Intrinsic Value Basics

[iiinvestsmart]

Buffett likes to control risk.  He does this primarily by avoiding companies if he thinks there is too much uncertainty about their future cash flows. 

Furthermore, because he believes there is little risk in buying companies that have predictable cash flows, he feels comfortable using the so-called risk-free rate to discount their projected cash flows. More specifically, he starts with the yield on U.S. Treasury bonds and makes some adjustments to it. 

[iiinvestsmart]

Buffett likes to control risk.  He does this primarily by avoiding companies if he thinks there is too much uncertainty about their future cash flows. 

Furthermore, because he believes there is little risk in buying companies that have predictable cash flows, he feels comfortable using the so-called risk-free rate to discount their projected cash flows. More specifically, he starts with the yield on U.S. Treasury bonds and makes some adjustments to it. 

A more conservative approach would argue for the use of a higher rate - in particular, one that properly reflects the stock's market-related risk.  Buffett believes he does not need to account for risk in the discount rate since he consciously avoids stocks that he considers too risky.

Analysts and academics have criticized Buffett for this.  They say that by using a discount rate that does not properly reflect risk, he is more likely to erroneously conclude that an overvalued stock is undervalued.  Furthermore, by ignoring companies whose cash flows are difficult to understand, he is likely to miss out on great investment opportunities.  Buffett stands guilty as charged, yet his track record speaks for itself.

[iiinvestsmart]

10 Essential Questions to Ask When Deciding What Multiple to Pay For a Stock

Buffett has correctly pointed out that the correct way to value a business is to calculate the discounted value of all its future cash flows. The concept is simple. The application is not.

For many businesses, it is difficult to calculate this with a level of precision that has much utility.

Some businesses are sufficiently predictable that a careful business analyst can make a reasonable and useful calculation of its DCF, or what Buffett calls its intrinsic value.

Also, sometimes in periods of extreme dislocation, a business will sell at such a depressed price that you can reasonably conclude that the market price is below intrinsic value, even if the range of possible DCFs is large.

The multiple at which a stock trades is nothing more than a shorthand proxy for its DCF.

In Buffett’s 1991 letter to shareholders, he concluded that, assuming a discount rate of 10%, a business earning $1 million of free-cash and with long-term growth prospects of 6% would be worth $25 million or 25 times earnings.

A no-growth business also earning $1 million would be worth about 10 times earnings.

Business 1: $1 million / (10%-6%) = $25 million

Business 2: $ 1 million / (10%) = $10 million

As a practical matter, what types of things should you be thinking about when deciding if you are dealing with a company that deserves a multiple of 25 times earnings versus one that only deserves a multiple of ten times earnings. There are many factors to consider.

Venture capitalist Bill Gurley has written an excellent list of characteristics to consider when evaluating a company and determining what multiple to use when valuing its earnings.

You should carefully think about each of these and add them to your checklists for evaluating a business.

I’ve put Gurley’s characteristics in the form of a question.

1. Does the business have a sustainable competitive advantage (Buffett’s moat)?

2. Does the business benefit from any network effects?

3. Are the business’s revenue and earning visible and predictable?

4. Are customers locked in? Are there high switching costs?

5. Are gross margins high?

6. Is marginal profitability expected to increase or decline?

7. Is a material part of sales concentrated in a few powerful customers?

8. Is the business dependent on one or more major partners?

9. Is the business growing organically or is heavy marketing spending required for growth?

10. How fast and how much is the business expected to grow?

Written by Greg Speicher

[Laughing Gor]

A more conservative approach would argue for the use of a higher rate - in particular, one that properly reflects the stock's market-related risk.  Buffett believes he does not need to account for risk in the discount rate since he consciously avoids stocks that he considers too risky.

Analysts and academics have criticized Buffett for this.  They say that by using a discount rate that does not properly reflect risk, he is more likely to erroneously conclude that an overvalued stock is undervalued.  Furthermore, by ignoring companies whose cash flows are difficult to understand, he is likely to miss out on great investment opportunities.  Buffett stands guilty as charged, yet his track record speaks for itself.

I totally agree with buffet on this.

Simple loh, better safe than sorry.

My Rule No. 1 to profit from stocks is "Protect your capital". You keep your army, tomoro still can make a comeback. You lose your army, there is no tomorrow.

[iiinvestsmart]

I totally agree with buffet on this.

Simple loh, better safe than sorry.

My Rule No. 1 to profit from stocks is "Protect your capital". You keep your army, tomoro still can make a comeback. You lose your army, there is no tomorrow.

Keep learning from Buffett, the sifu.

 

[soulsimple]

Valuing a Business - Seth Klarman's 3 Methods

"Price is what you pay. Value is what you get." says Buffett. Valuing a business is, therefore, a fundamental skill that every value investor must master to be able to discern the intrinsic value of a business from publicly available information.

The truth is all of us can recognize a discount when we see one. When I shop for organic fuji apples, I know they are at a discount at $2.39/lb if they normally sell for $3.99/lb. Keeping an eye on the price tags is the key. But when it comes to recognizing a business selling on a discount, the share price does not always reflect the value of a business. This is because a business is made up of people. Hence, businesses evolve for better or for worse. When a business evolve into a more valuable business, the share price must at some point reflect this change.

The trouble is no one perceives the value of a business the same way. This is why even Ian Cumming and Joseph Steinberg couldn't agree on the same intrinsic value for Leucadia. So when you throw the entire population of investors and speculators in the mix, you get a variable share price that changes by the second.

