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Beginner’s Guide To Investing

Class 13

How To Value A Stock

We are nearing the end of our basic course. You have discovered what is the meaning of value investing. You looked into the tools that can be used to research companies and create a watch list of companies you might be interested in investing. This is the part of learning how to find the value of a company and how to go about valuing them. We will look into the topic of Valuation.

Value A Stock

When we talk about valuation, there are many misconceptions on what valuation really is. We have been fed the myth that valuation is extremely complicated and that only professionals such as investment bankers and analysts have the ability to do them. However, that is far from the truth. Valuation is a learnable skill. We do see it as a skill similar to learning a musical instrument or learning a new language. That means that it is not that hard to learn the basic of valuation, however, it takes practice and hard work to perfect the craft. Valuation is also a combination of art and science. Even though it is expressed in term of numbers, these numbers are not facts but rather just opinion of the valuer. Therefore, the valuation would be different for the same company depending on who the valuer is. And because valuation is an expression of opinion, it is important for us to practice it together with the concept of Margin Of Safety.

What Are The Values To Be Found?

After investing for more than a decade interviewed many great investors around Asia, we discovered that there are mainly three types of value to be uncovered in the stock market. They are:

  • Asset Value
  • Current Earnings Power Value
  • Growth Value

Key Tools To Use For Research

Here are the key tools that you might want to use when investigating a company.

  • Annual Reports
  • SGX
  • Aastock
  • Bursa Marketplace
  • Google
  • Google Finance
  • Bloomberg
  • Morningstar

Value #01: Understanding Asset Value

The first type of value that could be uncovered in the market is Asset Value. These are companies that are trading at a discount to their net assets. This concept is first made famous by Benjamin Graham, the father of value investing and mentor to Warren Buffett. He was well-known for investing in “Net-net” companies during the great depression period in the 1930’s. These are companies that are so cheap that if you bought them and use its current assets to pay off all its liabilities, you will make a profit from the investment. Plus, you will be getting all its non-current assets for free. However, such companies are hard to come by in current times. The most we can most for are companies trading below its net assets (Total Assets – Total Liabilities). This type of valuation method is often used for companies with liquid assets such as Banks or insurance companies. It can also be used for companies with assets that are quite easily valued, such as properties. However, we talk about the book value, we do not mean the current accounting book value of the company. But rather we need to make adjustments to its balance sheet to reflect the current market value of its assets to come up with a more realistic adjusted book value.

The Advantages & Disadvantages

However, we need to know why this method is useful and also where are its limitations.

Advantages Disadvantages
  •  Easy To Use q  Fast q  Easy to Compare Among Peers q  Easy to Compare With History
  • Value Might Not Be Realize
  • The Value needs a catalyst to be extracted
  • Easy to fall into Value Trap

The method is easy to use and we can easily compare the price to book ratio among different companies in the industry. However, we have to be careful when using this valuation method. This is because sometimes this type of value is difficult to unlock in the market. Due to its assumption that the value of the asset can be unlocked after we invested into the company is flawed. As minority shareholders, we might not have the power or influence to force the company to unlock the value by selling these assets or better utilise them. Therefore, when we invest in such companies, it is important for us to invest when there is a catalyst in place to unlock the value. The catalyst can be a potential buyout of the company. Or the company has indicated that it will be selling off its assets. Without the catalyst, we might end up investing into a “Value Trap”, a company that is cheap in theory, but its value cannot be unlocked due to other reasons. These reasons can be inability or mismanagement of the management or main shareholders.

Value #02: Understanding Current Earnings Power Value

The second type of value that can be found in the stock market is Current Earnings Power Value. This is found in companies that are typically mature companies with stable earnings. Typically they are market leaders in industries such as utilities, consumer staples and even some manufacturing companies. The key is that these companies are cash flow generative and they have quite predictable future in term of their earnings. A common way to value such companies is with the Dividend yield, price to earnings ratio and even using the discounted cash flow method.

