The Basics of Share Valuation

You can only make money from investing in shares of good quality companies if you pay the right price for the shares.

A common mistake by investors is to think that buying quality companies is all that matters and the price paid for the shares is irrelevant.

Paying too high a price for a share is one of the biggest risks that you can take as an investor.

It is just as bad as investing in a poor-quality company in the first place.

The key to successful long-term investing is buying good companies at good prices.



Valuation

The price of a share is crucial to your long-term investing success.

You will need to learn how to value the shares of companies and set target prices for buying and selling them.

The valuation of shares can become a very complicated exercise.

There are lots of books out there on this subject and many make the process seem difficult to understand.

The good news is that it doesn't have to be this way.

Valuing shares is not a precise science: you only need to be roughly right and err on the side of caution.

The place to start is looking at the fair value of a share.



The fair value of a share

Professional analysts and investors spend lots of time trying to work out how much a share of a company is really worth.

To do this they need to estimate how much free cash flow the company will produce for its shareholders for the rest of its life and put a value on that in today's money, which is known as a present value.

This approach is known as a discounted cash flow (DCF) valuation.

There are three steps to doing a DCF valuation:

1.  Estimate free cash flow per share for a period of future years.
Most analysts would probably try to forecast 10 years of future free cash flows.

2.  Choose what interest rate you want to receive in order to invest in the shares.
Shares are risky investments - more risky than savings accounts and most bonds - and so people demand to receive a higher interest rate in order to invest in them.

3.  Estimate what the value of the shares might be in 10 years' time and give that a value in today's money.
This is the terminal value and it stops you having to estimate free cash flows forever.  

Learn to love stockmarket falls

• 13 Aug 07

Most people are net buyers of stocks throughout their lives, which means that market falls should be welcomed rather than feared.

You could be forgiven for thinking that there had been some major ructions in the stockmarket over the past couple of weeks. There’s been talk of crashes, collapses and crunches, with well-known Wall Street pundits shouting and screaming (if only for effect). So far at least, though, we haven’t even seen the 10% drop that people arbitrarily consider is necessary for a ‘correction’ and the All Ordinaries Index is still above where it stood in March.


The truth is that fear and panic get people’s attention and the media is well aware of it. But it’s at times like this that investors need to stand back from the crowd and make a cold assessment of what’s going on. No doubt some companies are affected by recent turmoil in global debt markets, but some have, and/or will generate, all the cash they need for their future investing plans and have little to fear from a recession, which might in fact help them take market share from competitors. Yet these companies have been getting cheaper along with everything else and we’ve been licking our lips.


Only a few stocks have so far drifted into our buying range – Corporate Express, Ten Network and Servcorp (almost) – but we’re hopeful of bigger falls and further opportunities.


It’s a truism to say that, all things being equal, you’ll do better from stocks if you buy them cheaply. But what people forget is that for most of their lives, they’re net buyers, or at least holders, of stocks. And the ideal situation is to reach retirement with enough in your pot that you never have to become a net seller. So for most people, for most of their lives, stockmarket falls are good things.

Price and value


The crucial point to understand is that the price of a stock and its value are two different things. The market sets the former and we spend our days trying to estimate the latter. To make our life easier, we generally avoid poorly managed, debt-laden or cyclical businesses where predictability is poor, and we look for a margin of safety to protect us against an error of judgement – the more uncertain we are about a company’s value, the greater the margin of safety we require.
Most of the time, price is pretty close to value. But sometimes it gets out of whack, and occasionally by enough to give us a decent margin of safety. It’s these situations that present the greatest opportunities for canny investors and the greatest dangers for those who succumb to understandable but irrational mood swings. Preparedness makes all the difference.


Imagine you’re researching a company, Little Acorn Limited, which operates in a predictable industry, has decent management and pays no dividends. It reinvests all its profits, meaning that returns are entirely in the form of capital growth. You’ve done the work, and are as comfortable as you can be that Little Acorn will grow earnings per share (EPS) at 10% per year, from the current level of $1.00, with very little chance of variability.


