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To use the Phil Town method for calculating the fair value for a stock, you need four numbers:

1. Current earnings per share (EPS)
2. Estimated (future) EPS growth rate
3. Estimated future price/earnings ratio (PE)
4. Minimum acceptable rate of return

Keep in mind that calculating fair value works best for companies that fairly and honestly report their earnings in an easy to understand way.  That little caveat excludes all financial companies.  It is also best to calculate fair value on companies that have real and actual earnings.  That requirement eliminates American automakers and homebuilders, and other bailout beggars! And fair value is also easier to calculate using companies with sustainable and consistent earnings, not erratic earnings such as with mining and defense companies.  Let’s take McDonald’s as an example of a company with real earnings to calculate fair value.

Excluding dividends, McDonald’s trailing twelve month earnings per share were $3.96, according to the MSN Money summary.  Next comes an estimate for future EPS growth rate.  MSN Money averages out analyst estimates of future earnings estimates on their website, and McDonald’s is currently listed with a 12% future growth rate over the next 5 years.  But Phil also recommends looking at past growth rates.  According to Google Finance, (more annual data history than MSN Money) the last 4 years of earnings per share data for McDonald’s were $2.06, $2.09, $2.44 and $2.88.  Those annual earnings per share results correspond to growth rates of 1.4%, 16.7%, 18%.  Therefore, a 12% analyst estimate of future earnings growth seems reasonable.

To get an estimated future P/E, Phil recommends taking the lower of either the historical P/E or twice the expected growth rate.  The analyst expected growth rate is 12%, which corresponds to a future P/E ratio of 24.  But McDonald’s is only currently trading with a P/E ratio of 15, so it is the better estimate to use for future P/E ratios.  In fact, conservative investors may want to go even lower than 15 in today’s secular bear market, and collapsing P/E ratios.

The final piece of information for determining fair value is the minimum acceptable rate of return for this investment.  Phil Town recommends a default rate of 15% as the minimum return.  So the four numbers that we will use to determine fair value of McDonald’s are:

• current earnings per share – $3.96
• estimated future EPS growth rate – 12%
• estimated future P/E ratio – 15 (perhaps less due to secular bear market collapsing P/E effect)
• minimum rate of return – 15%

The next step is to determine what the earnings per share will be in 10 years, based on the 12% growth rate in earnings, and starting with a base of $3.96 per share of earnings.  Using either a calculator, or Excel, the earnings per share of McDonald’s in 10 years based on a 12% EPS growth rate are $12.29 per share.  Assuming a future P/E of 15, McDonald’s could theoretically trade for $184.35 per share by achieving the assumed 12% growth rate over the next 10 years.  Finally, to get the sticker price of McDonald’s, we know that our minimum 15% rate of return requires an approximate quadrupling of the stock price over 10 years.  (Use calculator or excel to verify yourself) So all we have to do is divide the future expected stock price of $184.35 by 4 to come up with today’s theoretical sticker price of McDonald’s shares.  Based on all of the above assumptions and calculations, the sticker price of McDonald’s shares today is only about $46 per share, and it is currently trading at $61.29.  In fact, Phil Town also recommends a steep 50% margin of safety for new investments.  In following Phil’s approach, we would not want to pay more than $23 per share for McDonald’s today, and therefore would want to look elsewhere for rule #1 stocks.

Rule #1 investing is an aggressive method for buying stocks at a steep discount.  But finding those stocks is often very difficult to do.  But when you do find them, it is very unlikely that you will see events such as the 2008 financial crisis and stock market decline affect your portfolio of rule #1 investments.  Phil’s book is definitely worth buying!

Rule #1: The Simple Strategy for Successful Investing in Only 15 Minutes a Week! by Phil Town

Related Articles:

• Stock Fair Value and Rule Number One – Sticker Price
• The Basics Of Buy Low, Sell High And Channeling

Phil Town’s Rule Number 1 investment book is yet another classic that deserves a spot on every investor’s bookshelf.  Rule #1 of investing, if you are not aware is “Don’t lose money”.  Rule #2 of investing is also “Don’t lose money”, and Rule #3 is “Re-read the first two rules”!

