Chapter 8
Three Simple Valuation Techniques to Live By

Price is what you pay, value is what you get.

— Warren Buffett

After doing our due diligence and once we are convinced of its merits, it is time for our next step: to arrive at an estimation of its value, or more commonly known as a valuation. Because, at the end of the day, investing in a good company at an inflated price can lead to disaster as well.

It is important to note here that we believe that valuation of a company should only come near the end of your analysis, rather than using it as a starting point. This is because, as investors, we should be thinking like a businessperson. And we should approach our analysis in as businesslike a way as possible; understanding the business and finding a business that we are optimistic about. Only when we are confident in the business that we want to invest in do we look at the price we want to buy it at – hence the need for valuation.

And when it comes to valuation, we like to emphasise that there is no “one price”. Valuations are like fingerprints, no two are the same. Why so? Because everyone thinks differently.

Valuation is about forecasting the future of the company. Therefore, investors have to make many assumptions when doing a valuation exercise. These assumptions, which are different for everyone, cause the variance in valuation between two investors. Although the commonly used formulas don't vary too much, the difference is your inputs. The Chinese have a saying, images, images, meaning, “Rules are dead, people are living.”

As most of us can relate to property investments, let us use a residential property as an example. Assume that you have a 1,000-square foot, three-bedroom apartment which you are willing to let go for S$1.5 million, and you got to that figure based on your expectations that this place could get a net income of S$60,000 a year, an annual yield of 4%. Now, imagine that there are two bidders interested in your place. After visiting your place, Buyer A made a bid of S$1 million and Buyer B offered S$2 million. Same house, yet three different valuations. Who is right?

To make things sound even more complicated, all three are right, and yet none are right at the same time. It all comes down to each investor's own required rate of return.

  • Buyer A: Has a required rate of return of at least 6%. Based on the same S$60,000 rental a year, buyer A would arrive at a valuation of S$1 million for the property.
  • Buyer B: Is only looking for required rate of return of 3%. Based on the same rental, he would have an estimated valuation of S$2 million for the same property.

Think of your S$1.5 million as your intrinsic value, and Buyer A and Buyer B's offers of S$1 million and S$2 million respectively as what Mr Market might offer you – the lower one when he is sad, and the higher one when he's optimistic.

This example shows us that valuation is based on the assumptions of the investor. If investors have different assumptions, such as the rate of return required, this can lead to vastly different valuations.

Common valuation techniques for valuing a publicly listed company include:

  1. price-to-book (P/B)
  2. price-to-earnings (P/E)
  3. discounted cash flow (DCF).

Although there are many approaches out there, most of them are evolutions or extensions of these three methods. With just these three, you should be good to go. Now let's get the ball rolling with a look at how to use price-to-book ratio as a valuation technique.

Price-to-Book Ratio

Asset valuation is a pretty straightforward method of valuing a company. We are simply valuing the company's assets and then subtracting all its liabilities. We then arrive at our estimated intrinsic value of the company. We then compare that figure with the market price of the company to derive its price-to-book ratio (P/B).

P/B can be used to value asset-heavy companies, such as companies with the likes of property, liquid investments and, best of all, cash.

One such company which we could use P/B ratio to value is Singapore-listed Haw Par Corporation Limited (“Haw Par Corporation”). Haw Par Corporation's core operating business involves manufacturing and distributing the Tiger Balm series of products. Here is how we value the company.

To provide some brief background, Haw Par Corporation has been listed in Singapore since 1969.1 It has operations in the healthcare (Tiger Balm) and leisure (Underwater World) sectors.2 To value the earnings from these two operating segments requires us to make some assumptions. On the other hand, Haw Par Corporation also manages a portfolio of investments in properties and publicly traded equities, where fewer assumptions are required, and this is where the P/B method shines.

After a quick look at their balance sheet, we conclude that the company has a direct and easy-to-understand balance sheet (a good thing), where many assets are carried at reasonable valuation on the books.

As at December 2015, Haw Par Corporation's shareholders' equity stood at S$2.54 billion. Some might use this figure as the book value. However, sceptics like us do not simply accept a company's numbers at face value. Some due diligence still has to be done on the underlying assets to see whether the stated values make investment sense. Remember, accounting figures might not be interpreted in the same way as how an investor looks at things.

