How to value shares (checklist)

Here is a checklist to remind me of the process when valuing shares:

1.  Value the companies using an estimate of their cash profits.

• What is the cash yield a company is offering at the current share price?
• Is it high enough?

2.  Calculate the company's earnings power value (EPV).

• How much of a company's share price is explained by its current profits?
• How much is dependent on future profits growth? 
• If more than half of the current share price is dependent on future profits growth, do not buy these shares.

3.  What is the maximum price you will pay for a share.

• You should try and buy shares for less than this value.  
• Apply a discount of at least 15%.
• The interest rate applied to calculate the maximum price should be at least 3% more than the rate of inflation.

4.  To pay a price at or beyond the valuations above, you must be confident in the company's ability of continuing future profits growth (quality growth companies).

• The higher the price paid for profits/turnover/growth, the more risk you are taking with your investment.
• If profits stop growing, then paying an expensive price for a share can lead to substantial losses.

Additional notes:

Investing using checklists is a very powerful method.

It focuses your thinking and guides you in the investing process.

If you are to be a successful investor in shares, you need to pay particular attention to the price you for for them.

• The biggest risk you face is paying too much.
• It is important to remember that no matter how good a company is, its shares are not a buy at any price.

Paying the right price is just as important as finding a high quality and safe company.

• Overpaying for a share makes your investment less safe and exposes you to the risk of losing money.

Also, do not be too mean with the price you are prepared to pay for a share.

• Obviously you want to buy a share as cheaply as possible, but you should also realise that you usually have to pay up for quality.
• Waiting to buy quality shares for very cheap prices may mean that you end up missing out on some very good investments.
• Some shares can take years to become cheap and many never do.

Analysing a company's future performance and estimating its value

Analysing a company's future performance and estimating its value 

• begin with examining historical and current data and 
• then making projections.

Several sets of forecasts or scenarios

Several sets of forecasts or scenarios should be made using different assumptions concerning

• the business environment and 
• the strategy of the firm.

A simple example is where only two or three scenarios are created, example,

• a business-as-usual scenario,
• an aggressive marketing or acquisition scenario, and 
• an operational improvement scenario.

Estimating Value

The value should be estimated using

1. various explicit forecast horizons and
2. different methods.

1.  Estimating Value using Various explicit forecast horizons

There are usually two periods to forecast:

• the explicit forecast period and 
• the period after that in which the challenge is to estimate the continuing value for that period.

2.  Estimating Value using Different methods

There is also the choice of using these methods for estimating value:

• the free cash flow (FCF) method and 
• the economic-profit method.

Both methods should be used and their results compared.

By estimating value using different explicit forecast horizons and methods,

• the robustness of the model and 
• the consistency of the assumptions can be verified.

Business value cannot be precisely determined. Make use of ranges of values.

Business value cannot be precisely determined. 

Not only do a number of assumptions go into a business valuation, but relevant macro and micro economic factors are constantly changing, making a precise valuation impossible. 

Although anyone with a calculator or a spreadsheet can calculate a net present value of future cash flows, the precise values calculated are only as accurate as the underlying assumptions.

Investors should instead make use of ranges of values, and in some cases, of applying a base value. 

Ben Graham wrote:

The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate—e.g., to pro­tect a bond or to justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.

There are only three ways to value a business. 

1.   The first method involves finding the net present value by discounting future cash flows. 

Problems with this method involve trying to predict future cash flows, and determining a discount rate. 

Investors should err on the side of conservatism in making assumptions for use in net present value calculations, and even then a margin of safety should be applied.

2.  The second method is Private Market Value using Multiples. 

This is a multiples approach (e.g. P/E, EV/Sales) based on what business people have paid to acquire whole companies of a similar nature. 

The problems with this method are that comparables assume businesses are all equal, which they are not. 

Furthermore, exuberance can cause business people to make silly decisions. 

Therefore, basing your price on a price based on irrationality can lead to disaster. 

This is believed to be the least useful of the three valuation methods.

3.  Finally, liquidation value as a method of valuation. 

A distinction must be made between a company undergoing a fire sale (i.e. it needs to liquidate immediately to pay debts) and one that can liquidate over time. 

Fixed assets can be difficult to value, as some thought must be given to how customised the assets are (e.g. downtown real-estate is easily sold, mining equipment may not be).

When should each method be employed? 

They can all be used simultaneously to triangulate towards a value. 

In some cases, however, one might place more confidence in one method over the others. 

For example, 

• liquidation value would be more useful for a company with losses that trades below book value, while 
• net present value is more useful for a company with stable cash flows.

Using the methods of valuation described, you can search for stocks that are trading at a severe discount; it is possible, their stock price more than doubled soon after.

