Understand accounting allows you to understand how companies create value.

To better understand the wealth-producing advantages of the businesses, you have to understand accounting and the "vastly different" financial reporting characteristics of various businesses.

Accounting, just like eating spinach, may not be what you want, but it sure is good for you.  :-)

A little patience brings great rewards.  You can learn something important about each business and can also use your knowledge to understand how other companies create value.

You want to be informed, confident and loyal in your investing.

Discrepancies between price and value

One cannot be taught how to weigh the future.

The analyst is warned not to trust his projections of the future too far, and especially not to lose sight of the price of the security he is analyzing.

No matter how rosy the prospects, the price may still be too high.

Conversely, the shares of companies with unpromising outlooks may sell so low that they offer excellent opportunities to the shrewd buyer.

Also, the wheel of time brings many changes and reversals.

"Many shall be restored that now are fallen, and many shall fall that now are in honor."

The "Good Investment". Clarify your Investment Goals.

By pinpointing what you think represents value, you can now create your definition of a good investment.   You should be able to summarize it in one sentence.

Consider these examples:

Warren Buffett:  a good business that can be purchased for less than the discounted value of its future earnings.

George Soros:  an investment that can be purchased (or sold) prior to a reflexive shift in market psychology/fundamentals that will change its perceived value substantially.

Benjamin Graham:  a company that can be purchased for substantially less than its intrinsic value.

A few more examples:

The Corporate Raider:  companies whose parts are worth more than the whole.

The Technical Analyst:  an investment where technical indicators have identified a change in the price trend.

The Real Estate Fixer-Upper:  run-down properties that can be sold for much more than the investment required to purchase and renovate them.

The Arbitrageur:  an asset that can be bough low in one market and sold simultaneously in another at a higher price.

The Crisis Investor:  assets that can be bought at fire-sale prices after some panic has hammered a market down.


Coming to your definition of a good investment is easy - if you're clear about the kinds of investments that interest you and have clarified your beliefs about prices and values.

Value versus Price - Two Perspectives on Worth

Value versus Price

Two Perspectives on Worth

	VALUATION	PRICING
End	truth -- intrinsic value	illusion -- marginal opinion
Means	method of appraisal *	auction mechanism
Terms	case-by-case	standardized
Institution	private contracts	public exchanges
Approach	rational, logical	arational, emotional
Knowledge	economics	psychology, sociology
Principle	theory of investment	ad hoc, empirical
Result	value range	single price
Precision	highly imprecise	highly precise
Accuracy	within value range	outside value range
Investment	real assets	claims on assets
Units	operating enterprise	common stock issue
Data Source	company reports	market-generated
Measurement	absolute	relative, comparative
Analysis Type	investment	portfolio of stocks
Analysis-Units	one company	compare two stocks
Analysis-Time	one point in time	compare two times
Horizon	long-term (years)	short-term (minutes)
Frequency	sporadic, on demand	continuous supply
Stability	slow, small changes	quick, large changes
Application	individual stock selection	stock trading
* In contrast, the method of anticipation emphasizes earnings growth for the sake of growth rather than the sake of value. Thus, it is not recommended for purposes of estimating value.

Investors will frequently not know why security prices fluctuate. Must look beyond security prices to underlying business value.

Security prices sometimes fluctuate, not based on any apparent changes in reality, but on changes in investor perception.

• The shares of many biotechnology companies doubled and tripled in the first months of 1991, for example despite a lack of change in company or industry fundamentals that could possibly have explained that magnitude of increase. 
• The only explanation for the price rise was that investors were suddenly willing to pay much more than before to buy the same thing.

In the short run supply and demand alone determine market prices. 

• If there are many large sellers and few buyers, prices fall, sometimes beyond reason. 
• Supply-and-demand imbalances can result from year-end tax selling, an institutional stampede out of a stock that just reported disappointing earnings, or an unpleasant rumor. 

Most day-to-day market price fluctuations result from supply- and-demand variations rather than from fundamental developments.


Investors will frequently not know why security prices fluctuate. 

