Found a link to morningstar's approach to equity valuation

http://news.morningstar.com/article/article.asp?id=83572&ssection=topright1

Written by Manpreet

Recently, i did an evaluation on Sarin Technologies which is listed on SGX.Here is a summary from its annual report of its main businesses.

"Our products currently provide the diamond industry with technological solutions for five main areas:
(a) Planning the optimal utilization of the rough stones in order to cut the rough stones so as to achieve the maximum yield and value;
(b) Sawing, cutting and shaping of rough stones using advanced green laser technology, so as to significantly reduce the risk of stone breakage and reduce rough material waste;
(c) Polishing the facets on rough stones to transform them into polished gems, by using Sarin-developed disposable polishing discs, as source of recurring income for the Company;
(d) Measurement of two (Colour and Cut) of the four parameters of the polished diamond (Colour, Cut, Clarity and Carat) in order to help determine the value of the diamond, based on the quality grade of its colour and cut, as well as light performance measurement systems for enhancing a polished diamond’s certification; and
(e) Inscribing on polished diamonds with distinct marks like text, numerals and symbols, so as to aid in the diamond’s identification and personalisation.
Our business strategy is to consolidate our position as a market leader for the provision of high technology solutions in the diamond and gemstone industries"

Its largest market is India where 77.4% of its revenue comes from there.With the indian economy promising to maintain its stellar growth,this will continue to be a profitable source of operations.

Also, management has continued to maintain a large stake in the company,indicating their belief that the company will continue its growth

Ratios

Average net margin for last 5 yrs is 24.68


Current working capital ratio is 0.34 and stock is trading at a 20% premium
4 yr average ROA is 75.68%
4 yr average ROE is 156.9%
Current ratio is a healthy 2.98
Free cashflow per share after net capital expenditures is 0.14.So the stock is really selling at 0.41

Calculated intrinsic value is 0.75 USD. Buy price would be 0.56 USD

Assumptions:Using a 3 stage DCF,with growth rate of 20% for first 5 years, followed by 10% for the next 5 years and a terminal growth of 3%.Also assumed a debt level of 10% and discount rate 15% & a margin of safety of 25%

Written by Manpreet

Why Warren is big on intangibles and low on tangible assets!

See's was bought for 25 million with an earings of 2 million. At that time, it had roughly 8 million of tangible assets and hence the payment for see's created a 17 million goodwil intangible account.

If a hypothetical business did have an intangible asset base of 18 million and had 2 million in earnings, it would have earned 11% on tangible assets. We also assume that this business has no economic goodwill.

Now imagine if a doubling of price level or inflation did take place, both businesses would have to double their earnings to 4 million to keep pace with inflation. Hence, both businesses would have to sell the same number of units at double the earlier prices and assuming that profit margins were unchanged, profits must also double.

To bring about a doubling of profits and to be even with inflation, both companies would have to double their investment in net tangible assets. For See's candies, an investment of 8 million would have to be made while the other would have to make an investment of 18 million.

While both companies are attaining the same amount of profits , See's only had to spend an additional 8 million while the other business had to spend an additional 18 million. This just goes to show that companies with more intangibles (moat) and less tangible assets are better than asset heavy companies when it comes to fighting inflation.

Margin of safety

In 1972, Ben Graham gave a lecture and summarised the concept of margin of safety. It is the difference between the percentage rate of the earnings on the stock on the price you pay for it and the rate of interest in bonds and that margin of safety is the difference which would absorb unsatisfactory developments. If a company was selling at a PE of 11, the earnings yield would be 1/11 which is 9% while a bond yield of 10 year maturity is 4 %. Here in this case, the margin of safety is (9-4)/4 x 100 = 5/4 x 100 = 125%

Also if the intrinsic value of a company is estimated to be between a $100 and $120.(The variation in intrinsic value is due to pessimistic and optimistic growth rates and variations in discount rates. Note: Intrinsic value is an approximation and not an accurate figure) And if the market value is $60 , we say that the stock has a margin of safety of (100-40)/100 x 100 = 40%. For purposes of conservatism, we should take a lower value of $100 of the intrinsic value to calculate the margin of safety.

Test of retained earnings

Capital allocation is an extremely important process. To put it bluntly, poor capital allocation would lead to decreased intrinsic value and superior capital allocation under above average business conditions would lead to increased intrinsic value. According to Warren buffet he expects every dollar retained to result in an increase in a dollare of market value in a 5 year rolling basis. More recently, other test of retained earnings have been developed to check if increases in retained earnings has led to increases in net income or owner earnings. For example, if the change in retained earnings in the last 10 years was $100 and the increase in net income over the last 10 years was $20, then it can be argued that the company's earnings increased $20 from the increase of a $100 in retained earnings , 20% that is. However in my opinion this is still and inadequate test. What i would like to find out is how capital expenditures would lead to an increase in earnings per share in franchise businesses with competitive advantages? Does anyone have any comments over this or suggestions? Do feel free to contact me and share your views!!1