Beware of these failures

The failures of relying on a company's earnings per share - too easily massaged.

The failure of relying on a company's book value  - not necessarily relevant to today's value.

The failure of relying on a company's dividend yield - incentives of management to make yields appear attractive at the expense of the company's future.

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations

Valuation

To get ahead, be creative.

No matter what a client desired, a good banker could always tweak the numbers a bit and could produce the numbers:

• a higher selling price,
• a lower purchase price, 
• stronger margins,
• lower capital costs.

Valuation Basics

Time Value of Money

Present Value   

Methods of Valuation

Valuation is far more of an art than a science.

"The value of that work is $1 million, because that is what the buyer and seller agreed on."

With detailed valuation models, the key factors that drove a company in the past, along with those which will continue to drive it in the future, can be examined.

Both sides are able to form a better picture of the potential as well as the risks associated with this company.

Through this process of dialogue, they hope to be able to build a consensus.  With a little luck, they just might close a sale.

There are numerous uses for valuation.   

A few of the more common ones are:

• Venture capital
• Initial public offerings
• Mergers and acquisitions
• Leveraged buyouts
• Estate and tax settlements
• Divorce settlements
• Capital raising.
• Partnerships
• Restructuring
• Real estates
• Joint ventures
• Project finance.

Even if you have no dealings in these types of transactions and more specifically, no interest in them, it is important to have at least a basic understanding of the underlying principles and techniques of valuation.

Why?   Because so much of what we do and so much of what governs out personal lives is driven by these principles.

• The simple decision to lease or buy a care is driven by valuation.
• The decision to own or rent an apartment is driven by valuation.
• Changes in the stock market that might affect your job are a function of valuation.

It is important that each one of us understand the basics of valuation because we no longer can rely on the experts on Wall Street, in corporate America, and at the big accounting firms.

Ultimately, we all bear some responsibility because we were the ones who failed to educate ourselves.

Various Methods of Valuation

• Replacement Method
• Capitalization of Earnings
• Excess Earnings Method
• Discounted Cash Flow Valuation
• Comparable Multiple Valuation
• Net Present Value
• Internal Rate of Return

Which company is cheaper? (Understanding P/E, Earnings yield and EBIT/EV.)

Consider two companies, Company A and Company B.

They are actually the same company (i.e. the same sales, the same operating earnings, the same everything) except that Company A has no debt and Company B has $50 in debt (at a 10% interest rate).

All information is per share

Company A

Sales                     $100
EBIT                         10
Interest expense          0
Pretax Income           10
Taxes @ 40%             4
Net Income               $6


Company B

Sales                     $100
EBIT                         10
Interest expense           5
Pretax Income             5
Taxes @ 40%             2
Net Income               $3


The price of Company A is $60 per share.
The price of Company B is $10 per share.

Which is cheaper?

P/E of Company A is 10 ($60/6 = 10).  The E/P or earnings yield, of Company A is 10% (6/60).
P/E of Company B is 3.33 ($10/3 = 3.33). The E/P or earnings yield of Company B is 30% (3/10).

So which is cheaper?
Using P/E and earnings yield, Company B looks much cheaper than Company A.

So, is Company B clearly cheaper?


Let's look at EBIT/EV for both companies.

Company A
Enterprise value (Market price + debt)   60 + 0 = $60
EBIT   $10


Company B
Enterprise value (Market price + debt)   10 + 50 = $60
EBIT   $10

They are the same! Their EBIT/EV are the same.

To the buyer of the whole company, would it matter whether you paid $10 per share for the company and owed another $50 per share or you paid $60 and owed nothing?

It is the same thing!

*You would be buying $10 worth of EBIT for $60, either way!




Additional note:

* For example, whether you pay $200k for a building and assume a $800k mortgage or pay $1 million up front, it should be the same to you.  The building costs $1 million either way!

[Using EBIT/EV as your earnings yield provide a better picture than E/P, of how cheap or expensive the asset is.]

Pretax operating earnings or EBIT (earnings before interest and taxes) was used in place of reported earnings because companies operate with different levels of debt and differing tax rates. Using EBIT allowed us to view and compare the operating earnings of different companies without the distortions arising from the differences in tax rates and debt levels.  For each company, it was then possible to compare actual earnings from operations (EBIT) to the cost of the assets used to produce those earnings (tangible capital employed) and to the price you are paying.

Returns on Capital
= EBIT / (Net Working Capital + Net Fixed Assets)

Earnings Yield
= EBIT / EV
= EBIT / Enterprise Value

As an investor, you are looking for companies with high Returns on Capital and selling for a bargain or high Earnings Yield (EBIT / EV).

