Today we conclude our thoughts on making additional investments in stock positions at good prices.
First, a short preface to this column: For many investors, automatically investing more money in their companies regularly, rain or shine, often makes the most sense and works very well when buying good companies. Drip Port, however, doesn't invest enough money each month to send funds to all its companies, so with our limited monthly investment, we seek the best value.
Near the middle of each month, I run a few very simple numbers on our four active holdings: Intel (Nasdaq: INTC), Johnson & Johnson (NYSE: JNJ), Mellon Financial (NYSE: MEL), and PepsiCo (NYSE: PEP). This exercise takes five minutes.
Using the Fool's Quotes and Data, I gather the stock price and fiscal year-ending earnings estimate for each of our companies, along with the expected earnings growth rate for the year. (All three numbers are on one page for each company, the Estimates page). If I agree with the estimated earnings for a company, I then divide the company's current stock price by its forward earnings estimate to get its forward price-to-earnings ratio (P/E) for the year.
Next, I compare that forward P/E result to the company's earnings growth rate. Finally, I compare that forward P/E to the P/E ratios that we've seen for the stock over the past few years. (Usually I needn't worry about the historic five-year P/E, even though we shared those yesterday. They provide good context, but knowing how a stock's P/E has behaved over just the past few years is often benchmark enough when its business prospects have remained stable.) So, I'm basically looking at the forward P/E estimate for the year in comparison to the company's earnings growth rate. I then loosely compare the forward P/E to the stock's recent P/E performance. Simple.
Comparing a P/E ratio to an earnings growth rate is called the PEG. It is best used loosely -- as one simple reference tool. That's what we do. Looking at it, we next consider how reliable each company we own is, and how likely it is to achieve its estimates for the year and then keep growing afterward -- because if the following years don't appear promising, doing well this year won't mean much.
Here's a table of all the numbers that we just mentioned for Drip Port's stocks.
Co. Stock '01 EPS '01 EPS P/E on P/E to '01 Ticker Price Est. Growth Est. '01 Est. Growth Rate (PEG) INTC $33 $1.06 -36% 31.1 N/A JNJ $94 $3.83 13% 24.5 1.88 MEL $45 $2.28 12% 19.7 1.64 PEP $44 $1.63 12% 26.9 2.24
Aside from Intel, our investments are stable and typically predictable growers. J&J and Pepsi have averaged a P/E in the mid-to-high-20s during favorable markets (the past five years), and a PEG of nearly two times their growth rates, being top-tier companies. Mellon Financial is usually closer to a 20 P/E, or in the high teens, and usually has a lower PEG. So, when the P/E ratios are below these past patterns without a meaningful business reason attached, we're very likely to use the deviation as an opportunity to buy more shares than usual.
The best example was Johnson & Johnson in early 2000 when it dipped in one month from $92 to $68. At $68, the stock traded at only 19 times that year's earnings estimate. We also looked ahead to 2001 estimates, because the company is a stable grower, and we saw that the stock was at 17 times 2001 estimates. We knew that this was far below the average high-20s P/E that the stock has commanded since the mid-1990s, as this table of five-year average P/Es shows.
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
Knowing that Johnson & Johnson was cheaper than we'd seen it for at least a few years, we sent the largest chunks of money possible to it for two months in early 2000, buying more at $68 and $74, and then we stopped when it rose to $88 the next month.
This P/E-based system is far from complex. Even so, I believe that it has a strong chance of being valuable for us for a long time, as long as we remain knowledgeable about our businesses' prospects. The underpinning of this method -- the earnings estimate -- must be reliable, so we must know our companies' strengths and risks. That said, sentiment can change, too, and a stock that supports a 28 P/E today might only support a 14 P/E in a few years. Pharmaceuticals have been through that kind of love-hate wringer before.
Accepting and watching for these risks, there are still many good reasons for the Drip Port to use a forward P/E system to loosely guide it each month with its selective purchases. The forward P/E is easy, quick, and -- perhaps most importantly -- not just mechanical; it holds personal insight and knowledge about each business in high regard.
One more thing in relation to Drip Port: We try to build investments in our holdings evenly, as long as merited. Sometimes that desire plays a role in our monthly buy decision. It's not an accident that we have $1,300 invested in all three of our oldest holdings.
As for our February purchase, we need to send $100 tomorrow. Three of our stocks (all but Intel) are fairly near one another on a P/E basis. As you can see in the first table above, it's basically a toss-up this month (as happens many times -- it's Foolishly simple). So, since both have dipped lately without news for it, tomorrow we'll send $50 to Johnson & Johnson (which just reported earnings and said 2001 looks good) and $50 to Pepsi. (Since this column was written, J&J has declined from $94 to below $91, or a 23.4 forward P/E -- below its average low the past three years.)
To discuss this column, visit us on the Drip Companies board linked above. Next week we continue our high-growth study. Fool on!