Assets

From Haw Par Corporation's Annual Report 2015, there were a total of ten unique balance sheet items. However, from their balance sheet, out of the ten unique items, three of these items made up 97% of its total assets, valued at S$2.69 billion on its balance sheet.3 The three items were:

  • cash
  • available-for-sale financial assets (AFS)
  • investment properties.

We are going to show you how we analyse each of these items, and come up with an estimated intrinsic value for the company. Along the way, you might discover that for such an exercise, we do not have to be exactly right. Moreover, as long as we account for the things that matter, we should be good to go. Remember, not everything that can be counted counts, and not everything that counts can be counted.

Cash

In 2015, Haw Par Corporation had a cash position of S$316 million. Although in certain cases a company's cash position might not be what it seems, given Haw Par Corporation's long listing history and its association with one of the most reputable families in Singapore – the Wee Family – we did not see any reason to make any adjustments to their reported cash position.

We took its cash balance at face value: S$316 million.

Available-for-sale Financial Assets (AFS)

If we take a look at their 2015 Annual Report, Haw Par Corporation actually disclosed their three key investments, which totalled S$1.85 billion. It was even broken down to the companies they invested in, number of shares held in each company, the current market value and even dividend received.4 Here were the three main investments in 2015:

  1. United Overseas Bank Limited: S$1.38 billion
  2. UOL Group Limited: S$271 million
  3. United Industrial Corporation Limited: S$197 million.

In addition, Haw Par Corporation's financial review indicated the fair value of their other AFS, mainly Hong Kong-listed Hua Han Health Industry Holdings Limited at S$155 million.5

These few investments made up most of Haw Par Corporation's reported AFS of S$2.08 billion.

Although these investments are revalued based on their then current price, we would still give it a slight discount when valuing them, because in times of crisis these publicly traded shares might trade at a discount.

Assuming a 20% discount (arbitrary discount assuming a market sell down), we can value Haw Par Corporation's AFS in 2015 at S$2.08 billion × 80% = S$1.66 billion.

Investment Properties

Looking at Haw Par Corporation's notes to the financial statements on its investment properties, it is stated that they did engage external, independent and qualified valuers to determine the fair value of their properties annually. This means that the value recorded on its book is up to date.

It is possible for investors to check whether the properties are recorded using a reasonable valuation by making one of our own. Under the same financial note, it is indicated that Haw Par Corporation's net rental income for the year was S$8.46 million, with an occupancy rate of 65%.6 Compared to the value of its investment properties, we would get a yield of 4%, which is quite reasonable. Nevertheless, for the sake of our policy of being conservative, we will apply a 10% discount.

Our estimation of its investment properties is therefore S$211 million × 10% = S$190 million.

Liabilities

Think about it: when things happen, your assets might be reduced. However, don't expect any sympathy from your creditors.

With this logic, we always take liabilities at face value. And in this case 100% of its total liabilities = S$157 million.

Finally, Adjusted Shareholders' Equity

Taking our adjusted total assets and subtracting Haw Par Corporation's total liabilities, we arrived at our estimated intrinsic value of the company of S$2 billion.

With 219 million shares, this worked out to about S$9 per share.

In simple language, based on our assumptions and estimated intrinsic value at that point in time, we believe that the company might be interesting when it trades below S$9 per share. Again, this was our estimation of the company. As we mentioned, valuations are like fingerprints; no two are identical. You can try this exercise yourself to see what value you might end up with.

Our estimated value was at a 36% discount to Haw Par Corporation's FY2015 Shareholder' Equity. Additionally, our above valuation did not even account for its profitable operating businesses.

Utility of the P/B method

Like all other valuation methods, the valuation with P/B is not a magic formula. For instance, P/B does not work well with companies involved in businesses with large amounts of intangible assets like brand name, goodwill and intellectual property. Take for example the service industry. Given that their greatest assets – their people – are not recorded on the balance sheets, using P/B for valuing most companies in the service industry might not be best choice.

As a general rule of thumb, the price-to-book ratio is effective in valuing companies with these characteristics:

  • fairly valued assets, preferably with a liquid market
  • asset-heavy industry
  • profitable operations
  • little minority interest
  • little or no contingent liabilities.

