Warren Buffett: Earnings and not book value are what determine the value of a business.

 

 

@5.45  

Earnings are what determine value and not book value.  Book value is not a factor we consider.  Future earnings are a factor we consider.  

Earnings have been poor for many great Japanese companies.  If you think the return on equity of the Japanese companies is going to increase dramatically, then you are going to make a lot of money in Japanese stocks.  But the returns on equity of Japanese businesses have been quite low, and that makes a  low price to book ratio very appropriate because earnings are measured against books.  

A company earning 5% on book value, I do not want to buy it at book value, if I think it is going to keep earning 5% on book value.     A low price to book ratio means nothing to us.  It does not intrigue us.  In fact, if anything, we are less likely to look at something that sells at a lower value in relation to book than something that sells at a higher relation to book.  The chances are we are looking at a poor business in the first case and a good business in the second case.

Earning Power

It is properly defined as a rate of earnings which is considered as "normal," or reasonably probable, for the company or particular security.

It should be based both upon the past record, and upon a reasonable assurance that the future will not be vastly different from the past. 

Hence companies with highly variable records or especially uncertain futures may not logically be thought of as having a well defined earning power.

However, the term is often loosely used to refer to the average earnings over any given period, or even to the current earnings rate.


Benjamin Graham



Comment:

Invest for the long term earning power of the company to give you compounded returns over many years.

Using Earnings Power Value (EPV) to weigh up the value of a share

Earnings Power Value (EPV) is another way to weigh up the value of a share.

EPV gives you an estimated value of a share if its current cash profits stay the same forever.



Calculating EPV

This is how you calculate it.

1.  Take a company's normalised or underlying trading profits or EBIT.

2.  Add back depreciation and amortization.

3.  Take away stay in business capex.

4.  Tax this cash profit number by the company's tax rate.

5.  Divide by a required interest rate# to get an estimate of total company or enterprise value.

6.  Take away debt, pension fund deficit, preferred equity and minority intersts to get a value of equity.  Add any surplus cash.

7.  Divide by the number of shares in issue to get an estimate of EPV per share.



#What interest rate should you use when valuing a business?

All you need to know is that the higher the interest rate you use, the more conservative your estimate of value will be.

Here are some rough and ready guidelines of the interest rates you might want to use when valuing different companies:

• Large and less risky companies:  7% to 9%
• Smaller and more risky (lots of debt or volatile profits):  10% to 12%
• Very small and very risky:  15% or more.

Compare your estimate of EPV per share with the current share price.  

1.   Current Share Price > EPV

For example:
                      EPV per share                    151.4
                      Current Share Price            320 

We can see that the estimate of EPV accounts for less than half of the existing share price.

• A large chunk of the current 320 price is based on the expectation of future profit growth.  

2.   Current Share Price < EPV

EPV can be a great way of spotting very cheap shares. 

Sometimes it is possible to find shares which are selling at a significant discount to their EPV.

• When you come across a share like this, you need to spend time considering whether its current profits can stay the same, or whether they are likely to fall.  
• If profits are likely to fall, it might be best to move on and start looking at other shares.

To minimise the risk of overpaying for a company's shares, you should try to buy when its current profits - its EPV - can explain as much of the current share price as possible.

• As a rough rule of thumb, even if profits and cash flows have been growing rapidly, do not buy a share where more than half its share price is reliant on future profits growth.  

An example of how to calculate EPV

Company ABC  Earnings Power Value ($m)

Underlying EBIT                                      73.6
Dep & Amort                                              6.6
Stay in business CAPEX                           -8.9
Cash trading profit                                    71.3
Tax @ 20%                                              -14.3
After tax cash profits (A)                       57.0
Interest rate (B)                                        8%
EPV = A/B                                                713

ADJUSTMENTS
Net debt/net cash                                      40.4
Preference Equity                                          0
Minority interests                                          0
Pension fund deficit                                       0
Equity value                                          753.4
Shares in issue (m)                                497.55
EPV per share (cents)                           151.4

Current share price (cents)                         320
EPV as % of current share price                47.3%
Future growth as % of current share price 52.7%

The objective of fundamental analysis is to determine a company's intrinsic value or its growth prospects.

Fundamental analysis

Fundamental analysis is the study of the various factors that affect a company's earnings and dividends.  Fundamental analysis studies the relationship between a company's share price and the various elements of its financial position and performance.

Fundamental analysis also involves a detailed examination of the company's competitors, the industry or sector it is a member of and the broader economy.

Fundamental analysis is forward looking even though the data used is by and large historical.  The objective of fundamental analysis is to determine a company's intrinsic value or its growth prospects.  This intrinsic value can be compared to the current value of the company as measured by the share price.  If the shares are trading at less than the intrinsic value then the shares may be seen as good value.

Many people use fundamental analysis to select a company to invest in, and technical analysis to help make their buy and sell decisions.