Deeming Little Acorn to have all the right stuff, you buy the stock for $15 – a price-to-earnings ratio of 15. If your estimate of earnings growth is accurate, then EPS will grow from $1.00 to $2.59 over the next decade. If the market is still happy to pay a PER of 15 at that point, then the stock will trade at around $38.85, and you’ll have achieved an annual return of 10%, in line with the earnings growth.


The future is always uncertain


Of course, the stock might trade lower in a pessimistic market in 2017, giving you a lower annual return (but an underpriced stock that’s likely to do well in future years). Alternatively, it might trade higher, giving you a larger annual return (but an overpriced stock that you might choose to sell).


Which of those possibilities eventuates is of some importance. But what happens in the stockmarket over the next week, month or year doesn’t make a lick of difference as to how the market will view Little Acorn in ten years’ time.

Great oaks from little acorns grow
	Price in 2007	Price in 2017	Annual return
Expected	$15	$38.85	10.0%
outcome	$8	$38.85	17.1%
Lower	$15	$25	5.2%
outcome	$8	$25	12.1%
Higher	$15	$50	12.8%
outcome	$8	$50	20.1%

So let’s say that shortly after purchasing Little Acorn for $15, the market tanks and takes Little Acorn with it – down to $8. The talking heads everywhere go berserk over the ‘blood on the streets’ and you’re staring at a ‘loss’ of almost 50%. The emotional investor gets the chance to do some real and permanent damage here. Avoid this at all cost.


Assuming that Little Acorn is still as likely as ever to grow its EPS at 10% per year and arrive in 2017 with EPS of $2.59 and a stock price of $38.85, your forecast of its future is unchanged, and your expected return from yesterday’s investment is unchanged at 10% per year. You won’t get that return if you sell out now. But if you do nothing but hold, your eventual wealth will be just as great as if the share price followed a straight line from $15 to $38.85 over the course of a decade.


But wait there’s more


If you have some spare cash, though, you can actually improve your position, by going against the crowd and buying more shares in Little Acorn at $8. At that price, your additional investment will compound at 17% per year until the shares trade at $38.85 in 2017, dragging up your average return in the process. So the market tumble has actually provided an opportunity.


Of course, the real world isn’t so neat. Market crashes can hurt the economy, affecting company profits in the short and medium term. And the 2017 value of the stock will swing based on both the mood of the markets then, and the company’s growth in the intervening years. But that’s the case regardless of whether stocks are cheap or expensive today. Which brings us back to the trusim that the less we pay for our stocks, the greater the bargains they’ll prove to be.


So remember that when the market takes a tumble, it’s just changing the price that it’s setting for stocks. The value of those stocks, all things being equal, will remain the same. You don’t have to sell your stocks, but you can choose to buy, if you have the spare cash and can find something suitable. Viewed like this, market crashes won’t do any harm to long-term investors, but actually offer you the chance to compound your money at a greater rate.

http://www.intelligentinvestor.com.au/articles/230/Learn-to-love-stockmarket-falls.cfm

'Expensive' shares: Do not look at how high the share price is. It is the valuation that counts.

Quick Comment: 'Expensive' shares

Some time ago, I had a conversation with my ASX remisier based in Australia and I think some of his comments are worth sharing.

*Me refers to myself when I was speaking to him.
*Investssmart is also myself but from my point of view now.

Me: Good shares in Malaysia are expensive.
Remisier: What do you mean by expensive? When you say expensive, do you mean in absolute terms or in terms of valuation? When I say it is expensive, it normally means overvalued or fully valued. Some companies can trade at $30 but we still call them cheap.
Investssmart: This is very true. The word expensive should be used more carefully when talking about shares. The absolute value does not really count. A Mercedes for $100k is 'cheaper' than a Waja for $60k. It is the value that counts.

Me: Malaysians' perception is that the higher the share price is, the more it can drop.
Remisier: That happens all the time. It is important to remember that we should look at the movements in terms of percentage. If a $50 company can drop to $5, a $5 company can drop to 5c as well. The important thing is to fix the absolute amount you invest. Purchasing 100 shares in a $50 company is the same as purchasing 1000 shares in a $5 company. If both rise by 10%, you will still earn the same amount of $500 no matter which company you invest it. 
Investssmart: We should not be put off by the share price. It is the valuation that we should worry about. The chances of IRIS to drop from 90c to 20c is higher than the chances of BKAWAN dropping from $7.80 to $2. But somehow, if you give investors just these two choices, many would rather invest in IRIS because they think it is 'cheaper'!

