Important attributes to look for in an earnings statement - QUALITY
As the market exerts ever-increasing pressure on companies to perform to a stringent set of expectations, the idea of accounting "stretch" enters the picture.
Even in complying with the rules, companies have latitude to apply accounting principles in ways that make performance look better.
This lattitude can affect the quality of earnings reports.
Recent legislation and standardizations like the Sarbanes-Oxley Act, have brought financial reporting generally more in line with reality.
Wednesday 8 July 2009
What to look for: Healthy Components in the Earnings Statement
Important attributes to look for in an earnings statement - HEALTY COMPONENTS: COMPARATIVE and TRENDS
Value investors look at individual lines in the earnings statement, not just the bottom line.
Improving gross margins - especially sustained improvement - signal strong business improvement.
Costs are under control, and the company is improving its market position.
Likewise, improving operating margins can show better cost control, greater efficiency, and rewards from earlier expansion cycles.
And value investors constantly compare companies in similar industries.
Gross margins of competing computer manufacturers, for instance, tell a lot about who has the
Value investors look at individual lines in the earnings statement, not just the bottom line.
Improving gross margins - especially sustained improvement - signal strong business improvement.
Costs are under control, and the company is improving its market position.
Likewise, improving operating margins can show better cost control, greater efficiency, and rewards from earlier expansion cycles.
And value investors constantly compare companies in similar industries.
Gross margins of competing computer manufacturers, for instance, tell a lot about who has the
- best market position,
- production and delivery process, and
- business model.
Comparing the incomparable is an all-too-common investing pitfall. With earnings statements, this error takes three forms:
1. Earnings statements are not always broken down the same way.
- Although the bottom line is the bottom line, the intermediate steps may be different.
- One company's operating earnings may include marketing costs, while another's may not.
- Typically, statements from firms in the same industry are comparable, but not always.
- Commercial and industrial suppliers, such as Honeywell, have consumer divisions, while consumer businesses, such as Procter & Gamble, have industrial divisions.
- Many businesses supply a mix of products in a mix of categories to a mix of customers.
- "Pure plays" in a business or industry are not always easy to find.
- The upshot: You must understand businesses before comparing them.
- Before comparing operating or net profit numbers, consider whether there have been write-offs for discontinued businesses or impaired assets that may be causing one-time distortions in the numbers.
What to look for: Consistency
Important attributes to look for in an earnings statement - CONSISTENCY
Long-term growth should be sustainable and consistent.
Look for sustained growth across business cycles.
A big pop in earnings one year followed by malaise for the next two does not paint a pretty picture. Long, consistent successful earnings track records get the A grades.
Beyond earnings, consistency is a desired feature for other parts of the earnings statement.
Consistency is highly prized in:
Long-term growth should be sustainable and consistent.
Look for sustained growth across business cycles.
A big pop in earnings one year followed by malaise for the next two does not paint a pretty picture. Long, consistent successful earnings track records get the A grades.
Beyond earnings, consistency is a desired feature for other parts of the earnings statement.
Consistency is highly prized in:
- sales and sales growth,
- profit margins and margin growth, and
- operating expense and expense trends.
The less consistency, the more difficult to predict the future five or ten years and beyond, and the less attractive a company looks to value investors.
What to look for: Growth
Important attributes to look for in an earnings statement - GROWTH
After all is said and done, the long-term growth of a stock price is driven by growth in the business.
Growth in the business means growth in the earnings - there is no other way to sustain business growth without infusions of additional owner capital.
Sure, you can acquire, merge, or sell more stocks to make a business larger by common definitions, but has the business really "grown"?
The value investor works to obtain a deep understanding of business growth, growth trends, and the quality of growth.
A business' ability to grow on its own, through its own success and resulting earnings, is known as organic growth.
Growth through acquisition or other capital infusions are not "organic" and thus does not suggest growth in true business value.
After all is said and done, the long-term growth of a stock price is driven by growth in the business.
Growth in the business means growth in the earnings - there is no other way to sustain business growth without infusions of additional owner capital.
Sure, you can acquire, merge, or sell more stocks to make a business larger by common definitions, but has the business really "grown"?
The value investor works to obtain a deep understanding of business growth, growth trends, and the quality of growth.
