THE SECRET WHY ONLY A SMALL GROUP OF INVESTORS MAKE MONEY – VALUATION (Part 1 of 4)

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Source: masterworkscoaching

Summary:

1. What is Valuation and Why Most People Lose Money!

2. Comparable Company Analysis

• Step 1: Identify a Company that you Want, Find & Compare Market Capitalization & Enterprise Value
• Step 2: Find Metrics & Multiples, and Compare Against an Industry Average or Against its Competitors
• Step 3: Compare Multiples to Determine if Stock is Overvalued/Undervalued
• Step 4: Find EV
• Step 5: Subtract Total Liabilities from EV
• Step 6: Determine Intrinsic Value

1. What is Valuation and Why Most People Lose Money!

You have probably heard people say “Buy low, and sell high” but when you ask them how low is low and how high is high, most people can’t tell you. If you don’t know how low is low and how high is high, how is it possible for anyone to buy low and sell high and make money out of capital appreciation?

As such, one of the most important secret in the world of investing is VALUATION or rather knowing how much each stock is worth. You will be surprise at how much people who claimed that they are investors don’t know about how much their stock is worth.

Let me give an analogy. In the picture below, how much do you think this dollar note is worth?

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A silly question, isn’t it? Obviously, this dollar note is worth S$10!

This dollar note is just like any stock in the stock market. The offer price of this dollar note will go up and down depending on the mood of all the investors (or what Professor Benjamin Graham called Mr Market). When the stock price falls below S$10, you buy and when the stock price goes above S$10, you sell. So how much this dollar note is worth is also known as Intrinsic Value.

The diagram below gives an illustration that above S$10 is the selling zone and $10 and below is the buying zone.

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So if I were to ask you what is the Intrinsic Value of these Singapore stocks or how much each stock is worth, do you know?

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If not, aren’t you gambling when you invest your hard earned money into these companies?

The secret why only a small group of investors make money will be revealed in these 4-Part Series of valuation methods starting from this article as there are many ways to valuate a stock.

2. Comparable Company Analysis

Comparable Company Analysis one of the many ways to estimate whether a company is cheap/undervalue or expensive/overvalue. It’s simply a process of comparing ratios, metrics and multiples of a public company to companies of similar businesses, sizes and in the same industry. I will keep the terms as simple as possible.

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Above picture is an example of Comparable Company Analysis. You will see a list of companies A – I on the extreme left column and some headings such as Price. Shares, Mkt Cap and so on. Don’t worry about the terms first.

 

Step 1: Identify a Company that you Want, Find & Compare Market Capitalization & Enterprise Value

Example, Google “Walmart yahoo finance key statistics” and you can click on the first link.

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A stock’s Market Capitalization (Market Cap) and Enterprise Value (EV) can be found on Yahoo Finance under Key Statistics Tab.

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An explanation of these two terms: Market Capitalization and Enterprise Value.

Market Capitalization is used as a gauge to determine if the company is a big company (sometimes known as blue chip or large cap) or a small company (penny stocks or small cap). Market Cap is taking its share price multiplied by the number of outstanding shares of a company. Eg. Walmart stock price is US$71.37, and the outstanding shares (ie. Total number of shares you can buy and sell in the syock exchange) is 3.093 billion. Therefore Market Cap = 71.37 × 3.093 Billion = 220.7 Billion.

Enterprise Value (ie. EV) is different from Market Cap. EV is more comprehensive as it is calculated by adding the Market Cap to debt, minority interest and preferred shares less total cash and cash equivalents.

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An analogy to explain DV is that one day, assuming that you wish to take over a chicken rice store via buying all of its stocks. When you are buying over the entire store, what you are actually doing are as follows:

  1. You are buying its Common Stocks (ie. “Market Value of Common Stock” in the formula)
  2. You are buying also its Preferred Stocks (ie. “Market value of Preferred Stocks” in the formula). Preferred stocks are different from Common Stocks in the sense that if any dividends are paid out, the dividends will go to the preferred shareholders first. But these shareholders usually do not have voting rights.
  3. You are taking over its Debt (ie. “Debt” in the formula).
  4. You are buying over the shares that are owned by minority shareholders (ie “Minority Interest” in the formula)
  5. You are keeping the Cash that this store has (ie, “Cash and Cash Equivalents” in the formula)

Thus, EV is considered a more accurate representation of a company’s total value than Market Cap.

The key is in order to compare companies in the same industry, we have to take note of those with similar Market Cap and EV so that there is an apple to apple comparison.

Step 2: Find Metrics & Multiples, and Compare Against an Industry Average or Against its Competitors

Once you have identified a company, you may find companies with similar market cap and EV, and then compared among these companies using some of these multiples:

  • Price to Earnings Ratio (P/E),
  • Price to Book Ratio (P/B)
  • EV/Earnings Before Interest Taxes, Depreciation Amortization (EV/EBITDA).
  • Price to Cash Flow (P/CF)

These metrics and multiples can be found on websites like www.sg.finance.yahoo.com and www.morningstar.com.

For Yahoo Finance, Under Competitors Tab, you can compare a stock’s metrics to its industry’s metrics, which are boxed below.

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The EV/EBITDA ratio for a stock and its industry can be found in www.stockanalysis-on.net under the Relative Valuation Tab as shown below.

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In Morningstar, under the Valuation Tab, you will be able to find more multiples to compare your stock against the industry it is in. Such as the P/B and P/CF ratio shown below.

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Step 3: Compare Multiples to Determine if Stock is Overvalued / Undervalued

After gathering all these figures, you will be able to identify whether a stock is undervalued or overvalued.

Let’s take Wal-Mart(WMT) for example. Based on Morningstar’s figures, WMT’s P/E is trading at 15.1, compared to the industry average of 16.9. The rest of WMT’s multiples are also trading lower than the industry average. This indicates that WMT may be undervalued.

Note: Be aware that such methods of comparing multiples of different companies are relative valuation methods, and it’s not an absolute valuation method.

Step 4: Find EV

Once the metrics and multiples of your target company have indicated that it is undervalued (from Step 3), multiply the EV/EBITDA derived from its industry (Ie. 11 in this case. See blue arrow in the diagram below) by the EBITDA of the target company, which will give you back the EV.

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In this case, WMT’s EV is calculated as:

EV/EBITDA × WMT’S EBITDA = WMT’s EV

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Step 5: Subtract Total Liabilities from EV

Total Liabilities can be found under the Balance Sheet of a stock (ie. WMT in this case) 

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Step 6: Determine Intrinsic Value

Lastly, divide that amount by outstanding shares to get the intrinsic value of the stock.

Shares Outstanding of a stock can be found from sg.finance.yahoo.com under Key Statistics Tab or simply by googling “Outstanding Shares of XXX”). Below shows WMT’s outstanding shares.

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Intrinsic Value of WMT is:

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Advantages:

  • Simple as financial information is wide available

Limitations:

  • Reliability depends on the selected companies/industry for comparison
  • Does not work for comparing companies of different sizes or/and across different industries

If you want to learn about a Super Simple Way of Valuation simply by Copying & Pasting Numbers to obtain an Intrinsic Value, click on the picture below to join our Free Value Investing Masterclass or <<CLICK HERE To Register>>.

cta

Geraint Liu
Supervised by Cayden Chang
Research Analyst, Mind Kinesis Value Investing Academy

Disclaimer: Please note that all information stated in this article is just for education purpose only and should not be used as any form of recommendation or advice.

 

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