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Sri Lanka Equity Forum » Stock Market Talk » Expert Chamber » Value Investing

Value Investing

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1Value Investing Empty Value Investing on Fri Jun 27, 2014 9:19 am

SHARK aka TAH

SHARK aka TAH
Expert
Expert
Dear Members

I will be re-publishing series of articles about Value Investing here.
Appreciate your constant participation in this thread to educate newer members who are vulnerable to current speculative investing trends.

We are seeing some high risk high reward trading opportunities in CSE. There would be tendencies by new members to be victims if trades are not managed properly due to limited knowledge.

So this is a huge task for SLEF in the undertaking, but it must be said so that the initial foundation for the newer members would prevent getting too much leveraged into investing speculative shares.

The right message should go across to the newbies that there are various models of investing in existence & Value Investing stands out for me.

These articles will not only help newer members but also us to brush up our knowledge as well.

See you soon .......

Happy Trading

Shark

2Value Investing Empty Re: Value Investing on Fri Jun 27, 2014 9:29 am

SHARK aka TAH

SHARK aka TAH
Expert
Expert
How to Invest In the Stock Market-Background
As I’ve been receiving emails from people wanting to learn how to invest, I wanted to get a post out to share my experiences in order to help new visitors be confident that they too can invest in the stock market and manage their own money. I’ll be breaking the article into a couple of posts over the next few days due to the length.

My Background
In case you haven’t read the about me page, let me sum up my previous investing experience in one word. None

To be totally honest, at the sake or ruining my credibility, if I had any to begin with, I read my FIRST how to invest article on Fool.com in August 2007 and I bought my first company, Genlyte, on September 28, 2007 by subscribing to a 30 day trial Fool.com service. The DOW was at 13,895 on this day of purchase. Note that the DOW’s highest peak of all time was at 14,093 on Oct 12, 2007, just a couple of weeks after I invested in my first stock. Eventually Genlyte was bought out a couple of months later by Philips.

I started to invest at the worst possible time but had no idea. I knew nothing. No one informed me that bargains were hard to come by. Everyone I knew was just euphoric about AAPL and GOOG. Truth be told, I had no idea why a bull and bear were even mentioned in investments.
Seriously, I had never taken a finance, economics or accounting course in my life. I still haven’t. So for those just starting out or trying to, hold your head up high and keep your shoulders back. You can learn how to invest the stock market.
Fast forward 1.5 years and people are now actually interested in my opinions.

Why You Can Manage Your Own Money
More than 90% of mutual funds underperform the market and a majority of the mutual funds have very similar holdings as other mutual funds.
When brokers issue buy and sell recommendations, most of the recommended companies have already moved up and probably beyond a good buying price. Brokers also tend to issue sell recommendations when the stock is already down. Therefore, they are masters at the buy high and sell low game.
Financial advisors are paid on how well they sell you high commission funds, regardless of performance, and most mutual funds offered by your company are rubbish as the person in charge at HR or benefits, only look at the past return numbers.
The point is, never believe you cannot do it yourself. That’s what I first believed and that is what Wall Street and your 401k company want you to believe. “Smart money” is not as smart as you think. They are tightly constrained to operate within rules of their company and clients.
Don’t worry about the “invest early ” cliche. It’s never to late.

Before You Get Started
Do you agree with me that the purpose of investing is to increase your assets? Then the most basic of all steps to investing is to ensure your financial status is organized. This means you are not living paycheck to paycheck, your debt level is easily manageable, credit card balances are low, you have an emergency cash account which can support you and your family for at least 3 months. Money to be used within 2 years is in a liquid CD or high yield savings account.
Some other points to keep in mind and fully understand is that the stock market is not a high yield bank account. Also, now that I have a family, it is also my wife’s money that I am responsible for. If I had to suddenly realize a 50% total loss by investing recklessly, I would be sick to the stomach when it’s time to tell the wife. It’s this type of irresponsibility that creates negative views of the stock market by family members.
My brother, mother and I went through the same thing. I considered the stock  market to be a gamble because I witnessed my dad go pale in the face some days and I knew he lost a lot.

Stay Tuned
This concludes the initial background and why you should and can manage your own money. I hope that after reading my story, you can all find confidence in your abilities.

To be continued .....

