While picking stocks, one of the most important factors that a value investor looks for is the capitalization rate, which is represented by the P/E ratio (Price to Earnings per Share). We place value on the companies based on what capitalization rate they are trading at. A value investor, in general, wants to buy companies with strong potential that are trading at a low multiple or cap rate.
The investors also compare many companies based on their P/E multiple to identify which companies are undervalued or overvalued compared to each other. So, what does cap rate tells us, and how does one go about deciding what is the right multiple at which the company should be trading. Is 10 the right multiple or should it be 15? There are no right answers to these questions; however, there are certain indicators and criteria which can help us in identifying if the company is trading at the right multiple. Benjamin Graham, in his book The Intelligent Investor, lists five factors that thinks are the most important factors that affect the capitalization rate of a company.
The five factors are:
General Long-term Prospects
The long-term prospects of the company have a bearing on its growth. Most analysts and/or investors have a strong view about the long-term aspects of the companies they research or invest in. However, the truth is that future is uncertain and very difficult to know. However, an attempt needs to be made about how the company may do in the future years.
The management plays a significant role in shaping the company’s success and prospects. However, it’s a difficult task to judge the management competence. We really don’t have any scientific or objective method or reasonable reliable tests that we can use to measure the value that senior management and board adds towards the success of the business. For example, if a company is very success full, can we reliably say that the company has strong and skilled management? A misjudgement in this area can lead to a massive overvaluation of the business.
Financial Strength and Capital Structure
The next factor we look at is the financial strength of the firm. If you had to select between two companies trading at the same price and having the same earnings per share, the most likely choice will be the firm with surplus cash than the firm with large loans. We need to look at whether the firm has the financial strength to sustain during the times of crisis. We also look at the capital structure of the firm. Having long-term debt and preferred stock is not bad, but a combination of too little common stock and more bonds/preferred stock raises red flags and is suitable for speculative profits.
A company with uninterrupted dividend payment record for many years is a sign of the value firm generates and consistency in its approach.
Current Dividend Rate
Most companies have resorted to the concept of Standard Dividend Policy. For example, companies may pay 2/3 of earnings as dividends as specified in their standard dividend policy. However, growth companies tend to depart from this and may pay lesser dividends in some years. For example, a company may pay only 1/2 instead of the standard 2/3. In such a scenario an investor needs to investigate the reasons for such departure and the company’s plans for the extra cash.
Capitalization Rate for Dividend Stocks
Benjamin Graham provides the following formula that an investor can use to calculate the value of the stock.
Value = Current Earnings * (8.5 + 2*Annual Growth Rate)
Note that the formula in no way guarantees successful stock selection. An investor may use this formula as a guide but should not solely depend on it to value stocks. In fact, based on their own experience, it can be adjusted to suit the current day’s market conditions.