The Advantages & Disadvantages

However, we need to know why this method is useful and also where are its limitations.

Advantages Disadvantages
  • Easy To Use q  Fast q  Easy to Compare Among Peers q  Easy to Compare With History
  • More assumptions for cyclical, high Capex, turnaround companies
  • Miss out on new growth potential
  • Hard to use for conglomerate

Again, this method of valuation is easy to use. If you are using dividend yield or the price to earnings ratio to value them, it is highly comparable to its peers and even to the company’s own history. However, you would need to make more assumptions about the company compared to using Asset value. This is because you would need to think about the possible earning potential of the company and how its earnings might turn out to be in the next few years. For companies with volatile earnings like cyclical companies or companies facing a turnaround situation, it might be more difficult in making accurate assumptions about them. Moreover, you might miss out on the growth opportunities of these companies. If they are going into other sector or finding new niches of growth, it might not be captured fully by your valuation model.

Value #03: Understanding Growth Value

Lastly, we look into companies with Growth Value. These are companies that are growing rapidly in the market. They might be new startups, new disruptors in the market or just companies operating in fast growing industries, like the tech space. The value of such companies is not coming from its current form. Therefore its asset and current earnings might not be a good representative of its true value. This is because its potential is mostly in its future and how big it can grow into. The value is coming from the collection of earnings and cash flow the company can generate in the future for its shareholders. Thus, a typical method of valuing such company is the discounted cash flow method. Formula for discounted cash flow Where Vo = Intrinsic Value CFo = Free Cash Flow of Year 0 CF1 = Free Cash Flow of Year 1 CFt = Free Cash Flow in period t CFn+1 = Free Cash Flow at the next year after terminal year gn = Terminal Growth Rate g = High Growth Rate n = Length of the First High Growth Period   Discounted cash flow is a valuation method used to form a value to the collection of all free cash flow of the company in the future. Free cash flow is a measure of the cash flow that would benefit the shareholders of the company. Free cash flow = Operating Cash Flow after working capital – Capital Expenditure This would be the cash that is available for the shareholders. There are three main formulas for discounted cash flow; 1) Stable Growth, 2) 2-Stage Growth, 3) 3-Stage Growth. We will show in next lesson how to do a DCF calculation on Excel.

The Advantages & Disadvantages

However, we need to know why this method is useful and also where are its limitations.

Advantages Disadvantages
  • Give us a guide on valuing fast growing companies
  • Force you to give logical assumptions
  • Messy
  • 100% Inaccurate
  • Not Comparable

This method forces us to think about a growth company logically. Many times, growth companies can be exciting and we might get carried away thinking about the market potential of the company. However, doing a valuation on it forced us to make logical assumptions on the company and think about how fast it could grow in the market and does it deserve its current valuation. However, this method is very messy to implement. There would be many assumptions that need to be made in order to feed into the discounted cash flow model. It would not be accurate as we are just making assumptions based on our understanding and forecast. Lastly, it is hard to compare companies using this method of valuation as each company would require a different set of assumption and a completely new valuation.



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Now Available On Book Depository

Our Course is created based on some of the materials discussed within the book. Our book will take you through a more detailed study into how to apply value investing concepts in Asia.

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“The book is a great contribution to the investing society. Stanley and Mun Hong have been able to put together the valuable experiences and wisdom of many Asian outstanding fund managers!”
Dr. Tan Chong Koay

Executive Chairman, Phiem Asset Management

“This is not just a book about value investing. Instead, it is a manual for value investing with an Asian twist that investors with an eye on the fastest-growing region in the world will reach for whenever they have questions that need answers.”
Dr. David Kuo

CEO, The Motley Fool Singapore

“Stanley Lim and Mun Hong have skillfully weaved three things together in this book for the Asian investor: the key principles of value investing, where to identify the investment opportunities and the mine fields to side step in Asia. With these skills, the investor can start investing in Asia.”
Mr. Wong Kok Hoi

Founder & CIO, APS Asset Management

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