Picking Stocks: Value and Growth Metrics

by Alan Hartley 03-15-06 06:00 AM

Most great investors don't concern themselves with value versus growth, but instead focus on finding good stocks at good prices. After all, even a wonderful business isn't a good investment if the price is too high. To quote Warren Buffett on the matter, "growth and value investing are joined at the hip." If one of the greatest investors of all time doesn't pigeonhole himself, why should you? The quest for good "value" can often lead to a growth stock that many value devotees have overlooked, so use all the tools at your disposal.

At Morningstar, we pride ourselves on using our discounted cash-flow model to estimate a company's intrinsic worth. At its most simplistic, we forecast a company's financial statements for at least the next five years and discount the future cash flows back at the company's cost of capital. If the stock is trading significantly below our fair value estimate, what we call the margin of safety, we consider investing. This long-term approach captures both value and growth and gives Morningstar a powerful advantage of time horizon arbitrage over our competitors and other techniques that focus only on the next several quarters.

That said, multiple analysis, which captures only one year of data, is still valuable if used properly. The most popular and perhaps the most useful is the trailing price/earnings, or P/E, ratio (the price of the stock divided by the most recent 12 months' earnings per share). When a company that has averaged a 31 P/E over the last five years but today trades at a P/E of only 18 (think Wal-Mart WMT), it may represent a good buying opportunity. But historical earnings are not always representative of the future, of course. The next year could present an entirely different situation and may explain the drop in P/E.

A ratio widely used by growth enthusiasts is the PEG ratio (a company's P/E ratio divided by its estimated future earnings per share growth rate). A benefit that the PEG ratio has over P/Es is that it accounts for both the past and the future. But because the PEG ratio uses the company's P/E ratio, it has the same limitation with a caveat: The five-year EPS growth rate used in the calculation is only an estimate, and results could be materially different than expected. A simple rule of thumb is if a company trades for one-and-a-half times its growth rate (a PEG ratio of 1.5) or less, it may be worth a look.

Investors often swear by a particular method, but why not combine them and look for stocks that are cheap by each measure? Here are five 5-star stocks that pass each test and have compelling fundamentals:

3M MMM
Analyst: Scott BurnsFair
Value Estimate: $89
Consider Buying Price: $75.80
From the Analyst Report: 3M's history of innovation often overshadows the company's ability to generate strong profits on mundane products. Although many of 3M's products are high-margin branded or patented products, the company has made things such as sandpaper, adhesives, Post-it notes, and Scotch tape for decades. 3M fiercely protects its patents and uses its protected period to perfect its production processes. Combining this production expertise with the company's global manufacturing base makes it cost prohibitive for rivals to undercut its prices once items fall off patent. As a result of its patents, brands, and low-cost production, 3M has averaged 18% operating margins over the past five years.

Apollo Group A APOL
Analyst: Kristan Rowland
Fair Value Estimate: $70
Consider Buying Price: $54.00
From the Analyst Report: Apollo's regional accreditation, recognizable brands, and solid reputation contribute to its wide moat. Its University of Phoenix and Western International University are regionally accredited. Accreditation is difficult to obtain and allows UOP and WIU to participate in federal student aid programs (63% and 72% of students at each institution, respectively).

Applebee's International APPB
Analyst: John Owens, CFA, CPA
Fair Value Estimate: $33
Consider Buying Price: $25.40
From the Analyst Report: With a potential universe of 3,000 domestic restaurants, Applebee's still has substantial opportunity for growth, in our opinion. The management team has proved very adept at development, opening at least 100 new restaurants for 13 consecutive years. The company has been particularly successful in seizing a first-mover advantage in small-town locations with a unit design that generates healthy returns. Over the past five reported years, the firm delivered a 23% average return on invested capital, well above our estimate of its cost of capital.

Johnson & Johnson JNJ
Analyst: Tom D'Amore, CFA
Fair Value Estimate: $76
Consider Buying Price: $64.80
From the Analyst Report: J&J is a model of consistency and stability. The firm has delivered 19 consecutive years of double-digit earnings increases and 42 consecutive years of dividend increases. Cash flow from operations covers the dividend nearly 3 times. J&J has an excellent record of capital allocation and generation. Returns on invested capital averaged 22% during the past five years.

Maxim Integrated Products Inc. MXIM
Analyst: Larry Cao, CFA
Fair Value Estimate: $52
Consider Buying Price: $40.10
From the Analyst Report: Maxim's focus on profitable growth has achieved remarkable financial success. With high margins and stable returns on invested capital, Maxim's financials can easily be mistaken for those of a top-tier software company. In its fiscal 2005, Maxim achieved gross margin of 72%, operating margin of 47% (both before deducting stock option expenses), and return on assets close to 20%. Not only does its profitability outshine chip industry peers, it also rivals that of software giants Microsoft and Oracle.

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