3Value Investing Empty Re: Value Investing on Fri Jun 27, 2014 9:32 am

SHARK aka TAH

SHARK aka TAH
Expert
Expert
How to Get Started
I found that getting started was the hardest part simply because I just didn’t know where to begin. But I soon found out that learning how to invest is the same as learning anything else. i.e. you have to crawl before you walk and run. There was no shortcut if I wanted to do it properly.
After reading many news and stock tip articles off the internet, everything still made no sense and I remained clueless after spending so much time reading. So I did what we all do when we start learning about a new topic. Identify the basics work up towards the intermediate level followed by advanced techniques.
Basic Level Investing

The following sites will guide you in why you should invest, what should you invest in, how to invest, the different types of stocks, what causes price changes etc etc.

These two sites alone will provide you with more than enough information on the basics. I spent a considerable amount of time trying to read everything. I still consult Investopedia to this day.
Once the basics were down, I had a strong desire to understand the financial statements and what each line and term meant. I knew by this point that a thorough understanding of the accounting terms and financial ratios was required. With no prior education in accounting or finance, it went over my head at first, but as I kept referring back to it over and over again, it slowly started to make sense.

However, you can get a all this information in a clear and concise format in the book Financial Statements: A Step-By-Step Guide to Understanding and Creating Financial Reports Value Investing Ir?t=oldschval-20&l=as2&o=1&a=1564143414 . I also wrote a review of the book.
Intermediate Level Investing

After coming to grips with the basics and finally understanding what stocks and investing was all about, it was natural to try and figure out what companies I should buy.
It was at this point I stumbled upon a forum post by Joe Ponzio of F Wall Street and was introduced to the concept of owning a business. Although I had read about a stock being a business in The Intelligent Investor, Joe has to ability to explain it in a clear manner that helps us to visualize the whole process.
It was mind blowing and it completely flipped everything else I was reading on its head. I truly believed that I had to know the technicals and tricks like selling in December and buying in January would produce greater returns.

I came to understand that;

  1. buying a stock was owning a tiny piece of the business
  2. I had to think like a business owner

    • If you owned your own corner grocery what would you consider important? Is it your EPS is for the quarter or how much cash you have generated for each day? Would you splurge on jets, cruises or pay your cashier $100 an hour? Or would you rather cut useless costs and seek to grow the company?
    • Since we own parts of the business, it is important to identify whether the company you own follows your own ideas of business. e.g. I don’t invest in biotech because I have no knowledge about the industry or business and therefore would be a clueless owner. I also have yet to put my money in financials because I do not understand how one operates.
    • A business owner is also passionate about their business. Are you passionate about your companies?


  • I wanted to be an owner of high quality cash generating businesses
  • there is a price for everything and came to understand fair value or intrinsic value

  • F Wall Street has an outstanding series of valuing the business which really puts everything in perspective. I have read every single article ever written on F Wall Street which is over 100 and it has been better than any book. (Note that I pre-ordered Joe’s book from Amazon Value Investing Ir?t=oldschval-20&l=as2&o=1&a=1605500003 ). Visit his How to Value a Business series.
    The book I most highly recommend at this stage: Pat Dorsey’s The Five Rules for Successful Stock Investing.
    Both F Wall Street and The Fives Rules book introduce the concept of Discounted Cash Flow which was also the starting point of the ongoing investing spreadsheet project available for purchase or free download on this site. I spent hours going through calculations, ratios and formulas and this hands on experience is what I believed to have helped the most.
    Then came this blog. I had to force myself to write clear and organized content since it would be scrutinized by all. If I was going to write about something, I had better know what I was writing about. The best thing is, I received constructive criticism which I took to heart and the discussions with fellow like minded readers have helped immensely.
    The point is to get involved wherever you can, except Google and Yahoo Finance since it is so abused. Comment and ask questions on high quality content blogs. Discuss with other readers. Start your own blog. The best students were always the ones actively involved
     Very Happy 
    Coming Up
    We’ll be looking at what is involved in advanced investing topics in the next post. Don’t worry it isn’t really advanced

    4Value Investing Empty Re: Value Investing on Fri Jun 27, 2014 9:38 am

    SHARK aka TAH

    SHARK aka TAH
    Expert
    Expert
    Advanced Level Investing – Well…Not Really

    For lack of a better description, I’ve titled this stage as advanced.
    Following on from Part 2, the next step I took was to try and understand how the financial statements provided a future view of the company. Financial statements only provide a snapshot of the company at the time of writing and there wasn’t any useful information that explained how to interpret each line to determine the ongoing business.
    I was stranded on a frustrated plateau for many months until I got to reading The Art of Short Selling Value Investing Ir?t=oldschval-20&l=as2&o=1&a=0471146323 . Most books I’ve read tell you what to look for when buying a business. This book focuses purely on the warning signs of the business. Eventually I was able to understand statements better and wrote a series on analyzing and interpreting each financial statement .


