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ANALYTICAL BOOKS BOOKS FOR SERIOUS INVESTORS
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HOW MUCH CAN I AFFORD TO PAY? "What Are Stocks Really Worth?" helps you avoid paying too much for a stock. Here's how an investor can use "What Are Stocks Really Worth?" to find what Home Depot is worth. Nancy shops at Home Depot frequently. She is impressed by the amount of business Home Depot appears to do, and with the large inventory the store carries. She believes the stock would be a good investment, but she worries that the stock may cost too much. She decides to use the book’s worksheets to find what Home Depot is really worth. Forecasts Nancy examines Home Depot’s record over the past ten years and finds that Home Depot’s growth has been gradually slowing. Home Depot grew 21 %/yr. in the early 1990’s. Growth slowed to 17 %/yr. by the middle of the decade, and was only 12.5 %/yr. in 2003. Nancy recognizes that she must account for this slowing growth, or she will put too high a value on Home Depot. She expects that growth will continue to slow. She projects that growth will start at the current 12.5 %/yr. and gradually approach a long-run limit of 10 %/yr. She further projects that growth will slow with a six-year half life, that is, it will take six years to slow half way from the current 12.5 %/yr. to the long-run10 %/yr. The adjacent graph shows her growth forecast. Nancy also notes that Home Depot’s return on equity gradually fell from 20 percent in the early 1990’s to 15 percent in 2003. With growth slowing she expects that the rate of return will also drop. She uses the same approach she used for her growth forecast. She forecasts that return on equity will slowly fall from the current 15 percent towards a long-run limit of 12 percent. She does not expect the return to drop as fast as the growth rate slows, and chooses an eight-year half life for the return on equity. As growth slows and Home Depot’s return falls, Nancy recognizes that investors will lower the price/book ratio they are willing to pay for Home Depot. The price/book ratio varied from a low of 4.2 in 1996 to a high of 11.3 in 1999, but had dropped to 3.46 at the time of Nancy’s analysis. She uses the same model she used in her growth and return forecasts, and forecasts that the price/book ratio will fall from the current 3.46 towards a long-run limit of 3. She expects the price/book ratio to all faster than either the growth rate or return on equity as investors anticipate Home Depot’s slowing growth, and chooses a four-year half life. Nancy is a long term investor, and expects to hold the stock for five years. She enters her forecasts in the book’s worksheets and develops the values for Home Depot in the adjacent chart. She finds that she could pay as much as $36.25 if she were willing to accept an eight percent return, $32.38 if she were willing to accept a ten percent return, but only $29.98 if she insisted on a twelve percent return. Home Depot was selling for $34.50 at the time of her analysis. If she buys Home Depot, she can expect an 8.9 percent return on her investment. If Nancy had not allowed for slowing growth and falling returns and price/book ratios but assumed these critical elements would continue unchanged at their current levels, she would have calculated she could pay as much as $36.03 and still have earned a 10 percent return. Allowing for slowing growth yielded a value $3.65 lower, which is a significant difference. Click here to order the book Click here to see Nancy’s Risk Analysis of Home Depot
SmartValue has done its job. It has shown this investor how much she can afford to pay for Home Depot and still meet her investment target. NOTICE - This example is not a recommendation to buy, not buy, hold, or sell Home Depot. It is only an illustration of how you can use "What Are Stocks Really Worth?" to develop a dollars-and-cents value for any stock.
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