Business valuation is as much an art as a science. There is no one value that is the absolute right value for a company. Because of the imperfect knowledge of the future, we can only come up with a range of values for a company. Below are the three methods of business valuation that Seth Klarman postulates every value investor should have in his warchest.

[soulsimple]

1. Discounted Cash Flow / Net Present Value

In Theory of Investment Value, John Burr Williams was among the first to introduce the discounted cash flow (DCF) analysis. Seth Klarman categorizes this under the net present value (NPV) method. With a properly chosen discount rate and reasonably predictable future cash flows, the NPV method yields the closest to precise valuation of a profitable business.

DCF basically calculates the present value of all future cash flows by applying a discount rate. The discount rate is the interest that you would like to be compensated for incurring the opportunity cost of giving up alternative, less risky investments. The riskier the investment the higher the discount rate should be. Generally, the short term US Treasury securities are considered risk-free alternatives. In other words, if you are accepting a higher risk for an equity investment, you should expect to earn an interest higher than the current US Treasury yield. Don't just apply a 10% discount rate on all analysis. A smaller, less liquid company probably deserves a higher discount rate, say 12% - 15%, than its blue chip counterpart.

Despite its proximity to accuracy, DCF has a flaw: it depends on predictable future cash flows which no one can reliably estimate given the massive number of variables. Unlike a bond, the earnings of a business are not fixed every year. A one percent difference in your growth assumption can have a huge impact on the NPV. Unfortunately, most investors are overly optimistic when it comes to estimating growth. The best defense here is to err on the side of caution and always pick the more conservative estimate.

[soulsimple]

2. Liquidation

The net present value analysis works great for determining the value of a profitable business with predictable future cash flows. But when it comes to valuing an unprofitable business, the NPV analysis falls apart. Since there is no future cash flow, you can't calculate the NPV. Thus, most investors, unwilling to part with NPV, would simply pass on investing in unprofitable businesses. But this is precisely why investors who are willing to spend the time scouring the floors for cigar butts could find some wonderful bargains.

To value an unprofitable business, an investor needs to be extra conservative since many of these businesses are already troubled businesses headed for the dead pool. Typically, only tangible assets are considered. Intangibles such as brand names are assumed to be worthless. A good shortcut to evaluate the liquidation value of a business is to calculate the net-net working capital. Net-net working capital is calculated by subtracting current and long term liabilities from current assets. If the company trades below its net-net working capital and it is not depleting its net-net working capital nor does it have any off-balance sheet liabilities, the failing company could be a very successful investment.

However, there is a shortcoming with the net-net working capital analysis. Most of the time, in a liquidation, a company sells pieces of standalone operating entities too. These operating entities could very well be profitable going concerns despite its parent's fallout. The net-net working capital analysis would have underestimated the worth of these subsidiaries. Often, in this situation, investors resort to a breakup analysis to evaluate the worth of the subsidiaries. Basically, you treat the subsidiaries just like you would any company when valuing a business; applying the proper analysis. Once you have the values of each of its subsidiaries you sum them up to arrive at the total value of the parent. This is also known as the sum-of-parts analysis.

[soulsimple]

3. Market Value

The market value analysis is the best and only sensible valuation method for closed-end funds. Closed-end funds are funds that are closed to new capital after launch and their shares can be traded at any time in open market. Unlike a mutual fund, a closed-end fund usually trades at a premium or a discount to its net asset value (NAV). The NAV of a closed-end fund is the sum of all its securities. Since the value of the securities are realized when sold to the market, only a market value analysis of the securities makes sense.

Some investors make the mistake of extending the market value analysis to valuing companies. The reasoning behind this is simple, but irrational; if a similar company in the same industry trades at 12 times pretax cash flow, this company should trade at the same multiple. This is what Seth Klarman calls "circular reasoning". What if all the companies in the industry are overvalued?

A more appropriate relative valuation method for companies is the private market value analysis. The assumption here is that in a private transaction where sophisticated businessmen are involved, businesses are often bought at fair prices or at reasonable premiums. Often times, this is true. But when considering a leveraged buyout transaction for comparison, an investor has to be cautious about whether the buyer overpaid.

Conclusion

All three valuation methods are not without flaws. Therefore, it is sometimes necessary to use several methods simultaneously to arrive at a more comfortable estimate. It is important to pick the right tool for the right job lest you contract the man-with-a-hammer syndrome. As Munger would say, "To a man with a hammer, every problem looks like a nail."

[Laughing Gor]

Goodwork Mr. Soulsimple.

Your posts will benefit many people.

[iiinvestsmart]

To buy or to rent?

[stockraider]

2. Liquidation

The net present value analysis works great for determining the value of a profitable business with predictable future cash flows. But when it comes to valuing an unprofitable business, the NPV analysis falls apart. Since there is no future cash flow, you can't calculate the NPV. Thus, most investors, unwilling to part with NPV, would simply pass on investing in unprofitable businesses. But this is precisely why investors who are willing to spend the time scouring the floors for cigar butts could find some wonderful bargains.

To value an unprofitable business, an investor needs to be extra conservative since many of these businesses are already troubled businesses headed for the dead pool. Typically, only tangible assets are considered. Intangibles such as brand names are assumed to be worthless. A good shortcut to evaluate the liquidation value of a business is to calculate the net-net working capital. Net-net working capital is calculated by subtracting current and long term liabilities from current assets. If the company trades below its net-net working capital and it is not depleting its net-net working capital nor does it have any off-balance sheet liabilities, the failing company could be a very successful investment.

