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“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” Warren Buffett

I have written an article on “Stock Market Investing strategy: Buying good companies” in the link below,
https://klse.i3investor.com/blogs/kcchongnz/161473.jsp
Basically I was advocating that when one invest in a stock, he must treat it as investing in part of a business, rather than taking as as buying a piece of paper (share certificate) and shuffling it around to get a quick buck.
I have discussed in the above article that if one wish to build long-term wealth, he should first buy the stock of a good business.  I have deliberated what a good business is about with the following characteristics,
  1. The business must be durable and be able to last for a long time to come
  2. It has a record of stability of earnings and cash flows
  3. It earns return higher than the cost  of its capitals to be shareholder value enhancing, otherwise why do the business, or buy the stock? Unless it is selling dirt cheap.
  4. It has a good growth prospect, with the business expanding and earning more and more money.
  5. It is not overly geared as to face the bankruptcy risks during economic and financial crisis.
  6. It must have a smart and cabaple, forward looking, credible and honest mangement who would take care of the interest of minority shareholders.
  7. Other attributes of a good business
Isn’t the above common sense? Isn’t it business sense? If not, what is “business sense”?
But is that all about investing to be successful? Just go and buy any good business at any price and you will become rich one day?
No, not yet, not until you compare with the offer price and the value of the business.
A good company is not necessary a good investment and a bad company is not necessary a bad investment. It all depends on the price you pay.
One of the riskiest things to do in investing is to pay for high price for a stock, even for good stocks. The biggest losers-be they nifty-fifty stocks in 1969, internet stocks in 1999, or mortgage vehicle in 2006-had something in common: they were selling at very high prices. We will go on to discuss some simple ways which can provide powerful, quick and dirty ways to compare price versus value to determine if a share is worth buying.
First up is the most widely-used Price-to-earnings ratio, or P/E.

  1. Price-to-Earnings ratio
The P/E ratio is the most widely-used valuation metric among investors analysts and investment bankers alike. It is effectively shorthand for how expensive or cheap a share is compared with its profits. In simple term, the P/E ratio is the number of years an investor gets back his capital he invested in a stock. For many, this probably is the only metric they use when investing. Earnings per share results and estimates about the future are easily available from just about any financial data source imaginable.
Some value investors take on the CAPE or cyclically adjusted P/E ratio. It takes the current price and divides it by the average earnings per share over a cycle of a number of 7-10 years. Sometimes current earnings can be overly inflated due to a business boom, or overly depressed in an economic downturn.
The most useful way to use a P/E ratio is to compare it with a certain benchmark. Good benchmarks are the P/E of another company in the same industry, the P/E of the entire market, or the same company's P/E at a different point in time. Each of these approaches has some value, as long as you know the limitations.
P/E ratio also depends on the growth prospect of the company too. Stocks with high P/Es (exceeding 30) usually have greater future growth prospects, while stocks with low P/Es (below 10) tend to have lesser future growth prospects.

However, keep in mind that using P/E ratios only on a relative basis means that your analysis can be skewed by the benchmark you are using. After all, there will be periods when entire industries will become overvalued. In 2000, an Internet stock with a P/E of 75 might have looked cheap when the rest of its peers had an average P/E of 200. In hindsight, neither the price of the stock nor the benchmark made sense.

When you're looking at a P/E ratio, also make sure that the "E" part of the equation makes sense and is representative of a company's ongoing profits. A few things can distort the P/E ratio. A company may book a big one-time gain from the sale of a division, property plant and equipment, gain in foreign exchange etc. boosting reported earnings, but based on operating earnings, the stock may not be cheap at all. 
Cyclical firms that go through boom and bust cycles--semiconductor companies, plantation and property companies are good examples of companies which distort current earnings.
Also, there are different kinds of P/E, a trailing P/E, which uses the past four quarters' worth of earnings, and forward P/E, which uses analysts' estimates of the next four quarters' earnings to calculate the ratio. Unfortunately, estimates of future earnings by individuals, and even professional analysts were often way off the mark.
Lastly the trouble though with the P/E ratio in general is that it doesn’t take a company’s debt into account and, in a value investing situation, that’s a pretty serious shortcoming which makes comparing differently leveraged companies like-for-like almost impossible. This is where the EBIT Multiple for the whole firm comes in...


  1. Ebit multiple. Enterprise value/Ebit
Enterprise value multiples are better than equity value multiples because the former allow for direct comparison of different firms, regardless of capital structure.
[Think of enterprise value as the theoretical takeover price. In the event of a buyout, an acquirer would have to take on the company's debt but would pocket its cash. EV differs significantly from simple market capitalization in several ways, and many consider it to be a more accurate representation of a firm's value. The value of a firm's debt, for example, would need to be paid by the buyer when taking over a company, thus EV provides a much more accurate takeover valuation because it includes debt in its value calculation.]
An ebit multiple of 7 may be considered as a reasonable price for a slow or no growth company, whereas an ebit multiple of 15 may be considered as cheap for a very high expected growth company.