• They may change because of, in the absence of, or in complete indifference to changes in underlying value. 
• In the short run investor perception may be as important as reality itself in determining security prices. 
• It is never clear which future events are anticipated by investors and thus already reflected in today's security prices. 

Because security prices can change for any number of reasons and because it is impossible to know what expectations are reflected in any given price level,  investors must look beyond security prices to underlying business value, always comparing the two as part of the investment process.


Main Point: 
Investors will frequently not know why security prices fluctuate and must look beyond security prices to underlying business value, always comparing the two as part of the investment process

Price versus Value

US Supreme Court Addresses "Fair Price" and "Fair Value" in Appraisal Proceedings

Posted on December 31, 2010 by Francis G.X. Pileggi

Supreme Court Addresses "Fair Price" and "Fair Value" in Appraisal Proceedings; Declines to Adopt Bright Line Rules for Appraisal Proceedings

In affirming the Court of Chancery’s finding of fair value in an appraisal proceeding, the Delaware Supreme Court in Golden Telecom, Inc. v. Global GT LP, declined to adopt two bright line rules urged by the parties on appeal. Slip op. No. 392, 2010 (Del. Supr. Dec. 29, 2010). Read opinion here. Instead, the Supreme Court held that: (1) in an appraisal proceeding pursuant to 8 Del. C. § 262, the Court of Chancery must take into account all relevant factors and need not defer, either conclusively or presumptively, to the merger price as indicative of fair value; and (2) companies subject to an appraisal proceeding are not bound by the data in their proxy materials. The Supreme Court also held that the abuse of discretion standard of review for appraisal cases is a formidable standard wherein the Supreme Court will defer to the Court of Chancery even where the Supreme Court may have independently reached a different decision.

This summary was prepared by Kevin F. Brady and Ryan P. Newell of Connolly Bove Lodge & Hutz LLP.

The Merger and the Petition for Appraisal

In early 2007, Open Joint Stick Company Vimpel-Communications (“Vimpel-Com”) notified Golden Telecom, Inc. (“Golden”) that Vimpel-Com was interested in acquiring Golden. Because the two largest shareholders of Golden were also the two largest shareholders of Vimpel-Com, Golden formed a special committee of independent directors. After nearly three months of negotiations, the special committee ultimately recommended and the Board approved the merger at $105 per share. Golden and Vimpel-Com executed a merger agreement with a cash tender offer and a backend merger. Global GT LP and Global GT Ltd. (collectively “Global”) declined to tender its shares and sought appraisal. The Court of Chancery held that the fair value of Golden as of the date of the merger was $125.49.

Golden and Global Appeal

Golden appealed arguing that, among other things, the Court: (i) should have deferred to the merger price because it was an arms length transaction with an “efficient market price;” (ii) should have given some weight to market evidence; (iii) erred in considering a blended beta; and (iv) erred in accepting Global’s expert and its long term growth rate in its discounted cash flow analysis. Global cross appealed contending that the Court used the incorrect tax rate.

Fair Value Requires Independent Evaluation Not Deference to Merger Price

Relying on the language of § 262, the Supreme Court, stated that “fair value” is to be determined by “all relevant factors” valuing the corporation as a “going concern, as opposed to the firm’s value in the context of an acquisition or other transaction.” The Supreme Court also reasoned that “[s]ection 262(h) unambiguously calls upon the Court of Chancery to perform an independent evaluation of ‘fair value’ at the time of the transaction” and that “[r]equiring the Court of Chancery to defer—conclusively or presumptively—to the merger price, even in the face of a pristine, unchallenged transactional process, would contravene the unambiguous language of the statute and the reasoned holdings of our precedent.”