However, there is a shortcoming with the net-net working capital analysis. Most of the time, in a liquidation, a company sells pieces of standalone operating entities too. These operating entities could very well be profitable going concerns despite its parent's fallout. The net-net working capital analysis would have underestimated the worth of these subsidiaries. Often, in this situation, investors resort to a breakup analysis to evaluate the worth of the subsidiaries. Basically, you treat the subsidiaries just like you would any company when valuing a business; applying the proper analysis. Once you have the values of each of its subsidiaries you sum them up to arrive at the total value of the parent. This is also known as the sum-of-parts analysis.

Being a value..........investor raider like this theme loh.........!
The implementation is veri simple..........just make sure the liquidation value..........is veri much.........more than the share price.....!
Avoid heavy gearing company...............raider major pick here is LCTH at Rm 0.175..........loh..........!
With cash of Rm 0.27 net per share & property worth Rm 0.16...........this company conservative liquidation value is Rm 0.43 per share loh...!
Liquidation can be in the form of privitazation, takeover or complete liquidation loh..........!
Pls allow longer time frame loh............say about 5 yrs loh..........!
Investing at Rm 0.175.............holding for 5 yrs for a return of Rm 0.40...........woth it loh.........!
Just have patient loh........!

[stockraider]

1. Discounted Cash Flow / Net Present Value

In Theory of Investment Value, John Burr Williams was among the first to introduce the discounted cash flow (DCF) analysis. Seth Klarman categorizes this under the net present value (NPV) method. With a properly chosen discount rate and reasonably predictable future cash flows, the NPV method yields the closest to precise valuation of a profitable business.

DCF basically calculates the present value of all future cash flows by applying a discount rate. The discount rate is the interest that you would like to be compensated for incurring the opportunity cost of giving up alternative, less risky investments. The riskier the investment the higher the discount rate should be. Generally, the short term US Treasury securities are considered risk-free alternatives. In other words, if you are accepting a higher risk for an equity investment, you should expect to earn an interest higher than the current US Treasury yield. Don't just apply a 10% discount rate on all analysis. A smaller, less liquid company probably deserves a higher discount rate, say 12% - 15%, than its blue chip counterpart.

Despite its proximity to accuracy, DCF has a flaw: it depends on predictable future cash flows which no one can reliably estimate given the massive number of variables. Unlike a bond, the earnings of a business are not fixed every year. A one percent difference in your growth assumption can have a huge impact on the NPV. Unfortunately, most investors are overly optimistic when it comes to estimating growth. The best defense here is to err on the side of caution and always pick the more conservative estimate.

Dicounted cash flow..........or NPV is the best method of valuation.......as it put everything into bond value loh.......!
There are alot of uncertainty loh........like rates, forecast & future growth prospect loh.........sometime alot of analyst got carried away loh........! Raider don like to forecast growth...........bcos too much uncertainty........loh......!
But if raider can buy growth.........without paying........premium........raider happy loh...........!
Best pick raider here is ptras ............with a NPV of Rm 4.00............based on DCF rate  7% p.a.  mkt price now Rm 2.50 loh...!

[iiinvestsmart]

Margin of safety - first thing in the investment world

The definition of investment to me is you are utilizing current resources on the hope of achieving greater returns. You must be very sure that the investment is positive return before you invest in it. However there are some descipline you must follow, and margin of safety is the first principle you must remember.

Margin of safety by definition is to set aside a buffer of the target return which you would like to achieve. It was first introduced by Benjamin Graham. For example, if the intrinsic value after you calculation is $1.00, the investment guru advised us to purchase at $0.70 or 30% lower. This 30% is set as margin of safety.

The benefit of margin of safety includes:

1. As intrinsic value is always an estimated value based on current facts and subjective opinion from investor, we can avoid or reduce the possible downside when intrinsic value turns up to be much lower than what we expected. As a result of it, we can pay little for the potential losses.

2. As market is always rational, however there are sometime market react overly to the negative or positive event. If the prices drop below sharply against the intrinsic value, it is a great chance for us to earn more as compared to the time when nothing happens in the market.

3. It can train us to be patient as there is seldom chance of having a lot of good opportunities. Because we can invest in lower prices, we are in more confidence to hold it for a longer period and thus achieve a better results.


Nonetheless, we have to bear in mind that margin of safety is just part of the investment principles and there are still many principles we need to follow.




One of the way we can find out the margin of safety is through searching a good company operates in a good industry and invest it in a good time.



http://www.jackphanginvestment.com/2011/03/margin-of-safety-first-thing-in.html

[iiinvestsmart]

Margin of safety - first thing in the investment world




One of the way we can find out the margin of safety is through searching a good company operates in a good industry and invest it in a good time.

Hello Raider and Leno,
Your margin of safety fails to include two of the three highlighted characteristics.

[.]

Hello Raider and Leno,
Your margin of safety fails to include two of the three highlighted characteristics.

Actually have but u didn't realise it only. You buy at fair price, we buy at value price see the difference or not, so we got include lo ...................................... ............WAKAKAKAKAKAKAKAKAKAKAKAKA

[iiinvestsmart]

Actually have but u didn't realise it only. You buy at fair price, we buy at value price see the difference or not, so we got include lo ...................................... ............WAKAKAKAKAKAKAKAKAKAKAKAKA

Read carefully what I wrote.   

[.]

Read carefully what I wrote.   

Read carefully what I wrote too.   