    An excellent advanced application of analyzing financial statements can also be found at Investopedia .


    Special Situations
    So after all the reading and studying, I’m now at a point where I can study the company and be fairly confident in my analysis approach . But buying and holding just didn’t cut it for me. I wanted to find opportunities in places people didn’t know about and somehow I came across my first merger involving Tribune and made a tidy profit of 10% in less than a month while the market was sliding down.
    Something clicked.
    I did a little searching and found that Greenblatt had written a book, You Can Be a Stock Market Genius, Value Investing Ir?t=oldschval-20&l=as2&o=1&a=B00150GHTC specifically on special situations after which I wrote a series on special situations involving merger arbitrage, spinoffs and tenders.
    It was also around this time that Interactive Corp (IACI) spunoff 4 divisions. HSN Inc (HSNI), Ticketmaster (TKTM), Tree.com (TREE) and Interval Leisure Group (IILG). Too bad I didn’t purchase any of them because the volatility of the market got to me. I look back and kick myself for the 200%+ returns from HSNI and TREE and 30+% of the other two.

    Ben Graham Cheap Cigar Butts
    The only downside to special situations is that the profitable ones don’t appear so often. This led me to start going through Ben Graham’s screen to find many cheap distressed companies. These are the businesses that have one last puff remaining in them. Buffett referred to this as cigar butt investing.

    Now that I am comfortable going through the financial statements of each business except financial institutions, I am now over the fear of the dreaded “penny stock”. A company that is undervalued at $1 or $100 have the same thing in common. They are both undervalued. So by focusing on the financials and operations of the business, great opportunities can be found where people fear to tread.
    Take iGo Inc for example. It’s stock price is $0.62 with pretty good volume, yet the stock is rock solid. The company lost its biggest customer that accounts fo 42% of revenues but the stock dropped 0% on that news. That’s right, 0%. How many companies can boast the same thing?

    Bankruptcies, Debt and Distressed Debt
    Bankruptcies and distressed debt is a completely new field for me so I’m afraid I can’t elaborate. But I currently hold GGP and will definitely learn something from it.

    Selling
    Knowing when to sell is one of my biggest challenges. In a previous article on knowing when to sell , I mentioned the basics of selling.

    • You made a mistake in judging the company
    • The company fundamentals have changed
    • A better value or opportunity comes along
    • The need for emergency cash
    • Too far above intrinsic value

    What I should also include now is that when buying a company, an exit strategy must also exist. When you put in that trade order, someone is selling it to you. Why is that person selling? Only one person is right in the transaction.
    I still have trouble selling some ideas which is all pschylogical and something that I am still working on.

    To be continued

    5Value Investing Empty Re: Value Investing on Fri Jun 27, 2014 9:43 am

    SHARK aka TAH

    SHARK aka TAH
    Expert
    Expert
    To conclude this series on learning to invest in stocks, I originally planned to list up some sites, blogs and other resources but figured the investing blogroll I have up already is sufficient.
    Rather, I would like to close out this series with 10 points on my reflections from investing and what it has done for me over my short investment period

    Reflections on Investing
    If you have followed this series from the beginning, you’ll know I started with nothing. No knowledge and close to no money. I was biased that the market was equivalent to gambling and believed that working hard and going up the corporate ladder was the only method to success since I had no interest in economics, finance and business. I had laser tunnel vision in trying to do well at work. The fact that I have an engineering background and my thought process was wired to be analytical didn’t make it easier for me to “look around”.

    1. Investing broadened my mind
    I love the process of investing and I also have a thirst for knowledge. The resulting proceeds is the icing on the cake. My friend (probably reading this) tells me I should teach since I seem to be better at teaching people what to pick rather than doing it out myself.
    Investing has broadened my mind by forcing me to think in different ways and to look at a situation from different angles and perspectives. It broke the mold that many engineers have of straight line and top-bottom thinking.