REF:  The Little Book that still Beats the Market by Joel Greenblatt

How to analyze real estate developers***

Real estate stocks make up a significant number of companies in Asian stock exchanges and many of them are among the the most volatile stocks. Whether the real estate developer is listed or not, they are influenced by a host of cyclical factors ranging from government policies, interest rates, unemployment rates, affordability, etc. Hence, it is important to understand how real estate companies can be analyzed.

Profit Model

Real estate industry can be separated into the following sub-industries or types of real estate developers:

• Residential real estate developers
• Commercial and mixed use real estate developers
• Industrial real estate developers

Profit model of residential real estate developers

Residential real estate developers are more dependent on economies of scale than ever because of increasing land prices and declining rate of increase in residential property prices. In many developing countries, developers used to be able to acquire land at cheap prices and hope for rapid increase in home prices to make huge profits. In developed countries, land prices are higher, and price increases are more muted. Hence, brands and good management are playing an increasingly important role.

Profit model of commercial real estate developers

As prime real estate for commercial developments become more scare, commercial real estate developers tend to prefer to have rental incomes rather than selling units so that they can have consistent income and manage the properties. These developers are also more likely to sell their commercial properties to real estate investment trusts to free up capital and many are REITs that also develop properties.

Profit model of industrial real estate developers

Industrial real estate developers operate more like commercial real estate developers as they seek to have stable rental incomes and also sometimes selling their properties. Some industrial estate developers might even have a fund to invest in promising industrial companies so as to achieve higher profits.

Factors that Affect Value

• Land bank - the value of a real estate developer is directly influenced by its land bank. As the larger the land bank, usually means the developer can make more profits from developing the land banks later. Hence, the land bank that a real estate company has is always disclosed in detail in the listed companies' reports.
• Inventories - Real estate inventories an be separated into a few categories. Usually increasing values of construction-in-progress and land held for development will translate to higher future earningswill translate to higher future earnings for the company:
  • Completed developments - properties whose construction has been completed
  • Construction-in-progress - means the value of properties under construction.
  • Land held for development - value of land help for future developments.
  • Investment properties - properties held for rent or sale
• Customers deposits - for residential projects, it is often that developers will collect customers deposits or even prepayments of entire houses prior to completion of the units. As these properties are pre-sold and their profit and loss have yet to be recognized in the income statement, growing customer deposits could signal increasing revenue and most likely profits in the coming years ahead.
• Housing prices - the profits from real estate developers that primarily sell their developments come from selling the units at above costs. Hence, the moving of housing prices have direct impact on the profitability of residential real estate developers. Usually the stock price of real estate developers have high correlation with the anticipated housing price direction.
• Rental rates - Rental rates are especially important for commercial and industrial real estate developers as most of them do not sell all the units that they developed but they keep these units for rental returns. Rental rates have direct bearing on stock prices of such developers and REITs.
• Industry consolidation -  as economic difficulties mount and economies of scale becomes more important, mergers and acquisition activities will also drive prices of real estate companies as the merged entities might be more efficient given a larger land bank.
• Macro economic factors - government policies play a huge role in controlling property prices as the following factors will determine the direction of property prices. We have listed

Factor	Movement	Likely Effects
Interest rates	Up	Negative
Land supply	Down	Positive on short term price but will affect future profitability if land bank dries up
Loan Quantum	Up	Positive
Reserve ratio	Up	Negative
GDP	Up	Positive
Unemployment	Up	Negative

 

Valuing Real Estate Developers

A common method to value real estate developers is using the Revalued Net Asset Value ("RNAV") approach which basically determines the net asset value of a real estate developer by adding up the change in value of the investment properties held by the company, the surplus value of properties held for development using Discounted Cash Flow method and the net asset value of the company with any other adjustments that are deemed necessary.

Usually a discount or premium percentage is multiplied with the RNAV base on the developers other qualities such as management capabiltiies, branding, track record, etc. A smaller developer with poor record of continuously generating consistent income is usually given a significant discount to its RNAV.

Using the RNAV approach only takes into account of what the developer can earn with the assets that it has in its books at the time of the valuation. If properly applied, it is usually more conservative than the market approach such as P/E multiples.

However, to use this method, it requires a lot of work in revaluing the properties held by the developer, making it difficult to implement by most people as information needed to determine RNAV needs some skill in obtaining.

The price earnings ratio method could also be useful to cross check the RNAV method.