Phil Town is a classic value investor, and his book is filled with insight into what how to pick solid stocks to invest in, and then how to interpret the financial numbers to determine when to pull the trigger.  He talks in detail about return on investment capital (ROIC), sales statistics, earnings per share (EPS), stockholders equity, and cash balance.

Rule #1 also talks about the intangibles, such as betting on the jockey (strong company leadership), looking for companies with a moat (barriers to entry for competitors), and demanding a margin of safety.  And he goes into great detail on how to calculate the sticker price (intrinsic value or fair value) of a stock, or a reasonable value for the shares based on all the existing financial numbers, future forecasts and intangibles.  But requiring a margin of safety is critical and a margin of safety is achieved by never paying sticker price for a stock.

Rule #1: The Simple Strategy for Successful Investing in Only 15 Minutes a Week! by Phil Town

Also see:

• Calculating Fair Value For a Stock – Rule Number One

During the summer of 2008, consumer gas price hedging was a popular topic.  Consumers fed up with high gas costs could “hedge” their fuel purchases.  Hedging is essentially a glorified way of saying gambling, and many consumers who locked in those high prices are now realizing the losses from that gamble.  Mymoneyblog wrote a good summary about how to hedge against rising gas and oil prices earlier this year.  A gallon of gas was selling for $3.70 per gallon at the time.  The article mentioned three possibilities to hedge against even higher prices, including FuelBank, buying shares in an oil ETF (like USO), or buying futures directly on the oil commodity.

Many consumers did use Fuelbank or other services to lock in what are now much higher prices, and essentially losing the fuel price hedging gamble.  Unfortunately, a select few of those gas gamblers complained and demanded reimbursement for their gambles gone wrong.  Also in the summer of high prices, Chrysler created their new ad campaign to allow new car buyers to lock in $2.99 fuel. Anyone who bought a car based off the $2.99 per gallon promise have also lost money on the deal, and they need to take responsibility for their losses.

But fuel hedging did not start with consumers.  Corporations that wanted a more steady income stream would hedge their commodity purchases to even out the swings.  But over the long run, most corporations that hedge only do so as a means to even out the short term results.  Over the long run, an unhedged position will generally lose out over a hedged position.  Take the case of Southwest Airlines.  Jim Cramer praised Southwest as the only airline worth investing in because of their “foresight” into hedging fuel costs early.  Southwest had locked in those low fuel prices early and the later result was peace of mind at a time when United and American were drowning in jet fuel expenses.  But that peace of mind was only temporary as it watched oil tumble from the near $150 level down to the $40 level in just a few short months.  Businessweek wrote an excellent piece Southwest Sees Fuel Hedges’ Pesky Side.

The bottom line is that hedging can and does work to even out volatility, but at it’s heart, hedging is still a gamble.  Both corporations and consumers must realize the risks to the hedging gamble and roll with the punches that the market will inevitably deliver.

Other related articles:

• Portfolio protection – hedging todays roller coaster market ride
• Balanced and hedged portfolio using proshares
• Time for cover – the covered call
• Covered calls – removing the covers and going naked

As expected, Goldman Sachs reported today that it lost $2.12 billion in its latest quarter, averaging out to $4.97 per common share.  The full report can be viewed here, but a shamefully hilarious excerpt follows, along with [Geldpress comments]:

Goldman Sachs reported fourth quarter negative net revenues of $1.58 billion and a net loss of $2.12 billion.  The diluted loss per common share was $4.97 compared with diluted earnings per common share of $7.01 for the fourth quarter of 2007 and $1.81 for the third quarter of 2008.

[Geldpress:  With statements like these, Goldman Sachs continues to insist that they "earned" money in 2007, and that their financial woes only just recently started.  In reality, their executives walked away in 2007 with tens of billions of dollars in faked earnings, and then begged U.S. taxpayers to compensate them for the real losses]

The Goldman Sachs fourth quarter revenue results can be broken down as follows:

• Investment Banking – Consists of investment banking, financial advisory [Goldman advice to clients - Drive your company and the economy into the ground and then beg taxpayers for a bailout], and underwriting.  Revenues in these three components were all down significantly for the quarter – 20%, 54% and 37% respectively.
• Trading and Principal Investments – Negative net revenue of $4.36 billion.  With results like this, it’s no wonder their financial advisory business was down 54%.  Perhaps Goldman Sachs needs to learn that trading is not a sustainable business, but rather a market sum game.   According to Bart Stupak, Goldman Sachs made its money in trading only through heavy manipulation.  Now that they are under increased scrutiny, it will be to difficult for them to make any money from market manipulation pumping and dumping shares trading activities in the future.
• Asset Management and security services – revenues were 19% lower in the quarter for asset management and surprisingly 19% highre for securities services.

