This is my first entry on the blog. I am an investor who tries(and hopefully succeeds) in value investing. The main purpose of this blog is to use this channel to post my views on the listed companies in Singapore., and anything to do with investing, but primarily in stocks. Just wanna start things off with a bit on valuation metrics, and hopefully move on to analysing certain counters which I feel are worth taking a second look.
I have always been a fan of investing based on book value, specifically on net tangible assets, due to the relative limited downside based on this metric, and also the "margin of safety" that Benjamin Graham coined to emphasise on the importance of investing safely. Read an interesting article recently on a different type of valuation used, unlike the PERs and the DCFs that analysts and other professionals use. This form of valuation revolves around the book value of the company, whereby the expected free cash return above capital expenditures is projected for a foreseeable(therefore, not unrealistically too far ahead) future, and then discounted to present value and added to the current book value.
This assumes a few things: book value does not substantially increase over the years. Secondly, that the capital expenditures are either steady or steadily increasing over the years.
I personally feel that this form of valuation has a few advantages:
1) It serves to value a firm independently without referring to other similar companies' valuations, as the case for PERs.
2) It is technically more realistic as the markets would not want to pay more than book value for a company if it is loss making.
Take for example, a pen, which costs $1 to make, and which will generate you 20cents for the next 5 years, and nothing more. By using a simple DCF and an appropriate discount rate to account for the opportunity cost, you will arrive at a value somewhere between $1 and $2. That is roughly the price that another person will want to buy from you when you sell it. Similarly, if the pen will make losses for you, someone else will only buy it below $1, and not at your cost price.(although I can't think of any legitimate reason behind why he/she will even buy the pen from you in the first place.)
Disadvantages:
1) assumes that the book value of equity remains constant throughout this period. This may not be realistic for firms that will continue to grow(asset-wise, and through equity funding).
2) capital expenditures may not be stable for companies which are capital intensive, as they tend to spend more when they have more cash at hand, and less when raw material costs start to fall.
Please feel free to post your comments, and would love to have more ideas.
5 comments:
Hi patrick,
Another good article :)
I feel that there are some companies that are not so suitable for using book value. Examples will be those in the service industry. Another disadv of using book value is the fact that book value can be marked to market price. Thus 'buying below book value' might give an illusion of safety but when the market drops, the book value drops as well. A good example I can give are those palm oil companies. I'm always intrigued by this particular line on their income statement "fair adjustments to biological assets", which by itself made up a huge chunk of their profits.
Personally, I don't like to use FCF for calculation cos I feel that there's not much value (no puns intended!) added while increasing the volatility of the variables involved. Maybe I just suck at FCF haha :)
haha yes, I fully agree with u! I do agree with your point that the companies in the service industry do trade at multiples to book value,but only for a legitimate reason cuz the company itself generates much more from the assets and are not asset-heavy.
oh really?i believe the FCF to be probably the more accurate of valuations,but of course yes for the capital heavy industries,the FCF tends to be very volatile as a matter of fact.
So what kinds of valuation do you use then?
Hi patrick,
I use a discounted earnings for more serious valuations. It's wallstraits method. Basically, using earnings in place of cash, for a period of 10 yrs without terminal or perpetual value, and then discounting it to present. Earnings growth I limit to around 10% usually, regardless of how much growth it had made in the past historical records. I kind of think that earnings growth of >10% over 10 yrs seems a little optimistic.
For play play (and a quick feel of the value), I use annualised earnings for next fy based on quarterly or half year earnings. Then I'll find out the historical high and low PE (at least over 5 yrs), then multiple by the lowest historical PE to arrive at price. This method can be extended to 10 yrs down the road, by assuming constant ROE.
I used to be quite uptight over how I calculate valuations. But these days, I do a quick 10 min numerical valuation and apply a healthy margin of safety.
haha that's pretty much what I do as well.but for companies which are capital intensive and do not have consistent cash flows, i tend to use ur second-mentioned method.some similarities then;)
but well, for the DCF i think having 10yrs is a bit optimistic also,as it's quite difficult to see a company 10yrs down the road,except for market leaders.
Hi patrick,
I only do DCF for companies with a good record of stable and consistent earnings. Otherwise, as you said, really hard to pinpoint it :)
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