- Is reported growth based on internal core competencies?
- Or is it acquired or speculative growth based on unproven ventures?
A business' ability to grow on its own, through its own success and resulting earnings, is known as organic growth.
Growth through acquisition or other capital infusions are not "organic" and thus does not suggest growth in true business value.
The Importance of Earnings
Business and economic activity are undertaken with the idea of generating a profit.
Profit is simply the gross revenue of an enterprise, minus the cost of producing that income, over a defined period of time. For businesses, it's important to measure the profit and allocate capital resources in such a way as to maximise it.
It is the earnings that make the world go round.
So much is made of earnings and earnings reports. Do you hear much about a company's cash balance, accumulated depreciation, or owner's equity during CNBC and other financial shows?
Does everyone salivate four times a year for "asset season?"
No, but there's a definite "earnings season" at the end of each calendar quarter, giving financial analysts, journalists, and pundits plenty to talk about.
On an ongoing basis, earnings are the driving force and "macro" indicator of a company's success.
If a company is earning money, and particularly if it earns it at a growing rate, that's a good thing. As Warren Buffett says, "If the business does well, the stock always follows."
Earnings tell us how well a business manages its operations, while the balance sheet tells us how well it manages its resources.
Profit is simply the gross revenue of an enterprise, minus the cost of producing that income, over a defined period of time. For businesses, it's important to measure the profit and allocate capital resources in such a way as to maximise it.
It is the earnings that make the world go round.
So much is made of earnings and earnings reports. Do you hear much about a company's cash balance, accumulated depreciation, or owner's equity during CNBC and other financial shows?
Does everyone salivate four times a year for "asset season?"
No, but there's a definite "earnings season" at the end of each calendar quarter, giving financial analysts, journalists, and pundits plenty to talk about.
On an ongoing basis, earnings are the driving force and "macro" indicator of a company's success.
- If earnings are growing, the financial press doesn't worry much about the other stuff.
- Conversely, serve up a couple of double faults on the earnings front, and everybody is all over asset impairment, write-offs, debt, weak cash positions, and the other similar "disasters."
If a company is earning money, and particularly if it earns it at a growing rate, that's a good thing. As Warren Buffett says, "If the business does well, the stock always follows."
Earnings tell us how well a business manages its operations, while the balance sheet tells us how well it manages its resources.
Stick to what you need to know as an investor, avoiding deep accounting technicalities
Just as life cannot be measured or evaluated by a single snapshot, neither can a business.
Balance sheet gives a snapshot view of business resources (assets) and how they are contributed to the business (liabilities and owner's equity). Comparison of one snapshot to another tells you something changed. But what happened between shots, and why?
This is where earnings and cash flow statements come in. The balance sheet is critical in evaluating the financial state of a business; the income and cash flow statements together measure business activity and results.
Earnings and cash flow statements show the pulse of the business and explain changes in balance sheet snapshots. With these statements, the business analyst or investor can assemble a complete moving picture showing flows into and out of the business, successes and failures, growth and decline.
You need to stick to what you need to know as an investor, avoiding deep accounting technicalities.
Balance sheet gives a snapshot view of business resources (assets) and how they are contributed to the business (liabilities and owner's equity). Comparison of one snapshot to another tells you something changed. But what happened between shots, and why?
This is where earnings and cash flow statements come in. The balance sheet is critical in evaluating the financial state of a business; the income and cash flow statements together measure business activity and results.
Earnings and cash flow statements show the pulse of the business and explain changes in balance sheet snapshots. With these statements, the business analyst or investor can assemble a complete moving picture showing flows into and out of the business, successes and failures, growth and decline.
You need to stick to what you need to know as an investor, avoiding deep accounting technicalities.
Tuesday 7 July 2009
Bottom lines and other lines
Revenue
less COGS
-----------
Gross Profit
less Operating Expenses
-SGA
-R&D
-Depreciation & Amortization
-Impairment, Investments & Write Downs
-Goodwill amortization
-----------
less or add interest
-----------
PBT
less tax
-----------
Operating Income or Income from continuing operations
less or add extraordinaries
-----------
Net Income
The bottom line, refers to the net earnings or income after all expenses, taxes, and extraordinary items are factored in. The bottom line is the final "net" measure of all business activity.
