Are You Making The Right Assumption When Valuing A Company?

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Over my course of investing, I have my fair share of valuation mistakes. This was because many of the basic value investing concept is about buying a company below its intrinsic value. However, it is easy for an investor to include in false assumptions about a company’s prospect when valuing the company, which might in turn lead to a false sense of value in a company. Here is one such example.

Treating a cyclical company as a growth company

Sometimes, a company, especially one in the commodity business will see rapid growth during a boom time. This might give investors an incorrect perception that the company is experiencing a long term growth period when it is only in the upswing stage of its cyclical business cycle. For example, we take a look at a company such as Ann Joo Resources Bhd (AJR:MK), an iron and steel manufacturer and trader. The company experienced a huge growth in earnings before the global financial crisis. Due to the rapid increase in steel prices, the company enjoyed a huge jump in profits during the period. Earnings per share increased from just 4.3 sen per share in FY2005 to 38.6 sen in FY2007. Investors incorrectly thought the company was undergoing a long term growth stage and pushed its share price from a low of RM 0.63 per share in FY2005 to about RM4.18 per share in FY2007.

However, much of the earnings growth is mainly due to the build-up in commodity prices during the period and Ann Joo Resources has little control over the pricing of its product. As the supply and demand of a commodity product is influenced by its pricing; i.e. a low price will lead to higher demand which will push up the commodity prices, till a point where it is too expensive for its buyers. At this point, the high price will reduce the demand for the product at the same time when supply is increasing as manufacturers increase products due to the good margins. Subsequently, this will lead to lower prices. At this point, investors would realize that the growth of the manufacturer is not sustainable and realized they made a mistake in valuing the company as a constant growth company when it is only experiencing a short upswing cycle.

Value In Action

Although we are taught valuation methods to value a company, investors have to understand the economics of different industry and businesses before proceeding with its valuation process. This is because, having a wrong assumption during your valuation process can have deep consequences.

 
 
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All views and opinions articulated in the article were expressed in Stanley Lim’s personal capacity and does not in any way represent those of his employer and other related entities. Stanley Lim does not own any companies mentioned above

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