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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Thursday, September 20, 2007

Understanding the Drivers of the Price to Book Multiple

Price to book ratios are a popular method for gauging a stocks relative value. Just like price to earnings ratios, P/B multiples that are relatively high usually signify that the stock is overvalued. Investing in low P/B companies has forever been a staple strategy among value investors. Yet, stocks trading at higher P/B ratios can still be good investments and actually be undervalued.

Understanding the drivers of the P/B ratio helps determine whether the stock deserves a high multiple. Often, the P/B multiples published are not forward looking. The share price is forward looking, yet the book value (denominator) is a historical figure taken from the balance sheet.

This shortcoming results in P/B multiples failing to capture the full picture. Trailing P/E (historical) ratios exhibit exactly the same symptom therefore forward P/Es are more meaningful and popular. Thus, determining a forward P/B multiple is essential for assessing a stock’s fair value.

Lloyd Sakazaki recently wrote about P/B multiples recently in this article. Lloyd has a very informative blog which I recommend checking out. Lloyd’s primary point is that high P/B multiples may stem from high expected earnings growth.

Essentially, the future is expected to be better than the past, thus investors have bid prices higher given that expectation. Additionally, relatively high P/B multiples may be justified if the firm produces high returns on equity (ROE). Expanding on Lloyd’s commentary, we can illuminate the underlying factors affecting P/B ratios .

1) Return on Equity: ROE= EPS/BVPS

Stocks with higher ROE should trade at higher P/B multiples. Now, that’s expected future ROE, not historical. Often, a link may exist between a firm’s historical ROE and future ROE. Companies with stable performance (predictable), the past may be an indicator of the future, and what has happened usually continues to happen. Sometimes. Analyzing historical ROE trends can help in making sense of a P/B ratio. Yet, stock prices reflect future expectations; undoubtedly, it is only future returns on equity that affect share value.

ROE projections are vital to the evaluation process of P/B multiples. Future ROE estimations can be accomplished by estimating future EPS and future BVPS: Expected ROE= EPS (expected) / BVPS (expected).

To figure out next year’s BVPS, dividends and share buy-backs need to be subtracted from EPS and then added to beginning BVPS.

Expected BV/Share= BV/share (last fiscal year) + (EPS (current yr estimate) – DPS (expected dividend) - Share Repurchases/share)

Comparing expected ROE to last year’s ROE aids in analyzing the P/B multiple. If future ROE is expected to be much higher than historical returns, a relatively high P/B may be reasonable especially given the forward P/B will be much lower due to the ROE increasing.

Higher ROE translates into higher P/B multiples assigned by the market. P/B ratios have to be evaluated in the context of ROE, and since stock prices are forward looking, forward P/B multiples must be compared to expected ROE. To ascertain the appropriate P/B ratio warranted for any given ROE rate, peer comparisons are needed.

2) Expanded ROE (Dupont Formula) = Profit Margin x Asset Utilization x Leverage

Margins, asset efficiency, and capital structure determine ROE. Analyzing these underlying factors give insight in estimating future ROEs.

Net Margin (Income/Sales) x Asset Utilization (Sales/Total Assets) equals return on assets, or ROA. Multiplying ROA by the ratio of Assets/Equity (leverage) gives ROE.

a) How attractive income stream? (profit margin)
b) Amount of capital investment (Assets) required to capture income stream?
c) Shareholders’ investment required to finance total assets?

Investors’ willingly pay premiums for firms possessing highly profitable business models. The distinguishing variable is asset turnover. High profitability may require large sums of assets, hence greater investment offsets the benefit of greater return on sales. Contrarily, low margin businesses can boost returns if asset requirements are small.

Thus, firms having high margins and low asset investment needs are the most attractive and command higher P/B multiples. Finally, using debt will boost ROE since additional capital can be employed without diluting the ownership base. The use of excessive leverage compresses P/B ratios because of the increased financial risk weighs down share prices.

Companies can generate high ROE from intangible assets not recorded on the balance sheet. This will cause greater asset turnover since recorded assets are lower.