    2. Investing proved I was wrong
    I was the type of person you hate to get into arguments with because I always had to be right and I would always find some way to prove it. If I didn’t have the facts with me at that point in time, I would gather it later and let you know why I was right again. When I first started this blog, it started off with a bang by receiving negative comments from people because the methods I use were “hideous” to them. I would spend as much time on a comment as I would on an article just to point out every single detail. You get the idea.
    Investing has shown me that I am wrong. People leaving comments have proven that I am wrong and then the market nails that fact in. The more important thing now is that I don’t care whether I am wrong. I like to be told constructively that I am wrong. I listen to why people believe I am wrong. I ponder their points and if what they say is true, I now admit my mistake, learn and move on to more lessons.

    3. Investing has helped me to ignore noise
    Investing has helped me in determining what was real useful information and what was noise. It has helped me to become efficient in processing data and to ignore the noise that fills the world today.

    4. Investing taught me about businesses
    I would never have dreamed on wanting my own business. Investing and looking at stocks as pieces of businesses has placed a desire to start my own business and I am in the process of doing so. The things I have learnt by reading annual and quarterly reports, financial statements and books have all been beneficial in how to approach starting and running a business.
    5. Investing has made me responsible
    I would probably still be spending my cash on gadgets, toys and other useless things to satisfy my hobbies rather than working towards the things that were important. I’ve dropped the hobbies that were time wasters and concentrated on helping my wife feel secure by managing our finances properly.

    6. Investing reminds me of my purpose
    I don’t invest to purely just accumulate wealth. That isn’t something I believe in. I have a purpose and reason for why I invest and it isn’t to get rich or retire comfortably. This helps to prevent me from getting over greedy. Do you have a purpose or is it just to get rich?

    7. Investing has made me part of a social community
    I was never into the whole internet friend/community thing. Just never bothered, but I realized that interacting with like minded and driven people was stimulating in so many good ways.

    8. Investing makes me want to help others
    You’ve heard horror stories of people losing their entire wealth in the market and going bankrupt. They bring devastation not only to themselves but to their family and other close relationships. I don’t want this happening to anyone so at any given chance I enjoy discussing financial issues to help others.

    9. Investing organizes my thoughts
    I’m not a very good speaker as I tend to jump between points often. When performing research and writing on this blog, I am required to lay out my thoughts in an easy to follow and understandable manner which in turn helps me to see things clearer as well. If my writings were jumbled and all over the place, I’m sure you wouldn’t be here reading anything I had to say.

    10. Investing has opened up different avenues of skills
    The whole process of investing and this blog has taught me many new skills. I now understand web design platforms, some coding, graphic design, sales, marketing, SEO and other little bits and pieces that truly are valuable. How do I know this is valuable? Well, I’ve been able to use every piece of information accumulated for a personal business project I am currently undertaking.

    Conclusion
    Investing is more than just gaining money. The 1000+% return with VNDA sure would have been nice but investing opens up a pandora’s box. Some refer to it as a journey or a game but whatever you call it, have fun with it, don’t go wild or do crazy things.
    One final important point I would like to make is that, if I can do it, so can you.

    To be continued.....

    6Value Investing Empty Re: Value Investing on Fri Jun 27, 2014 9:46 am

    SHARK aka TAH

    SHARK aka TAH
    Expert
    Expert
    Here is the process I follow which is rooted in the Graham and Dodd approach:

    Search
    I usually scan for ideas reading print media such as the Wall Street Journal , Barrons , and websites such as Google Finance and blogs looking at 52-wk lows lists looking for headlines that just spell “bad news” and articles that may lead to ideas with catalysts, event driven ideas and sometimes macro-event driven ideas.
    I’ll use screens if I don’t find anything in the headlines. If something peeks my interest a bit, I’ll try to gather more news and get an idea as to what is happening with the company, look at historical highlights, pull some efficiency, liquidity ratios and some basic numbers to look for consistency and I’ll think about the risks to the current situation a company is in and decide if I could potentially profit off the situation.
    If I think I can profit off the situation, I’ll really do some due diligence.

    Analysis

    Financial Reports and Statements
    At this point, I would grab at least the last three years of annual reports, 10K/Q’s, 8-K’s, proxies, conference calls transcripts and sometimes trade journals or magazines for additional information not included in the public documents.
    Of all those documents, I start out with reading the three annual reports usually starting with the oldest and work up to the most current report to quickly scan the highlights to look for consistency and also get a “story” of the company leading up to the current year.
    I’ll read the letter to shareholders (while taking it like a grain of salt of course) and scan for negative results or problems and again look for consistency in what the management has said and if they followed through on on-going issues.
    Next, I’ll quickly breeze through the auditor’s report (again taking it with a grain of salt) and look for problems that they found with the accounting or any mentions of change in accounting methods, uncertainties, specific disclosures and going-concern problems.