....................................... ..................................WAKAK AKAKAKAKAKAKAKAKAKAKAKAKAKAKAKA

[stockraider]

Hello Raider and Leno,
Your margin of safety fails to include two of the three highlighted characteristics.

Just look at the number of good in this characteristicss

Good company
Good Industry
Good Time

Raider ask Can buy at good price with wide margin of safety or not ?
The answer is not mah....!


It just that at the moment......those good company in good industry did not fall below the margin of safety raider reqn loh....!

[bursa superman]

 

[soulsimple]

Just look at the number of good in this characteristicss

Good company
Good Industry
Good Time

Raider ask Can buy at good price with wide margin of safety or not ?
The answer is not mah....!


It just that at the moment......those good company in good industry did not fall below the margin of safety raider reqn loh....!

Hmmmmm................................. ..i dont really agree with this but i could b as usual totally wrong!!!! buying at fair price sometimes does give u a great margin of safety

 

[soulsimple]

Actually have but u didn't realise it only. You buy at fair price, we buy at value price see the difference or not, so we got include lo ...................................... ............WAKAKAKAKAKAKAKAKAKAKAKAKA

just curious leh, u say WE, as in.......?
me blur leh!!!!

[SEA PEN]

One of the way we can find out the margin of safety is through searching a good company operates in a good industry and invest it in a good time.

kekekekek ... show me which part in "intelligent investor" or "security analysis" by Graham mention these.
Obviously u make up these thing.

As a matter of fact, people like iinvest is mention and decribed specifically in the book ...
the group is labeled as ".................." by Graham.
He said they are not an intelligent investor nor a value investor.



 

[iiinvestsmart]

just curious leh, u say WE, as in.......?
me blur leh!!!!

Leno and bb are probably two sides of the same coin.  Raider is the edge of the coin. 
SS, now you will understand why bb said "WE".   

[iiinvestsmart]

kekekekek ... show me which part in "intelligent investor" or "security analysis" by Graham mention these.
Obviously u make up these thing.

As a matter of fact, people like iinvest is mention and decribed specifically in the book ...
the group is labeled as ".................." by Graham.
He said they are not an intelligent investor nor a value investor.



 

Can someone re-post Leno's stock selection?  Perhaps, I can give some constructive or critical comments.   

[iiinvestsmart]

Value versus Price

[.]

just curious leh, u say WE, as in.......?
me blur leh!!!!

I say we bcos i understand their thinkings ma, same like i also understand your comments on fair price got margin of safety lo, no right no wrong, as long as all is working well for yourself lo, why bother which method more superior, only those c2pid dumb dumb always do that ......................WAKAKAKAKAKAKAKA KA

[mohsin]

whatever method used don't care as long as making 
no point @ useless after using sofisticated technique still  burnt finger ( some roasted to death)

even grandma using her old fashioned tactic , oso make  - shame to those using chart , TA , FA and what not 

[stockraider]

Value versus Price

Current good value with wide margin of safety -favor slow accumulation is now in secondary stock loh...!
collect slowly loh....!

[iiinvestsmart]

Finance for Managers - How to value a company? Summary

This chapter has examined the important but difficult subject of business valuation.  It described three approaches:

1.  Asset based: The first valuation approach is asset-based:  equity book value, adjusted book value, liquidation value, and replacement value.  In general, these methods are easy to calculate and understand, but have notable weaknesses.  Except for replacement and adjusted book methods, they fail to reflect the actual market values of assets; they also fail to recognize the intangible value of an ongoing enterprise, which derives much of its wealth-generating power form human knowledge, skill, and reputation.

2.  Earnings based. The second valuation approach described is the earnings-based:  P/E method, the EBIT, and EBITDA methods.  The earnings-based approach is generally superior to asset-based methods, but depends on the availability of comparable businesses whose P/E multiples are known.

3.  Cash-flow based.  Finally, the discounted cash flow method, which is based on the concepts of the time value of money. The DCF method has many advantages, the most important being its future-looking orientation. This method estimates future cash flows in terms of what a new owner could achieve.  It also recognizes the buyer's cost of capital.  The major weakness of the method is the difficulty inherent in producing reliable estimates of future cash flows.


In the end, these different approaches to valuation are bound to produce different outcomes.  Even the same method applied by two experienced professionals can produce different results.  For this reason, most appraisers use more than one method in approximating the true value of an asset or a business.


http://www.amazon.com/Finance-Managers-Harvard-Business-Essentials/dp/1578518768

[iiinvestsmart]

http://www.amazon.com/Finance-Managers-Harvard-Business-Essentials/dp/1578518768

[soulsimple]

Finance for Managers - How to value a company? Summary

This chapter has examined the important but difficult subject of business valuation.  It described three approaches:

1.  Asset based: The first valuation approach is asset-based:  equity book value, adjusted book value, liquidation value, and replacement value.  In general, these methods are easy to calculate and understand, but have notable weaknesses.  Except for replacement and adjusted book methods, they fail to reflect the actual market values of assets; they also fail to recognize the intangible value of an ongoing enterprise, which derives much of its wealth-generating power form human knowledge, skill, and reputation.

2.  Earnings based. The second valuation approach described is the earnings-based:  P/E method, the EBIT, and EBITDA methods.  The earnings-based approach is generally superior to asset-based methods, but depends on the availability of comparable businesses whose P/E multiples are known.

3.  Cash-flow based.  Finally, the discounted cash flow method, which is based on the concepts of the time value of money. The DCF method has many advantages, the most important being its future-looking orientation. This method estimates future cash flows in terms of what a new owner could achieve.  It also recognizes the buyer's cost of capital.  The major weakness of the method is the difficulty inherent in producing reliable estimates of future cash flows.