Intangible assets such as brands, technology, human capital, knowledge etc. have value since they drive earnings. Investors will pay accordingly for ownership of these intangible assets. Paying a premium results in a higher share price, and coupled with a lower BVPS due to non-recorded assts, P/B ratio is higher.
I discussed this aspect in more detail in a previous

3) Expected Earnings Growth:

EPS growth rate will affect future ROE since EPS is the numerator in the ROE formula.

P/B ratios are most often calculated by dividing the share price by the book value per share. The BV/share is the amount of shareholder’s equity found on the balance sheet (assets-liabilities=equity) divided by the number of common shares outstanding.

Since stock prices reflect future expectations, a P/B multiple calculated from a historical book value leads to distorted ratios. We can calculated a forward looking P/B multiple that will make comparisons more meaningful.

Forward P/B Ratio= Current Price / Expected Book Value Per Share

If expected earnings causes a significant increase in future book value per share, then there will a considerable difference between trailing P/B and forward P/B ratios. This is especially true is EPS has been negative causing BVPS to decline. Hence, P/B ratios may be distorted if BVPS is depressed, yet estimating a forward P/B ratio will reveal if the P/B is still relatively high.


To better gauge if a P/B ratio is warranted, earnings and ROE expectations need to be examined. P/B ratios may be high on a trailing basis, but considerably lower on a forward basis. After uncovering the firm’s prospects, peers should be referenced for comparison. If P/B is relatively high and ROE is much higher than comps, then the higher multiple may be warranted. A common mistake is thinking a stock is undervalued because of a low P/B. If ROE and EPS growth are below average, then that’s the reason why the multiple is below average. It’s not undervalued; it deserves a low multiple because it’s expected to deliver low returns. Share prices indicate the future expectations of ROE as indicated by the P/B multiple. High multiples are justified when the ROE expectations implied are reasonable, and even higher multiple is warranted if you believe the implied ROE is too low.

Tuesday, September 18, 2007

Investors Overlook the Mac as a Windows PC

Much, if not all attention regarding Apple has been focused on the iPhone. Apple’s recent $200 price reduction on the iPhone resulted in analysts, journalists, and investors debating the true demand for new device. Additionally, the effects of the price cut on Apple’s earnings has been a hot topic of discussion. Certainly the iPhone is relevant to Apple’s performance, but ostensibly it’s the Macintosh computers that will have the most impact. Specifically, Mac’s ability to run Windows natively has the potential to be a colossal catalyst for boosting Mac market share.

Apple released “Bootcamp”, which allows Mac users to install and run Windows just like one would on a PC. Apple’s new OS, OS X 10.5 “Leopard”, slated for release this November will include Bootcamp software. Additionally, third party software called “Parallels” allows users to run Windows and Mac OS simultaneously.

The Windows capability has not yet been aggressively publicized by Apple, and analysts and investors have been relatively quiet on this issue. Yet, for more than two decades, the lack of Windows compatibility has been the primary reason behind consumers’ decision to NOT purchase a Mac computer. Now that Windows can be installed on Macs, sales could really explode. I believe that this aspect of Apple should garner more attention, and I will explain why.

Macs are a perennial top award winner in consumer surveys and industry publications. Marketing research has suggested that for many PC buyers Macs were their first choice, yet they declined to purchase due to the need to run Windows software. Computer buyers employ what marketers refer to as a “non-compensatory” purchase decision model. For every product attribute evaluated and compared, supremacy in most categories cannot offset a deficiency for a particular attribute. Explicably, Macs may score higher in a consumer’s mind for every attribute, but the fact that it’s a non-Windows machine eliminates the purchase possibility from the buyer’s selection set of product alternatives.

Simply, consumers want a machine that runs the same operating system that 95%-99% of all other computers run. In most cases, consumers require a machine than runs windows due to work or school related factors. Alternatively, there is a significant risk in buying a computer that may become extinct or no longer supported by software developers. That was a real concern years ago, when Apple was against the ropes as market share had been estimated to fall as low 1%.

