CHECKLIST ON HOW TO VALUE SHARES

BIGGEST RISK:  PAYING TOO MUCH

The biggest risk you face to be a successful investor in shares 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.

USUALLY HAVE TO PAY UP FOR QUALITY

Be careful not to 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 bear in mind 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.

CHECKLIST ON HOW TO VALUE SHARES

When valuing shares, you can use the following checklist to remind of the process to follow:

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

2.  Work out the cash yield a company is offering at the current share price.  Is it high enough?

3.  Calculate a company's earnings power value (EPV) to work out how much of a company's share price is explained by its current profits and how much is dependent on future profits growth.  Do not buy shares where more than half the current share price is dependent on future profits growth.

4.  Work out the maximum price you will pay for a share.  Try and buy shares for less than this value.   At least a discount of 15% or more.

5.  The interest rate use to calculate the maximum price should be at least 3% more than the rate of inflation.

6.  You must be very confident in continued future profits growth to pay a price at or beyond the valuations estimated here.

7.  The higher the price you pay 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.

Using owner earnings to value shares: Setting a maximum price method

Setting a maximum price and buying price for Company X shares

Current cash profit per share 11.6 sen

Divide by interest rate [inflation +3%]  4.4%

Maximum price (cash profit / interest rate)   $2.636

Current price  $3.20

Ideal price at 15% discount $2.24

Cash yield at ideal price (cash profit/ideal price)  5.18%

ANALYSIS:

This approach is saying that Company X shares are currently too expensive to buy.

The most (maximum price) you should pay is $2.63 per share, compared with a current share price of $3.20.

If you want even more of a buffer (margin of safety) compared with the maximum price - a good rule of thumb is 15% - you will only want to pay $2.24.

Additional notes:

You might be waiting a long time for a share to reach your target price and it might never do so.

However, it is far better to wait or even risk missing out on the few shares that are too expensive than to risk paying too much and lose money.

When to sell?

This kind of analysis can also give you some guidance of when to sell a share.  

If a share that you own reaches a maximum price, it doesn't mean that you should automatically sell it.   Shares can and do go beyond and below their fair valuations.   

In the above example, Company X, one would not sell at $2.63 but if the share price exceeded this (maximum price) by 25% ($3.29), you might sell and then look for something cheaper to buy.

Warren Buffett has looked at owner earnings (cash profits) of businesses for many years.

 In his 1986 letter to shareholders, Warren Buffett described how he worked out what he called the "owner earnings" (referred here as cash profits) of a business.  He did this because he believed the reported profits of a business were not a conservative estimate of the amount of money that really belonged to the shareholders of a business.

Owner earnings 

= net income + depreciation & amortisation + other non cash items - maintenance capital expenditure.

Buffett's view was that the amount of money a company needed to spend to maintain its competitive position (known as maintenance, or stay in business capex) often exceeded the depreciation and amortisation expense and therefore, profits were overstated.

Also, if a business needed extra working capital (more stocks, or more generous credit terms to customers), this should be added to the maintenance capex figure.  Generally speaking, though, this calculation ignores changes in working capital that are included in free cash flow.

The hardest part of this calculation is trying to estimate what maintenance or stay in business capex is.  As a company outsider without intimate knowledge of its assets and their condition it is virtually impossible for you to be exactly right on this. 

So how do you get an estimate of stay in business capex?

There are three reasonable methods:

1.  The company tells you.  This figure may be in the annual report.

2.  Use a multiple of the current depreciation or amortization expense.  For example, use a figure that is bigger than this, such as 120%.  This can be a reasonable estimate sometimes, but for some companies it can be way off if the cost of replacing assets is falling.

3.  Use a 5 or 10 year average of capital expenditure or capex.  This is likely to include money spent to grow a business but these assets will need to be replaced in the future and so this could provide a good proxy for cash needed to stay in business.  This is a good approach to use if the company does not state the figure outright.  As a rough rule, if the 5 year capex figure is higher than the 10 yr average you should use the higher figure.

Annual depreciation expense <<<  average 5 or 10 year capex.

