Lessons in valuation

For more on valuation using discounted cashflow check this link out and my previous post....


http://www.fool.com/investing/value/2005/12/27/foolish-fundamentals-valuation.aspx


Cheers,
Lucas

Valuation issues

Someone once asked me how to value companies. Valuations done are never right. However, it is important to be approximately right than precisely wrong. For that reason, Me and Manpreet always feel that valuation should be done conservatively.

Here are some pointers to note:

1) Don't overestimate growth rates! In fact try to underestimate them for future years!

2)Use some form of sensitivity analysis with reference to the discount rate use

3) Since the beta concept is utter nonsense, i suggest using a discount rate of 8% - 15% to find a range of intrinsic values with regards to discounted cash flows

4) Terminal value growth rate should approximately be 2% because long term growth rate of GDP in the US is approximated at 2%

5) If possible, dont even impute a terminal value in the model! If the price is drasitically below a model without terminal value, it is a screaming buy!


You can use online valuation calculators to help you and here are some resources if you are a newbie to the game:

1)http://www.moneychimp.com/articles/valuation/buffett_calc.htm

Owner earnings

Owner earnings has been discussed quite frequently in Warren Buffets letters to his shareholders. What is owner earnings? It is essentially the rfee cash flow to equity and it can be written in a simple formula.


Owner Earnings = Reported earings + depreciation,depletion,amortization + other non cash charges - average capital expenditure - change in working capital to maintain competitive position and unit volume

Through Warren's letters, we know that he would rather pay for $2 of unreported earnings than for a $1 of reported earnings and it is on this basis that he values his company. By conservatively predicting owner earnings 10 years into the future and using a suitable discount rate, he is able to find a range of intrinsic values for the company.

More Jewels:Buffett on Valuation

As the build up to the BRK shareholder meeting continues,i would like to share more excepts from a previous Buffett interview( this time taken from Harvard Investment Magazine).Here, Buffett outlines his criteria for valuing companies and gives us a peak into his thought processes.Indeed, its a fascinating look into one of the greatest investment minds ever and gives us invaluable advice into how to value companies which is crucial for successful investing.


Q: What do you stay away from when valuing a company?

Buffett: What I donʼt understand. Get a  x on your own limita-tions of knowledge. Ted Williams [the only Major League Base-ball player to hit .400, or a 40% success rate, over an entire sea-son] divided the strike zone into 77 areas. You only swing at the pitches you can hit with an average of .400. Also, I donʼt want to know the price of a stock as I value it. Knowing the price anchors your thoughts.

Q: What is the more valuable area of academic study, accounting or nance?

Buffett:Accounting is the more valuable. It is the language of business… A number of CEOs donʼt understand accounting. Some people have an intuitive grasp, [but] some people will try to cheat you and lie to you.

Q: Explain your business evaluation criteria.

Buffett: Where is this business going to be in 5 to 10 years? What is the moat? What protects it? With Coca-Cola, the moat is the brand name in the mind. Seeʼs Candies [a Berkshire Hathaway company] owns the boxed chocolates business in California and has been there since 1921. A boy buys a box of chocolates, and she kisses him: We own him. Other examples of moats: Microsoft operating systems; and Meg Whitman [CEO of pioneering online auction company eBay Inc., who] has all of the buyers and sellers. Businesses with moats are easy to value. How do you knock off Wrigley? — the Internet doesnʼt change the way people chew gum

(Excerpted from Harvard Investment Magazine)

The Magic of Compounding

Buffett always keep mentioning this at shareholder meetings and university talks.
Rule No.1 Don't lose money .
Rule No.2 Don't forget Rule No.1

In other words, Buffett is saying that the preservation of capital is necessary to make compounding work to your benefit.For example, traders are known to make huge profts and losses by frequently jumping in and out of stock positions.However, if one considers the daily losses and stock transaction fees,this makes even more unlikely that one can beat the stock market consistently over time.Traders who can do so are few and far.Only a handful have made it in the dog-eat-dog world of stock trading.

The Sequoia Fund run by the late Bill Ruane and now current managed by Bob Goldfarb is one of the best examples on the magic of compounding.Employing the time tested concepts of value investing, $10 000 investment would be compounded at a annualized return of 15.68 over 36 years, turning that investment into $2 024 960.Now that's magic!