Our process with Haw Par Corporation showed the utility of this valuation from an internal approach, by studying the company's assets. Keep in mind that there are also other ways to implement this technique. For instance, P/B ratio could also be externally applied in the form of peer comparables, something we will touch on in the next section on Price-to-Earnings.

Price-to-Earnings Ratio

Due to the ease of both its understanding and application, the price-to-earnings ratio (P/E) is one of the most common valuation tools in investing.

The P/E ratio indicates how much an investor is paying for $1 of a company's earnings. The higher the multiple, the more investors are paying for the company's future earnings.

Now, if a company has earnings per share of $1 and the stock is at $20, its P/E ratio is 20 times. That is how the P/E multiple works.

Generally, out-of-favour companies tend to fetch a lower multiple and popular growth companies (the next “in” thing) tend to fetch higher multiples. This means that the market expects strong growth from the company that's trading at a higher multiple (i.e. high double-digit growth or doubling in production). In contrast, companies with low P/E ratio tend to be the companies which investors have low expectations of. Hint: It is this mismatch between expectation and actual performance that creates possible investment returns in both high-growth and low P/E ratio stocks. We think that it is always better to underpromise and outperform than overpromise and underperform.

Another method to interpret the P/E ratio is using its inverse – the earnings yield or E/P. This gives you a quick gauge of how much return to expect out of your investment at the price you are looking at. This earnings yield can then be used for easy comparison across the board.

For example, if Singapore-listed supermarket operator Sheng Siong Group Limited (“Sheng Siong”), traded at a P/E of 20 times, you would arrive at an earnings yield of 5%. Assuming all things were constant, if we were to compare it to another company with a P/E of 30 times or 3.33% earnings yield, Sheng Siong appears to have a higher implied rate of return.

As per the P/B method, P/E valuation is only applicable to certain companies. Furthermore, as both methods are based on the past results, investors need to understand that future performance might differ from past performance. Therefore, P/E ratio might be more suitable for companies with these characteristics:

  • fairly consistent earnings
  • stable growth
  • industries not too vulnerable to major disruption (Hint: not tech industry).

A P/E valuation consists of two parts, the earnings and the price, one internal and the other an external factor.

Earnings

To get a better sense of the company's “true” P/E ratio, it is important for us to make an adjustment to the company's earnings to show its “core” earnings.

These adjustments include:

  • non-operating items such as government grants, interest income
  • one-off income/expense
  • fair value gains or losses.

As an example, we will look at Singapore-listed OSIM International Limited (“OSIM”). In 2008, the company recorded a one-time impairment of S$77 million for their investment in Brookstone, essentially wiping out that investment on its book7 (Table 8.1). However, as it was a one-time non-cash expense, this meant that it had no impact on its cash flow. By writing it down to zero, this meant that it was the final impairment and the loss was just a one-off event and would not impact the long-term prospects of OSIM's core operations, which were still doing decently.

Table 8.1: OSIM International Limited Net Profit After Tax

OSIM FY Results (SGD million) 2004 2005 2006 2007 2008
Net Profit after Tax (excluding Brookstone) 31 37 48 12 15
Net Profit after Tax (including Brookstone) 31 47 34 3 –99

The company promptly returned to profitability in 2009, with net profit of S$23 million.8 Given the situation with its impairment, it would have been quite reasonable to assume that OSIM would not continuously make losses of S$99 million year after year. With the write-down of its Brookstone investment, OSIM had actually, on paper, become a “stronger” company, without the loss-making business hanging around.

For simplicity, let us assume that OSIM could return to a net profit of S$20 million (average earnings ex-Brookstone over the five years from 2004 to 2008 were S$29 million). Next, we assume the company could fetch a P/E of 10 times, arriving at a valuation of S$200 million for the company. Fundamentally, we are aware that sales of discretionary products like massage chairs are likely to be affected by the financial crisis, but we do not see the culture of massage chairs in Asian homes going away any time soon.

Between late 2008 and early 2009, OSIM traded between S$0.05 and 0.20/share.9 Safe to say, this translated to a market capitalisation of below S$150 million. Some could contend that 2008 to 2009 was a unique time. On the other hand, we are not here for imaginary perfect-world types of situation. No one can dispute that this actually took place. And even with our conservative estimates, OSIM traded significantly lower than our earlier calculations.