A popular statement: “I really want and prefer to buy a Mac, but I need a Windows machine since that is what we use at work.” The lack of Windows compatibility has been an insurmountable hurdle for Apple for decades even though significant demand for its machines exist.

Apple has certainly recovered since the days of old with market share currently estimated well above 5%. While still miniscule, Apple has delivered substantial progress. The bright side of the matter is the enormous room for potential growth from seizing share from the Windows PC makers- Dell et al.

In one aspect, Mac’s ability to install and run Windows OS makes them no different than Dell, HP, Gateway, etc., which there is little difference among those traditional PC devices. In essence, installing Windows on a Mac means that there are no longer grounds for consumers to eliminate Macs as a products choice on that reason. Thus, a consumer could just as well buy a Dell or Gateway or Mac. Think about it. The primary factor keeping buyers from purchasing a Mac for decades has been overcome. Plus, if that barrier hadn’t existed we know that Mac sales would have been significantly higher. The bottom line: pent-up Mac demand can come to fruition now.

Given that Macs now compete with Dells and HPs as product choice in buying a PC, Macs retain an edge. Macs provide all of the functionality as other PCs, yet the Mac OS serves as a bonus, if you will. Why would someone choose a Dell or Gateway when that can buy a Mac, and not lose Windows functionality, yet gain all the benefits of Mac OS? I think that is a very central question. Especially since Mac prices have become more competitive.

Despite the lack of publicity I think this is huge. We know that there are a significant number of consumers who would prefer to buy a Mac but can’t get past the Windows issue. Now that this is no longer an issue, how many Macs can Apple sell? I can envision some individuals buying a Mac to solely run Windows just because they prefer the aesthetics of Mac’s design.

We have seen a dramatic increase in Mac sales and market share, yet I perceive the general consumer is unaware of the Windows capability. I am confident that when a more aggressive publicity campaign occurs, Mac sales will react robustly. I think that it’s the PC savvy segment, aware of Bootcamp that has been snatching up Macs recently, not entirely the normal, less aware consumer. Just from anecdotal evidence, people I have surveyed exhibit little awareness. Eventually that will change with time, and the impact on Apple’s revenues will be much greater than the iPhone or iPod.

Running dual OS on a single machine allows the Windows to Mac OS migration process much easier. Previously, it has been either one or the other. Moving to Mac OS means turning off the light on Windows. That’s a very difficult process and extremely risky. Any migration works best under a dual, parallel operating environment since it doesn’t require choosing one over the other. Particular tasks can still be handled in the Windows environment if the Mac OS proves to be unsatisfactory. Apple experienced much difficulty in persuading users to abandon Windows for a Mac, now that is no longer an issue.

It’s seems that the only benefit in using Windows is the fact that nearly everyone else uses it too. It’s unstable, crashes frequently and susceptible to a host of viruses. That’s the antithesis of the Mac. Granted there is much more software available to Windows, that will surely change as Mac OS gains acceptance. As more and more software is developed for Mac OS, adoption will follow suit. And as Mac share has been increasing, we have witnessed already increased interest from software developers.

It’s not unreasonable to predict that Apple can progress to 10% share soon. Especially given the “Halo Effect.” Sales of iPhones and iPods will drive consumer interest in Mac computers, and when consumers become more aware of the Windows capability I believe market share can easily reach 30%. It’s not unrealistic to think that Macs could capture even more share. Why not? Apple’s iPod has 70-80% share, and why would a consumer purchase a Dell over a Mac? Price is the only reason that I can think, but for a higher price, the consumer receives more. I know I will never buy a traditional PC again.

Friday, September 7, 2007

Positive Aspects to Apple's iPhone Price Cut

Here are several of Apple's advantages for pricing the iPhone high initially, and the benefits to later cutting price:

1) Attract more non-AT&T customers to switch carriers. Apple receives bonus revenue for new subscribers. Eventually, Apple will have to offer the iPhone to other carriers, but while it’s exclusive to AT&T Apple can capture high margin revenue. Service revenues fall straight to the bottom line, thus it makes sense for Apple to ramp up adoption as much as possible before their exclusive carrier agreement expires.