Remisier: Do you remember me recommending you Rio Tinto ($30), BHP ($15), Woodside ($20) and Cochlear ($25)? You did not purchase any either! Perhaps, this changed your view on 'expensive' stocks!
Investssmart: These four stocks have skyrocketed since his recommendation. They are now about $75, $30, $45 and $50 respectively. Never say that upside of highly priced shares are limited. There is no such thing. Upside of overvalued/expensive shares is limited but upside of highly priced shares is not. Although I did not purchase these shares, it was not because I was scared of the high prices. It was mainly because I did not have the strong confidence in the commodity bull and sadly, I was proven to be wrong. Could have made tonnes more from the ASX. Nevertheless, in a bull market, almost everything on the ASX rose.


Me: I did not buy those few but I still bought some highly priced ones. What would I be trading if I don't buy any highly priced shares? I don't remember you ever recommending me any penny stocks!
Remisier: Good stocks are normally highly priced because the demand for good stocks is very strong. Lowly priced shares are normally those that are speculative or not performing. 
Investssmart: It is strange but true to a certain extent. Of course, it does not apply to all company shares.

Strange but could be true: I don't think it is a coincidence that most of the true blue chips throughout the world are trading at high prices. Most of these blue chips have been there for ages. It had to start off somewhere as a smaller company and it takes time to reach where it is today. If the company was trading at $1 ten years ago, it will probably trade at $10 today to be considered a top performer. Otherwise, it would not be considered a blue chip.

Fundamental based investors always look at companies that have excellent track records and therefore, end up investing in highly priced shares. That is because it is very rare that we can get such companies at low prices as share prices should have risen as companies perform well over the years. I doubt fundamental based investors would be interested in companies that trade at low prices over the last few years because that means that they probably do not have a good track record. Of course, this does not apply to all shares but I believe that it is true to a certain extent.



Conclusion: Do not look at how high the share price is. It is the valuation that counts.

http://investssmart.blogspot.com/2006_04_01_archive.html

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/

FAIR VALUE OF SHARES

FAIR VALUE OF SHARES

March 8, 2010 in General by paresh_singh86

The fair value of a shares is the average of the value of shares obtained by the net assets method and the one obtained by yield method. 

• Under net assets method, the value of an equity share is arrived at by valuing the assets of a company and deducting there from all the liabilities and claims of preference shareholders and dividing the resultant figure by the total number of equity shares with the same paid up value.
• Under yield method, the value of an equity share is arrived at by comparing the expected rate of return with the normal rate of return.  If the expected rate of return is more than normal rate of return, the market value of the share is increased proportionately.

The fair value of shares can be calculated by using the following formula:

Fair value of share

= value by net asset method+ value by yield method / 2

This method is also known as dual method of share valuation. 

• This method attempts to minimize the demerits of both the methods. 
• This is of course, no valuation but a compromised formula for brining the parties to an agreement. 
• However, it is recognized in government circles for valuing shares of investment companies for wealth tax purposes.

http://churmura.com/general/fair-value-of-shares/32817/

Bargain Conundrum - another cognitive error

A stock has done tremendously well for a period of time. Investors tend to extrapolate linearly, assuming that a company which has done well in the last few years is expected to continue to do so.

Then came the correction. For many buyers, it was an opportunity to get in.

Here lies the bargain conundrum - another cognitive error that consistently lead us to make irrational decisions. The belief is that the price uptrend would resume. That this correction could be a reversal may not feature in the thinking or radar of most.

One risk in the investment world that is often overlooked is behavioural risk. Recognising such flaws which the field of behavioural finance has uncovered is the first step towards being more rational in one's investing.


Also read:
Evaluating Changing Fundamentals (Part 3 of 5)
· Don't automatically buy because a stock falls in price; re-evaluate as if new.
Ask ourselves:
Is the correction a true bargain?
Maybe the price uptrend would resume?
Or, maybe not, this being a reversal of the uptrend?
Obviously, having an idea of where the "fair value" of the stock is, helps.