Price-to-Earnings Multiple

The magic of the P/E ratio is that when it is used to compare against something else then, in financial parlance, this is known as a relative valuation. A relative valuation can be done by comparing the P/E ratio of a company with either:

  1. its historical P/E range (internal); or
  2. the P/E range of its competitors (external).

For an internal approach, we start by taking the company's current P/E ratio and compare it against its historical P/E ratio. A good range would be data of the past 5–10 years. Do note that these P/E ratios should be adjusted for extraordinary items, as previously mentioned.

Other things to take note of when comparing historical P/E ratios are significant events that might have happened affecting the fundamentals of the company. These changes can be categorised into two types:

  1. significant internal change
  2. significant external changes.

An example of a significant internal change can be illustrated by Singapore-listed Petra Foods Limited (“Petra Foods”). In 2013, Petra Foods (now Delfi Limited)10 sold their entire cocoa ingredients business to Barry Callebaut AG.11 Prior to the sale, their cocoa ingredient business was 68% of FY2012's revenue.12 This meant that its business model changed drastically after the sale of its core business. Therefore, comparing the historical P/E ratio of this type of company might no longer be relevant.

When it comes to an example of a significant external change, Singapore-listed SMRT Corporation Limited (“SMRT”) comes to mind. In July 2016, the Land Transport Authority of Singapore and SMRT concluded discussions on a new rail financing framework. The new framework allowed the Land Transport Authority (“LTA”) to take over all operating assets from SMRT.13 In turn, rail operators like SMRT would then become pure service providers, operating the rail network while the LTA took care of the rail assets. As this change was fuelled by factors beyond the company, it can be classified as an external change. Yet, similar to the previous example, this change would transform the business model of SMRT, making its P/E ratio comparison less relevant.

These two examples will most definitely impact the company's P/E comparison when viewed historically, because following these changes, the past is no longer that relevant to what's going to happen in the future. This will lead to the market having different expectations of the companies. Different expectations may lead to different methods of valuing the companies by the market.

On the other hand, another set of challenges arises when it comes to peer comparison. P/E ratio comparisons are generally performed between companies in the same business or industry. Typically, high-growth companies such as technology companies tend to trade at a much higher multiple compared to traditional companies like printing or engineering companies. To say that a run-of-the-mill precision engineering company with a P/E of 15 times is “cheaper” than a technology giant like Hong Kong-listed Tencent Holdings Limited with a P/E ratio of above 40 times might not be “true”. But why?

Generally, the market tends to place a higher value on companies with:

  • higher growth
  • more consistent earnings
  • operations in growth industries
  • strong reputation
  • dominant market share.

Other Factors Affecting Different Valuation

Even when comparing across the same industry, investors need to take note of the differences in business model, brand equity or other company-specific issues. A simple example to grasp is the differences between the Singapore commodity trading companies. Although companies like Noble Group Limited, Olam International Limited and Wilmar International Limited are all commodity firms, when we drill down into their core operations, things could not look more different.

First, companies are involved in completely different types of commodities. Another key factor is the management. Companies that are managed fantastically well can trade significantly above their peers. They may also display much higher margins, return on capital and capital allocation ability compared to other competitors.

Therefore, when comparing between companies, we need to see if they have similar business models and management skills. Interesting opportunities may arise when two fairly similar companies vary significantly in their valuation. That may warrant a deeper look.

The P/E Ratio Is Not A Fixed Rule

We need to understand that P/E ratio is not a fixed rule. A company with a P/E ratio of 5 times does not mean that the company is undervalued or a great investment. Likewise, a company with a P/E ratio of 50 times does not always mean it is overvalued, and vice-versa. In fact, a fast-growing and well-managed company with a high P/E ratio might end up being a better investment compared to a poorly managed company with no growth prospect, even if it has a low P/E ratio.

  • Company at P/E of 5 times: If earnings continue to halve for the next two years in a row, you would have paid 20 times for its future earnings two years down the road. Not so cheap now, is it?
  • Company at P/E of 50 times: If the earnings double for two years in a row, you were essentially paying just 12.5 times of its earnings two years in the future. Not so expensive now, is it?

We can't always accept P/E multiples at face value; at the end of the day, it's still all about the company and the business they are in.

