Warren Buffett is the living gold standard of value investors today; practically every different approach to determining how much a stock should be worth borrows from some element of the methods Mr. Buffett has employed in building his wealth and reputation over the course of decades. Investors like me look forward to his annual reports for Berkshire Hathaway (BRK.A) because of the insights they provide into his investing methods as well as his view of current market conditions, and most of us have a handful of his many aphorisms about the market and value investing ingrained in our own approach.
One of my favorite Buffett concepts is the idea that value investing doesn’t just mean buying a stock at a cheap price; it means “buying a good stock at a nice price.” That means that seeing a stock at or near historical lows can be a very nice thing, if the company’s book of business suggests the price should be significantly higher. It also means, however that the mere fact a stock has been increasing in value doesn’t automatically mean you shouldn’t think about putting your money in it. If the fundamentals are good, there’s a reason the stock is going up in price, and sometimes the implied value (or what I like to think of as the intrinsic value) based on the company’s book of business still points to a much higher price. Admittedly, those are pretty hard to find, but it does mean that I try not to disregard a stock just because its price has been going up. It could still be offering a “nice price,” even if it is higher now than it was weeks, months, or even years prior, and if it is that’s a reason to pay attention.
Identifying what the nice price for a stock is really where a lot of subjectivity can come into play. I’ve learned to use a stock’s Book Value as the first tentpole of my value analysis process, because as Mr. Buffett has explained, a stock’s Book Value represents the amount of money per share a shareholder can expect to get back in the even the company suddenly decides to liquid its assets, pay off its debts, and close its doors. Book Value is what is left to distribute to shareholders. Under absolutely ideal circumstances, a real bargain means that the stock’s current price should be below its Book Value; the further below that, the better.
The problem with that ideal Price to Book circumstance is that the market has also learned to use Book Value in the same way, which means that for nearly as long as Book Value has been a useful measurement, investors have pushed the prices of stocks to various multiples of their Book Value. So the most practical way to use a stock’s current price relative to its Book Value (called the Price/Book ratio) is to compare it to its historical norms. If the stock’s current price puts the Price/Book ratio significantly lower than the level the market has historically been willing to keep the stock at, the same kind of “nice price” scenario often applies.
So what if a stock doesn’t fit into the “nice price” description, or what if current market conditions could make even value investing look prohibitively risky? A strict value investor would put the stock aside and move on to something else, or possibly even decide to get out of the market altogether and wait until the market self-corrects and pushes stocks to more attractive levels. The problem with that is that bull markets usually extend significantly beyond the point that most strict value investors are willing to work with, and so if you want to draw that hard line, you have to be willing to pass on a lot of useful opportunities to keep your money working for you.
One approach is to start thinking about alternative investing strategies that may be better suited to a stock’s particular set up at the time. Where value investing really is a long-term proposition, where you have to be willing commit to buying and holding a stock for an extended period of time even if the stock goes down, a lot of the kinds of strategies I’m talking about operate with a shorter time frame in mind. If you’ve been reading my daily posts in this space for a while, you know that this means working with a stock’s near-term trading ranges and trends to think about strategies like swing and momentum trading. It might mean buying a stock and holding it only until it hits a specific target, or using call options; or it could mean shorting the stock to take advantage of near-term bearish momentum to a stock’s next closest support level.
Dolby Laboratories (DLB) is a stock that fits half of Mr. Buffett’s value description; in fact, it isn’t just a “good company,” it’s a great one. Most of the critical fundamental measurements for this stock look really attractive. It’s a business that feeds the entertainment industry, providing imaging and audio solutions for film, television and broadcast media. You’re undoubtedly familiar with the brand, because its products are incorporated in practically every end market that has anything to do with the viewing or listening experience. The problem for a value investor is that it only fits that “good company” half of the value question; its current price put the stock at levels right now that could put long-term investors at a high degree of risk right now – a fact that is even more serious given the last increase in volatility in the market and the rising concern the bull market could be reaching a turning point. I’m going to show you why I like the company so much, and why I don’t like the stock’s price. I’m also going to show you what additional information you should pay attention and that could offer some useful ways to keep working with the stock on a shorter-term basis.