With results like this, I would hardly call the gang at Goldman Sachs geniuses.  Just like every other short sighted real estate and financial services company, they cracked under the pressure to increase earnings.  They embraced financial engineering to the extreme and managed to look really good on paper for a few short years.  But the facade has come crumbling down, and Goldman Sachs is left scratching their heads, and completely confused as to what their business model for making money should even be in the future.  In the meantime, their greedy little hands are outstretched and pointing upward, willingly taking in every last cent they can squeeze from hardworking taxpayers.

*Warning: Don’t be fooled into embracing Goldman Sachs just because Warren Buffett is aggressively buying shares.  Remember, he is also buying shares of Moody’s.  Warren Buffett is brilliant, but even brilliant people make foolish gambles.  It turns out that Warren Buffett is making at least two.

Disclosure: The author does not currently own GS or MCO but may trade their shares in the future, but just for fun.

Other interesting reads:

• Why does Warren Buffett like Moody’s?
• Warren Buffett And Derivatives

If you thought Greenspan was a maniac for temporarily dropping interest rates to 1% in the years after 9/11, just wait until you seen what Uncle Ben Bernanke has in store.  Since taking on his positioin, Bernanke has so far ratcheted the federal fund rate down to Greenspan’s low of 1%.  But the two day fed meeting that started today is expected to commence tomorrow with an announcement that interest rates are going lower, and quite possibly to zero percent!

The United States bubble based economy is in trouble.  Instead of focusing on innovating and exporting our way to a stronger economy, we instead choose to borrow more, cut taxes, inflate, and spend.  Our government insists on short sighted solutions to keep asset prices artificially high.

In 1981, the federal fund interest rates topped out at over 19% and mortgage borrowing costs were expensive.  Borrowers were responsible, 20% was the customary home down payment, and the economy was humming along.  But with the first sign of economic trouble, the targeted strategy was to inflate asset prices at any cost, and the preferred solution was lowering interest rates.  Since that time, every new sign of trouble brings lower and lower interest rates, and those rates are now widely expected to hit zero percent in 2009, if not sooner.

Stimulating after zero percent? – Japan had deflating asset problems in the 1990′s Rather than allow the market to naturally self correct, they chose instead to aggressively lower interest rates.  When they approached and  hit zero perecent, they extended mortgage terms to 100 years to dupe consumers. 100 year mortgages were introduced in Japan starting in 1995 obsessed only with monthly payments and no comprehension of true value.  If desperate homebuilders, mortgage lenders, and real estate agents have their way, they will be introduced in the United States starting in 2009.

The sellsius real estate blog called for 100 year mortages recently.  Sellsius attempted to justify 100 year mortgages with seven ridiculous and unfounded benefit claims to the 100 year mortgage.  Unfortunately, every indication is that the United States will follow on with every policy mistake Japan has already made, including the 100 year mortgage.  Consumers will initially resist 100 year mortgages, but later embrace them.  Stupid Creative financing wins over most unsophisticated borrowers in the end as they consider only the monthly payments with no regard for longer term considerations.   But a few savvy consumers will make better choices.  And in most parts of the country, the wiser choice is still building equity through renting.  The equity comes from investing and compounding all the additional disposable income you keep from not buying inflated assets!

Other interesting reads:

• Reading the comics – aka Real Estate section
• FDIC won’t say if your bank is safe – find out yourself
• Inflation Nation and the Fed tightrope
• Mortgage insurance won’t help banks who ignored it

2008 was a tough election year for many Americans due to the lack of quality candidates.  Once again, Americans were forced to choose amongst the better of two evils.  I wrote back in August that the election would be determined by the best vice presidential choice, since neither of the two main party candidates were serious about the number one issue facing this nation – fiscal discipline.