----
Gross profit:
This is simply the sales less the direct cost of producing the company's product or service.
Direct cost includes:
Gross profit, often called gross margin, is the purest indicator of business productivity, because each cost dollar is directly generated by production and sale of the product.
Value investors closely watch gross margin trends as an indicator of market dominance, price control, and future profitability.
----
Operating Income:
This term refers to gross profit less period expenses, such as overhead or marketing costs not directly attributable to product production.
Selling, general, and administrative expenses (SG&A) usually cover all headquarters functions, information technology, marketing, and other indirect costs.
It generally includes financing costs, such as interest, and taxes.
Amortization is usually included, because cost recovery for property, plant and equipment is part of operating expense.
Items deemed extraordinary are not included.
Operating profit gives a more complete picture of how the business is performing on a day-to-day basis.
It sometimes appears as operating income, earnings from operations, or something similar.
----
Net Income:
This represents the net result of all revenues, expenses, interest, and taxes.
----
There are other supplemental earnings measures, such as free cash flow and "EBITDA."
The point is that there are many ways to measure income.
Each reveals an important layer of business performance, both for determining intrinsic value and also for comparing companies.
less COGS
-----------
Gross Profit
less Operating Expenses
-SGA
-R&D
-Depreciation & Amortization
-Impairment, Investments & Write Downs
-Goodwill amortization
-----------
less or add interest
-----------
PBT
less tax
-----------
Operating Income or Income from continuing operations
less or add extraordinaries
-----------
Net Income
The bottom line, refers to the net earnings or income after all expenses, taxes, and extraordinary items are factored in. The bottom line is the final "net" measure of all business activity.
----
Gross profit:
This is simply the sales less the direct cost of producing the company's product or service.
Direct cost includes:
- labor,
- material, and
- expenses directly attributable to producing it.
Gross profit, often called gross margin, is the purest indicator of business productivity, because each cost dollar is directly generated by production and sale of the product.
Value investors closely watch gross margin trends as an indicator of market dominance, price control, and future profitability.
----
Operating Income:
This term refers to gross profit less period expenses, such as overhead or marketing costs not directly attributable to product production.
Selling, general, and administrative expenses (SG&A) usually cover all headquarters functions, information technology, marketing, and other indirect costs.
It generally includes financing costs, such as interest, and taxes.
Amortization is usually included, because cost recovery for property, plant and equipment is part of operating expense.
Items deemed extraordinary are not included.
Operating profit gives a more complete picture of how the business is performing on a day-to-day basis.
It sometimes appears as operating income, earnings from operations, or something similar.
----
Net Income:
This represents the net result of all revenues, expenses, interest, and taxes.
----
There are other supplemental earnings measures, such as free cash flow and "EBITDA."
The point is that there are many ways to measure income.
Each reveals an important layer of business performance, both for determining intrinsic value and also for comparing companies.
Cash Flow from Financing Activities
Investing activities tell what a firm does with cash to increase or decrease fixed assets and assets not directly related to operations.
Financing activities tell where a firm has obtained capital in the form of cash to fund the business.
Bottom line: Company X is using surplus cash generated from operations to give something back to shareholders. That's a good thing.
Financing activities tell where a firm has obtained capital in the form of cash to fund the business.
Source of cash for financing: Proceeds from the:
- sale of company shares or
- sale of bonds (long-term debt).
Use of cash for financing: If a company:
- pays off a bond issue,
- pays a dividend, or
- buys back its own stock.
A consistent cash flow from financing activities indicates excessive dependence on credit or equity markets. Typically, this figure oscillates between negative and positive.
A big positive spike reflects a big bond issue or stock sale. In such a case, check to see whether the resulting cash is used:
- for investments in the business (probably okay) or
- to make up for a shortfall in operating cash flow (probably not okay), or,
- if the generated cash flows straight to the cash balance, you should wonder why a company is selling shares or debt just to increase cash, although often the reasons are difficult to know. Perhaps an acquisition?
An illustration:
Company X's statement shows a happy story for investors:
- $15.4 m paid to investors as dividends
- $8.2 m paid out in "Sale Purchase of Stock" (- this is most likely for a share buyback. In fact, the company X actually repurchased $17.2 million in its own stock on the market; then issued $8.9 million in stock, most likely for employee stock options ESOS, and compensation.)