Fundamental and Value Profile
Dolby Laboratories, Inc. designs and manufactures audio and imaging products for the cinema, television, broadcast and entertainment industries. Its products for cinema include Digital Cinema Servers and Cinema Audio Products, and broadcast and other include Dolby Conference Phone and Other Products. It offers services to support theatrical and television production for cinema exhibition, broadcast and home entertainment, including equipment training and maintenance, mixing room alignment and equalization, as well as audio, color and light image calibration. Its technologies include Advanced Audio Coding and High Efficiency Advanced Audio Coding, Dolby AC-4, Dolby Atmos, Dolby Digital, Dolby Digital Plus, Dolby TrueHD, Dolby Vision, Dolby Voice and High Efficiency Video Coding. It distributes its products in over 80 countries. Its technologies are incorporated in offerings in various end markets, such as the broadcast, Personal Computer, mobile, consumer electronics and other markets. DLB’s current market cap is $4.5 billion.
- Earnings and Sales Growth: Over the last twelve months, earnings growth was modest, at a little over 5%. Sales growth was also modest with an increase of a little under 4%. In the last quarter, the picture turned noticeably better, as earnings increased almost 18%, while sales growth was a little over 5%. The stock operates with a healthy margin profile; over the last twelve months, Net Income was a bit over 8% of Revenues, but improved to nearly 24% in the last quarter.
- Free Cash Flow: DLB’s free cash flow is healthy and translates to a Free Cash Flow Yield of about 5.5%.
- Debt to Equity: DLB has a debt/equity ratio of 0. DLB has no debt to speak of and more than $1 billion in cash and liquid assets on its balance sheet, which means the company has excellent liquidity, with abundant flexibility to adjust to changing market conditions and take advantage of new opportunities as it finds them.
- Dividend: DLB pays a modest annual dividend of $.64 per share, which translates to a yield of .9% at the stock’s current price.
- Price/Book Ratio: there are a lot of ways to measure how much a stock should be worth; but one of the simplest methods that I like uses the stock’s Book Value, which for DLB is $21.12 per share and translates to a Price/Book ratio of 3.34 at the stock’s current price. Their historical Price/Book average is 2.48, which suggests that the stock is trading at a premium right now of almost 26%. Another useful measurement is the stock’s Price/Cash Flow ratio, which is currently running more than 40% above its historical averages. Together, these two measurements put the stock’s “fair value” target somewhere between $42 and $52 per share and provides the strongest criticism for this stock as a useful value opportunity.
Here’s a look at the stock’s latest technical chart.
- Current Price Action/Trends and Pivots: The chart above outlines the stock’s movement over the past year. It’s pretty easy to see the stock’s attractive performance over the past year, since it has increased in value over that period by nearly 20%. Even more tempting may be the fact that most of that movement has come in just last five months, and also that the stock has more than doubled since early 2016, when the stock hit a downward trend low at that point of around $30 per share. That’s great performance if you were in the stock during that time enjoy it; but it also means that buying the stock right now is really a great example of coming late to the party. The stock has pretty solid support right now in the $67.50 price area, and very strong resistance between $71 and $71.50 per share.
- Near-term Keys: The narrow range I just described is useful for identifying what other strategies might be profitable with a shorter time frame in mind. A move above $71.50, for example, with strong buying volume could push the stock to new historical highs, and since the stock’s last big surge after a resistance break in August translated to a gain of around $6, it isn’t unreasonable to think about buying the stock at that point or working with call options with a target price in mind of $77 to $78 per share. If, however the stock breaks below $67.50, the smarter trade would probably be to think about shorting the stock or buying put options, with a target price anywhere between the stock’s June pivot high at $65 to its swing low point in early July at around $61.