    Management Discussion & Analysis
    If anything catches my eye, I’ll look for more info on that in the MD&A, financial statements and notes to the financial statements for explanations about any issue.
    After reading the auditor’s report, I’ll read the Management’s Discussion and Analysis (MD&A), and sometimes I’ll have the 10K in my hand to read more about an issue discussed in the MD&A as SEC filings tend to have more detail. With the MD&A, I’ll read about how they recognize revenue (this is important for my own valuation purposes — garbage in/garbage out), restructuring charges, impairments to assets, pension plans to get an idea how they are financing it for their employees (this can be really helpful for the future financial landscape of the company), read about environmental and product liabilities in the case that if there is a problem in the future, the company can weather any future financial burden from liabilities.
    I’ll also look at compensation to see how management is compensating themselves as it can be foretelling of a possible scandal such as dating back stock-options at below market rates and it will also show if they are shareholder friendly.
    In addition, I read the discussion about sales increasing or decreasing and get an explanation, read about the company’s product lines (I usually try to match that with the reviews and feedback of customers), read about economic, market and sometimes political conditions that may have an impact on the company’s performance.
    I’ll read about operational aspects such as distribution systems, R&D and changes to products to improve performance or appearance and how much they are spending on R&D and cost controls, manufacturing capacity and associate that with capacity utilization. I’ll also read about acquisitions and expansion plans to see if it makes sense and also how they will finance its current and new debt and effect cash going forward.
    Lastly, I finish up the MD&A by looking for liquidity information. I want to see what they say about its cash position and its ability to pay its bills to see if it makes rational sense.

    Scanning the Proxies
    From there, I’ll quickly scan through the last three years worth of proxies just to get an idea of the board makeup, insider ownership, related party transactions and also see how management responds to shareholders. After reading the proxies, I’d want to see if there are any changes to any SEC filings via the most current 8-K.
    Occasionally, I’ll look at the 13-D just for curiosity to see what major shareholders I am up against as someone smarter with more information could be on the other side of the trade with me or it could be an institution that can move a stock in either direction because of charter reasons and I could possibly take advantage of that.
    After the first phase of going through the Annual Reports and SEC Filings, I usually have a comfortable idea as to what the company does, it’s key drivers, how they make money and if it’s profitable and organic, how they allocate capital and at what targeted return and if they can and have met it.

    Phase 2 Analysis
    My second phase is to get an idea of the market perception, general consensus and concerns of the company. I do this by reading the last five conference call transcripts (if available) and go to the company website and view any company presentations (if available).
    I’ll read blogs, forums and email journalists who wrote articles about the company and get an idea as to what the general market thinking is. I do this to get a general idea of what the “crowd” is thinking or doing because it allows me to identify if the “herd mentality” is present and also this tells me if a possible mispricing may exist because of irrationality in the air.
    After I get an idea of what the general market view is and if they are irrational or not which could lead to a possible mispricing, I do a bit of scuttlebutt research to try to confirm the mispricing. I will contact suppliers and try to probe them on their experience with working with the company and how they feel about them.
    I also contact the actual stores to try to confirm issues discussed in the annual reports and SEC filings. I also contact the actual stores of the competition to get their views on the company. If I have trade magazines, I will try to contact authors for their views and any other details related to the company. It’s usually by this point that I’ll know that
    (1) management is attuned to what’s really happening on the ground and
    (2) management is able and honest and
    (3) an indicator of a mispricing is now really possible.
    The only issue with contacting people is that it is more of a waiting game and sometimes people are not cooperative.
    After I have completed the first and second phase of due diligence on the subject company, I will do the same research on the competition which usually is three to four companies ranked by market position. After I have completed the same research on the competition, I’ll have a mental picture of the viability and economic value of the industry and who would likely be the winners and losers this way I’ll know who or what to handicap.
    Then I do one last bit of scuttlebutt research and contact the investor relations department of all the companies and if possible executive management (subject to availability) and probe them on how they view the competition by asking them questions like

    • if you were to merge with one competitor, who would it be and why?
    • if you could buy one subsidiary of your competitor, who would it be and why?
    • if you were given one wish where you could destroy a company, who would it be and why?”
    • if you had the chance to trade places with the executive of a competing company, who would it be and why?