Court Refuses to Adopt Bright Line Rule

Global contended that in the appraisal proceeding, Golden should not have been permitted to walk away from the tax rate set forth in the fairness opinion. While the Court agreed that the primary purpose of fairness opinions is to convince shareholders that a merger price is fair, it declined to set forth a bright line rule because: (i) the appraisal process is a flexible process with the Court of Chancery having significant discretion in the factors it considers; (ii) section 262 does not require the Court to bind the parties to previously prepared data, but on the contrary requires consideration of “all relevant factors;” and (iii) “public companies distribute data to stockholders to convince them that a tender offer price is fair[;] [i]n the context of a merger, this ‘fair’ price accounts for various transactional factors such as the synergies between the companies.” The Court emphasized the distinction between valuation at the tender offer stage seeking “fair price” under the circumstances of the merger and valuation at the appraisal stage seeking “fair value” of the company as a going concern.

While the Supreme Court held that corporations subject to an appraisal proceeding may deviate from data in their proxy materials, the Court of Chancery “can—and generally should—consider and weigh inconsistencies in data advocated by a company.” In this case, the Court of Chancery had a “rational basis” for accepting the tax rate Golden relied upon in the appraisal proceeding, but not in its proxy.

Court of Chancery Did Not Abuse Its Discretion in the Valuation

The Court described the “abuse of discretion standard of review” as a “formidable standard” predicated on the Court of Chancery’s expertise in appraisal proceedings. Even where the Supreme Court might independently reach a different conclusion, the Court of Chancery’s decision will not be dismissed unless the factual findings are not supported by the record or the valuation is “clearly wrong.” The Supreme Court affirmed the Court of Chancery in this case because it “addressed each of these findings of fact and valuation methods, and [it] followed an orderly and logical deductive process in arriving at [the Court’s] conclusions . . . .”


http://www.delawarelitigation.com/2010/12/articles/delaware-supreme-court-updates/supreme-court-addresses-fair-price-and-fair-value-in-appraisal-proceedings-declines-to-adopt-bright-line-rules-for-appraisal-proceedings/

Value in the context of Your Overall Portfolio

A stock's value is the sum of its future cash flows, each discounted to today's value at the base return you're aiming to make.

But that doesn't mean you'd rush straight out and buy stocks at that value - if you did, you'd only expect to make whatever return you'd factored in, and you wouldn't be leaving yourself any margin for error.


Margin of safety

To be interested in the investment, we'd have wanted to see a discount to that fair value, and it's very much a case of the more the merrier.

The larger the discount to your estimate of expected value, 

• the greater the likely returns and 
• the less chance you have of losing money.

So how might the margin of safety work with a stock?

Let's say your expectation is for ABC Company to pay dividends in the current year of $1.20, and that you expect this to increase forever by 6% a year.

• To get a targeted return of 10%, you'd therefore need to pay a price that provided a dividend yield of 4% (so that the yield of 4% plus its growth of 6% would equal your targeted return of 10%), which comes out at $30 ($1.20 divided by 4%, or 0.04.)

Calculations:

$1.20/4% = $30.

Next year, dividend = $1.20 x 1.06 = $1.272
Share price = $1.272/4% = $31.80
Total return = Capital gain + Dividend = ($31.80- $30) + $1.20 = $3
Total return = $3/$30 = 10%.

But that is just your estimate of a fair value for the stock. To get you interested in buying it, you'd need to see a discount to this - and the riskier the situation and the better the opportunities elsewhere, the more of a discount you'd need.

• Balancing it all up, you decide you only really find ABC Company compelling at $20.
• That would give you a 33% margin of safety, but it would also increase your dividend yield to 6% and your total expected return to 12% (the 6% yield plus the 6% growth).

The intrinsic value of $30 is also the level you might reasonably expect the stock price to return to (or 6% higher than that for each year into the future to allow for the growth) - so it also defines the capital gain you're secretly hoping to make if the price returns to the underlying value. 

• The trouble is that you don't know when - or even if - the price will return to that underlying value.  
• But the bigger the margin of safety and the more confident you are about it, the better your chances of capital appreciation.  
• And if you're left holding the stock, a large margin of safety should at least make it a decent ride.

The price wobbles around, either side of the underlying value, and your aim is to buy when it's a good way below it.  