This is the case in asset intensive companies.  These companies usually have very poor free cash flow track records and modest ROCE and CROCI performances.   These are two good reasons against investing in them.  Avoid them unless they have been able to produce a good ROCE whilst investing heavily.

Capex <<< depreciation and amortization.

Normally this kind of behaviour would make you suspicious, thinking that a company has been      under-investing, which would hurt its ability to make money in the future.

On the other hand, there maybe nothing bad going on.  You need to study the company's history on this issue to make sure that it is not under-investing.

Using average capex figures to estimate of cash profits (owner earnings)

If the 5 year capex figure is higher than the 10 year average, use the higher figure.

Comment:   Note the key outlier is Tesco.  Its cash profit is negative.  If you come across a company that looks as if it is losing money when estimating its cash profits you need to either do some more research to see if you have missed something - such as the company investing in lots of new assets rather than replacing them - or look for another share to buy.

Here is the process to derive owner earnings or cash profits again:

• Use the most recent annual underlying or normalised net income/profit
• Add back depreciation and amortization
• Minus an estimate of maintenance or stay in business capex.
• From these, you derive cash profit (owner earnings)
• Divide by weighted average number of shares in issue for the latest financial year to get an estimate of cash profit per share.

Knowing the company's cash profits, you can use these to value shares.  HOW?

Calculating Owner Earnings of Buffett or the Company's Cash Profits

Buffett in his 1986 letter to shareholders described how he worked out what he called the "owner earnings".   

This is also referred to as the cash profits of a business.

Buffett believed the reported profits of a business were not a conservative estimate of the amount of money that really belonged to the shareholders of a business.



How to calculate owner earnings or cash profits of a business?

Owner earnings are calculated as follows:

Owner earnings =   net income
                               + depreciation & amortisation
                               + other non cash item
                               - maintainance capital expenditure.


Buffett's view was that the amount of money a company needed to spend to maintain its competitive position (known as maintainance, or stay in business, capex) often exceeded the depreciation and amortisation expense, and therefore profits were overstated.

Also, if a business needed extra working capital (more stocks, or more generous credit terms to customers), this should be added to the maintainance capex figure.



The difference between Owner Earning of Buffett and FCF

Generally speaking, in the owner earnings of Buffett or cash profits of a business, the calculation ignores changes in working capital that are included in free cash flow.



Hardest part of calculating owner earnings is estimating maintainance or stay in capex

The hardest part of this calculation is trying to estimate what maintainance or stay in business capex is.

As a company outsider without intimate knowledge of its assets and their condition it is virtually impossible for you to be exactly right on this.

But the good thing is, you don't need to.

The whole purpose is to get a figure for the amount of cash needed to keep fixed assets in good working order so that you can then have a conservative estimate of cash profits to value a company

Basing your valuation on a conservative figure is more prudent and lowers your changes of paying too much for a share, which in turn lowers your investment risk.

(Additional notes below)



What to do when the owner earnings or cash profits of a business are negative?

If you come across a company that looks as if it is losing money when estimating its cash profits you need to either

• do some more research to see if you have missed something - such as the company investing in lots of new assets rather than replacing them - or 
• look for another share to buy.

Summary:

In summary, here is what you need to do in calculating owner earnings or company's cash profits:

1.  Take the company's most recent annual underlying or normalised net income/profit.

2.  Add back depreciation and amortization.

3.  Take away an estimate of stay in business capex.

4.  Divide by the weighted average number of shares in issue for the latest financial year to get an estimate of cash profit per share.


Knowing a company's cash profits, we can use these to value shares.  




Additional Notes:

How do you get an estimate of stay in or maintainance business capex?

There are 3 reasonable methods:

1.  The company tells you.

Some companies are very good at simply stating what the figure is.  They give this figure in their annual reports.

2.  Use a multiple of the current depreciation or amortization expense.

Use a figure that is bigger than this, such as 120%.  This can be a reasonable estimate, sometimes.

For some companies, it can be way off if the cost of replacing assets is falling.

3.  Use a five or ten-year average of capital expenditure or capex.

This is likely to include money spent to grow a business but these assets will need to be replaced in the future and so this could provide a good proxy for cash needed to stay in business.

This is a good approach to use if the company does not state the figure outright.