    Asking these questions gives me an idea as to who is the real top dog of the industry.
    After completing phase one and two, I will perform valuation exercises which is phase three.
    My valuation methodology is rooted in the modern Graham and Dodd approach so I work with asset values , earnings power value (EPV) and view growth as either a margin of safety or buying it for free.
    Here’s how I do it.

    Stock Valuation – Asset Values
    Note that a lot of the tedious task involved in stock valuation such as finding and plugging in numbers can be performed automatically with the stock valuation calculator .
    I start with what kind of industry the business is in. If the industry is depressed or unsustainable, I will value the business at liquidation. This involves making necessary adjustments to the balance sheets from the top going down based on what I think assets will go for in a firesale or for scrap.
    I will usually mark liabilities at book value and take that number and subtract it from my calculation of assets and get a net asset value or otherwise called liquidation value . The rule is to buy the security at 2/3of that. Also, using liquidation value gives me a floor for the stock price if I think it can rebound from distress or bankruptcy.
    To me, the floor of a price is more important than the top on price. Preservation of capital is key in this.
    If the industry is viable and not going away, then I’d want to value it at a reproduction cost. Because of the nature of capitalism which really is creative destruction, the company making boat loads of money will attract competition. A person or institution with lots of money can start up the same business to compete with the incumbent. The entrant will have to assess what it would cost to start up and maintain the same business.
    That cost is known as reproduction cost.
    To get reproduction cost, again I have to make adjustments to the balance sheet starting with assets from the top going down this time based on what it would cost to make identical assets as the incumbent.

    Making adjustments is dependent on the type of account on the balance sheet:

    • For cash accounts, there is no adjustment needed as they are marked-to-market and represent fair value.
    • As for accounts receivable, the rule is to add bad debt allowances and adjust for collections to get a realistic value of accounts receivable.
    • Inventory is valued at FIFO basis and if the firm is using LIFO, then add LIFO reserve to the balance sheet number.
    • With Property, Plant & Equipment, the adjustment is made on case-by-case bases, but the general adjustment is made with the original cost plus any adjustments such as previous comparable sales of similar PPE.
    • When working with intangibles or goodwill, there is no adjustment number as intangibles or goodwill is based on the product portfolio and research and development. Since there is no replacement cost, I can use one of three ways to figure out a conservative book value estimate: (1) is to look at previous deals of a similar brand and see the acquisition price, (2)could also add up the costs of R&D spending attributable to the product or brand created from conception to deliverable or (3) add up the costs of three years worth of marketing and sales expenditures.
    • As for deferred taxes, if the company is going to have a profitable year, perform a discount to present value calculation on the cash to be paid in the future for taxes or if the company is going to generate losses, push the payment further out into the future and do a discount to present value calculation as well.
    • Lastly, for long term liabilities, there is no calculation to be done as it is marked at book value, unless otherwise, account for any new issues of debt. Then take the total liabilities and subtract from total assets and I get reproduction cost or reproduction value.

     

    Stock Valuation – Earnings Power Value (EPV)
    Earnings Power Value also known as just Earnings Power is I think a better way to analyze stocks as other forms of valuation such as discounted cash flow or present value calculations that relies on the rate of growth and cost of capital assumptions many years into the future. The thing I don’t like about the word assume is that if you break it apart, what you would get is “ass-u-me”. Assume makes an ass out of you and me. Making assumptions about a company is in my opinion not something to lean on for reliability even if we apply a higher margin of safety. Basically, how can anyone predict the future?
    EPV uses a very basic equation which is (adjusted earnings) x (1/cost of capital) and it assumes no growth and it relies on the judgment that current and extractable earnings while leaving the business intact are expected to be sustainable and consistent from the operations of the business. But before we can start the equation, we have to clean up earnings and come up with a cost of capital.