• The further the price gets from the value, in either direction, the more likely a snap-back becomes.  
• Riskier stocks are those that have a wide range of potential outcomes.  They will probably bounce more wildly, making the prospects of a snap-back less reliable, and you'll want to buy at a wider discount to provide some comfort.

Diversification

Even with a fat margin of safety, you wouldn't put too much just in single stock because of a remote and variable chance of a complete wipe-out.

With stocks, diversification comes from spreading your portfolio over a range of different companies and sectors, and from the amount of time you are invested. 

The more time you allow, the greater the chances of the value being reflected - which, of course, is why the sharemarket beats cash more consistently the longer you give it.



Interaction between diversification and margin of safety.

There's an interaction between diversification and margin of safety, because the more you've got of one, the less you might need of the other.

There is, however, a crucial difference:

• as you increase the number of stocks in your portfolio, your selections gradually get worse.  
• An increased margin of safety, on the other hand, will mean better selections.

The flip side is that margin of safety relies on you making correct assessments of value, while diversification will tend to take you towards an average return, whether you're getting the value right or wrong.  

• So if you're very confident in your ability to assess value, you might focus on finding stocks where you see a huge margin of safety and not worry so much if you end up holding only a few of them.  

• But if you're less sure about assessing value correctly, you'll want to focus more on achieving a decent diversification, with the inevitable reduction in apparent margin of safety from your additional selections.

Related:

• Value Investing is about Buying Stocks for less than they're worth
• Simple ways to value stocks and shares
• Value in the context of Your Overall Portfolio

Simple ways to value stocks and shares

The fundamental basis of value

Stocks and shares confer the right to receive money in the future, and it's this ability to put money in your pocket that gives them their value.  Specifically, the value of a stock is the value of each of those future bits of money all added together.

This is where things start to get a bit tricky, because the value of money you are going to receive in the future depends on three elements:

• how much it is
• when you actually receive it (time value of money) and 
• the return you plan to make in the meantime (internal rate of return or the discount rate).  

For illustration, you plan for your money to make 10% each year.  This is the internal rate of return or the discount rate, depending on which end of the sums you're coming from.  The key point is that a payment of $161.05 in five years' time would have a value today of $100 if you wanted it to deliver a return of 10% a year.

• If you paid more than that then you'd make less than 10%; 
• if you paid less, you'd make more than 10%; and
• if you paid a lot less, you'd make a lot more than 10%.  That's value investing.

When you get a payment that repeats every year, forever, something really handy happens:  the sum of all the individual payments simplifies down to just one payment divided by your discount rate.  

If the payments received are growing - at least if you assume they'll grow at the same rate each year:  you just divided the first payment by the difference between the discount rate and the growth rate (the growth rate effectively offsets part of the discount rate).


The return you plan to make.

For money you plan to commit to the share market, we'd recommend using the long-term return from shares as your discount rate (your "opportunity cost of capital").

• We think 10% is a nice round number to aim for. 
• As long as you choose something in the ballpark of 8 to 12%, though, most of any difference should get lost in the rounding.

Don't confuse value and risk.

Conventional theory says you should finetune your discount rate for different shares, using a higher discount rate for riskier stocks and vice versa, but we think that just confuses the issue.  If something is riskier than something else, it doesn't necessarily mean it has a lower value, it just means that the value is more variable.

How you deal with risk for any particular stock depends on your margin of safety, your diversification and how much risk you're prepared to take.  To understand how these factors all stack up, though, you need to put all stocks on a level playing field in the first place by valuing them on the same basis - which means using the same discount rate.


Related:

• Value Investing is about Buying Stocks for less than they're worth
• Simple ways to value stocks and shares
• Value in the context of Your Overall Portfolio

The Value Equation

What is the correct company value? Value versus Price

What is the correct company value?

Nobel Prize winner in Economics, Milton Friedman, has said; “the only concept/theory which has gained universal acceptance by economists is that the value of an asset is determined by the expected benefits it will generate”.

