Woodward Governor Company (WGOV)

I based my CAPS “purchase” on an analysis that I did back on April 1 when the stock was at $10.74, which is what I am writing up here. The appreciation in stock price since then caught me off guard (typically when making picks based on value, it takes a while for others to appreciate the value), and the appreciation since I actually made the pick is also more than I expected for such a short run.

The EPS has been generally been growing since 2001. For the 2001-2008 period, the compounded annual growth (CAGR) has been 12%. The return on equity (ROE) has exceeded 18% for the last two years, and the free cash flow has been positive since 2001 and generally increasing since 2005.

Before I look at the valuations, I look at three indicators of financial safety. For this stock, all three are reasonable. The Altman Z is 3.0; below 1.8 is risky, above 3 is the safe range. The Piotroski F is 5; 2 or below indicates caution, while 8 or 9 indicates that the stock is expected to rise within the next year. The weak spot was the Sloan accrual, which is -.06; 5 or higher is high risk, while -5 or lower is excellent.

I use more than one valuation method to gauge intrinsic value; the first three all provide a reasonable to substantial margin of safety (MOS). The first three are standards in the valuation literature. The estimate based on Graham’s formula was $41 (73% MOS). The Earnings Power Value (value of the firm) was estimated, on a per share bases, to be $40 (73% MOS). The Discounted Cash Flow estimate valued the stock at $17 (38% MOS).

The last two were based on a spreadsheet found on the AAII website; these are designed to mimic Buffett’s valuation methodology. One is based on projecting EPS growth 10 years into the future based on past EPS growth; I discount the resulting valuation to reflect the price at which the stock will realize a compounded earnings (including dividends when applicable) return of 15%. Based on this method the target purchase needs to be below $12, and at the current price there is a 10% MOS

The second is based on estimating EPS growth through the sustainable growth rate. The per-share projected book value is estimated by taking the previous year’s book value, adding EPS and subtracting dividends (when applicable). The projected EPS is estimated by multiplying the projected book value by the average Return on Equity, and the projected dividend is estimated by multiplying the projected EPS by the average payout ratio. I then discount the resulting valuation to reflect the price at which the stock will realize a compounded earnings return of 15%. Based on this method the target purchase needs to be below $12, and at the current price there is an 11% MOS.

To ascertain that the price is attractive to me, I take one more thing into consideration. At the current price, would I expect an immediate 15% return on my investment (ROI) based on earnings and dividends? In this, the EPS represents about 16.6% of the share price by itself, so while the 2.2% dividend yield was not essential, it did provide a bit more safety. However, had the dividend been needed to achieve the desired 15%, I would have discounted it to some degree because there is a moderate risk that the dividend may be cut. This risk is assessed by evaluating several factors (Current Price, Current Yield, Current Payout Factor, Gross Margin, Operating Margin, Financial Leverage, EPS Growth). Both the most recent fiscal year and trailing twelve months (TTM) risk of a dividend cut were moderate. If they had been different, I would give greater weight to a TTM assessment and less weight to the most recent fiscal year.

Based on fundamentals, indicators of safety, and valuation, WGOV rates to be a reasonably good investment.