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Co-founder & CEO of AllenWargent property buyers & WargentAdvisory (subscription market analysis for institutional clients).
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Co-founder & CEO of AllenWargent property buyer's agents, offices in Brisbane (Riverside) & Sydney (Martin Place), and CEO of WargentAdvisory (providing subscription analysis, reports & services to institutional clients).
4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.
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Friday, 21 February 2014
OK, I've had a bit of caffeine, so a quick technical post today. Feel free to skip if you're not in the mood.
The most common question I'm asked about shares is "should I buy XYZ, the price has fallen?". The answer may be yes or no depending on how you value the company and see its future earnings prospects, although if the price is falling the answer is quite likely to be "no". But how to value a company? Here are a few of the more popular ways:
A few ways to value a company
1 - Price/earnings (PE) ratio
Australia's largest companies by market capitalisation include BHP Billiton at around $124 billion, and Commonwealth Bank (CBA) at around $120 billion.
The simplest way to get a handle on how 'cheap' or otherwise the share price are is to look at the price-earnings ratio. BHP are CBA are trading at around 15-16 which is line with the wider market and quite middle of the road. Popular companies like Wesfarmers (WES) are trading above 20, which is getting expensive.
The forward PE ratio is a bit more of an aggressive measure and uses forecast earnings, while the trailing PE ratio looks at previous earnings from the past 12 months.
Obviously the PE ratio is only a guideline for comparing similar companies in similar industries.
A younger, growth company might have a high PE due to its expected future earnings growth. A start-up company which has yet to make a profit could have an infinite PE (e.g. a tech stock), and a company which has fallen on hard times and is making only a marginal net profit might have a sky-high PE if the market expects stronger earnings to return.
Value investing doyen Ben Graham opined that you should look to buy stocks at a PE of under 15, so on this measure, there's not much of an argument for their being value in CBA or BHP today.
2 - Price-to-book
Very much out of vogue these days, the price-to-book value simply compares the company's valuation to the its balance sheet total, although you may choose to strip out intangible assets etc. Since a bank like CBA is valued on its cash flows we should intuitively know we will find no value here.
CBA had equity of around $45bn at June 2013, so throw in a bit more for the half year result and you can see that equity of just under $50bn does not compare favourably to a valuation of $120bn, giving a price to boom of around 2.5.
Graham argues that a higher price to book can be justified by a lower PE. Graham suggests that a PE ratio of lower than 15 can sometimes justify a correspondingly higher price-to-book of above 1.5 times (he suggests that the product of the PE multiplier and the price-to-book should not exceed 22.5 - i.e. 15 multiplied by 1.5).
Big fail here for CBA - 15 X 2.5 = 37.5.
3 - Present value of future cash flows
I've changed my view a bit over the years on people picking their own stocks. Most people don't take the time to analyse financials properly, so would likely be better served to find a diversified product with a proven history of growing dividends over decades (longer than the employment life of any individual manager).
The value of a company is ultimately the sum of its future cash-generating ability, so the most thorough approach to valuing a company is to estimate all of its future cash flows (e.g. in the case of a small mining company: mine construction costs, cash earnings, mine closure costs) and then discount them back to today's value at an appropriate discount rate to adjust for risk e.g. 10%.
For a mature company such as CBA, a great deal therefore comes down to its projected future earnings growth rate. If, for example, in the past decade CBA has been able to increase its earnings at 10% per annum then you can project today's earnings forward and discount them back to a present value (the half year results showed cash NPAT of $4.25bn).
If CBA was able to grow its earnings at 10% in the future, then you don't need to be a genius to discount future cash flows back to a present value at 10% (the present value figure would remain constant) - and you can immediately see that the 'payback' on a market cap of $120bn is...a long time.
Of course, this is all highly subjective. If forecast earnings growth for the next 2 years is only 7%, then a more conservative projected earnings calculation might suggest that the banks are well overvalued.
Why so? Because the Big 4 banks are perceived to be stable and pay very strong dividends, and therefore investors are prepared to accept that earnings will be grown for many years in to the future, which would not be the case for a smaller or more volatile company.
4 - EPS growth
Of course, there are many ways to calculate value. Here's another popular way:
-take the company's earnings per share and 10 year equity growth rate
-tale the average of the high and PE ratio
-take the current EPS and project 10 years of growth using the 10 year equity growth rate
-shrink the future EPS figure calculated above back to today's price at the rate of return sought (e.g 15%).
-if this price is more than, say, double the price of the stock today, then there is value and you should buy
You can immediately see why there is often no consensus on stock valuations and why occasionally there will be anomalies between price and value, particularly when the market is despondent, which it currently is not.
An easier way?
As noted, I know very few people who take the time to analyse a company's financials, with most preferring to take a 'gut feel' approach, or hazard a guess based upon the share price chart.
Here's an easier approach. Find a diversified LIC with a proven track record of increase its dividend over decades and buy shares regularly. You might not get the timing spot on, but a regular buying plan smooths the entry price.