13. A Comparison of Four Listed Companies
The author has selected four firms "more or les at random" to demonstrate his approach to common stock valuation: Eltra Corporation, Emerson Electric, Emery Air Freight, and Emhart.
The most striking fact is that the current price/earnings rations vary much more widely than their operating performance and financial condition. Eltra and Emhart are "modestly priced" at 9.7 and 12 times earnings (15.5 being the DJIA average at the time), whereas Emerson and Emery at at high multiples of 33 and 45.
Some of the factors that might explain this disparity are considered:
- Overall Profitability. Emerson and Emery (the two overpriced firms) are showing much higher earnings in comparison to book value, and all but Emery shows high annual EPS growth.
- Profit Margin. In manufacturing, the profit per dollar of sales is often taken as an indication of strength or weakness. In this regard, all seemed satisfactory, with Emerson being especially impressive.
- Stability. The author considers the maximum decline in earnings over the past ten years, comparing the worst year against the average of the three preceding years. He finds no red flags here.
- Growth. The two modestly price firms show "quite satisfactory:" growth rates, showing greater growth over the long term (ten years) than the two overpriced issues, but less over the short term (past three years)
- Financial Position. All three manufacturing firms are in sound financial shape, each showing at least $2 in current assets for every $1 in current liabilities. While Emery compares unfavorably, it's also noted that it is a service rather than manufacturing firm - but it does not miss the mark by much ($1.70 rather than $2) and has no long-term debt.
- Dilution. This is a special note on the financial strength of Emerson, in that it had $163 million in convertible preferred shares, which have the potential to decrease earnings per share by about 4%
- Dividends. All firms have a relatively good history of paying an uninterrupted dividend. The modestly-priced pair offering a bit more than the overpriced pair (about 4% compared to 2% dividend yield)
- Price History. Over the long run (1936-1968), all of the firms have grown considerably, and over the past year, their price volatility has been moderate.
In all these respects, all four firms seem intrinsically sound and stable, yet there remains a wide disparity between price and value between the overpriced and modestly priced pairs.
Emerson gives the author great pause: it is a "good-will giant' in that its price has been inflated to 33 times its earnings, meaning that 97% of the cause of its price in the market is based on its popularity among investors for non-financial reasons. This is a dangerous position, as any loss in investor confidence can cause a tumultuous fall in the price of the issue, a phenomenon that has been witnessed in the market, particularly wit hthe example of Zenith Radio, whose price fell by 75% in a single year after reporting a drop in profits.
Emery Air Freight also has an enormously high price in consideration of its earnings (PR of 45), but compounding the danger of high hopes and speculation is that it is a small firm that has had significantly elevated performance in recent years that may not be sustainable or scalable.
Emhart has done better in business than the stock market over the past 14 years, and has sold as high as 22 times earnings. Since 1958, its profits have tripled, against a rise of less than 100% for the DJIA, but its price has grown by only a third.
Eltra's record is somewhat similar to Emhart. These two stocks are solid performers, but lack the glamour of other firms in the present markets. Perhaps complicating its lack of sex appeal is the cyclical nature of its operations.
It is likely the two overvalued stocks are more interesting to speculators because of their "market action" and their exceptional short-term performance in recent years.
The latter notion has some validity, but also carries with it some concern over whether the recent performance of the stock is sustainable for the long term. The speculator's interest, being short-term, does not sufficiently account for this risk, but assumes that the performance of the coming months will continue along the same steep trajectory of the recent few years, and it is speculation of this nature that leads to sharp decline as well as sharp growth.
By contrast, Eltra and Emhart are companies whose price is more closely tied to their value, and whose growth and decline move along a more steady and predictable curve, such that they are unlikely to fall much in value, though unlikely to skyrocket either. As such, they seem better suited to a defensive investor's portfolio.
Naturally, this points to the notion that a defensive investor would seek to close his positions in Emerson and Emery, and acquire holdings in Emhart and Eltra. But it is unlikely this would be advised by an experienced security analyst, who would find them to be stable and growing concerns and would either disregard their popularity in the market, or see it as a criteria that makes the overpriced securities even more attractive than those that are modestly priced.