Value is not the same as price. Price is what the market is willing to pay. Even if the value is high, most want to pay as little as possible. One basic relationship will be the investor’s demand for return on capital – investor’s expected return rate. There will always be alternative investments, and in a free market, investor will compare the investment alternatives attractiveness against his demand for return on invested capital. If the expected return on invested capital exceeds the investments future capital proceeds, the investment is considered less attractive.



http://www.strategy-at-risk.com/2009/02/15/what-is-the-correct-company-value/

Is Poh Kong a Great, Good or Gruesome Stock? Is it Undervalued, Fair price or High price?

There is a rising trend in its EPS.  However, earnings are rather cyclical, as evidenced by its ups and downs.
Poh Kong has grown its revenue and earnings through opening new outlets.  Its SSS figures are probably stagnant (this need to be confirmed).  It has acquired a lot of debt in growing to its present size.  Though its recent CFO and FCF are strongly positive, its FCF will mainly be used for paying down its debt and reinvesting into new stores.  Its DPO is in the region of 20% of its earnings and its DPS has increased little if any over the years.

Its ROE in 2009 was 10.05%.

Is Poh Kong a Great, Good or Gruesome stock?
Not a Great stock.  Perhaps more a Good stock rather than a Gruesome stock.

So,  perhaps it is better to skip this stock and search for another.

But then, let's look at the fundamentals of Poh Kong.

http://spreadsheets.google.com/pub?key=tx8wcqGqfTVH8s7RRSy-19g&output=html

What should be its intrinsic value?  Note in particular, its net working capital minus total debt owed equals RM 146 m.

At a price of 39 cents, its market cap is RM 160 m.

Therefore, effectively, the investor is buying the whole business of Poh Kong for RM 14 m.

Is Poh Kong not undervalued?  Severely undervalued?

Moreover, owning this stock gives you a DY of 3.6%.  Given its strong FCF, this dividend level can probably be sustained and this should protect the downside of your investment dollar.  Therefore, the upside reward/downside risk ratio is also favourable.

Disclaimer:  Please invest based on your own assessment and decision.  Always do your own homework.

Also read:

What are value traps?

5 Value Traps to Avoid Right Now

 I’m all for buying stocks on the cheap.  But there’s a catch: We’re only interested in good values if they also happen to be great businesses, companies with years of exceptional performance behind and ahead of them. And, of course, ones that pay us to wait for our thesis to play out.


and this:
Understanding  "Value Trap"

Everything has a value.

Everything has a value.  Putting value in dollar terms is the cornerstone not only of running a business but also of investing in almost any form.  Knowing how to arrive at a value for the physical and intrinsic characteristics of a business is essential to building wealth of all kinds.

People who invest in companies need to look beyond the current state of the business they own (or want to own) and consider what decisions they need to make to boost value.  People who have experience in those industries are often best equipped to make those decisions, but it often helps to engage a business valuation expert for guidance. 

Price Versus Value When Buying a Business

Price Versus Value When Buying a Business
Written by Bobby Jan for Gaebler Ventures

If you are an entrepreneur and looking to buy a business, there are a few concepts worth understanding. This article covers the concepts of price, value, and cost.

Wondering how to value a business?
(article continues below)

Warren Buffett once said, "Price is what you pay, value is what you get."

Business valuation is difficult and too many people use price as the signal for value. The price for value confusion can be costly.

Price is the amount of currency paid to acquire an asset. Cost is the total amount of one or more commodity to acquire an asset.

These commodities could be anything from time, natural resources, currency, etc. Cost and price are closely related and are often interchangeable. However, in many cases, the price paid for an asset and the cost of acquiring it might be significantly different.

Without getting philosophical, value is the intrinsic economic worth of an asset. Value refers to the true worth of an asset as according to some standard. For example, you an asset's value might be how much it can produce another product.

Often, the value of an asset is ultimately how much it contributes to the bottom line of a business. The goal of business valuation is to determine the value of a business.