Source: http://roccapitalholdings.com/content/how-analyze-real-estate-developers

http://secret-gems.blogspot.com/2013/04/how-to-analyze-real-estate-developers.html

Valuation in a Business Divorce

THE LEGAL INTELLIGENCER BLOG
Valuation in a Business Divorce
Terry Silver, The Legal Intelligencer
March 19, 2015

My advice to lawyers and CPAs is to prepare your clients for the prospect of a business divorce. A business relationship is no different than a marital one; people change, circumstances change, and people grow (and don’t grow) in different directions. And by “preparing for a business divorce,” I am referring to the need to create an operating agreement from the outset of a business relationship to address the following issues, if and when they arise:

Death of an equity owner;
Disability of an equity owner;
Sale of an equity interest to a third party;
Termination of an equity owner’s employment; and
The subject of this article: the predetermined steps to value an equity interest.

When a new business begins, financial resources are usually devoted to its tangible needs, while intangible needs are usually delayed. An operating agreement is typically recognized as an intangible need that can wait until cash flow improves. I, however, advise both new and newer business owners to negotiate the terms of an operating agreement as early in the business life cycle as possible, as once issues develop, it will be too late to negotiate a mutually acceptable operating agreement.

To address valuation, an operating agreement typically will either provide a specific method to value the business, or will designate the means by which to value the business. For example, the operating agreement can specify a methodology such as 5 x EBITDA or 1.5 x revenue. I strongly advise against this approach for two reasons: (1) The person selecting the valuation approach is most likely not qualified in business valuation, so the method selected may be flawed; and (2) there is no one correct way to value a business. As time and circumstances change, so too may the appropriate method to value a business change.

For these reasons, a fixed valuation method, to be used for all time, is ill-advised. I recommend the operating agreement specify the business be contemporaneously and independently valued, and the valuation be binding, as to avoid time-consuming and costly litigation. I further advise the operating agreement specify the credentials of the business valuator chosen to insure a credible valuation product. Commonly accepted valuation credentials include ASA, CVA, ABV and CFA.

Lastly, there may be a dispute between owners in the selection of the business valuator. This can be avoided by incorporating a provision in the operating agreement that enables each owner to select a business valuator. These two business valuators, in turn, jointly select the final business valuator, whose valuation opinion will be binding. This is a lesser used provision, as it is almost always preferable for the parties in dispute to choose a mutually acceptable valuator.

Taking the time in the early stage of a business to address potential adversarial issues via the operating agreement will save a great deal of time, anxiety and money once problems develop between owners.

Terry Silver is a partner at Citrin Cooperman, a full-service accounting, tax, and consulting firm with offices located throughout the Northeast. Based in Citrin Cooperman’s Philadelphia office, Silver focuses his attention on business valuation services and mergers and acquisitions. To learn more, visit www.citrincooperman.com.

http://www.thelegalintelligencer.com/all-news/id=1202721048001/Valuation-in-a-Business-Divorce?mcode=1202615493286&curindex=0&slreturn=20150220005029

How to Value Stocks

Where do you always want to start a valuation?

STARTING A VALUATION 

Asset Valuation 

Where do you always want to start a valuation?  You want to start with assets.  Why?  Because they are tangible.  You could technically go out and look at everything that is on the firm’s balance sheet. Even the intangibles like the product portfolio you could investigate it today without making any projections or extrapolations.  You could even investigate the quality of things like the trained labor force and the quality of their business relationships with their customers (I think this is very difficult to ascertain). 

Start with that. It is also your most reliable information. It is also all that is going to be there if this is not a viable industry, because if this is not a viable industry, this company is going to get liquidated.  And what you are going to see is the valuation in liquidation. And that is very closely tied to the assets.   In that case, with that strategic assumption, you are going to go down that balance sheet and see what is recoverable.  But suppose the industry is viable, suppose it is not going to die. How do you value the assets then? Well, if the industry is viable then sooner or later the assets are going to be replaced so you have to look at the cost of reproducing those assets as efficiently as possible.   So what you are going to do is you are going to look at the reproduction value of the assets in a case where it is a viable industry.  And that is where you are going to start. We will go in a second and a little more tomorrow about the mechanics of doing that reproduction asset valuation. But that is value that you know is there.  


Earnings Power Valuation

The second thing you are going to look at because it is the second most reliable information you are going to look at is the current earnings. Just the earnings that you see today or that are reasonably forecastable as the average sustainable earnings represented by the company as it stands there today.   

And then we are going to extrapolate.  We are going to say suppose there was no growth and no change what would the value of those earnings be? Let’s not get into the unreliable elements of growth. Let’s look secondly at the earnings that are there and see what value there is. And that is the second number you are going to calculate and the likely market value of this company.  But it turns out that those two numbers are going to tell you a lot about the strategic reality and the likely market value of this company.  