    Income Statement Adjustments
    (1) We start with operating earnings or EBT/EBIT and make an adjustment to allow for the business cycle and it’s cyclicality affects by taking a 7-year average of operating earnings, which includes at least one economic downturn (basic economics assumes one downturn every decade) and apply it to the current year’s net sales.
    Note: Although at the peak of a business cycle, adjustments reduces earnings and in a cyclical trough, the adjustment raises earnings, I prefer just to get an average because the assumption of economics implies a cyclical downturn.
    (2) Deduct the 7-year average of non-recurring charges or normalize these expenses to reflect their economic nature (if applicable).
    (3) Multiply the adjusted operating earnings by the 7-year average corporate tax rate usually somewhere between 30-33%
    (4) Add depreciation of the most recent year. This depreciation is already calculated in the statement of cashflows by the accountants, but it does not take into consideration of any advancements in technology or manufacturing efficiencies which can have an effect on lower capital goods prices or it can have an effect in an inflationary environment where reproduction costs is higher.
    This means we have to adjust this accounting depreciation to a true measure of depreciation by using maintenance capital expenses (CAPEX).
    (5) Calculating Maintenance Capex


    • A. Calculate the Average Gross Property Plant and Equipment (PPE)/sales ratio over 7 years
    • B. Calculate current year’s increase in sales
    • C. Multiply PPE/Sales ratio by increase in sales to arrive to growth capex
    • D. Maintenance CAPEX is the capex figure from the cash flow statement less growth capex calculated above, which is the true depreciation for the company

    (6) Once we have deducted the true (adjusted) depreciation from steps 1-4, we then have to come up with a cost of capital estimation (R). Because of one of the cardinal rules of Value Investing which is that income streams of companies and the operations themselves should be extremely predictable and consistent, simply choosing a rate like the federal bond rate (seen as risk-free) plus 2% is good enough. I tend to use a range of rates from 6% to 12% depending on what I feel is realistic for the company or average.
    (7) Once I have both the adjusted earnings figure and my chosen cost of capital rate, I can perform the equation.
    Earnings Power Value = Adjusted Earnings X 1/R, where R = Cost of Capital
    or
    Earnings Power Value = Distributable Cash Flow X 1/R, where R = Cost of Capital
    (Cool It’s at this point now that I have both the Asset Value and the Earnings Power Value, that I can tell if management is creating value for shareholders.
    If EPV is higher than Asset Value, then it is said that management is creating value and the company is operating at a competitive advantage. If the reverse is true, then management is destroying shareholder value by earning less than the value of the assets and the company operates at a competitive disadvantage.
    This difference between the EPV and Asset Value is known as the franchise value. This can also be expressed in per share values.
    (9) If I find that the company is operating with a competitive advantage and management is creating value for shareholders, I am now at the point where I want to compare the EPV with the market price. But before I can make any comparison, I have to make one final adjustment.
    That is to subtract out any corporate debt and add in cash in excess of operating requirements.
    EPV + Cash/Debt Adjustment
    (10) After adding in the cash/debt adjustment to EPV, then I would express EPV in per share value by dividing it by the amount of shares outstanding.
    Then I can compare the EPV/per share to the market price. If the market price is below the EPV/per share, then the stock appears to be undervalued by the market.

    Thesis
    After completing my research, analysis and valuation in this fashion, I’ll have a picture of what the company does and how it makes money.
    I’ll know if management is consistent, able, whether they are shareholder friendly and if management is really in sync with things happening on the ground. I’ll know how the accounting is done and if they fudged some numbers. I’ll have an idea as to what the general risks are to the company, how it affects cash and whether these things can be minimized. I’ll see the market perception of the company and I can decide to go either against them or hold off on the investment. I’ll see what their competitors thinks about the company and it will either change the way I think about the company, reinforces my conviction about the company or fill in holes on my analysis of the company.
    The way I think about my valuation exercises is that I was using reliable earnings to come up with a conservative estimate of intrinsic value and if management is creating shareholder value.
    I’ll have an idea where the margin of safety lies or know how to apply a margin of safety because I’ve read cases where people slapped a blanket margin of safety to a valuation and their estimates became way off that they missed out on some really smokin’ deals — basically an error of omission. And doing this type of valuation gives me a range of values without having to use assumptions about growth into the future. And since I don’t just value just the one company, I value the basket of companies since I have already done the homework on the basket, I could just wait for one of those stocks to get beaten up and pounce on them with vigor or if I want I could buy the basket if the industry had gotten beaten up for some irrational reason.

    Disclosure
    Credits belong to Francis Chou of Chou Funds , Hunter at Distressed Debt Investing , Bruce Greenwald of Columbia University, Joe Ponzio of F Wall Street and of course Jae of Old School Value . 70% of my “swing” came from them and the rest is from everywhere else.

    8Value Investing Empty Re: Value Investing on Fri Jun 27, 2014 11:18 am

    Octopus

    Octopus
    Expert
    Expert
    Shark do you think all these people investing and make money know these stuff.

