?
Say you're an investor
with $10,000. How many years do you want to endure before your
investment provides a 100% gain. Lets not get into the sub issues of
'how' the returns are generated, whether by capital gain or via
dividends. The issue is about return on investment.
Would a century be too
long? Ohh, then I guess you don't much like stocks with a Price
Earnings (PE) ratio of 100?
How about 15 years,
does that seem like a reasonably good time frame to get a 100% return
on your investment? Arguably, for most people, 15 years is a
reasonable time frame.
interestingly!), the PE for the US equity market is usually somewhere
in the 10-15 range. During the bubble periods, ratios of 30, even low
40s have occurred. Similarly, a 'depression era' PE of 5 is also
important to recognise.
As at Feb'22 2012: S&P
500 PE Ratio: 22
Now, one final issue
about PE ratios. There will of course be a range between different
stock types during any given era, such as the following that I
suggest we presently have...
Mid-level growth: 25/40
*there have of course
been some insane tech/social media IPOs in recent years where the PE
is 1000/1500 or worse.
There are many other
smaller issues about PE ratios. Most notably, there is no PE ratio of
course is a company is losing money. Secondly, if a company is making
a VERY small amount relative to number of shares, its possible we get
bizarre PE ratios of 5000, or even higher.
The PE ratio is
certainly not everything when considering a company, but contrary to
what many have come to forget, it is still usually a great starting
A brief reminder on
2011's greatest decliner
Look at the Netflix
chart. It had a superb run, truly amazing – justifiably based on
massive revenue growth and ever increasing profits. Such
near-exponential growth though could never last. Besides having to
deal with the 2008 collapse wave, increasing competition (legal or
otherwise), NFLX faced a number of problems – not least shooting
itself in the foot via changing its price structure which really
annoyed its unreliable customer base.
The point is that in a
matter of just a few months, the once beloved NFLX became a horror
story. No company, no matter how many cheerleaders on either of the
financial clown channels it has, is immune to real world
AMZN – the online
retailer almost everyone uses
So where do we start
with this retail behemoth? Current market cap of $82bn
Current PE: 131
Forward: 67 (fiscal
Profit margin: 1.3%
operating margin: 1.8%
*for some good details
on AMZN's key numbers
Initial summary: The
obvious problem is profit margins are razor thin, plenty of cash,
debt is not a problem – and thus AMZN is at least not significantly
exposed to any future rise in interest rates.
So, what would 'fair
value' be for AMZN.
All other things being
equal, lets take 3 scenarios.
A. AMZN - starts
posting losses...and losses increase through 2012.
B.AMZN – remains
posting in-line earnings, but growth remains low
C. AMZN – profit
margins start to rapidly increase, and growth accelerates
Fair value philosophy –
First, the chosen PE
ratios 15, 25, and 35. Why have I chosen these? I'm trying to take
the more 'bullish' approach, and thus the eventual $ price levels are
the minimum targets, rather than what might be the ultra doomish
Frankly, being a
permabear-doomster, I would be more inclined to look for PE's of 5,
10, 15. After all, if a company is regularly losing money, why would
it not be slammed under PE'10?
The three ratios:
15 is a good historic
average for a stable and comfortably profitable company.
25 is a touch above the
current market average, and considerably over the long term average
35 is historically on
the high end, even the most bullish cheerleaders would struggle to
If Scenario'A, then how
could anyone justify a PE over 15?
If B', how could AMZN
be justified to hold a PE of even 25 ?
If C', despite
recovering profit margins, would AMZN really be justified PE'35 ?
That would still be historically high for a stock – no matter how
good the company.
With AMZN currently
trading at $180 per share, what does that mean for a 'fair value'
A. $21 (180/131 x15)
B. $34 (180/131 x25)
C. $48 (180/131 x35)
The above uses the
current PE of 131 as guidance. Lets also use the forward PE of 67–
as projected for year end 2013.
A. $40 (180/67 x15)
B. $67 (180/67 x25)
C. $94 (180/67 x35)
So, let me state
clearly, even under the 'bullish' scenario – where 'everything in
the world is a-okay', AMZN should not be trading above $94. The $100
level is obviously a huge psychological support level for AMZN, so
its kinda interesting that my own rough estimates fail to even
support AMZN above this level.
Worse case for AMZN,
are we really looking at AMZN in the 20s? From a chart/technical
perspective, the old $40 level was a huge issue for AMZN.
value' for AMZN is between $21 and $48
Best case 'fair
value' for AMZN is between $40 and $94
One thing I will note
at this point, is that of course there are so many variables, and at
Q1 earnings, these 'fair value' targets would need to be re-assessed.
However, based on historic data and standards, I believe the 3 ratios
are very balanced, and in fact are overly fair to the bullish
Will 2012 be the year
AMZN acts like NFLX'2011 ?
determining factor will be earnings of course. Can AMZN stabilise
falling profit margins, or will it start posting increasingly large
losses? Q1 earnings (due late April) will be fascinating to see. I
certainly would not be surprised to see a minor loss. The market
appears to be looking for another minor EPS profit of around 10
A secondary issue will
of course be the wider equity/capital market mood. If the doomster
wave'3 were to occur, then it'd seem likely that AMZN will at least
test the big $100 level sometime this year.
Great company - but not
making enough profit.
Let me end this first
posting for this 'fair value' series, by noting that AMZN is clearly
a superb company. Since its incorporation in 1994 it has managed to
become one of the worlds leading online retailers, and has seized a
huge amount of sales from the old brick & mortar retailers. It
has near saturation brand recognition, and has become a very
established corporation, and doubtless has a strong future ahead.
Yet, in the immediate
term AMZN does face serious issues. Those profit margins are truly
razor thin. With just a minor increase in its cost base (whether its
through wage inflation, energy costs, taxation), the point stands -
AMZN either starts to rapidly expand – with good growth in revenue
and much higher profit margins (to around the 8/10% level), or my
fair value target 'should' in theory be attained at some point within
the next 6-18mths.
When you take into
consideration the larger economy, the stage of the economic cycle we
are in, and the various chart support/resistance levels:
AMZN: fair value: $95,
with potential for downside to the permabear-doomster level of $40