Illustration

Suppose this is a commodity business like Allied Chemical and you have looked at the cost of reproducing the assets.  And you think you have done a pretty good job at that—And you could build or add buildings, plants, cash, accounts receivables and inventory that represents this business-- customer relationships, a product line--for a billion dollars.  This is usually going to be the cost for their most efficient competitors, who are the other chemical companies.  So the cost of reproducing this company is a billion dollars. Suppose on the other hand its earnings power is $200 million, and its cost of capital is 10% so the value of it s earnings which mimics its market value is two billion dollars ($200 million/0.10).  What is going to happen in that case?  Is that  two billion $ going to be sustainable?   $2 billion in earnings power value (EPV) is double the asset value (AV) of the company but there are no sustainable competitive advantages. If EPV is > than AV, then sustainability depends upon franchise value (“FV”). 

Well, think about what is going on in the executive suites of all these chemical companies. They are going to seed projects where they can invest $1 billion dollars and create two billion dollars of value.  What these guys love better than their families are chemical plants.  So you know those chemical plants are going to get built if there is not something to prevent that process of entry.


Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School 
Edited by John Chew at Aldridge56@aol.com                           
studying/teaching/investing Page 24 


Additional notes:

Reversion to the Mean or the Uniformity of One Price 

As the chemical plants get built, what is going to happen to this chemical price?  It is going to go down. The margins will decline, the earnings power value and the market value of the company will go down. Suppose it goes down to a $1.5 billion.  Will that stop the process of entry?  No, not at all. Because the opportunity will still be there.  (Profits still above the cost of capital) 

In theory, the process of entry should stop when the cost of reproducing those assets equal the market value of those assets.  In practice, of course, it is easier to buy a puppy than to drown it later.  Once those puppies are bought, you are stuck with it.  The process of exit is slower than entry.   The same thing applies to chemical plants.  Once those chemical plants are built, they are likely to stay there for a long time.  Typically, the process may not stop there.  It applies equally to differentiated products. Suppose Ford, to reproduce their assets of the Lincoln division is $5 billion and the earnings power value and the market value is 8 billion. What is going to happen then?  Mercedes, the Europeans and the Japanese are going to look at that opportunity, and they are going to enter. 

Now do prices necessarily fall?  No, not in this case, they match Ford’s price. What will happen to Ford’s sales?  Inevitably they are going to go down because they will lose sales to the entrants.  What therefore will happen to their unit fixed costs?  The costs will rise.  Their variable costs are not going down, so their unit costs are going up.  The prices are staying the same, their margins are going down and their per units sold and their sales are going down, so what happens to profits here with a differentiated market and with a differentiated product?  Exactly the same thing.  

The differentiated products won’t save you. And that will go on until the profit opportunity disappears.  Unless there is something to interfere with this process of entry, sooner or later the market value of the company will be driven down to the reproduction value of the assets.  Especially, in the case of the Internet. You had companies that didn’t have any earnings that were $5, $10 or $15 billion dollars whose assets could be reproduced for $10 million or $15 million dollars.  Unless there is something to stop the process of entry, the earnings to support that are not going to materialize.  So what you are looking at is a decline.

How to Value a Company in 3 Easy Steps

How to Value a Company in 3 Easy Steps - Valuing a Business Valuation Methods Capital Budgeting


Valuing a Business
How much is a business worth?
Don't care about the 'asset value' or 'owner equity' of the business.
We look at the present value of its net free cash flows (FCF) plus present value of its horizon value".



Step2 - How to Value a Company for Valuing a Business Valuation Methods Capital Budgeting



Step3 How to Value a Compay for Valuing a Business Valuation Methods Capital Budgeting

Uploaded on 15 Mar 2010

Clicked here http://www.MBAbullshit.com/ and OMG wow! I'm SHOCKED how easy.. 