Here is an example of how we use P/E ratio to value a consumer company listed in Hong Kong. Want Want China Holdings Limited (“Want Want”) is in the dairy beverages and snack business. Although Want Want is not a common brand outside of China, many might still recognise its mascot, once they are shown the Hot-Kid or images picture. This shows the strong branding that the company has, and Want Want has leveraged this advantage by branding the bulk of their goods with the logo of its mascot. The “Hot-Kid milk” range of dairy products and beverages made up close to 90% of this segment's revenue.14

Being in the consumer staples space with a strong branding by itself affords a certain degree of competitive advantage to the company. Why is this business appealing to us?

The key reasons are:

  • branding
  • strong distribution network
  • cash flow-generative
  • easy-to-understand business.

Want Want has recorded an average net profit of about US$560 million from 2010 to 2015.15 That Want Want can continue generating net profit of about US$500 million in the future might not be too far-fetched an assumption. Right here, we are making a very general assumption that they can continue at this level of profitability, without factoring for growth.

Again, a model is only as good as the inputs. We arrived at our assumptions after considering the following:

  • business – stable demand for its product
  • financial track record – prudent with strong balance sheet
  • cost management – good cost control with high return on equity and gross margins
  • management track record – history of steering the company well
  • shareholder track record (buy-backs and dividends) – strong buy-back and dividend culture
  • peer comparison – one of the leading consumer companies in China.

With a P/E ratio of 20 times, we would arrive at an estimated value of US$10 billion, or HKD77 billion for the company. During January 2017, the company had a market capitalisation of about HKD62 billion.16 Considering that we were rather conservative in our assumptions when it came to future growth, at such valuations, Want Want might warrant a deeper analysis.

However, there exists a dilemma for most investors when it comes to the P/E valuation. Unlike the P/B valuation, where things are more straightforward, the earnings portion of the P/E valuation encompasses both current and future earnings.

Future earnings are something that is never certain and this might create some uncertainty in predicting the future P/E of a company. This is because future earnings depend greatly on both the direction and growth rate of the company.

Yes, growth is also a component of value and can be a major contributor towards a company's valuation. It is all well and good to consider past performances; however, we cannot just keep our eyes on the rear-view mirror. At the end of the day, investing is a forward-looking exercise.

Companies such as a pharmaceutical company nearing a new breakthrough in a new drug or companies diversifying into other areas of business will require more assumptions in predicting their future earnings. If you are right, the returns can be huge. On the other hand, if things go south, you might end up way off the mark. It doesn't even have to be something complicated. You would be surprised at the number of things that a restaurant operator could be faced with, even for a relatively simple plan of store expansion.

Tsui Wah Holdings Limited (“Tsui Wah”) is the owner and operator of the famous images (Tsui Wah) brand of cha chaan teng (casual-dining) restaurants in Hong Kong, China and Macau. “Cha chaan tengs” literally means “tea restaurants”. Think fast food with a mixture of Cantonese fare fused with western and Asian elements. Tsui Wah has signatures like crispy bun with sweet condensed milk, Swiss sauce chicken wings and jumbo frankfurter hot dog. You can literally taste the attraction of this business.

When Tsui Wah had its IPO in November 2012, it operated a total of 26 restaurants.17 Post-IPO, Tsui Wah has been consistent in its goal of reaching a total of 80 stores by 2017.18 In 2014, the company was halfway there.19 If things went according to plan, Tsui Wah could double their revenue and, in turn, potentially double their earnings. Together with plans to centralise its operations, Tsui Wah's growth story looked pretty encouraging.

In early 2014, Tsui Wah traded at HKD5 per share, priced at close to 45 times its FY2014's Shareholders' profit of HKD156 million.20 Yet its competitors like Hong Kong-listed Café de Coral Holdings Limited, Tao Heung Holdings Limited and Fairwood Holdings Limited were in the range of 20–25 times. This meant that the market had high expectations for them. Already being rather efficient, with most of its existing stores operating long hours and achieving decently good profitability, it still had to grow fast enough to live up to those high expectations. At those valuations, the downside risk appeared to outweigh the potential upside.

Based on an expected restaurant count of 80 by 2017, an optimistic investor might project them to achieve future net profits of HK$300 million, or double their FY2014 profits. Assuming a P/E ratio of about 20–25 times for its future earnings, Tsui Wah could be worth around HKD6–7.5 billion by 2017. However, business is not always simple maths, not even for something as simple as store openings. Increasing revenue does not always mean higher earnings; similarly, increased store count does not always lead to increased revenue. Moreover, at a market capitalisation of HKD7 billion, it looked like future growth was very much priced into the market price.