In the end, these different approaches to valuation are bound to produce different outcomes.  Even the same method applied by two experienced professionals can produce different results.  For this reason, most appraisers use more than one method in approximating the true value of an asset or a business.


http://www.amazon.com/Finance-Managers-Harvard-Business-Essentials/dp/1578518768

 
after learnin how to value companies........what next?

 

[iiinvestsmart]

after learnin how to value companies........what next?

 

Move on to analysing the companies in the stock market.
From theory to the play grounds. 

[iiinvestsmart]

Finance for Managers: What is its value?

Whether you are buying or selling a global corporation, an operating division, a local restaurant, or a share of stock, the question, "What is its value?" outweighs most others, and for good reason.  The rate of return from a good company or a good stock is likely to be disappointing if purchased at too high of a price.  Likewise, underestimating the value of an entity in a sales transaction can leave plenty of the owners' money on the table.

Valuing an ongoing business - large or small - is neither easy nor exact.  The field of finance, however, has developed methods for getting close to the value.  This post will introduce you to several methods.

But before we get started, consider several cautions.  The true value of a business is never knowable with certainty.  We may seek it, but we can never be sure that we have found the true value of the business.  This lack of certainty is the result of two problems.

1.  Alternative valuation methods consistently fail to produce the same outcome, even when meticulously calculated.

2.  The product of valuation methods is only as good as the data and the estimates we bring to them, and these are often incomplete or unreliable.  For example, one method depends heavily on estimates of future cash flows.    In the very best cases, those estimates will only be close.  In the worst cases, they will be far from the mark.

Another consideration is that a company is worth different amounts to different parties.  Different prospective buyers are likely to assign different values to the same set of assets.

The acquisition of a small, high-tech company, for example, might provide an acquirer with the technology it needs to leverage its other operations.  This explains, in part, why so many firms are bought out for more than the market value of their existing share.

It is also important to keep in mind that valuation is the province of specialists.  Small and closely held businesses typically turn to professional appraisers when their value must be established for purpose of the entity's sale, to determine the value of its shares when an employee stock ownership trust is used, or for some other purpose.  When large, public firms or their business units are the subject of a valuation, executives generally turn to a variety of full-service accounting, investment banking, or consulting firms.  Many of these vendors have departments devoted entirely to mergers and acquisitions, in which valuation issues are a central focus.  Nevertheless, a well-rounded manager should understand the nature of different valuation methods - and their strengths and weaknesses.

Valuation problems often arise in the context of closely held businesses - that is, businesses with only a few owners - or in the sale of an operating unit of a public company.  In neither case are there publicly traded ownership shares.  Public markets for ownership, such as NASDAQ or the New York Stock Exchange, make value more transparent.  Everyday buying and selling in these markets establishes a company's per-share price.  And that price, multiplied by the number of outstanding shares, often provides a basis for a fair approximation of company value at a point in time.

[iiinvestsmart]

Finance for Managers: Asset-Based Valuations - Equity Book Value
One way to value an enterprise is to determine the value of its assets.  Here are four approaches to asset-based valuations:

1.  Equity book value,
2.  Adjusted book value,
3.  Liquidation value, and,
4.  Replacement value.


Equity Book Value

Equity book value is the simplest valuation approach and uses the balance sheet as its primary source of information.  Here's the formula:

Equity Book Value = Total Assets - Total Liabilities

Example:  Amalgamated Hat Rack
Total assets $3,635,000
Total liabilities $1,750,000

Equity book value = Total Assets - Total Liabilities = $1,885,000

In other words, reduce the balance sheet (or book) value of the business's assets by the amount of its debts and other financial obligations, and you have its equity value.

This equity-book-value approach is easy and quick.  And it is not uncommon to hear executives in a particular industry roughly calculating their company's value in the context of equity book value.

For example, one owner might contend that his or her company is worth at least book value in a sale because that was the amount that he or she had invested in the business.   But equity book value is not a reliable guide for businesses in many industries.  The reason is that assets are placed on the balance sheet at their historical costs, which may not be their value today.  The value of balance0sheet assess may be unrealistic for other reasons as well.  Consider Amalgamated assets:

-  Accounts receivable could be suspect if many accounts are uncollectible.
-  Inventory reflects historic cost, but inventory may be worthless or less valuable than its stated balance-sheet value (or "book" value) because of spoilage or obsolescence.  Some inventory may be undervalued.
- Property, plant, and equipment net of depreciation should also be closely examined - particularly land.  If Amalgamated's property was put on the books in 1975 - and if it happens to be in the heart of Silicon Valley - then its real market value may be ten or twenty times the 1975 figure.

The preceding are just a few examples.  For many reasons, however, book value is not always true market value.

[iiinvestsmart]

Finance for Managers: Asset-Based Valuations - Adjusted Book Value

The weakness of the quick-and-dirty equity-book-value approach have led some to adopt adjusted book value, which attempts to restate the value of balance-sheet assets to realistic market levels.  Consider the influence of adjusted book value in a leveraged buyout of a major retail store chain in the 1990s.  At the time of the analysis, the store chain had an equity book value of $1.3 billion.  Once its inventory and property assets were adjusted to their appraised values, however, the enterprise's value leaped to $2.2 billion - an increase of 69 percent.