Just for instance I possessed a company comprising of a neighborhood store. To put together that center, I invested $1,000 one year ago on apparatus along with other assets. The equipment in addition to other assets have depreciated by 10% in a single year, so now they're valued at only $900 inside the accounting books. In case I was going to make an effort to offer you this company, what amount would an accountant value it? Relatively easy! $900. The cost of the whole set of assets (less liabilities, if any) can give accountants the "book value" of a typical organization, and such is systematically how accountants observe the worth of an enterprise or company. (We employ the use of the word "book" because the worth of the assets are penned within the company's accounting "books.") 
http://www.youtube.com/watch?v=6pCXd4...
However, imagine this unique company is earning a juicy cash income of $2,000 annually. You would be landing a mighty incredible deal in the event I sold it to you for just $900, right? I, on the flip side, might be taking out a pretty sour pact in the event I offered it to you for just $900, on the grounds that as a result I will take $900 but I will shed $2,000 per annum! Due to this, business directors (dissimilar to accountants), don't make use of merely a company's book value when assessing the value of an organization.So how do they see how much it really is worth? To replace utilizing a business' books or even net worth (the market price of the firm's assets minus the business enterprise's liabilities), financial managers opt to source enterprise worth on how much money it gets in relation to cash flow (real cash acquired... contrary to only "net income" that may not generally be in the format of cash). Basically, a company making $1,000 "free cash flow" monthly having assets worth a very small $1 would remain to be worth a great deal more versus a larger company with substantial assets of $500 in the event the humongous company is attaining only $1 yearly.So far, how do we achieve the exact value of your business? The simplest way would be to mainly look for the net present value of the total amount of long run "free cash flows" (cash inflow less cash outflow).Needless to say, you will come across much more sophisticated formulas to find the value of a company (which you wouldn't genuinely need to learn in detail, since there are numerous gratis calculators on the web), but practically all of such formulas are in a way driven by net present value of cash flows, plus they are likely to take into consideration a few factors for example growth level, intrinsic risk of the company, plus others.

The only 2 classes that an investment student needs to take

Buffett believes that investment students need only two well-taught classes:

1.  How to Value a Business?

2.  How to Think about Market Prices?

Most valuations (even good ones) are wrong

Now this can be shocking to you if you spend a lot of time arriving at that magical number (intrinsic value) that helps you ascertain whether you must buy a stock or not.

Damodaran talks about three kinds of errors that cause most valuations – even the ones “meticulously” calculated – to go wrong:

1. Estimation error…that occurs while converting raw information into forecasts.
2. Firm-specific uncertainty…as the firm may do much better or worse than you expected it to perform, resulting in earnings and cash flows to be quite different from your estimates.
3. Macro uncertainty…which can be a result of drastic shifts in the macro-economic conditions that can also impact your company.

The year 2008 is one classic example when most valuations – even the good ones – went horribly wrong owing to the last two factors – firm-specific and macro uncertainties.

As Damodaran writes…

While precision is a good measure of process in mathematics or physics, it is a poor measure of quality in valuation.

So, to value or not value?
Knowing that your valuation could be wrong (and in most cases, it would be) despite any kind of precision you employ in your calculations, it should not lead you to a refusal to value a business at all.

This makes no sense, since everyone else looking at the business faces the same uncertainty.

Instead what you must do to increase the probability of getting your valuations right is…

1. Stay within your circle of competence and study businesses you understand. Simply exclude everything that you can’t understand in 30 minutes.
2. Write down your initial view on the business – what you like and not like about it – even before you start your analysis. This should help you in dealing with the “I love this company” bias.
3. Run your analysis through your investment checklist. A checklist saves life…during surgery and in investing.
4. Avoid “analysis paralysis”. If you are looking for a lot of reasons to support your argument for the company, you are anyways suffering from the bias mentioned above.
5. Calculate your intrinsic values using simple models, and avoid using too many input variables. In fact, use the simplest model that you can while valuing a stock. If you can value a stock with three inputs, don’t use five. Remember, less is more.
6. Use the most important concept in value investing – ‘margin of safety’. Without this, any valuation calculation you perform will be useless.

At the end of it, Damodaran writes…

Will you be wrong sometimes? Of course, but so will everyone else. Success in investing comes not from being right but from being wrong less often than everyone else.

So don’t justify the purchase of a company just because it fits your valuation. Don’t fool yourself into believing that every cheap stock will yield good returns. A bad company is a bad investment no matter what price it is.

Charlie Munger explains that – “a piece of turd in a bowl of raisins is still a piece of turd”…and…“there is no greater fool than yourself, and you are the easiest person to fool.”

So, get going on valuing stocks…but when you find that the business is bad, exercise your options.

Not a call or a put option, but a “No” option.

Have you ever avoided buying a stock you “loved” because its valuations were not right? 

http://www.safalniveshak.com/avoid-2-bitter-truths-of-stock-valuations/

2 Bitter Truths of Stock Valuation

1. All valuations are biased

2. Most valuations (even good ones) are wrong

Alternative to Discounted Cash Flow Method

What do you use if you don't want to or can't use the discounted cash flow (DCF) method of valuing a stock?  

There are other methods for valuing a stock (not valuing the company).  The most popular alternative uses various multiples to compare the price of one stock to a comparable stock.

The price earnings ratio (P/E) is the most popular multiple for these comparisons.

You can use the P/E formula to find the price based on comparable stocks.