The effect of this was best seen in 2016. Even with an increase of ten stores, up 20% from 2015, revenue was flat year on year. Revenue per store (directly operated stores) fell from HKD37 million to HKD32 million, resulting in declines in both its operating and net profit.21

Upon deeper investigation, you would realise that this trend was not something new. Over the past five years (2012–2016), it was pretty clear that 1% increase in revenue did not translate to a 1% increase in both operating and net profit.22 So what gave?

At a glance, we could see that over the years, increasing operating expenses like staff costs and rental costs had hit its profitability hard. Coupled with a decrease of revenue per store, the company's bottom line was hit with a double whammy. This resulted in Tsui Wah's net profit being HK$72 million in 2016, less than half the company's FY2014 net profit.

In November 2016, Tsui Wah traded at a market capitalisation of HKD2 billion,23 a fair distance away from the range of HKD6–7.5 billion we mentioned above. Back in 2014, it might seem that the market appeared to be overly optimistic. However, could the market be swinging to the other extreme now? That is always a question we have to keep asking ourselves.

The lesson here is not to overpay for future expectations. In most cases, when making assumptions about future earnings, it pays to err on the side of conservatism.

To summarise, the limitations of using the P/E method generally apply for companies:

  • with no earnings – #Obviously
  • with ultra-high growth – the current earnings have no relevance to its future
  • facing structural decline in its business – earnings can go to zero or, worse, negative
  • in a fast-changing industry – the prospect and earning power of the company can change rapidly, so its current earnings are of little importance.

Discounted Cash Flow

P/B and P/E ratios are two of the most commonly used metrics when valuing companies. This was mainly due to their ease of use and direct comparison. However, besides the balance sheet and the earnings of a company, its cash flow is also a critical part of its value. Therefore, one of the most effective methods of valuing these future cash flows from the company is using the discounted cash flow valuation model.

The P/B and P/E ratios are known as relative valuation methods. They only make sense if they are being compared against a reference point, and this reference point can be either the ratios of its historic records, or its peers. Without that, it would be meaningless.

On the other hand, the discounted cash flow approach, or DCF, is an absolute valuation method. The method does not need a reference point to compare to. The valuation method would help investors arrive at an estimation of the company's valuation directly, without comparing it to its peers or its past.

The definition of discounted cash flow is the present value of the entire expected cash flow from the company in the future. Simply put, the sum of the company's discounted cash flow is your estimation of the company's intrinsic value.

However, given the definitive nature of this method (compared to P/E and P/B), it also means that there are quite a number of inputs needed for this method.

Key assumptions include:

  • Base operating cash flow
  • Capital expenditure
  • Growth rate and period
  • Retention ratio
  • Discount rate
images

where:

  • CF=Cash flow
  • r=Discount rate

The formula for discounted cash flow is just the sum of all future free cash flow, discounted back to present value. The formula works like this:

images

A common variation of the DCF model is the Gordon Growth Model, or dividend discount model. In this case, instead of free cash flow being the star, the company's expected dividend is a key factor in deriving its value.

The formula for the Gordon Growth Model is:

images

Once we have mastered the simplest form of DCF, other variations are just extensions of this approach. That's all you need to know about the framework behind the DCF model. Remember, more than the formula (which doesn't change much), the key factor is the assumptions you make when it comes to the inputs.

For starters, just think about what you must consider to arrive at a reasonable estimate of a company's operating cash flow. This is important as this first step has significant effects on our final estimate. Also, keep in mind that it is important not simply to extrapolate the past into the future; doing so can often lead you to believe that a stock is worth a lot more, or a lot less than it really is, especially in a growth company.

  • If a company's net income is projected to grow at 3% per year over 5 years, its growth would just be 16%.
  • On the other hand, if a company's net income is projected to grow at 10% per year over 5 years, its growth would be 61%.

See the difference?