When adjusting asset values, it is particularly important to determine the real value of any listed intangibles, such as goodwill and patents.  In most cases, goodwill is an accounting fiction created when one company buys another at a premium to book value - that is, at a price higher than book value.  The premium must be put on the balance sheet as goodwill.  But to a potential buyer, the intangible asset may have no value.

[iiinvestsmart]

Finance for Managers: Asset-Based Valuations - Liquidation Value

Liquidation value is similar to adjusted book value.  It attempts to restate balance-sheet values in terms of the net cash that would be realized if assets were disposed off in a quick sale and all liabilities of the company were paid off or otherwise settled.  This approach recognizes that many assets, especially inventory and fixed assets, usually do not fetch as much as they would if the sale were made more deliberately. 

[iiinvestsmart]

Finance for Managers: Asset-Based Valuations - Replacement Value

Some people use replacement value to obtain a rough estimate of value.  This method simply estimates the cost of reproducing the business's assets.  Of course, a buyer may not want to replicate all the assets included in the sale price of a company.  In this case, the replacement value represents more than the value that the buyer would place on the company.

The various asset-based valuation approaches described here generally share some strengths and weaknesses.  On the up side, the approaches are easy and inexpensive to calculate.  They are also easy to understand.  On the down side, both equity book value and liquidation value fail to reflect the actual market value of assets.  And all  approaches fail to recognize the intangible value of an ongoing enterprise, which derives much of its wealth-generating power from human knowledge, skill, and reputation.

[iiinvestsmart]

Finance for Managers - Earnings-Based Valuation

Another approach to valuing a company is to capitalize its earnings.  This involves multiplying one or another income statement earnings figure by some multiple.  Some earnings-based methods are more sophisticated than others.  There is also the question of which earnings figure and which multiple to use. 

[iiinvestsmart]

Finance for Managers - Earnings-Based Valuation - Earnings Multiple

For a publicly traded company, the current share price multiplied by the number of outstanding shares indicates the market value of the company's equity.  Add in the value of the company's debt, and you have the total value of the enterprise.  Think of it this way:  The total value of a company is the equity of the owners plus any outstanding debt.  Why add in the debt?  Consider your own home.  When you go to sell your house, you don't set the price at the level of your equity in the property.  Its value is the total of the outstanding debt and your equity interest.  Likewise, the value of a company is shareholder's equity plus the liabilities.  This is often referred to as the enterprise value.

For a public company whose shares are priced by the market every business day, pricing the equity is straightforward.  But what about the closely held corporation, whose share price is generally unknown, since such a firm does not trade in a public market?  We can reach a value estimate by using the known price-earnings multiple (often called the P/E ratio) of similar enterprises that are publicly traded.  The price-earnings approach to share value begins with this formula:

Share Price = Current Earnings x Multiple

[iiinvestsmart]

Finance for Managers - Earnings-Based Valuation - Earnings Multiple (2)

We calculate the multiple from comparable publicly traded companies as follows:

Multiple = Share Price / Current Earnings

Thus, if XYZ Corporation's shares are trading at $50 per share and its current earnings are $5 per share, then the multiple is 10.  In stock market parlance, we'd say that XYZ is trading at ten times earnings.

We can use this multiple approach to pricing the equity of a non-public corporation if we can find one or more similar enterprises with known price-earnings multiples.  This is a challenge, since no two enterprises are exactly alike.  The uniqueness of every business is why valuation experts recognize their work as part science and part art.  To examine this method further, let's return to our example firm.

Since Amalgamated Hat Rack is a closely held firm, we have no readily available benchmark for valuing its shares.  But let's suppose that we were successful in identifying a publicly traded company (or, even better, several companies) similar to Amalgamated in most respects - both as to industry and as to size.  We'll call one of these firms Acme Corporation.  And let's suppose that Acme's P/E ratio is 8.  Let's also suppose that our crack researchers have discovered that another company, this one private, was recently acquired by a major office-furniture maker at roughly the same multiple 8.  This gives us confidence that our multiple of 8 is in the ballpark.  With this information, let's revisit Amalgamate's income statement presented in chapter 1 (table 1-2) to find its net income (earnings) of $347,000.

Plugging the relevant numbers into the following formula, we estimate Amalgamated's value:

Earnings x Appropriate Multiple = Equity Value

$347,500 x 8 = $2,780,000

Remember that this is the value of the company's equity.  To find the total "enterprise" value of Amalgamated, we must add int he total of its interest-bearing liabilities.  Table 1.1 shows that the company's interest-bearing liabilities (short term and long-term debt) for 2002 are $1,185,000.  Thus, the value of the entire enterprise is as follows:

Enterprise Value = Equity Value + Value of Interest-Bearing Debt

$3,965,000 = $2,780,000 + $1,185,000

The effectiveness of the multiple approach to valuation depends in part on the reliability of the earnings figure.  The most recent earnings might, for example, be unnaturally depressed by a onetime write-off of obsolete inventory, or pumped up by the sale of a subsidiary company.  for this reason, it is essential that you factor out random and nonrecurring items.  Likewise, you should review expenses to determine that they are normal - neither extraordinarily high nor extraordinarily low.  For example, inordinately low maintenance and repair charges over a period of time would pump up near-term earnings but result in extraordinary expenses int he future for deferred maintenance.  Similarly, nonrecurring, "windfall" sales can also distort the earnings picture.