Bottom line: Company X is using surplus cash generated from operations to give something back to shareholders. That's a good thing.
Free Cash Flow
Free cash flow is a good indication of what a company really has left over after meeting obligations, and thus could theoretically return to shareholders.
Free cash flow is sometimes called "owners' earnings."
Free cash flow is defined as net after tax-earnings, plus depreciation and amortization and other noncash items, less annual capital expenditures, less (or plus) changes in working capital (current assets and liabilities).
It is surplus cash that is really free, not waiting for a bill to come for a big capital purchase or inventory increase.
Earn income, pay for costs of doing business, and what's left over is yours to keep as an owner.
Free cash flow is a much more realistic long-term view of business success and potential owner proceeds than EBITDA and is used by many value investors as the basis for calculating intrinsic value.
Free cash flow is sometimes called "owners' earnings."
Free cash flow is defined as net after tax-earnings, plus depreciation and amortization and other noncash items, less annual capital expenditures, less (or plus) changes in working capital (current assets and liabilities).
It is surplus cash that is really free, not waiting for a bill to come for a big capital purchase or inventory increase.
Earn income, pay for costs of doing business, and what's left over is yours to keep as an owner.
Free cash flow is a much more realistic long-term view of business success and potential owner proceeds than EBITDA and is used by many value investors as the basis for calculating intrinsic value.
Cash Flow from Investing Activities
Cash flow from operations tells what cash was generated in the normal course of business and by changes in current asset and liability (working capital) accounts on the balance sheet.
This section shows, among other things: cash used for investments in the business, including
Why? Because growing companies need more physical investments - property, plant, and equipment (PP&E) - to sustain growth.
It is possible to generate positive cash flows in this part of the statement either
TIP: By comparing net cash flows from operations and net cash flows from investing activities, you can get a first glance at whether a business is productive and healthy.
If positive CFO > negative CFI, then the business produces more cash than it consumes.
But don't jump to a favourable conclusion too quickly - you may be looking at an airline (e.g. Air Asia ?) that's about to pay for five new jets in the next quarter. A surplus cash situation must be sustained to be meaningful.
- But what about cash used to invest in the business?
- Invest in other businesses?
- What about cash acquired by selling investments in other businesses?
This section shows, among other things: cash used for investments in the business, including
- capital expenditures for plant, equipment, and
- other longer-term product assets.
Why? Because growing companies need more physical investments - property, plant, and equipment (PP&E) - to sustain growth.
It is possible to generate positive cash flows in this part of the statement either
- by selling PP&E or
- by selling investments owned by the company.
TIP: By comparing net cash flows from operations and net cash flows from investing activities, you can get a first glance at whether a business is productive and healthy.
If positive CFO > negative CFI, then the business produces more cash than it consumes.
But don't jump to a favourable conclusion too quickly - you may be looking at an airline (e.g. Air Asia ?) that's about to pay for five new jets in the next quarter. A surplus cash situation must be sustained to be meaningful.
How changes in Working Capital affect Cash
How changes in Current Liabilities affect cash
Increase in accounts payable (a bigger liability) generates cash.
Increase in accounts payable (a bigger liability) generates cash.
- Suppose the company you're watching has a $45 million increase in cash from accounts payable.
- There is $45 million in cash floating around in the business that didn't show up in net income.
- Let's suppose that one large item was purchased for $45 million. An accounting expense was incurred when the payable was created, but no cash has yet been used to pay the bill. It's still in the bank.
- So while the expense was incurred, reducing earnings, the cash wasn't paid and, at least for now, there's more cash in the business.
Increase in current liabilities provide cash.
Decrease in current liabilities use cash.
How changes in Current Assets affect cash
In different financial statements, it is common to see account receivable, inventories and accounts payables either providing or using cash.
Increases in current assets (other than cash) use cash.
Decreases in current assets (as in a net decrease in inventory) provide cash.
Cash Flow from Operations
Net Income
----------
Operating Activities, Cash Flows Provided By or Used In:
Depreciation
Adjustment to Net Income
Changes in Accounts Receivable
Changes in Liabilities
Changes in Inventories
Changes in Other Operation Activities
----------
Total Cash Flow from Operating Activities
Cash flow from operations, CFO, tells what cash is generated from, or provided by, normal business operations, and what cash is consumed, or used in the business.