Factors affecting future earnings prospects of a company:

1. Change in senior management
2. New efficiency measures
3. Product innovations
4. Acquisition of another business
5. Industrial action

Analysing individual companies

The analysis of an individual company has two components:

-  The 'story' - what the company does, what its outlook is
-  The 'numbers' - the financials of the company, balance sheet and income statement and ratio analysis.

Unfortunately, balance sheet and ratio analysis is probably the most daunting part of fundamental analysis for non-professional investors.  A large number of numerical techniques appear to be used.  However, you can make it less painful by adopting a methodical approach and by always remembering that behind all the numbers is a real business run by real people producing real goods and services, this is the part we call "the story".

It is unlikely that you will need to do the number crunching for every company, your time will be more profitably spent developing the company story.  Balance sheets and ratio analysis, both historical and forecast, can be obtained from either a full service or discount stockbroker.


What are you trying to learn about a company?

Before trying to leap into the calculations behind fundamental analysis there are some basic questions that are worth considering as a starting point:

1. Where is the growth in the company coming from?
2. Is the growth being achieved organically or through acquisition?
3. Is turnover keeping pace with the sector and with competitors?
4. What about the profit margin - is it growing?  Is it too high compared to competitors?  If it is too high then new competitors could enter on price reducing margins.  Low earnings could suggest control of the cost base has been lost or factors outside the company's control are squeezing margins.
5. To what extent do profits reflect one-off events?
6. Will profits be sustainable over the long term?

Companies are multidimensional.  For example, debt funding may have increased - this may be a positive move if the funds produce new productive assets.



Fundamental analysis (Summary)

When you buy shares you are becoming a part owner in that business.

To make an informed decision if you want to be an owner in that business, it is important to understand how that company operates and what its prospects are.

To understand a company, you can read its annual report which is one of the most important publications it releases to the market.

Analysing an annual report gives you the ability to build a good picture of how that business has performed over the past 12 months and what its prospects might be for the future.

To compare the annual reports and prospects of different companies, there are commonly used financial ratios, these include dividend per share, dividend yield, PE ratio and earnings per share.



http://www.asx.com.au/courses/shares/course_10/index.html?shares_course_10

Most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

The high CAGR in the early years of the investing period, due to buying at a discount, tended to decline and approach that of the intrinsic EPS GR of the companies over a longer investment time-frame.

Chapter 20 - “Margin of Safety” as the Central Concept of Investment

A single quote by Graham on page 516 struck me:

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

This seems obvious on the surface, but it’s actually a great argument for thinking more carefully about your individual stock investments. If most of your losses come from buying companies that seem healthy but really aren’t, isn’t that a profound argument for carefully studying any company you might invest in?

Safety with a security residing in earnings -not collateral

 "Experience has shown that in most cases safety resides in the earning power, and if this is deficient the assets lose most of their reputed value." 

The Estimate of Future Earning Power

The Estimate of Future Earning Power

Any estimate of earning power extending over future years may easily fall wide of the mark, since the major business factors of volume, price, and cost are all largely unpredictable.

Assuming that profits develop as anticipated, there remains a similar doubt as to whether the multiplier, or capitalization rate, will prove correctly chosen.

A valuation may be very skillfully done in the light of all the pertinent data and the soundest judgement of future probabilities; yet the market price may delay adjusting itself to the indicated value for so long a period that new conditions may supervene and bring with them a new value. Thus even though the price ultimately converges with that new value, the old valuation may have proved undependable.

These handicaps that are attached to the value approach should be clearly recognized by the analyst, and they should make him modest and circumspect in its use. In particular he must use good judgement in distinguishing between securities and situations that are better suited and those that are worse suited to value analysis. Its working assumption is that the past record affords at least a rough guide to the future. The more questionable this assumption, the less valuable is the analysis.

Hence this technique is:

• more useful when applied to senior securities (which are protected against change) than to common stocks;
• more useful when applied to a business of inherently stable character than to one subject to wide variations; and , finally,
• more useful when carried on under fairly normal general conditions than in times of great uncertainty and radical change.
  

Fields of value analysis

There are three general areas in which value analysis will operate most successfully.

1. That of inherently stable securities. These include

• good quality bonds and preferred stocks, and also – because of the nature of the industry –
• the common stocks of conservatively capitalized public utilities, and perhaps of the strongly entrenched industrial and railroads as well.

2. This includes cases of extreme disparity between price and indicated value. Here the analyst relies upon a large initial margin of safety to absorb and offset the uncertainties of the future. In this area the insurance principle of diversification, or spreading of risk, is especially valuable.

3. Finally, there is the field of comparative analysis. Where the securities studied are corporately related or are affected by closely similar conditions, it may often be possible to reach a reliable and useful conclusion that one is preferable to the other.

Source: Graham's Security Analysis

Also read:
The Estimate of Future Earning Power
Analytical Judgments in Value Analysis
Securities Not Suited to Valuation Analysis