In small, closely held companies, you need to pay particular attention to the salaries of the owner-managers and the members of their families.  If these salaries have been unreasonably high or low, an adjustment of earnings is required.  You should also assess the depreciation rates to determine their validity and, if necessary, to make appropriate adjustments to reported earnings.  And while you're at it, take a hard look at the taxes that have reduced bottom-line profits.  The amount of federal and state income taxes paid in the past may influence future earnings, because of carryover and carryback provisions in the tax laws.

[iiinvestsmart]

Finance for Managers - Earnings-Based Valuation - EBIT Multiple & EBITDA Multiple

The reliability of the multiple approach to valuation we have just described depends on the comparability of the firm and firms used as proxies for the company whose value we seek to estimate.  In the preceding Amalgamated example, we relied heavily on the observed earnings multiple of Acme Corporation, a publicly traded company whose business is similar to Amalgamated's.  Unfortunately, these two companies could produce equal operating results yet indicate much different bottom-line profits to their shareholders.  How is this possible?  The answer is twofold:  the manner in which they are financed, and taxes.  If a company is heavily financed with debt, its interest expenses will be large, and those expenses will reduce the total dollars available to the owners at the bottom line.  Likewise, one company's tax bill might be much higher than the other's for some reason that has little to do with its future wealth-producing capabilities.  And taxes reduce bottom-line earnings.

Consider the hypothetical scenario in table 10-a.  Notice that the two companies produce the same earnings before interest and taxes (EBIT).  But because Acme uses more debt and less equity in financing its assets, its interest expense is much higher ($350,000 versus $110,000).  This dramatically reduces its earnings before income taxes relative to Amalgamated.  Even after each pays out an equal percentage in income taxes, Acme ends up with substantially less bottom-line earnings.

This earnings variation between two otherwise comparable enterprises would produce different equity values for the two, and would have to be reconciled by adding in the liabilities for each company.  The problem can be circumvented, however, by using EBIT instead of bottom-line earnings in our valuation process.  Some practitioners go one step further and use the EBITDA multiple. EBITDA is EBIT plus depreciation and amortization.   Depreciation and amortization are noncash charges against bottom-line earnings - accounting allocations that tend to create differences between otherwise similar firms.  By using EBITDA in the valuation equation, this potential distortion is avoided.

Table 10-a

Hypothetical Income Statements of Amalgamated Hat Rack and Acme Corporation

                                                         Amalgamated     Acme
Earnings before Interest and Taxes      $757,500        $757,500
Less:  Interest Expenses                      $110,000        $350,000
  Earnings before Income Tax              $647,500        $407,500
Less:  Income Tax                               $300,000       $187,000
  Net Income                                       $347,500       $220,500

[iiinvestsmart]

Finance for Managers - Discounted Cash Flow Valuation Method

One big problem with the earnings-based methods just described is that they are based on historical performance - what happened last year.  And as the oft-heard saying goes, past performance is no assurance of future results.  If you were making an offer to buy a local small business, chances are that you'd base your offer on its ability to produce profits int he years ahead.   Likewise, if your company were hatching plans to acquire Amalgamated Hat Rack, it would be less interested in what Amalgamated earned int he past than in what it is likely to earn in the future under new management and as an integrated unit of your enterprise.

We can direct out earnings-based valuation toward the future by using a more sophisticated valuation method:  discounted cash flow (DCF).  The DCF valuation method is based on the same time-value-of-money concepts.  DCF determines value by calculating the present value of a business's future cash flows, including its terminal value.  Since those cash flows are available to both equity holders and debt holders, DCF can reflect the value of the enterprise as a whole or can be confined to the cash flows left available to shareholders.

For example, let's apply this method to your own company's valuation.of Amalgamated Hat Rack, using the following steps:

1.  The process should begin with Amalgamated's income statement, from which your company's financial experts would try to identify Amalgamated's current actual cash flow.  They would use EBITDA and make some adjustment for taxes and for changes in working capital.  Necessary capital expenditures, which are not visible on the income statement, reduce cash and must also be subtracted.

2.  Your analysts would then estimate future annual cash flows - a tricky business to be sure.

3.  Next, you would estimate the terminal value.  You can either continue your cash flow estimates for 20 to 30 years (a questionable endeavor), or you can arbitrarily pick a date at which you will sell the business, and then estimate what that sale would net ($4.3 million in year 4 of the analysis that follows).  That net figure after taxes will fall into the final year's cash flow.  Alternatively, you could use the following equation for determining the present value of a perpetual series of equal annual cash flows:

Present value = Cash Flow / Discount Rate

Using the figures in the illustration, we could assume that the final year's cash flow of $600 (thousand) will go on indefinitely (referred to as a perpetuity).  This amount, divided by the discount rate of 12 percent, would give you a present value of $5 million.

4.  Compute the present value of each year's cash flow.

5.  Total the present values to determine the value fo the enterprise as a whole.

We have illustrated these steps in a hypothetical valuation of Amalgamated Hat Rack, using a discount rate of 12 percent (table 10-2).  Our calculated value there is $4,380,100.  (Note that we've estimated that we'd sell the business to a new owner at the end of the fourth year, netting $4.3 million.)

In this illustration, we've conveniently ignored the many details that go into estimating future cash flows, determining the appropriate discount rate (in this case we've used the firm's cost of capital), and the terminal value of the business.  All are beyond the scope of this book - and all would be beyond your responsibility as a non-financial manager.  Such determinations are best left to the experts.  What's important for you is a general understanding of the discount cash flow method and its strength and weaknesses.