2) A high initial price meant that the early adopters would be mostly “die-hard Apple loyalists.” This consumer segment has significant Apple bias, thus those users will talk very positive about the product, hence generating significant buzz. In addition, loyalists won’t focus on any drawbacks, for they focus on all the strong points of the device. Thus, Apple is less likely to receive negative word of mouth from the product release.

3) The initial high selling price means fat margins that can be allocated toward the recapture of up-front development costs. The sooner these development costs are recovered, future margins will expand at a faster pace.

4) The new iPod Touch is essentially an iPhone, without the phone capabilities. Thus, both the new iPod and iPhone will share the same components which will drive scale efficiencies. The shared costs between the two products will aid in offsetting the margin decline stemming from the lowered selling price. Increase in volume spreads fixed costs over more units, which improves the incremental profit margin per unit.

5) The lower price point of the iPhone should dramatically boost adoption. According to a ChangeWave Alliance survey of 3,000 non-owners, one-third stated “high price” as the reason for not buying an iPhone. Roughly 25% of those respondents indicated they would “likely” purchase an iPhone in the future, which one-third said they were waiting for the price to come down.

6) Apple is switching from a price-skimming strategy to a market penetration strategy. Apple will be able to expand market share quicker; this will strengthen competitive barriers.

A skimming strategy is defined by an initial high selling price followed by gradual decreases. The concept is to capture all the demand at the highest price point, and when that demand is exhausted, the price is reduced slightly to capture demand at the lower price point. This continues until no additional demand can be generated at a lower price point.

A penetration strategy, on the other hand, is setting price lower than product costs or competitors’ price. The objective is to drive volume rapidly which will enhance economies of scale and reduce unit cost. If there are high switching costs involved, then a penetration strategy is most appropriate. An excessively high selling price just invites competitors to offer similar devices at the lower prices consumers are willing to pay.

After a consumer buys an iPhone, it’s likely they will not be looking to buy a phone for two years. Additionally, given Apples strong brand and customer loyalty, once a consumer gets his hands on an iPhone it will be very difficult for a competitor to pull them away. Apple can repel competition with the adoption of more users since it’s doubtful that other firms will want to spend the effort in pursuing satisfied iPhone users. It hasn't worked for those firms seeking to convert iPod users.

I don’t think the move by Apple is a suggestion that iPhone sales were soft. Analysts closely following iPhone sales had been reporting that sales were tracking as expected. There was a disconnect between expected sales and consumer interest.

Customer satisfaction is extremely high, yet given the underlying positive perception, adoption hasn’t seemed to develop as sentiment would suggest. The high price is certainly a barrier. Surveys and polls indicated there is significant demand potential, but the steep cost has been a formidable barrier. Lowering the price will have an immediate impact on sales, immediate.

In my social circle, the majority of my friends say they are waiting for the price to drop. Or, they were waiting for the second generation (and a cheaper price tag). I got the impression that it’s a widely-held belief that Apple would release something better and cheaper soon which made folks hesitant to take the plunge. It was bound to happen. But, no one expected it would come this soon and the price reduction would be so great.

I wonder if this price reduction isn’t preparation for a future model with enhanced functionality.
An improved camera function would seem most logical. The current camera is pretty sweet for a phone device, yet it’s still far from a digital camera. Apple already has incredible software applications- iPhoto and iMovie, which can sync with the iPhone, thus improving this feature would really make the iPhone a slam dunk.

Apple’s iPhone revenue will certainly be lower than previous forecasts since projections were assuming $550-600 average selling price. Unit volume will be much higher, it’s doubtful that volume will be great enough to completely offset the decrease in price. Service revenues should be significantly higher, and margins should recover modestly from increasing economies of scale.

The exact magnitude the price reduction has on demand will be an important indicator. If demand reacts sluggishly then Apple has a serious problem. Thus, it will important to pay close attention to how Apple’s new move plays out in the consumer market.

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