Take for example, Hong Kong-listed Tencent Holdings Limited (“Tencent Holdings”). Although dominant in China's technology space, it is still operating in a relatively new industry with so many possible applications yet to be monetised. Therefore, it is extremely difficult to predict the growth rate for Tencent Holdings, and correspondingly its valuation. From 2006 to 2015, revenue and shareholders' profit was up 3,300% and 2,800% respectively.24 To quantify things, Tencent Holdings' revenue in 2015 was RMB103 billion. Even in 2015, the company's revenue and net profit grew by 30% and 63% respectively. Not bad for a HKD2 trillion company.25

However, to assume that every company can continue its phenomenal growth rate for the considerable future might be optimistic. On the other hand, a great company might also be able to live up to its expectations. That said, the difficulty in projecting such high expectations is the risk of “the higher they are, the harder they fall”. Even though there is no “right” rule for how to predict the growth rate of a company, we need to be very familiar with the fundamentals of the business and industry to make our assumptions. The less we know, the more our assumptions look like guesswork. With that said, to make your life easier, you don't have to consider every single thing to make your decision; just stick to the key stuff and make a reasonable call.

However, if your assumptions were made without even considering the company's operations and future, things might end up rather uncomfortable. Imagine an investor back in 2005, looking at Singapore-listed Global Yellow Pages Limited (“Global Yellow Pages”) without giving much thought to the industry's prospects.

Global Yellow Pages was traditionally in the printed directory business. Back in 2005, close to 100% of Global Yellow Pages' revenue of S$61 million came from their directory advertising in Singapore, with the majority from the sale of advertising space in its Singapore phone directories. At that time, the then management highlighted Singapore's low advertiser penetration of 11% relative to mature markets overseas.26 To them, the future looked bright. If an investor was unaware of what was happening in the advertising industry, the picture that management was painting looked appealing. Well, that was before Google and Facebook came to the party.

Fast forward to 2015, and other than revenue being down to just S$32 million, the contribution from their sale of advertising space was just S$11 million, down by over 80%. To its credit, the company tried to diversify into a wide range of activities, from river taxi tours (Singapore River Explorer), food and beverage businesses (licensor of Wendy's Supa Sundaes brand) to property investments (freehold property in New Zealand), as well as being investors in publicly listed equity involved in mushroom farming (Singapore-listed Yamada Green Resources Limited).27

Global Yellow Pages' 2015 annual report even led with the tagline “Transforming through Diversification”. However, our point is that if an investor projected its earnings solely based on past performance, the investor could end up rather disappointed.

Even more than with P/E and P/B techniques, the DCF approach is applicable for simple-to-understand, low-probability-of-disruption type businesses. One example, in the consumer staples field, consider Malaysia-listed Nestlé (Malaysia) Berhad, a company with decades of consistent record of profitability and free cash flow.

With increasing profitability across the board, Nestlé's record in Malaysia looked rather stellar. From 2006 to 2015, the company grew its profit after tax and operating cash flow by 124% and 110% respectively.28 Given the business model of such a consumer staple, it is not unrealistic to expect both its profitability and capital expenditure to be relatively stable.

Let's start with these assumptions:

  • Base free cash flow of RM527 million, the average of the past two years.
  • The company can grow its free cash flow at 5% over the next five years.
  • After five years, growth slows down to 3%.
  • Discount rate of 8%.

Again, we emphasise that this example is purely to run you through the mechanics of how the DCF works. With an 8% discount rate, our estimation would be RM12 billion (Table 8.2).

Table 8.2: Sample DCF Calculation

FY End Dec RM (mil) Free Cash Flow Present Value
2016 553 512
2017 581 498
2018 610 484
2019 641 471
2020 673 458
Terminal 2021 13,856 9,430
TOTAL 16,913 11,853

Also, you might have noticed that we do not tend to place much emphasis on the figures being down to the exact decimal place, because in the grand scheme of things, this is only an estimation. Moreover, the thing about the DCF is that it is very vulnerable to adjustments.

For illustration purposes, if we took:

  • a lower discount rate of 6%, we would arrive at an estimated value of RM20 billion
  • a higher discount rate of 10%, we would arrive at an estimated value of RM8.4 billion.

In June 2016, Nestlé (Malaysia) had a market capitalisation of RM18 billion.29 Depending on your discount rate, the company's traded value could be either over-, under- or fairly-valued compared to your estimation. See how much your assumptions will affect the final estimate. Keep in mind that the discount rate is only one of many variables!

Utility of the DCF method

You might face problems with this method if the company:

  • is in a cyclical industry
  • is in a disruptive industry
  • has lumpy cash flow
  • has a high level of minority interest
  • has a low level of disclosure.

