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The Barron’s 400 Goes On Sale

Barron's 400 Newsletter. Powered by: MarketGrader.com

Investors in some of ‘America’s Most Promising Companies,’ also known to our regular readers as the Barron’s 400 Index, have probably rejoiced at the stock market’s recent behavior, which in the span of two weeks put some of their favorite stocks on sale (along with many other not-so-favorite names). Since reaching its 2015 high of 586.75 on June 23, B400 fell 14.4% through its Tuesday low of 502.25. This begs the question: are these 400 companies (actually 397 that are currently in the index since three have been acquired since March), really worth, collectively, one seventh less today than they were a couple of months ago?

In order to try answering this question, we went back to basics; more specifically, to Ben Graham’s simple wisdom that “price is what you pay; value is what you get.” So knowing that ‘price’ fell by more than 14% for B400, what happened to value? Is today’s price reflecting a suddenly lower value represented in these companies’ common stock? We took a look at all B400 components today and compared their ‘value’ to where they started the year. After all, these are productive enterprises focused on growing shareholder value, which means that, if recent prices are correct, they should be reflecting an impairment in their collective ability to make shareholders wealthier. So, let’s start by looking at company sales.

On December 31, 2014, based on numbers reported through that date by the current crop of B400 companies, collectively they had reported trailing 12-month sales of $3.84 trillion while, in the aggregate, they had a total market value of $7.86 trillion. In other words, all B400 companies were trading at 2.05 times sales less than eight months ago. Today, these same companies are collectively worth $7.49 trillion, while trailing 12-month sales, in the aggregate, have risen by 3.8%. So, these same companies are now worth only 1.88 times sales. When looking at the individual names, instead of the aggregate amounts, we found that B400 constituents have increased their trailing 12-month sales by 7.2%, on average, since the end of 2014. The median increase, perhaps a better gauge of how the whole bunch has done, was 4.9%.

Sales, of course, are not the best reflection of a company’s value since they don’t include any of the costs of achieving such levels of revenue nor do they show how much of that accrues to the company’s owners, its shareholders. For that, our next stop down the income statement is operating income, MarketGrader’s preferred measure of earnings power. By this measure, current B400 constituents earned, in aggregate, $595.46 billion from operations in the 12 months ended last December (or, to be precise, during the 12 months ended on their most recently reported fiscal quarter at that time). This represented a market value of 13.2 times operating income. Fast forward by almost eight months and these same companies have generated $624.45 billion in operating profit during their most recently reported 12 months, or 4.9% more than they had earned by the end of last year. So, through Wednesday, their collective market value had fallen to 12 times operating income, a 9% haircut from this perspective.

Operating income, of course, excludes non-operating expenses such as interest and taxes, so, it doesn’t really represent how much shareholders earned. Net income does. By that measure, B400 companies had reported aggregate trailing 12-month net income of $400.72 billion by the end of last year, while, more recently, they have reported 12-month profits of $420.34 billion, an increase of 4.9%. Therefore, their aggregate price to earnings ratio went from 19.6 eight months ago to 17.8 through Wednesday’s close. Not surprisingly, this aligns pretty closely with the group’s median P/E ratio of 20.0 last December and 17.9 today. Figure 1 summarizes the changes in all of the values mentioned above between December 31, 2014 and Tuesday.

Figure 1 – Changes in select financial measures of B400 constituents from December 2014 through August 25, 2015.

Change in:AggregateMeanMedian
Market Capitalization-4.76%-1.00%-3.95%
Trailing 12-Month Sales+3.77%+7.15%+4.89%
Trailing 12-Month Operating Income+4.87%+9.74%+5.97%
Trailing 12-Month Net Income+4.89%+12.28%+8.19%
Shareholders’ Equity+2.71%+19.85%+5.10%

Source: MarketGrader.com

The best measure of shareholder value, of course, is shareholders’ equity, which, coming from the balance sheet, offers a good complement to all the values listed above, which come from the companies’ income statements. Shareholders’ equity, or net worth, essentially gives us a glimpse of what shareholders own today, while earnings, particularly the expectation of future earnings, give us a measure of the future values of a shareholder’s stake in the company. Aggregate shareholders’ equity for all B400 companies increased from $2.06 trillion to $2.12 trillion between December and now, a 2.7% jump. The market’s valuation of this equity, though, fell from 3.8 times to 3.5 times shareholder equity, the clearest example of price falling despite a rise in value.

Some readers may argue—with some merit, we admit—to the backward looking nature of these figures, which to many may seem irrelevant if today’s focus is on what will happen to China’s economy, U.S. interest rates and overall global growth in corporate earnings tomorrow. So, absent a crystal ball, we thought we’d use the next best thing: analysts’ estimates. According to these, B400 companies were, on average, trading at 17.6 times one-year forward earnings last December. The median forward P/E, or the midpoint between the highest and lowest of these values at the time, was 17.2. Today, the same B400 constituents (397 companies) are trading at an average of 17.8 times one-year forward earnings, virtually the same as eight months ago. The median value, though, is lower today, at 16.1 times forward estimates. Which brings us to growth, the key component, we would argue, in estimating future earnings, of course, and with it, the direction of prices. Rather than looking at growth rates alone, though, we did so in the context of valuations by using FactSet’s PEG ratio. This is the P/E ratio divided by the company’s estimated growth rate (in this case, the average for all companies in the underlying index). Therefore, the lower the PEG ratio, the lower the price you’re paying for every unit of growth. Figure 2 illustrates the PEG ratios for select U.S. equity benchmarks relative to B400.

Figure 2 – PEG Ratios for B400 and Select U.S. Equity Indexes

IndexForward P/EPEG RatioImplied Growth Rate
Barron’s 400 Index17.81.989.0%
S&P 500 Index16.82.217.6%
Russell 1000 Index17.32.377.3%
Russell 2000 Index25.23.207.9%
Russell 3000 Index17.82.417.4%

Source: FactSet

In summary, when looking at the combination of EPS growth rates, as calculated by FactSet and current valuations, based on forward P/Es, it is clear that in U.S. equities, B400 offers the best ‘value’ at current ‘prices.’ So, assuming the U.S. economy doesn’t fall out of bed, investors would be wise to own stocks at current valuations even in the absence of further multiple expansion, as we have argued in earlier Newsletters. They could do worse than earning the rate of earnings growth implied in B400’s current valuations. To this effect, we close with another tidbit of Ben Graham, who said “the investor’s chief problem—and even his worst enemy—is likely to be himself.”

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