Paying attention to price instead of value caused many personal and social tragedies in history. Investing based on price is responsible for the Tulip Mania in the 17th century, the Great Depression in early 20th century, and most recently the dot.com bubble in the late 1990s

On the other hand, buying based on value has made many individuals very wealth, including the richest man in the world, Warren Buffett.

Cheng Ming (Bobby) Jan is an Economics major at the University of Chicago who has a strong interest in entrepreneurship and investing.

Recognizing Value Situations - Growth at a Reasonable Price (GARP)

Recognizing Value Situations - Growth at a Reasonable Price (GARP)


GARP is the mainstream scenario of reasonable market valuation - or undervaluation - of growth potential. Solid and improving fundamentals and supporting intangibles are key. As part of the assessment the value investor must ask how realistic are the growth projections, particularly over time, and whether the company takes a balanced approach to the business and fundamentals. In short, is the business a good business, capable of sustained growth, and selling at a reasonable price? Key words not to lose sight of are good, sustained, and reasonable.


Or is the business a bet on an extreme but temporary success in short-term margins, market share, revenue, or profit? The G in GARP must be sustainable, not based on a short-term blip, fad, acquisition, or worse, a wild hope. The business model and its perception in the marketplace must be solid and on the rise.


Stocks with a PEG ratio of 2 or less with other solid fudamentals are good candidates, but "GARP" is not a matter of ratios alone.


Select companies with solid fundamentals and strong growth prospects based on various factors to analyse, but beware the growth maybe far from a sure thing.

Also read:
Recognizing Value Situations
Recognizing Value Situations - Growth at a Reasonable Price
Recognizing Value Situations - The Fire Sale
Recognizing Value Situations - The Asset Play
Recognizing Value Situations - Growth Kickers
Recognizing Value Situations - Turning the Ship Around
Recognizing Value Situations - Cyclical Plays
Recognizing Value Situations - Smoke and Mirrors

**Appraising the Value of a Business

Appraising the Value of a Business

Investment is most intelligent when it is most business-like.
( Benjamin Graham)

Value investing means treating an investment as though you were buying the entire business. If you were indeed buying a business, you would look for the following:
1. Income: Profits and strong positive operating cash flows exceeding capital requirements are good thing. A company starting at a loss and banking on future profits is starting in the hole, particularly considering the time value of money. Look for companies that produce more capital than they consume.
2. Income Growth: If income and cash flow are steady but unlikely to grow, there can be value. Without growth, time value depreciates earnings value over time. And competition and declining marketplace acceptance can erode the business. There’s little to make a stock price rise unless the market values the steady income stream incorrectly in the first place. Value investors should ignore the common “growth versus value” paradigm and consider growth part of the value equation.
3. Productive Capital Investment: If a company is able to invest additional capital productively – at a greater return than it would get by putting it in the bank – that indicates future value if the capital is available. A company should be able invest capital more productively than you can; otherwise, it makes sense for the company to return the capital to you, and for you to invest the capital elsewhere. If the company doesn’t have productive places to invest but pays you a good return (dividends or share buybacks), the company has value, but growth potential may be in question.
4. Rising Productivity and Falling Expenses: A good business makes increasingly better use of assets and creates more output per unit of input. Businesses that can do so are likely to generate more income sooner.
5. Predictability: Generally, a business with a predictable, steady income stream is more valuable than a company that has erratic or cyclical earnings. The erratic company may return as much money in the long run as the steady company, but the uncertainty surrounding the earnings stream requires a higher discount rate or margin of safety because you just don’t know. The higher discount rate reduces value. Look for simple and steady businesses that you understand.
6. Steady or Rising Asset Values: To the extent that asset values, particularly current assets, are steady or rising, higher returns, if and when paid out to the owners, will ultimately be the result. A company with falling asset values is suspect unless its productivity gains are significant.
7. Favourable Intangibles: Many things can affect or serve as leading indicators of business value. Management effectiveness, market presence, brand strength, customer base, intellectual property, and unique skills and competencies all play a part in driving business value. By nature, these items are hard to quantify but are part of the valuation playing field. Look for companies that do things right in the marketplace.