Any DCF model is only going to be as good as your inputs. As they say, “Garbage in, garbage out”.

Always Remember Your Margin of Safety

If there is one thing that all value investors agree on, it is the concept of “Margin of Safety”, a concept first coined by Benjamin Graham. This investment approach is applicable for almost any asset under the sun. For instance, say you invest in a secured bond priced at $100 million. If your estimation of the assets backing the bond is worth $200 million, it means that you have a margin of safety of 50%. In theory, the underlying assets need to decline by more than 50% before bondholders suffer permanent losses. Similarly, for a publicly listed company, the margin of safety principal is maintained by buying the company below our estimated value.

At this point we are reminded of a quote from the famous investor, Warren Buffett, “It is far better to buy a wonderful business at a fair price than a fair business at a wonderful price.”30 This means that it is particularly risky to invest in a mediocre business. What is worse is to invest in a poorly managed company during an industry peak. That is because, when times are great and everyone seems to be having fun, these poorly managed companies rise with the tide. It is only when the tide is down that you discover who has been swimming naked. Therefore, while we might feel that we have a wide margin of safety when investing in these companies, that “value” might prove to be just an illusion when the business cycle goes in another direction.

An observable example of such a situation is the leveraged companies found in the oil and gas industry during 2015. During the boom years, these leveraged companies saw record profits year after year as they enjoyed the expanding demand for their products and services while using relatively cheap debt financing. Since the tide came in for oil prices in 2014, many of these leveraged companies have not been having the time of their lives.

This example serves as a warning to investors: the concept of margin of safety should be used after we are fairly confident of the long-term prospect of a company. We should not be looking for investments that merely give us a significant margin of safety, irrespective of the quality of the business.

Before going into our final chapter on how all this ties in together, we think that Walter Schloss's “Factors needed to make money in the stock market”31 is a great piece to keep in our back pockets:

Factors needed to make money in the stock market

  1. Price is the most important factor to use in relation to value.
  2. Try to establish the value of the company. Remember that a share of stock represents a part of a business and is not just a piece of paper.
  3. Use book value as a starting point to try and establish the value of the enterprise. Be sure that debt does not equal 100% of the equity.
  4. Have patience. Stocks don't go up immediately.
  5. Don't buy on tips or for a quick move. Let the professionals do that, if they can. Don't sell on bad news.
  6. Don't be afraid to be a loner but be sure that you are correct in your judgement. You can't be 100% certain but try to look for the weaknesses in your thinking. Buy on a scale and sell on a scale up.
  7. Have the courage of your convictions once you have made a decision.
  8. Have a philosophy of investment and try to follow it. The above is a way that I've found successful.
  9. Don't be in too much of a hurry to sell. If the stock reaches a price you think is a fair one, then you can sell but often because a stock goes up 50%, people say sell it and button up your profit. Before selling try to re-evaluate the company again and see where the stock sells in relation to its book value. Be aware of the level of the stock market. Are yields low and PE ratios high? Is the stock market historically high? Are people very optimistic, etc?
  10. When buying a stock, I find it helpful to buy near the low of the past few years. A stock may go as high as 125 and then decline to 60 and you think it's attractive. 3 years before the stock sold at 20 which shows that there is some vulnerability in it.
  11. Try to buy assets at a discount rather than to buy earnings. Earning can change dramatically in a short term. Usually assets change slowly. One has to know much more about a company if one buys earnings.
  12. Listen to suggestions from people you respect. This doesn't mean you have to accept them. Remember it's your money and generally it is harder to keep money than to make it. Once you lose a lot of money, it is hard to make it back.
  13. Try not to let your emotions affect your judgement. Fear and greed are probably the worst emotions to have in connection with the purchase and sale of stocks.
  14. Remember the word compounding. For example, if you can make 12% a year and reinvest the money back, you will double your money in 6 years, taxes excluded. Remember the rule of 72. Your rate of return into 72 will tell you the number of years to double your money.
  15. Prefer stocks over bonds. Bonds will limit your gains and inflation will reduce your purchasing power.
  16. Be careful of leverage. It can go against you.

We believe that combining the knowledge of the business together with the “margin of safety” philosophy is the best approach an investor can have when approaching the stock market.

Notes

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