For example, three stocks in a particular industry had an average P/E of say 18.5.  If another stock ABC in the same industry had earnings of $2.50 per share, you could calculate a stock price of $46.25 per share (= 2.5 x 18.5).  This is just an approximation, but it should put stock ABC on a comparable basis with the other three stocks in the same industry.



This strategy has several flaws.

1.  The P/E is not always the most reliable of value gauges.
2.  The process depends on the three comparables being priced correctly and there is no guarantee of that.
3.   Its biggest flaw is that the process tells you nothing of the future value of the company or the stock.

If you use this method, and many investors do, you will need to watch the stock more closely and continually measure it against comparables.  However, it does not require you to estimate anything or consider multiple variables, which is why it is so popular.

This method is best used for a quick decision on whether the stock is under-priced or over-priced.
Although you can arrive at a stock price based on the P/E formula, it is not nearly as accurate as the DCF method.



You can also use other key ratios in valuation.

These include the followings:
1.  Price/Book - Value market places on book value.
2.  Price/Sales - Value market places on sales.
3.  Price/Cash Flow - Value market places on cash flow.
4.  Dividend Yield - Shareholder yield from dividends.



So, which method should you use - DCF or multiples?

In the end, you will have to decide which method is for you.

There is no rule against using both.

Whether you calculate your own DCFs or use the estimates from others, reputable websites or analysts estimates, make sure you have the best guess available on the variables the formula needs.

Either way, make a conscious decision to buy a stock based on the valuation method of your choice and not a "feeling" for the stock.

Stock valuation. Why does the value of a share of stocks depend on dividends?

Does the value of stocks depend on dividends or earnings?

Management determines its dividend policy by evaluating many factors, including:

• the tax differences between dividend income and capital gains,
• the need to generate internal funds to retire debt or invest, and,
• the desire to keep dividends relatively constant in the face of fluctuating earnings.

Since the price of a stock depends primarily on the present discounted value of all expected future dividends, it appers that dividend policy is crucial to determining the value of the stock.

However, this is not generally true. It does not matter how much is paid as dividends and how much is reinvested AS LONG AS the firm earns the same return on its retained earnings that shareholders demand on its stock. The reason for this is that dividends not paid today are reinvested by the firm and paid as even larger dividends in the future.

Dividend Payout Ratio

Management's choice of dividend payout ratio, which is the ratio of cash dividends to total earnings, does influence the timing of the dividend payments. 

The lower the dividend payout ratio (that is more earnings are retained), the smaller the dividends will be in the near future. Over time, however, dividends will rise and eventually will exceed the dividend path associated with a higher payout ratio.

Moreover, assuming that the firm earns the same rate on investment as the investors require from its equity (for example, ROE of 15%), the present value of these dividend streams will be identical no matter what payout ratio is chosen.

How to value Stocks?

Note that the price of the stock is always equal to the present value of ALL FUTURE DIVIDENDS and not the present value of future earnings. 

Earnings not paid to investors can have value only if they are paid as dividends or other cash disbursements at a later date. Valuing stock as the present discounted value of future earnings is manifestly wrong and greatly overstates the value of a firm. (Note: Firms that pay no dividends, such as Warren Buffett's Berkshire Hathaway, have value because their assets, which earn cash returns, can be liquidated and disbursed to shareholders in the future.)

John Burr Williams, one of the greatest investment analysts of the early part of the centrury and author of the classic The Theory of Investment Value, argued this point persuasively in 1938. He wrote: 

"Most people will object at once to the foregoing formula for valuing stocks by saying that it should use the present worth of future earnings, not future dividends. But should not earnings and dividends both give the same answer under the implicit assumptions of our critics? If earnings not paid out in dividends aree all successfully reinvested at compound interest for the benefit of the stockholder, as the critics imply, then these earnings should produce dividends later; if not, then they are money lost. Earnings are only a means to an end, and the means should not be mistaken for the end."


Ref: Stock for the Long Run, by Jeremy Siegel

http://myinvestingnotes.blogspot.com/2009/05/does-value-of-stocks-depend-on.html

Using PEG ratio: Not all growth is created equal.

As the risk increases, the PEG ratio of a firm decreases. When comparing the PEG ratios of firms with different risk levels, even within the same sector, the riskier firms should have lower PEG ratios than safer firms.

Not all growth is created equal. A firm that is able to grow at 20% a year, while paying out 50% of its earnings to stockholders, has higher quality growth than another firm with the same growth rate that reinvests all of its earnings back. Thus, the PEG ratio should increase as the payout ratio increases, for any given growth rate.