• The Choice Is Clear On Obama vs McCain – Fiscal Responsibility

Sometime between August and the November election, Obama updated his candidate website and added fiscal discipline as one of his listed top issues.  In fact, he now hosts his fiscal discipline plan on his campaign website.  In the document, he mentions the following:

The cost of our debt is one of the fastest growing expenses in the federal budget. This rising debt is a hidden domestic enemy, robbing our cities and states of critical investments in infrastructure like bridges, ports, and levees; robbing our families and our children of
critical investments in education and health care reform; robbing our seniors of the retirement and health security they have counted on. … If Washington were serious about honest tax relief in this country, we’d see an effort to reduce our national debt by returning to responsible fiscal
policies.

Faced with the choice of the McCain and Palin team, a handful of unqualified third parties, or Obama and Biden, I voted the only way I could:

• Geldpress Endorsement For Obama – Barely

With evidence of Obama’s fiscal plan, why did I only reluctantly vote for him and Biden?   Despite his words, Obama is not really serious about fiscal discipline. As I mentioned, he only added it to his campaign issues list after August when he realized Americans wanted it.  Since that time, he has reverted once again to embracing reckless fiscal policies, runaway government spending, and fruitless handouts to ignorant financial CEO’s and underwater home owners.

Like virtually every president before him, Obama has cracked under pressure to spend more.  He hasn’t even been inaugurated yet, but already he has flip flopped again, and abandoned his call for fiscal discipline.

The consensus is this: We have to do whatever it takes to get this economy moving again — we’re going to have to spend money now to stimulate the economy. … [W]e shouldn’t worry about the deficit next year or even the year after; that short term, the most important thing is that we avoid a deepening recession.

Obama is now planing a massive drunken deficit spending spree stimulus plan that is rumored to be in excess of $1 trillion.  That’s an additional $1 trillion on top of the trillions of dollars already handed out to greedy and incompetent CEO’s everywhere.  That’s $1 trillion of new unfunded government spending on:

• Direct bailouts of irresponsible mortgage borrowers
• Tax cuts
• New infrastructure projects
• Spreading broadband access
• Promoting healthcare information technology
• Renewable energy projects
• Bailing out state and local governments overrun with their own bout of fiscal recklessness

Jim Jubak from MSN Money recently listed 10 picks for income investors.  Jubak also expressed caution to his readers who are to hung up with extremely high dividend yields.  Genco Shipping (symbol GNK) as an example currently shows a 35.2% yearly dividend yield on Yahoo Finance.  But high dividend yields can and do get eliminated often in bear markets.  Just look at the mix of financial shares, whose incompetent CEO’s announced one week that they were adequately capitalized, and days later eliminated dividends and begged taxpayers for handouts.

With that word of caution against lofty dividends, Jubak goes on to list his 10 dividend play picks.  Among them are:

• Enbridge Energy Partners (symbol EEP)
• Energy Transfer Partners (symbol ETP)
• Natural Resource Partners (symbol NRP)
• Caterpillar (symbol CAT)
• JPMorgan Preferred G (symbol JPM-G)
• Rayonier (symbol RYN)
• Chevron (symbol CVX)
• Deere (symbol DE)
• FPL Group (symbol FPL)
• Nucor (symbol (NUE)

Unfortunately, there is NOT one on Jubak’s list that I’m eager to throw my own money at.  The first 3 are paying out close to or in some cases more in dividends than they make in income.  I just don’t see those level of dividend payments as sustainable.  And if they are, I question the logic of any CEO who would borrow money from the capital markets just to pay dividends to shareholders.

The rest of Jubak’s list is just to debt intensive for my blood.  2007 was the year for debt financed mergers and stock buy backs.  In 2008, investors have wisened up and they are now looking for long term and sustainable growth in well managed companies.