Table 10-2
Discounted Cash Flow Analysis of Amalgamated (12 Percent Discount Rate)

               Present Value                  Cash Flows
              (in $1,000, Rounded)       (in $1,000)

Year 1    446.5                               500
Year 2    418.5                               525
Year 3    398.7                               500
Year 4    381.6+2,734.8                 600+4,300

   Total    4,380.1



The strength of the method are numerous:

-  It recognises the time value of future cash flows.
-  It is future oriented, and estimates future cash flows in terms of what the new owner could achieve.
-  It accounts for the buyer's cost of capital.
-  It does not depend on comparisons with similar companies - which are bound to be different in various dimensions (e.g., earnings-based multiples).
-  It is based on real cash flows instead of accounting values.

The weakness of the method is that it assumes that future cash flows, including the terminal value, can be estimated with reasonable accuracy.

[soulsimple]

 
 

[iiinvestsmart]

Excellent video on Valuing Stocks and Bonds



Valuing Stocks and Bonds
by U. Michigan    / Jack Wheeler

http://www.cosmolearning.com/video-lectures/valuing-stocks-and-bonds-7388/

[stockraider]

Warren Buffet mention keep it simple....raider as someone who had not attended formal education beyond Form 5......totally agree loh...!

If u read iinvestsmart valuation..... u get confuse loh.....!

Raider say whatever u do it combine to 3 key area loh....!

1) Earnings based like EPS & growth
2) Cashflow....Discounted cashflow equivalent to bond like investment
3) Assets based valuation- Like Book Value, replacement cost and net book value

No single basis .....can be used loh.....!
Raider will like to use a multiple basis loh....!

Let take Ptaras example

EPS Rm 0.40 Growth 53%.
NTA Rm 2.75 with Rm 1.25 net cash per share.
Dividend Rm 0.19 and Freecashflow per share Rm 0.32

How u value Ptaras ?

1) Nett book value Rm 2.75 loh......!
2) Based on PE 10...........value at Rm 4.00 loh.........! If factor growth maybe Rm 5.00 loh....!
3) Based on cashflow yield of min 9%......................then Ptras should worth..........Rm 3.55 mah.....!

Market value PTras at Rm 2.41...........! But based on assets,earnings and cash flow should worth about Rm 2.80, 3.55 and 5.00....!
Correct meh ? Raider say about Rm 3.50................is an art mah........no proper scientific explaination loh....!
Sometime people simply.........say raider con loh........but it is a matter of assumption & judgement........and raider just keep it simple loh.........! Yes Ptara value at Rm 3.55 loh.......!

[pearl_white]

You can derive DCF from Earnings Based Valuation.  Do not see them as mutually exclusive.

Question is how? 

[iiinvestsmart]

Warren Buffet mention keep it simple....raider as someone who had not attended formal education beyond Form 5......totally agree loh...!

If u read iinvestsmart valuation..... u get confuse loh.....!

Raider say whatever u do it combine to 3 key area loh....!

1) Earnings based like EPS & growth
2) Cashflow....Discounted cashflow equivalent to bond like investment
3) Assets based valuation- Like Book Value, replacement cost and net book value

No single basis .....can be used loh.....!
Raider will like to use a multiple basis loh....!

Let take Ptaras example

EPS Rm 0.40 Growth 53%.
NTA Rm 2.75 with Rm 1.25 net cash per share.
Dividend Rm 0.19 and Freecashflow per share Rm 0.32

How u value Ptaras ?

1) Nett book value Rm 2.75 loh......!
2) Based on PE 10...........value at Rm 4.00 loh.........! If factor growth maybe Rm 5.00 loh....!
3) Based on cashflow yield of min 9%......................then Ptras should worth..........Rm 3.55 mah.....!

Market value PTras at Rm 2.41...........! But based on assets,earnings and cash flow should worth about Rm 2.80, 3.55 and 5.00....!
Correct meh ? Raider say about Rm 3.50................is an art mah........no proper scientific explaination loh....!
Sometime people simply.........say raider con loh........but it is a matter of assumption & judgement........and raider just keep it simple loh.........! Yes Ptara value at Rm 3.55 loh.......!

Very complicated.
I keep my investing simple and safe.  (Keep It Simple & Safe)

Like Nestle:

Not useful to use Book Value for the valuation.

Use either earning multiple or DCF

Price = signature PE x projected EPS

or

PV = Div/(r-g) or EPS/(r-g)

[iiinvestsmart]

1) Earnings based like EPS & growth
2) Cashflow....Discounted cashflow equivalent to bond like investment
3) Assets based valuation- Like Book Value, replacement cost and net book value

No single basis .....can be used loh.....!
Raider will like to use a multiple basis loh....!

Valuation of GSB

Of these 3 valuation methods: Book value, Earning Multiple and DCF, I will use Asset value in valuing GSB for the moment.

It certainly has a lot of unproductive assets in its book.  Also there are too many related party transactions, which usually lead to lowering of potential return in its profits.

Accordingly, AVOID this stock. 

If you must get involved with GSB, perhaps, only have a look when it is trading at 50% to its present book value, that is, when its price is < 4.5 sen per share.   

[pearl_white]

Not the correct way anyway since this is not industry practice.

Valuation of GSB

Of these 3 valuation methods: Book value, Earning Multiple and DCF, I will use Asset value in valuing GSB for the moment.

It certainly has a lot of unproductive assets in its book.  Also there are too many related party transactions, which usually lead to lowering of potential return in its profits.

Accordingly, AVOID this stock. 

If you must get involved with GSB, perhaps, only have a look when it is trading at 50% to its present book value, that is, when its price is < 4.5 sen per share.