At the end of 2000, we discussed the importance of buying companies at good prices, especially mature companies that are easier to value.
When you consistently dollar cost average into your holdings, you're granted more leeway where valuation is concerned because you buy stocks at various values over time and form an average price. If you need to choose between several companies when determining where to send a monthly investment, though, you might as well try to get the most value for your dollar each time.
That's what Drip Port does. We are selective regarding which company we send our new dollars to every month. This discipline proved fruitful last year. We bought more shares of our companies at attractive prices, and avoided buying shares when prices were considerably higher -- especially in the case of Intel (Nasdaq: INTC).
Our secret to accomplishing this is not spectacular. First, we consistently follow the general health of our companies by keeping current on news; we know a company's stock price range over the past few years by doing the same; and we follow the price-to-earnings (P/E) ratio at each company we own. In following the P/E, we are ready to buy more shares of our stocks when the P/E declines to certain levels without significant news. This works best with mature, steadily growing companies.
At the end of 2000, we stated that we would attempt to develop a system to help "automatically" direct us in making our monthly investment decisions. This might not prove possible, partly because a great deal of human knowledge is still used in each month's purchase decision (by keeping up with news, for example). However, at the least, we can share the numerical thinking used in our monthly decisions so that others can use it in their own situations.
In our case, the companies that we buy more of regularly are Intel, Johnson & Johnson (NYSE: JNJ), Mellon Financial (NYSE: MEL) and, recently, PepsiCo (NYSE: PEP). Below are these companies' average high and average low P/E ratios for the past five years, as well as the average P/E that each company sported at the end of each year.
Intel's average high P/E the past five years was 40.4. However, last year when the stock soared, its P/E jumped briefly to 62. So, realize that this table shows the average high P/E for each company over the past five years. It does this by taking the highest P/E reached in each individual year and averaging those numbers (30, 28, 37, 42, and 62 in Intel's case, from 1996 to last year, respectively). The same is done for the low.
Listed below the historic P/Es in the following table, we show the current P/E of each stock and the forward P/E based on this year's earnings estimate from First Call.
Average P/Es, 1996 - 2000 Ticker INTC JNJ MEL PEP
High 40.4 32.6 23.1 36.7
Low 18.6 24.5 14.3 24.4
Year-end 25.9 29.2 20.1 31.5
Stock price $34 $94 $44 $44
Current P/E 19.4 28.5 21.6 28.4
'01 est. P/E 31.1 24.5 19.7 26.9
The number we're most interested in for our new monthly purchases is the 2001 estimated P/E (the last number in the table), because investors look ahead when pricing stocks. We compare this number to the stock's low P/E averaged over the past five years. The closer these two numbers are, the better the stock price looks (all else in the business being equal). On this measure, Johnson & Johnson looks best.
At $94 per share, Johnson & Johnson trades at 24.5 times 2001 earnings estimates. Over the past five years, the stock's average low P/E each year was 24.5. Though far from faultless, this indicates that J&J is at an appealing price today.
PepsiCo is also near its low average P/E, which was 24.4 the past five years. At $44, the stock trades at 26.9 times 2001 estimates. Mellon Financial trades at 19.7 times 2001 estimates, while its average low P/E since 1996 is 14. Finally, Intel is at 31 times greatly lowered 2001 estimates, which puts it nearer the high-end of its five-year P/E.
Of course, there are other factors to consider. For example, Pepsi's stock is near its low average P/E, but the company isn't growing as quickly this year as it did the past few years. Also, Intel's 2001 earnings estimates have been lowered so much this month that the company probably has the best chance of providing a positive surprise in 2001.
We'll continue this discussion tomorrow by rounding out these thoughts with a conclusion, and by showing a distilled, short-and-easy way to make monthly purchase decisions based on P/Es. After that, we continue our high-growth study. If you have questions or thoughts about the topic of trying to optimize your buy prices (for many investors, just automatically investing each month makes the most sense), please post them on the Drip Companies board.
Fool on!
-Jeff Fischer, TMF Jeff on the boards