Net income from continuing operations is the starting point, to which cash adjustments are made.
To that figure, add (or subtract) what was called the "adjustments to reconcile net income to net cash provided by operating activities."
The first adjustment item is depreciation.
Finally, you arrive at a total "Total Cash Flow from Operating Activities," derived by netting the adjustments to toal income.
----------
Operating Activities, Cash Flows Provided By or Used In:
Depreciation
Adjustment to Net Income
Changes in Accounts Receivable
Changes in Liabilities
Changes in Inventories
Changes in Other Operation Activities
----------
Total Cash Flow from Operating Activities
Cash flow from operations, CFO, tells what cash is generated from, or provided by, normal business operations, and what cash is consumed, or used in the business.
Net income from continuing operations is the starting point, to which cash adjustments are made.
To that figure, add (or subtract) what was called the "adjustments to reconcile net income to net cash provided by operating activities."
The first adjustment item is depreciation.
- For example, depreciation in Company X was $24 million. So, we known that without other adjustments, $24 millionn more in cash was generated than reported as net income, because depreciation was subtracted from net income, but not from cash flow because it isn't a cash expense.
Then a catch-all "Adjustments to Net Income" category.
After this, comes:
- "Changes In Accounts Receivables"
- "Changes in Liabilities"
- "Changes in Inventories"
Finally, you arrive at a total "Total Cash Flow from Operating Activities," derived by netting the adjustments to toal income.
- This is a very important figure. Essentially, this is cash generated by ongoing day-t0-day business activities.
- If this amount is negative, that's bad, because it means that the business isn't even supporting itself on a day-to-day basis and requires an infusion of cash.
- If it's positive - we're still not out of the woods yet - capital investments may still require more cash than the business is producing.
A bit of EBITDA
EBITDA measures operating cash generated before:
In a sense, EBITDA is operating income before:
- non-operating interest,
- taxes, and,
- noncash depreciation & amortization.
In a sense, EBITDA is operating income before:
- bankers (non-operating interest), and
- government (taxes), and
- accountants (noncash depreciation & amortization).
EBITDA is also sometimes looked at as a liquidity measure:
- Positive-EBITDA companies can service their debt, while
- Negative-EBITDA companies must borrow more.
Income from continuing operations versus EBITDA
Revenue
less COGS
-----------
Gross Profit
less Operating Expenses
-SGA
-R&D
-Depreciation & Amortization
-Impairment, Investments & Write Downs
-Goodwill amortization
-----------
less or add interest
-----------
PBT
less tax
-----------
Operating Income or Income from continuing operations
less or add extraordinaries
-----------
Net Income
----
EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortization
EBITDA measures operating cash generated before:
less COGS
-----------
Gross Profit
less Operating Expenses
-SGA
-R&D
-Depreciation & Amortization
-Impairment, Investments & Write Downs
-Goodwill amortization
-----------
less or add interest
-----------
PBT
less tax
-----------
Operating Income or Income from continuing operations
less or add extraordinaries
-----------
Net Income
----
EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortization
EBITDA measures operating cash generated before:
- non-operating interest,
- taxes and
- noncash depreciation and amortization.
Income from Continuing Operations
Operating income is simply sales less cost of goods sold, less operating expenses.
Because it includes noncash amortizations, it is a "fully loaded" view of operating performance in the business. (Depreciation and amortization expenses are usually broken out on the earnings statement, but may also be buried in a consolidated SG&A, or other operating expense line.)
If you closely observe the effects of amortizations, special write-downs, and accounting changes, you can better understand operating income and operating income trends.
Income from continuing operations tell shareholders, in total, what their investment is returning, after everyone, including Uncle Sam and his brethren, is paid.
Income from continuing operations is a good indicator of total business performance, but be aware of truly extraordinary events driving expenses or income.
Because it includes noncash amortizations, it is a "fully loaded" view of operating performance in the business. (Depreciation and amortization expenses are usually broken out on the earnings statement, but may also be buried in a consolidated SG&A, or other operating expense line.)