With that said, here are the latest Geldpress dividend picks:

1. Wabtec (symbol WAB) – Westinghouse Air Brake Technologies Corporation, doing business as Wabtec Corporation (Wabtec), is a provider of technology-based equipment and services for the global rail industry. The Company primarily serves the worldwide freight and passenger transit rail industries.  The dividend yield is tiny, at only .10%, but rather than increase the dividend, the company instead chose to pay down nearlt $400 million in long term debt over the last 8 years.  Their current debt/equity ratio is only .219, according to Yahoo Finance.  For my own account, I recently purchased shares in Wabtec, and hedged them by selling an in the money covered call against them (Jan 40). My personal called out return will be 7.1% over 5 weeks, not counting commissions.  If I don’t get called out, I’ll decide in January what my next move will be.  More aggressive players can sell an out of the money covered call (Jan 45), or just buy and hold Wabtec shares naked.
2. Bristol Myers Squibb (symbol BMY) – Bristol-Myers Squibb Company (BMS) is engaged in the discovery, development, licensing, manufacturing, marketing, distribution and sale of pharmaceuticals and other healthcare-related products.  According to Yahoo Finance, it currently pays a dividend of 3.4%, based on today’s closing price.  It’s current debt/equity ratio is less than .5, but with it could easily pay off the entire long term debt using its nearly $7.5 billion in cash.  In my own account, I recently purchased shares in Bristol Myers, and am currently holding them naked. I may or may not hedge the position in the future.
3. Bemis Company Inc (symbol BMS) – Bemis Company, Inc. is a manufacturer of flexible packaging products and pressure sensitive materials. The Company sells its products to customers throughout the United States, Canada, South America and Europe, as well as Asia Pacific and Mexico. It operates in two segments: Flexible Packaging and Pressure Sensitive Materials.  The current dividend yield is 3.4%.  In my own account, I recently purchased shares in Bemis, and am currently holding them naked. I may or may not hedge the position in the future.

***Disclaimer: Geldpress picks are NOT advice of any kind.  Trade at your own risk!  You can lose money!

Is the China game over?  Has the world satiated it’s appetite for cheap plastic and lead tainted toys and toxic food?  According to the latest report from the Associated Press, China is still expected to grow their economy by a staggering 7.5% in 2009, but Chinese exports recently declined for the first time in seven years.

November’s exports fell 2.2 percent from the year-earlier period, the first decline in seven years, the government reported. That was down sharply from October’s export growth of 19.1 percent and well below analysts’ forecasts of a 13 to 15 percent rise…

“China is facing its most serious economic downturn in two decades,” the rating agency said in a report. The stimulus package, while large, “will not be able to offset fully the negative effects from the contraction in global trade.”…

China’s economy is expected to grow by about 9 percent this year but forecasters expect that to weaken in 2009. The World Bank has cut its 2009 growth forecast from 9.2 percent to 7.5 percent, its lowest since 1990…

It’s pretty clear now that the entire housing market run up over the last 10 years was fake, and mostly based on wide spread fraud.  Anyone still in denial needs to read the latest businessweek article entitled Sex, Lies, and Subprime Mortages.

The women allegedly offering sexual favors were bank employees. Evan Stone, president of Walnut Creek (Calif.) mortgage brokerage Pacific Union Financial, says “minimally trained and minimally dressed” wholesalers often wooed brokers. He says he regularly got visits in his suburban office from representatives wearing unusually short skirts to entice him and his team of brokers to party at the local Ruth’s Chris Steak House. Stone says one New Century wholesaler offered to fly him to Chicago to “have a good time.” He says he declined all offers of sexual favors. “There were some indecent proposals made,” he says. “That was part of building the relationship.”

Check out the New York Times article, entitled “Investors buy U.S. debt at Zero Yield“. The rampant fear in the market and flight to safety is pushing demand for U.S. treasuries so high, that yields have approached zero.  And for brief moments the yields even dipped into the negative territory!  At negative yields, you are essentially paying the government to “preserve” your cash.  And at negative yields, now may finally be the time to stuff some of your cash under the mattress, where you will at least preserve your capital.

In the market equivalent of shoveling cash under the mattress, hordes of buyers were so eager on Tuesday to park money in the world’s safest investment, United States government debt, that they agreed to accept a zero percent rate of return…Demand was so great even for no return that the government could have sold four times as much…In addition, for a brief moment, investors were willing to take a small loss for holding another ultra-safe security, the already-issued three-month Treasury bill.

The bright side of this news, of course, is that incoming president Obama will likely no longer be dependent on the Chineese for funding new and rolling over our existing government debt obligations.  There are enough suckers right here at home to obviate the need for Chineese debt investors.