Below discussion is copy from kcchongnz post on http://klse.i3investor.com/servlets/forum/900214344.jsp

Cold Eye 5 yardsticks presentation by Cold Eyed - http://klse.i3investor.com/blogs/kianweiaritcles/26614.jsp

Cold Eye冷眼’s 5 yardsticks for investment 

Cold Eye, during his talk on 16/3/2013, listed 5 important criteria for investing in a stock as below: 
1. Return on equity, ROE, 
2. Cash flow from operations and free cash flow, 
3. PE ratio, 
4. Dividend yield and 
5. Net tangible asset backing per share, NTA 

If you invest RM100,000 in a business, you would want to have a reasonable return from the capital, or equity you put in. A business is risky and probably you may want a minimum return of say 25%. For investing in the share market, you may want a minimum return say 10%, 6% above the return you get from bank deposit? If the business only returns you 4%, why would you want to invest in it when you can get that rate from FD without having any worries at all? 

In your business, you would expect that all your debtors pay you promptly and that you don’t have to stock up a lot of inventories which will tied up your capital. Otherwise you would have to put in more capital each year even though you make money. I would expect the hard cash I can received must be about the earnings I make each year. My business would also require capital expenses each year to keep it going, better growing bigger so that I would earn more in the future. This I would need to buy more and replenish the equipment , buy or open more shops etc. It would be ideal if these expenses can be met with the cash I receive each year and not having to come up with more of my own money or borrow from bank. After that, I would be happy if there is still money left for me to draw out (as dividend), or the company can have extra money to invest in other lucrative business. This money available after all the capital expenses is termed as free cash flow, or FCF. 

If the above business make a lot of money, say 30000 a year, or 30%, would you buy it if the asking price is 1 million, or a PE of 33? This will give you a earnings yield of only 3%. Hence a good business does not mean it is a good investment if the price is too high. 

How nice it would be if the business earns enough for me to draw down 10,000 a year consistently. For my dividend yield would be 10%, 2.5 times that of FD rate. Besides my business is still growing. 

Well if at the end if I want to exit from the business, if the net tangible asset of my assets worth more than what I put in, or more, I can recoup my initial investment. These assets must of course the more valuable the better, for example hard cash, property and land etc, rather than some money which I have been arguing with the debtors whether they are going to pay me or not, or some inventories which are outdated. Hence NTA is important too although in some businesses, example the service industry where the important assets are its people, its technology or brand name rather than hard assets. 

Do you have any good stocks meeting the majority of the above criteria as given by Cold Eye to share? Or any lemon you may know which you want to tell others to be careful about? This discussions here is for sharing of knowledge and information and should not be construed as a forum for hard selling or condemning others of their stocks without giving justifications. 

Kcchongnz 17/3/2013

Full Stock Pick List - http://klse.i3investor.com/blogs/5_rules_cold_eye_kcchongnz/blidx.jsp

5 Rules of Investing by Cold Eye - Portfolio Simulation

Posted by kcchongnz > Mar 19, 2013 05:51 PM | Report Abuse X

The power of arbitrage 

[Gark: If a business is making 10 cent/share now and in 10 years time will also make 10 cents/share. Do you think, although at PE 5, the price will go up? More like the price will be relative stagnant, and your returns get eaten by inflation. 10 cents now and 10 cents 10 year later does not have the same buying power. This is a classic value trap.] 

The stock above (S) earns 10 sen every year and sells at 50 sen, a PE ratio of 5. It still earns 10 sen a share 10 years later, no growth, not even grow with inflation. Will the share price of S goes up? Or rather it is a value trap? That is the question. 

If there is such a stock (S) exists, I will borrow RM500,000 from bank to buy 1,000,000 shares of S. Say the interest rate is 5% and hence annual interest payment is RM25,000. I get a dividend of 10 sen per share a year as the company pays out all its earnings, leaving no money for growth. So I get a dividend of RM100,000 each year. I use one quarter of the dividend, i.e. RM25,000 to pay the interest to the bank . I pocket RM75,000, “kon lou”, meaning earning RM75,000 net a year, every year. At the end of 10 years, I sell off S and get a proceed of RM500,000 (The share still sell at 50 sen, or a PE of 5). I use this proceed to pay back all my debt to the bank. 

So I come out with no money, just borrow from bank. Each year I earn RM75,000 for 10 years. Do you think this stock S will be a value trap? Do you really think the stock price will stay at 50 sen? 

The thing is whether to buy a stock or not is not whether it has high growth or not; it is the price of growth. Many people pay too high a price for growth but it has been proven statistically that the expected high growth does not materialized. On the other hand, if there is no growth for a stock, but if you can get it at a high margin of safety, you make extra-ordinary return.

Posted by kcchongnz > Apr 2, 2013 05:42 PM

Tptan45, you must a great fan of Philip Fisher, father of Kenneth Fisher, one of the earliest proponent of growth. I am one of his fan too. A growing company is great, there is no doubt about it. But my point is don’t overpay for growth. Let me show you in an analysis below. You see numbers won’t lie, only assumptions may not be true. The analysis I show below is pure mathematics, no assumptions, or little assumptions. 

Say a company whose EPS is 10 sen and its stock is selling at $1. It pays no dividend. So the PE ratio is 10. It is growing at 10% per year. After 5 years, its EPS would be 16.1 sen (10*(1+10%)^5). Assuming the PE ratio remains the same when you sell it then, i.e. 10 and my required return is 10%. The present value of this future cash flow is also $1 (1.611/(1+10%)^5). So if you have bought the share at $1, you are paying a fair price. If you pay 1.50 for the stock, or a purchase price at a PE of 15, are you paying a fair price? 

Look at another stock, B. Its EPS is also 10 sen now but its expected growth is 20% for the next 5 years. Its EPS will grow to 24.9 sen in 5 years time. Assuming you pay a higher price at $2 to buy B now, or a PE of 20 and after 5 years, it is still selling at a PE of 20, the price will be $4.98 (20*0.249). If you discount this price at 10% back to the present value, it is $3.09, more than 50% above the price you pay. You got a great deal even if you pay a higher price of PE of 20 for a stock growing at 20% for the next 5 years. But is it still a good deal if you buy it now at $4.00, or a PE of 40? Or instead of growing at the forecast growth rate of 20%, it is growing at only 10%? Is it a good buy also?