If you closely observe the effects of amortizations, special write-downs, and accounting changes, you can better understand operating income and operating income trends.
Income from continuing operations tell shareholders, in total, what their investment is returning, after everyone, including Uncle Sam and his brethren, is paid.
Income from continuing operations is a good indicator of total business performance, but be aware of truly extraordinary events driving expenses or income.
Monday 6 July 2009
Earnings Yield: Bond versus Growth Stock
PE Ratio and Growth
It would be nice if looking at price, P/E, and earnings yield was all there is to it. Find an earnings yield of 6% (PE of 17), beat the bond, and move on.
But you're buying equities, not bonds, right?
Less risk.
----
But suppose the $5 earnings "coupon" grows at 10% per year. What happens at the end of year 10?
If the price were to stay the same, your $100 investment would be returning $12.97 in year 10, which is almost 13% earnings yield, or an implied PE of 7.7 at today's price.
A pretty nice yield, which really means the price of your investment should go up, because it's worth more.
This spreadsheet shows future earnings yields realized in the case of a bond with no growth versus a stock with a 10% earnings growth.
http://spreadsheets.google.com/ccc?key=0AuRRzs61sKqRcjdfd19OVTZrVVRlTUJnb05naGo3TWc&hl=en
So you can see that assessing growth is a major factor in analysing a stock price through PE.
Above all else, earnings growth drives stock price growth.
So value investors look closely at what the earnings yield is today and what will it be in the future.
It would be nice if looking at price, P/E, and earnings yield was all there is to it. Find an earnings yield of 6% (PE of 17), beat the bond, and move on.
But you're buying equities, not bonds, right?
- Because you want to participate in company growth and success.
- Because, simply, you want to leave that static bond yield in the dust - if not today, sometime in the near future.
- And you want to keep up with - or better yet, beat - inflation.
- So to do that, you assume some risk that earnings won't happen, but you are hanging your hat on growth and a stock price that keeps up with it.
- Buy a bond for $100; receive $5 per year for 10, 20, 30 years; never look back.
or
- Buy a stock for $100, earnings per share constant at $5 for 10, 20, or 30 years with no change.
Less risk.
----
But suppose the $5 earnings "coupon" grows at 10% per year. What happens at the end of year 10?
If the price were to stay the same, your $100 investment would be returning $12.97 in year 10, which is almost 13% earnings yield, or an implied PE of 7.7 at today's price.
A pretty nice yield, which really means the price of your investment should go up, because it's worth more.
This spreadsheet shows future earnings yields realized in the case of a bond with no growth versus a stock with a 10% earnings growth.
http://spreadsheets.google.com/ccc?key=0AuRRzs61sKqRcjdfd19OVTZrVVRlTUJnb05naGo3TWc&hl=en
So you can see that assessing growth is a major factor in analysing a stock price through PE.
Above all else, earnings growth drives stock price growth.
So value investors look closely at what the earnings yield is today and what will it be in the future.
Risk - the most difficult to quantify element (II)
If you reflect on Buffett's approach, you realize that the risk isn't inherent in the stock's price, but rather on the clarity and consistency of a company's future prospects.
The more unpredictable (hard to understand) the company and its future, the greater the risk.
There is no way to easily quantify this kind of risk.
Generally, business risks are accounted for in the discount rate by making a conservative assumptions - a high discount, or hurdle, rate - to provide a margin of safety.
The more unpredictable (hard to understand) the company and its future, the greater the risk.
There is no way to easily quantify this kind of risk.
Generally, business risks are accounted for in the discount rate by making a conservative assumptions - a high discount, or hurdle, rate - to provide a margin of safety.
Risk - the most difficult to quantify element (I)
Risk is perhaps the most debated, theoretical, difficult to quantify element of all. There are many types of risk in the business and investing world.
Investment books mention high beta stocks are riskier and low beta stocks are safer. However, beta is relatively meaningless for value investors. Why?
Investment books mention high beta stocks are riskier and low beta stocks are safer. However, beta is relatively meaningless for value investors. Why?
- Because it measures the fluctuation of stock prices.
- As a value investor, you aren't concerned with stock price fluctuation, only whether the stock price is a bargain compared to long-term value.
- Value investors ignore the type of risk measured by beta.