As with the PE ratio, the PEG ratio is used to compare the valuations of firms that are in the same business.  The PEG ratio is a function of:

• the risk,
• growth potential and
• the payout ratio of a firm.

http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf

http://myinvestingnotes.blogspot.com/2009/11/using-peg-ratio-not-all-growth-is.html

Valuation Methods: How to value a business, a company or its shares

How to Value a Company in 3 Easy Steps

Valuing a Business:
How much is a business worth?
Don't care about the 'asset value' or 'owner's equity' of the business.
We look at the present value of its net free cash flows (FCF) plus present value of its "horizon value".

Two Approaches to Stock Valuation

There are two broad approaches to stock valuation. One is the ratio
based approach and the other is the intrinsic value approach.

If you have ever talked about a P/E ratio, you've valued a stock using
the ratio-based approach. Valuation ratios compare the company's
market value with some financial aspect of its performance--
earnings, sales, book value, cash flow, and so on. The ratio-based
approach is the most commonly used method for valuing stocks,
because ratios are easy to calculate and readily available.


The downside is that making sense of valuation ratios requires quite
a bit of context. A P/E ratio of 15 does not mean a whole lot unless
you also know the P/E of the market as a whole, the P/Es of the
company's main competitors, the company's historical P/Es, and
similar information. A ratio that looks sky-high for one company
might seem quite reasonable for another.

The other major approach to valuation tries to estimate what a
stock should intrinsically be worth. A stock's intrinsic value is based
on projecting the company's future cash flows along with other
factors. You can compare this intrinsic or fair value with a stock's 
market price to determine whether the stock looks underpriced, fairly
 valued, or overpriced.


http://news.morningstar.com/classroom2/course.asp?docId=145096&page=5&CN=COM

The 3 Types of Investment Risk

The 3 Types of Investment Risk
The Basics of Risk Management 
 By Joshua Kennon, About.com Guide

Smart investing includes risk management. For each stock, bond, mutual fund or other investment you purchase, there are three distinct risks you must guard against; they are business risk, valuation risk, and force of sale risk. In this article, we are going to examine each type and discover ways you can protect yourself from financial disaster.

Investment Risk #1: Business Risk

Business risk is, perhaps, the most familiar and easily understood. It is the potential for loss of value through competition, mismanagement, and financial insolvency. There are a number of industries that are predisposed to higher levels of business risk (think airlines, railroads, steel, etc).

The biggest defense against business risk is the presence of franchise value. Companies that possess franchise value are able to raise prices to adjust for increased labor, taxes or material costs. The stocks and bonds of commodity-type businessesdo not have this luxury and normally decline significantly when the economic environment turns south.

Investment Risk #2: Valuation Risk

Recently, I found a company I absolutely love (said company will remain nameless). The margins are excellent, growth is stellar, there is little or no debt on the balance sheet and the brand is expanding into a number of new markets. However, the business is trading at a price that is so far in excess of it's current and average earnings, I cannot possibly justify purchasing the stock.

Why? I'm not concerned about business risk. Instead, I am concerned about valuation risk. In order to justify the purchase of the stock at this sky-high price, I have to be absolutely certain that the future growth prospects will increase my earnings yield to a more attractive level than all of the other investments at my disposal.

The danger of investing in companies that appear overvalued is that there is normally little room for error. The business may indeed be wonderful, but if it experiences a significant sales decline in one quarter or does not open new locations as rapidly as it originally projected, the stock will decline significantly. This is a throw-back to our basic principle that an investor should never ask "Is company ABC a good investment"; instead, he should ask, "Is company ABC a good investment at this price."

Investment Risk #3: Force of Sale Risk

You've done everything right and found an excellent company that is selling far below what it is really worth, buying a good number of shares. It's January, and you plan on using the stock to pay your April tax bill.

By putting yourself in this position, you have bet onwhen your stock is going to appreciate. This is a financially fatal mistake. In the stock market, you can be relatively certain of what will happen, but not when. You have turned your basic advantage (the luxury of holding permanently and ignoring market quotations), into a disadvantage.

Consider the following: If you had purchased shares of great companies such as Coca-Cola, Berkshire Hathaway, Gillette and Washington Post at a decent price in 1987 yet had to sell the stock sometime later in the year, you would have been devastated by the crash that occurred in October. Your investment analysis may have been absolutely correct but because you imposed a time limit, you opened yourself up to a tremendous amount of risk.

Being forced to sell your investments is really something known as liquidity risk, which is important enough I wrote a separate article about it to help you understand why it poses such a threat to your net worth.

The Moral

There is always some degree present in every investment you purchase. At the same time, by avoiding or minimizing specific types of risk, you can keep temporary hiccups in the economy or financial markets from destroying your wealth.


http://beginnersinvest.about.com/cs/valueinvesting1/a/080103a.htm