    I don't think even Dhammika perera and company know all these.  Question 

    But I am proud of you. I can trust your advise. Thanks

    9Value Investing Empty Re: Value Investing on Fri Jun 27, 2014 11:59 am

    SHARK aka TAH

    SHARK aka TAH
    Expert
    Expert
    Thanks for your encouraging words.... It pushes me to the limits to post good articles.
    This is series of articles on Value Investing.
    Yes this will take time and effort.
    I am re-publishing these articles for the New Members so that they learn the importance of Investing in solid shares.

    So keep watching this thread, I will post more articles from this website I found whilst googling.

    Good luck
    Shark

    10Value Investing Empty Re: Value Investing on Fri Jun 27, 2014 2:08 pm

    cruiserdude


    Senior Equity Analytic
    Senior Equity Analytic
    thank you shark....

    11Value Investing Empty Re: Value Investing on Fri Jun 27, 2014 2:47 pm

    SHARK aka TAH

    SHARK aka TAH
    Expert
    Expert
    These Articles are worth reading during the week-end ......

    So I will republish some more during next week.

    Good Luck
    The Site is full of information....

    Shark

    12Value Investing Empty Re: Value Investing on Fri Jun 27, 2014 4:37 pm

    stevenapple


    Assistant Vice President - Equity Analytics
    Assistant Vice President - Equity Analytics
    Thanks Sharks in advance.Seems to be weekend is deemed for very valuble lessons.

    13Value Investing Empty Re: Value Investing on Fri Jun 27, 2014 4:48 pm

    VALUEPICK

    VALUEPICK
    Expert
    Expert
    Good one. Value! value! Value! Great Value ................
    Some Value stocks have formed their uptrend. Value is there in banking, plantations, motor and manufacturing sectors. Value stocks can be found in other sectors as well. Value stocks with growth potentials are the best.

    No one valuation method is perfect for every situation. Investors will not limit to just using one method. According to the characteristics of the company, we can select a valuation method that best suits the situation.

    14Value Investing Empty Re: Value Investing on Fri Jun 27, 2014 6:07 pm

    SHARK aka TAH

    SHARK aka TAH
    Expert
    Expert
    Yes VP you are right  Laughing

    15Value Investing Empty Re: Value Investing on Sat Jun 28, 2014 9:49 am

    SHARK aka TAH

    SHARK aka TAH
    Expert
    Expert
    We will be discussing about
    Financial Statement Analysis
     As part of Value Investing Topic

    So stay tuned and don't let the thread get buried.....

    Shark

    16Value Investing Empty Re: Value Investing on Sat Jun 28, 2014 12:06 pm

    stevenapple


    Assistant Vice President - Equity Analytics
    Assistant Vice President - Equity Analytics
    SHARK wrote:We will be discussing about
    Financial Statement Analysis
     As part of Value Investing Topic

    So stay tuned and don't let the thread get buried.....

    Shark

    True Shark. Had it been the topic is about none-value share I'm 100% sure u wouldn't have to make such a comment.

    17Value Investing Empty Re: Value Investing on Sat Jun 28, 2014 12:15 pm

    SHARK aka TAH

    SHARK aka TAH
    Expert
    Expert
    All Investing styles are tolerated......

    Value Investing Contrarians too must be discussed for the benefit of majority member community.

     
    Thanks Steve

    Shark

    18Value Investing Empty Re: Value Investing on Sat Jun 28, 2014 4:06 pm

    stevenapple


    Assistant Vice President - Equity Analytics
    Assistant Vice President - Equity Analytics
    After reading Are you really a Value investor? Started to read this.
    Still in the first stage.
    Feel like it's written to me and soo excited to read thru. But couldn't resist my self to just to show my appreciation for this wonder thread. Thanks Sharks.Hope the remainng part will not dissapoint me.Thanks.

    19Value Investing Empty Re: Value Investing on Sat Jul 12, 2014 3:33 am

    SHARK aka TAH

    SHARK aka TAH
    Expert
    Expert
    Please Read Graham Number on Expert Chamber  Very Happy 

    20Value Investing Empty Re: Value Investing on Sat Jul 12, 2014 12:00 pm

    stevenapple


    Assistant Vice President - Equity Analytics
    Assistant Vice President - Equity Analytics
    SHARK wrote:Please Read Graham Number on Expert Chamber  Very Happy 

    Thanks. Will do that. cheers 

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