Tuesday, 2 September 2014

Valuation (Pratical Experience)

If you know about Warren Buffet or his teacher Benjamin Graham, you probably come across a term so called: "Intrinsic Value". Intrinsic Value can be defined as the "Real Value" of a company. Benjamin Graham tell us that, when the price of a stock is lower than its intrinsic value, we should buy it. One day in the future, both price will converge.The difference between price and intrinsic value is "safety margin". The bigger the safety margin, the safety we are.

My friend once ask me, is there any formula that can calculate the intrinsic value of a stock. If there is such a standard formula, there will not be a gap between price and intrinsic value. Because every investor will go search for one.

Although there is no such a formula, there are still some guides to discover the intrinsic value. Now I introduce a guide that I usually use to find misplaced price stock.

Firstly, we discuss why we create a company?   Profit! Profit!! and Profit!!!
If a company cant earn a profit, no one will buy it. A company that earn a lot should  have higher value.  There is a measure that directly link the profit to its value which is PE.

PE= Share Price/ Earning per Share 

The best example to indicate what is PE.
Let say PE of a company is 10, it means if you buy that company, and the earning remains constant in future, you will get your money back in 10 years.  

Therefore, if we value a company only by the profit it makes, the PE of all company should be the same. The price of a large company  with profit 100m should be equal to the price of 10 company with profit 10m. If this is the case, then all company PE should be equal and problem solved.

However, in our reality, it is not exactly like that (not exactly does not mean not at all.) 
Firstly, we as investors always hope that the profits will be stable and most importantly will not suffer a lose. If a company can offer a more stable profit, we maybe willing to pay higher price for that company (higher PE).

How to ensure stability of profit of a company?
There are three particular ways to justify it.

1 Looking for its past record
If the company has long past record of stable profits(>10years) , then we can probably predict that its future profit will be stable too.

2 Firm size 
A big company is usually considered has higher profit stability than a small company if  other things remain the same. Besides have longer experiences in its few, a large company also has other advantages such as brand recognition, customer loyalty, market power to influence price, connection and the others.
All this advantages usually give a company with larger firm size a higher PE compared to small company.

3 Industry the company involved in
Industry can be divided in cyclic industry and non-cyclic industry. An industry is whether cyclic depends on the supply and demand condition and the types of products. Non-cyclic industry such as consumer product has more stable profits(higher PE) because of the continuous  demand of consumer product.

Besides stability, there is another important factor which can affect value and PE of a company, which is growth of the profit.
The profit used to calculate PE is profit gained by company from the past. If the profit has higher tendency to grow in the future, investors are willing to pay more for that company which means a higher PE for now.

How to predict company with higher growth?

1 Looking for its past record
Unlike stability, we look for long term past profit of a company(10years), for profit growth, we should look at its short term past record(<5years). This is because high growth usually will not last long.

2 Industry
For some production company (such as industrial product)cannot has high growth in short period because it need time to build new factory or building in order to expand its revenue. Its revenue is highly depend on its customers and capacity of production line. However, there are some industries do not have such a lead time. For example technology sector, if they can find many customers, they can increase their production  in short period.

3 Any reason for high growth
Every high growth will have its own reason. Whether the demand of industry increase, or the ability of company to find customers. However before the actual financial report coming out, it will have signs. For industry, look for the statistics such as gdp, industry, exports and others.

Theoretically, all company should have same PE.
Exceptionally, for company with high profit stability or high profit growth, higher PE is reasonable.

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