Posted by kcchongnz > 2013-09-07 17:02 | Report Abuse

Some people ask me how to be a good value investor. In my opinion, a value investor should know that when he buys a stock, he is investing in part of the business of a company. There is a company behind the stock.

So how does one know if a company is worth investing and at what price? Isn't it logical that he must first know what is the value of that company, instead of letting the market to decide what price to invest?

To be a good value investor and know how to value a company, you need not look too far away. Just read the articles posted by Tan Kian Wei. Just now he posted so many good articles on valuation methods by Jae Jun, a very popular value investor in US. To me, these are all the methods you need to know in valuation.

Good work again Tan KW.

Posted by inwest88 > 2013-09-07 17:06 | Report Abuse

Yes, KW Tan has indeed been doing a wonderful job sharing all these articles with the members in the forum.

Posted by kcchongnz > 2013-09-07 19:29 | Report Abuse

In his book, "Margin of Safety", Seth Klarman stated that

Quote "While a great many methods of business valuation exist, there are only three that I find useful. The first is an analysis of going-concern value, known as net present value (NPV) analysis. NPV is the discounted value of all future cash flows that a business is expected to generate.

A frequently used but flawed shortcut method of valuing a going concern is known as private market value. This is an investor's assessment of the price that a sophisticated businessperson would be willing to pay for a business. Investors using this shortcut, in effect, value businesses using the multiples paid when comparable businesses were previously bought and sold in their entirety.

The second method of business valuation analyzes liquidation value, the expected proceeds if a company were to be dismantled and the assets sold off. Breakup value, one variant of liquidation analysis, considers each of the components of a business at its highest valuation, whether as part of a going concern or not.

The third method of valuation, stock market value, is an estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market. Less reliable than the other two, this method is only occasionally useful as a yardstick of value.

Each of these methods of valuation has strengths and weaknesses. None of them provides accurate values all the time. Unfortunately no better methods of valuation exist. Investors have no choice but to consider the values generated by each of them; when they appreciably diverge,
investors should generally err on the side of conservatism." Unquote.

Posted by houseofordos > 2013-12-11 10:06 | Report Abuse

Hi KC, I m curious if you have attempted to tweak this model to use EV/EBIT multiples rather than PE ? As u know PE numbers can be manipulated by share buybacks goodwill charges or one off gains. Thanks

Posted by kcchongnz > 2013-12-11 12:05 | Report Abuse

In investment, the simpler it is, the better. If PE can do the job properly, that would be wonderful. However, The E there can mean anything and hence highly unreliable. E can also be boasted with leverage, which during bad time can cut one badly. EV accounts for other stuff which P does not do such as debt and cash levels and ignore non-operating thingy. Ebit is the "middle line" and earnings at the firm level and hence should not be affected by one off items.

Hence I think EV/Ebit is good enough. Of course if you have time, do more like look at cash flow etc.

Posted by houseofordos > 2013-12-11 13:03 | Report Abuse

yea I agree on that. I was just wondering what would the basic EV/EBIT be for the calculations if we were to use EV/EBIT rather than PE for valuation method in this thread.

Posted by kcchongnz > 2013-12-11 14:02 | Report Abuse

Posted by houseofordos > Dec 11, 2013 01:03 PM | Report Abuse
I was just wondering what would the basic EV/EBIT be for the calculations if we were to use EV/EBIT rather than PE for valuation method in this thread.

This sounds like an interesting statement to me. First of all, all these thing is arbitrary. For example why use the base PE of 8? Why not 10, 5, 15? But if you flip the PE ratio over, the earnings yield (E/P) is about 12%. That may be is the yield the original author of this absolute PE valuation method wants. What about EV/Ebit, what should be the base then?

All I can say is if you replace P/E with EV/Ebit, you should demand a EV/Ebit of lower than 8 above. This is because:

1) The cost of debt is lower than the cost of equity, and hence valuation using EV must be lower when compared with market capitalization.

2) The denominator Ebit has not taken tax into consideration. Hence EV/Ebit must be lower than PE.

But how much lower we must demand EV/Ebit than PE ratio? Again it is arbitrary. What about an earnings yield of 20%, or EV/Ebit of 5? Or should earnings yield be 15%, or EV/Ebit of 6.7?

It also depends on what kind of industry it is.

Posted by houseofordos > 2013-12-11 14:20 | Report Abuse

Tax rate of about 25%, cost of equity (the returns required to own the stock) of about 10%

So lets say the base EV/EBIT = Basic P/E (8) x 0.75 x 0.9 = 5.4x which is close to what you calculated

Your last statement "It also depends on what kind of industry it is." is more like relative P/E approach. In this case I would just compare the EV/EBIT for companies in the same business and put a target EV/EBIT based on the average EV/EBIT of all the companies whereas the absolute EV/EBIT method would assess the business and financial risks to come up with the target EV/EBIT. I suppose the more practical way should be the former as any take over would be justified based on relative valuations rather than absolute.

Posted by houseofordos > 2013-12-11 14:25 | Report Abuse

Mistake... actually

Basic EV/EBIT = Basic P/E (8) x (1-0.25) x (1-0.04) = 5.7x (around 6x)
Where 25% is the tax rate
and 4% is the difference between cost of equity and cost of debt (could be subjective.. assuming 6% cost of debt)