Tuesday, June 24, 2014

Valuation techniques on stock investment

When I first started investing in the stock market, like most people, I just listened to what the market told me which stocks to buy. You know those days you went to the Broker firm and many punters sitting and standing around and talked about stocks? “This stock can Okam (pass out gold)” and this was the common gossip which I based my investing on. That experience of course didn’t end well for my investments.

Later I started to read some magazines such as Malaysian Business, I learned a couple of simple valuation metrics such as price earnings ratio and price-to-book. So I happily used PE and PB ratios to gauge if a stock is worthwhile to buy after hearing the rumours in the market. That was a big improvement, even in today’s standard. Unfortunately, my those experience did not turn out well too. Gosh, I am not even sure it was good or bad as I didn’t keep track on my investing experience. But one thing I know, I never got rich. In fact as far as I can remember, I was always short of money even though I worked as a professional, who supposed in the higher bracket earnings. How I wish I had learned some fundamental investing at that time.  

The Simple Valuation Metrics

This was what I have done when using some simple techniques to compare companies. Let us look at two confectionery companies listed in Bursa, A and B. I would doubtless bought company B and would never even looked at company A. Table 1 below shows all the reasons why I would buy company B, yes, just based on their market valuations alone.

Table 1:

Price-earnings growth


All metrics above show company B is much cheaper than company A to invest in. You will be surprised many “investors” think B is much cheaper than A because it is trading at 83 sen compared with RM4.85 of A, no kidding. But of course most of you would know that B is cheaper because of its PE ratio at 9.3 is lower than that of A of 12.1. Assuming an expected growth rate of 10%, the PEG of B is also much cheaper at PEG of less than 1. In other metrics such as price-to-book of just 0.4 would  make company B like one of the best sales in Bursa. The price-to-sales of B is also so cheap. Even when we compare price-to-cash flows from operations, B also appear to be cheaper. So how could you go wrong in choosing to invest in company B over A?

But is company A very expensive to invest in? Compared to B it appears so, but not necessary if you compare with the industry average. For example, its PE ratio of 12 is much lower than the industry average of 22.8. If you flip the PE ratio over, you get an earnings yield of more than 8%, not bad too compared to fixed income return. Actually if you look at A’s dividend yield, it is also not bad at all at 5.2%. Price-to-book wise, A at 1.7 is also very cheap if compared to the industry average of 3.0.
But wait a minute, there are so many participants in the stock market, and how come nobody seems to see that the stock price of B is so attractive that everybody would buy stock B, and in turn bid up its share price? I didn’t know the answer 30 years ago.

Growth of profit

The chart below shows the high growth of steady earnings of company A compared to the down trending earnings of company B. In the last two years, you can actually see the good growth of A’s earnings in contrast with the deterioration of B’s earnings. Hence the stable and growth in earnings plays an important part in the valuation of stock such as PE and PEG ratio.

Figure 1: Growth in earnings of company A and B.

Quality of assets
Figure 2 below shows that the quality of assets of A is much higher as 25% of its assets are in hard cash whereas for B, the major portion of its assets is its extremely high 77% in property, plant and equipment. This will definitely has a huge impact on the valuation using price-to-book ratio.

Figure 2: Assets distributions of A and B

Balance sheet

Looking at the balance sheets of company A and B, A is debt free with plenty of excess cash, while B is laden with increasing debts every year and negative net working capital. The solvency and long-term financial strength ratio below shows the vast difference in their financial health. In fact company B  is at high solvency risk with current ratio and quick ratio well below 1 as shown in Table 2 below.

Table 2: Financial health
Current ratio
Quick ratio

Cash flow

While B’s price-to-cash flow from operations appear to be lower than A, the more important metric should be the price-to-free cash flow. Figure 3 below tells the whole story. While company always has positive FCF and slightly trending up, company B has no positive FCF at all for most of  the years.
Without FCF, the company continues to need cash injection from shareholders and bank loans for capital expenses and its continue operations, and paying dividends. 

Efficiency comparison

The comparisons of return on equity and return of invested capitals as shown in Figure 4 below shows that there is vast difference in their returns on capitals; A’s returns on capitals is easily above its costs, while that of B is way below its costs of capital, and clearly trending  downwards. Clearly a more efficient company like A deserves much higher market valuation than B.

So is company B really cheap compared to A? Or it is cheap for good reasons? The metrics we used to compared company A and B as shown in Table 1 above is clearly not good enough. Table 3 below shows the right metrics to be used instead of those shown in Table 1 above.

Table 3 below shows that company A is in fact cheaper than B using the more appropriate enterprise value which includes all stakeholders, equity and debt holders. Company A with its earnings yield of the whole firm as 13.1% is clearly a better buy compared to 5.8% of B. In terms of Price-to-FCF and enterprise value over sales, A is also cheaper.

Table 3: Enterprise valuation


Which valuation metric to use?

The choice of which of these valuation ratios to use will come down to the situation at hand. Some companies are cheap for good reasons. Good companies are not cheap. In general, the quality of earnings and its assets are very important when comparing companies. Some companies are laden with debts and some have excess cash and many ratios do not show these distinctions. Hence it is important to be able to compare apple and apple.

Five years ago the share price of Company A and B were RM2.50 and 80 sen respectively. B’s share price was RM2.60 ten years ago before it retreated to its lowest at 56 sen in 2008. Its share price was rammed up again to RM1.38 4 years ago. Today, the share price of company A has risen steadily to RM4.91, not forgetting the more than 5% dividend yield yearly, while the share price of company B is still languishing at 88 sen. The results clearly shown that picking the right company to invest is the way to go to build long-term wealth.

Will the future shows the same pattern? Well after analyzing the past and recent financial statements of A and B, and the actions of the same management, do you foresee any change in the trend for the future? I personally do not see any change so far, absolutely nothing,  and hence do not expect me to think that this time will be different.
Valuation does matter.

K C Chong in Auckland (22 June 2014)

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