- They're more interested in how the company performs, not how the stock performs relative to other stocks.
Beta is useful only in the sense that higher price volatility for an issue may reflect underlying uncertainty in the company itself, such as with many of the higher flying tech stocks in 2000 and 2001. But the risks associated with these stocks become apparent long before you examine beta.
Who is Mr. Market?
Who is Mr. Market?
Mr. Market is the character Benjamin Graham uses to explain illogical mindset of traders . The story goes something like this:
Imagine that you own 50% of a business, which you purchased for RM3,600 mil. Mr. Market approaches everyday to tell you what he thinks the business is worth based on latest news. And everyday, he offers to either buy your business for a price which he forms in his head, or, to sell you his share of the business for that price.
Each day, however, he quotes you a different price from the day before. Sometimes the price he quotes sounds about fair. Sometimes it’s high. Sometimes it’s low.
Let’s say the whole business is producing on average, RM 1,200 mil free cash flow with net profit of RM 600 mil. What is the value of the business to you?
By owning 50% of the business, you own RM 600 mil FCF and net profit of RM 300 mil per annum.You paid around RM 3,600 mil for this business a year ago. Hence, you bought this business for 6 times its FCF and 12 x earnings.Let’s say the nature of the business is stable and you anticipate the FCF and net profit will increase over time,you might not want to sell it unless Mr. Market offers you a ridiculously high price.
One day, Mr. Market offers you an additional 40% extra of what you paid a year ago. He offers RM 5,040 mil to for your holdings.Most of us will let go after making 40% profit per annum.
But if you are a sensible businessperson, you won’t let Mr. Market’s daily communication determine your view of the value of 50% interest in the business. He is a sweet talker and convince you with various economic prediction,charts,information and etc to create doubt and fear in you.
Most of us will be swayed by Mr Market ’s offer.
But as a sensible business owner, you may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.
Remember, fluctuations in the market price for a given business don’t really affect the fundamental value of that business. If you own a share in a company, the value of each share is a function of the business ’s profitability/cash flow/management/branding and not a related to the price quoted in Bursa M’sia.
So, as long you understand the business you’re buying, today’s market price is totally irrelevant.
Ref:
Who is Mr. Market?
http://boyboycute.wordpress.com/2009/03/29/who-is-mr-market/
Mr. Market is the character Benjamin Graham uses to explain illogical mindset of traders . The story goes something like this:
Imagine that you own 50% of a business, which you purchased for RM3,600 mil. Mr. Market approaches everyday to tell you what he thinks the business is worth based on latest news. And everyday, he offers to either buy your business for a price which he forms in his head, or, to sell you his share of the business for that price.
Each day, however, he quotes you a different price from the day before. Sometimes the price he quotes sounds about fair. Sometimes it’s high. Sometimes it’s low.
Let’s say the whole business is producing on average, RM 1,200 mil free cash flow with net profit of RM 600 mil. What is the value of the business to you?
By owning 50% of the business, you own RM 600 mil FCF and net profit of RM 300 mil per annum.You paid around RM 3,600 mil for this business a year ago. Hence, you bought this business for 6 times its FCF and 12 x earnings.Let’s say the nature of the business is stable and you anticipate the FCF and net profit will increase over time,you might not want to sell it unless Mr. Market offers you a ridiculously high price.
One day, Mr. Market offers you an additional 40% extra of what you paid a year ago. He offers RM 5,040 mil to for your holdings.Most of us will let go after making 40% profit per annum.
But if you are a sensible businessperson, you won’t let Mr. Market’s daily communication determine your view of the value of 50% interest in the business. He is a sweet talker and convince you with various economic prediction,charts,information and etc to create doubt and fear in you.
Most of us will be swayed by Mr Market ’s offer.
But as a sensible business owner, you may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.
Remember, fluctuations in the market price for a given business don’t really affect the fundamental value of that business. If you own a share in a company, the value of each share is a function of the business ’s profitability/cash flow/management/branding and not a related to the price quoted in Bursa M’sia.
So, as long you understand the business you’re buying, today’s market price is totally irrelevant.
Ref:
Who is Mr. Market?
http://boyboycute.wordpress.com/2009/03/29/who-is-mr-market/
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