Good investors rarely rely upon Wall Street analyst recommendations. They perform their own analysis before buying or selling securities.
About a month ago, one brokerage house downgraded oilfield service titan Halliburton (NYSE:HAL) "due to aggressive 2014 Street margin expectations." A one-two punch combining the downgrade and a general market pullback has seen the stock fall some 11%.
Savvy investors see downgrades and market retreats as potential opportunities. Short-term traders and weak hands often shake out on the news, thereby providing a chance to pick up shares on the cheap.
Boiling down valuation
Full-on securities analysis and valuation requires careful review of a number of financial/operational fundamentals and of course, understanding the underlying corporate narrative. However, at the foundation of the exercise is assessing forward earnings and assigning a reasonable price/earnings ratio to it.
Step 1: project forward earnings
With only one quarter to go, Halliburton 2013 consensus operating EPS is projected to fall between $3.13 to $3.20, depending upon what group of analysts is compiled.
Wall Street estimates for next year's earnings are $4.26 to $4.28.
To be conservative, let's suggest that Halliburton will earn about $3.15 this year, and $4.25 in 2014. This projection is buttressed by the fact that Halliburton management hasn't missed a consensus Wall Street quarterly earnings estimate since 2009. The company has met or beat the estimate every time.
Step 2: determine the historic P/E ratio
There are a number of online sources that provide historic stock P/E data. If you don't subscribe to one of them that actually calculates it for you, an easy way to determine the historic multiple is to calculate it yourself. By finding the average annual P/E for the past 10 years, throwing out the high and low, then averaging the remaining eight years' data, one can get a very good approximation. The result is called the "10-year, normalized P/E ratio."
In the case of Halliburton, this figure is 18.
Step 3: do some math
Now that we have estimates for the current year and next year's operating earnings, plus the historic P/E multiple, we can make an educated, reasonable price estimates for the stock. Since we know that Price = Earnings x P/E, we can plug in our numbers and see what they tell us.
For Halliburton, we get a price target of $57 on 2013 earnings, and $76.50 on 2014 operating EPS.
Given the recent $50 closing price, the near-term fair value upside is 14%, and over 50% for next year. Indeed, more conservative investors may wish to use a slightly lower P/E multiple projection or further shave the 2014 earning forecast to add a greater factor of safety. However, since Halliburton management has demonstrated a fine record of meeting earnings expectations, our "fair value" calculation appears reasonable.
The valuation process is further confirmed by a more detailed review of the business. At the 2013 Halliburton Investor Day, management has promised to focus upon several key initiatives:
- Outgrow the overall deepwater energy services market by 25%
- Expand business in mature fields by 3x
- Improve North American operating margins by 500 bps
- Generate 20% ROCE (Return on Capital Employed)
Execution of these initiatives will translate into continued earnings improvement. Given management's outstanding track record of making good on earnings promises, investor know there's a plan in place for continued future growth.
Bonus exercise: Do a peer group check
Thorough investors often reconfirm their work by doing a peer group check to compare alignment of earnings growth and historic P/E multiples. Halliburton's major oilfield giant peers are Schlumberger (NYSE:SLB) and Baker Hughes (NYSE:BHI).
Here's how they stack up:
|10-yr normalized P/E ratio||18||25||22|
|Est. EPS growth rate 2013 / 2014||36%||23%||41%|
Even though Halliburton is expected to report superior earnings growth, historically the market has assigned it the lowest P/E versus peers.
This review helps reinforce Halliburton's investment potential.
Schlumberger and Baker Hughes sport modified PEG ratios (P/E divided by EPS growth rate) of 1.1 and 0.54, respectively. Halliburton has the lowest modified PEG at 0.50. By this measure, it's the most undervalued of the trio.
Halliburton and Baker Hughes operate primarily within the energy industry as straight field service providers. Schlumberger is the biggest of all, and provides additional technical and information solutions to the industry. On balance, Halliburton management offers the most highly focused, results-driven business model.
Additional fundamental research also reveals that Halliburton has better returns on equity, assets and total investment than peers. Other metrics like debt-to-equity and operating margin find Halliburton standing right alongside its competitors. Given no separation between Halliburton and the others on basic fundamentals, investors may decide it's time for this company's stock to shine above its peers.
Wall Street frequently flashes "Buy" and "Sell" recommendations and stock prices bounce up and down. The oft-changing recommendations are frequently based upon short-term perspectives or fears. Many times they end up being wrong. While novice traders may be whipsawed by analysts, wise investors do their own homework, making educated fair value forecasts.