  1. Price-to-Book ratio
The book value, or net asset backing (NAB) is the net equity position left over when everything a company owes is taken away from what it owns.
It is worth noting that this book value often includes assets such as goodwill and patents which aren’t really ‘tangible’ like cash, receivables, inventories, plant, property and equipment. Some investors remove such ‘intangible’ assets from calculations of P/B to make the more conservative Price to Net Tangible Asset (P/NTA).
The P/B ratio doesn’t rely on volatile measures like profits as asset-value doesn’t change much year-on-year. It has a hard accounting foundation in the company’s books, and hence often been used as the key barometer of value by academics. Legendary investor Benjamin Graham, one of Warren Buffett's mentors, was a big advocate of book value and P/B in valuing stocks in his early days. Walter Schloss was another one.
Most Value Investors try to buy stocks at a discount to their Book Value – or when the P/B ratio is less than 1. However, this may not be applicable for asset light company which its value is heavily dependent on its earnings power. For this type of companies, a price-to-book value of less than 3 may also be considered as cheap.
The P/B ratio is also tied to return on equity. Taking two companies that are otherwise equal, the one with a higher ROE will be accorded with a higher P/B ratio. This is especially through for banks which the assets and liabilities are mostly marked-to-market.
The reason is clear--a firm that can compound book equity at a much higher rate is worth far more because absolute book value will increase more quickly.

  1. Price-to-EBITDA
Price to EBITDA is the ratio of a company's enterprise value to its Earnings before Interest, Taxes, Depreciation and Amortization - EBITDA.'
This may be a better way to compare the underlying businesses of companies with different amounts of debt, or which require big upfront capital investments.

  1. PEG: Buy earnings growth on the cheap
Price-to-Earnings Growth ratio was popularised by Peter Lynch, an ex-Fidelity star fund manager. It takes into consideration of the growth of the company which the previous earnings-based valuations don’t. By dividing the PE Ratio by the forecast EPS growth rate an investor can compare the relative valuation of each more comfortably.
It is generally accepted that a PEG ratio of under 1.0 signifies growth at a reasonable price.

  1. Price-to Cash Flow
The price-to-cash flow ratio offers investors a somewhat more useful look at a company's value than the P/E ratio, because the price-to-cash flow ratio uses a denominator that focus on cash flows from operations, or free cash flows after capital expenses.
However, cash flows are very lumpy numbers as in certain years, there may be more build-up of inventories, receivables, higher capex, and some years not. Be sure to take an average cash flows over a number of years, say 5 years or so.
As FCF is hard cash, a Price-to-FCF of 20 may be a good benchmark.

  1. No earnings: Price-to-Sales Ratio
During the Dotcom euphoria in the late 1990s, many new technology companies mushroomed. Their share prices were chased sky high but they had no earnings at all. So, the market invested this valuation metric to cater for these new economy stocks.
While earnings can vary from year to year, sales are much more stable and as a result one of the more popular approaches is to look at a stock’s Price to Sales Ratio. It got a bad name when it was misused in the dotcom bubble to justify nosebleed valuations.  But it does remain a key indicator for isolating potential turnaround stocks.
Look out for Stocks with historically reasonable margins trading on P/S ratios of less than 1.0 without much debt.

  1. Dividend Yield
Dividend yield is one of the oldest valuation methods. It was very popular back in the days when dividends were the primary reason people owned stocks, and it is still widely used today, mainly among income-oriented investors.
A dividend yields of 4% would mean the stock is undervalued as it is about the fixed deposit rate now, notwithstanding that most stocks have growth potential, whereas, FD has none.
As with all valuation ratios, dividend yield must be used with caution. Stocks with very high dividend yields might seem like bargains, but these companies are often going through financial problems that have caused their stock price to plunge. It's not unusual for companies in such situations to cut their dividend to save cash, so their actual dividend yield going forward might be lower than the currently reported figure.
 

Which valuation technique to use?
As you can see, there are various relative valuation methods which investors can use to see if a stock is cheap or expensive. The choice of which of these valuation ratios to use will come down to the situation at hand. Some companies are consistently profitable (use P/E or Earnings Yield), some have more consistent cash flow than profits (use P/FCF), some are losing money on their sales (use P/S), others have no sales to speak of but do have hard assets (use P/B), and others are a bit pricier but are cheap for their growth (use PEG).
By understanding this array of value factors you’ll be far better placed to turn over different stones when circumstances favour it.
Remember, the return of your investment depends solely on the price you pay. This is the second part of the puzzle for you to invest in the stock market to build long-term wealth safely and surely.
Bear in mind the above valuations are mainly relative in nature. You may have heard of the term “intrinsic value” from professional analysts which is based on the absolute valuation technique to obtain a range of intrinsic values of the company or its stock. We will discuss this in the next article.
If you wish to learn more about valuation, you may contact me at
ckc14invest@gmail.com

K C Chong

http://klse.i3investor.com/blogs/kcchongnz/162226.jsp
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