Value investing is a powerful tool in the road to wealth creation.One should not confuse this approach with day trading or other popular investment strategies.For some, value investing is seen as risky and illogical.Its true to say that value investing is not entirely easy as one has to continually make contrarian decisions against the psychology of markets.Nevertheless, its a very powerful tool.

Studying the insiders!

I know for a fact that many articles have been written about insider trading. Tons of them available on the internet. Even Tweedy Browne looks for value through the confirmation of insider trades. My personal take is that insider trades are not enough. What one needs to look for is a 'significant pattern of insider trades' according to Tweedy Browne. What that means is that one should look for a certain consensus among the insiders. What i look for is for the heavy weights. I want to make sure that the heavy weights of the company have loaded up on shares within the company and who are the heavyweights? The heavyweights are namely the Chief executive officer, the chief financial officer and the chairman. If these 3 fellows are scooping up shares in the open market, one can be to a large extent sure on one thing: The insiders think that their shares are worth a lot more. Why? These fellows are the ones who know their industry best, and the earnings estimates for the future or whether their recent marketing programs work. These fellows know it all baby! And what they are pretty sure of is that all these will eventually translate into positive news announcements in the near future and the bottom line.

As a practitioner, i would go one step further by considering one more point. From a psychological standpoint, a behavioural standpoint, all humans have 2 vital elements that causes market prices to fluctuate and that is 'fear' and 'greed'. What i want to know is that these fellows are acting out of greed. One is most greedy when one is most certain about the positive outlook for his company. So just to illustrate a real life example of my various info digging sessions, i was looking at one company on the Singapore stock exchange. It was a poor company by buffet's standards, No moats, no high ROEs etc but what happened was that the insiders were loading shares like crazy! And it so happened that one of the C level officers bought about a million dollars worth of the company's shares. I called its investor relations department up and as rude as they may have sounded, they revealed that this C-level officer earned about 1.2 million dollars in remuneration. That, to me was "greed"! He used up a huge portion of his salary to buy shares in the open market.

Although i did not buy its shares as i felt that it went against my own philosophy, my parents scooped it up in the open market. 3 months later, its shares doubled in price.


Of course, i am not advocating this approach in its entirety but i feel that one should combine it with fundamental analysis to buy a truely valuable company.

When it comes to investing there are only 2 rules: (forgive me for being a ripoff but i could not have said it better than buffet)
Rule No 1 : Dont lose money!
Rule No 2: Dont forget rule number 1!


Written by:
Lucas

Tweedy Browne's principles to value investing

For those in the investing community, they might know who Tweedy Browne is. Tweedy Browner used to be a brokerage executing trades for Ben Graham, the father of value investing. And since then, Tweedy has been raking returns of around 15 - 20% for the past 20 years or so. Impressive isnt it? And so here it is, certain principles of Tweedy Browne that we can all apply:

1. Low price in relation to assets

2. Low PE

3.Insider Purchases

4.Significant decline in stock price

5.Small market Capitalization

Found a link to morningstar's approach to equity valuation

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

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

Washington post, a classic buy and a 100 bagger

As reported in the letters to shareholders, Warren invested 10 million in Washington post in 1973. It has to be one of his most successful investments of all time. Due to lack of data on washington post in the 1970s i can only make intelligent guesses while getting to why Warren bought Washington Post. In his letters to shareholders, he claimed that he bought Washington Post at and average price of $5.63. Using Thomson Financial, i could only get the net income of Washington Post back to 1980. Assuming that net income was similar to 1973's net income of Washington Post back to 1980 and there was no growth in per share net income since 1973, the quick and dirty method for calculating the intrinsic value without efforts for discounting would be:

14 million shares oustanding

Dirty intrinsic value= (30 million x 10 years)/14 million shares outstanding = $21.42 per share

Average price paid by Warren= $5.63

If you asked me, he was essentially buying $21.42 worth of earnings with $5.63 and that is assuming no growth. However, Washinton Post did grow its per shares earnings and hence $21.41 seems to be a conservative valuation. Even at that time, Warren also did feel that the Washington Post was worth approximately 4 to 5 times its average share price in 1973.

Subsequently, Warren managed to influence management through Katherine Graham to perform share buybacks thereby increasing per share intrinsic value. Today, Warren's 10 million investment in WashingtonPost has blossomed to a market value in excess of 1 billion. Thats a 100 bagger for the record!