Stocksbaby
Unearth the Value of a Growth Company
During the stock selection stage, it is important to unearth the value of a company. Annual Report serves as the best tools to get to know more about the company.
10 Basic Rules of Thumb of a Growth Company:
- CAGR of Revenue > 15%
- CAGR of Net Profits > 15%
- Net Profit Margin > 8 %
- CAGR of Operation Cash Flow > 15%
- Positive Free Cash Flow
- Cash Ratio > 0.5
- ROE > 15%
- Debt to Equity Ratio < 0.5
- Price Earning Growth Ratio < 0.5
- Price < Intrinsic Value
Revenue is the sales or turnover of a company. Money received from the sale of items will be recorded under Revenue. By looking at Revenue itself, we cannot tell whether the company is profitable. However, a good growth company will show increases in revenue. Increase in revenue signaled that the company is growing by able to sell more items.
Net Profit can be found at the bottom line of the Income Statement. It is derived from subtracting all the expenses (including costs of goods, finance expenses, tax and other expenses) from Revenue. Therefore,
Net Profit = Revenue – Cost of Goods Sold – Total Expenses
Net Profit Margin measures how much profit percentage a company makes for every RM 1 of sales. The formula is,
Net Profit Margin = (Net Profit/Revenue) x 100%
A good growth company must able to maintain or increase its net profit margin 8% to 10% to prove some competitive advantage. However, Net Profit Margin varies from industry to industry and it has to be compared against its competitors.
Cash Flow Statement is important as we can easily see how much cash is generated by the company’s operating activities, as well as how they spend it.
Operation Cash Flow (OCF) determine the true earnings through business operations.
Cash Flow from Investment (CAPEX) refer to the capital expenditure such as purchase of property, plant & equipment. This is the money spent to fix, upgrade or acquire properties, plants and equipment in order to grow and keep the business going in long run.
Free Cash Flow (FCF) is the money is the money left after paying the capital expenditure. The formula is:
Free Cash Flow = Operation Cash Flow – Cash Flow from Investment (CAPEX)
A good growth company should have a positive Free Cash Flow.
The Cash Ratio provide a better measure of true working capital by ignoring the inventory and receivables amount. This show that the company will be able to meet its short-term debt without selling away its inventory or other short-term assets. The formula is:
Cash Ratio = Cash & Cash Equivalent / Current Liabilities
Return of Equity (ROE) is one of the most important profitability ratios in determining a good growth company. By calculating the ROE, investor are able to determine how much money they are getting back for every dollar of invested capital.
ROE = Net Profit / Shareholder’s Equity
Debt to Equity Ratio is also known as Gearing Ratio. Debts referring to the short and long-term bank loans. The lower it is, the lesser the risk of failure or bankruptcy. It is measured by:
Debt to Equity Ratio = Total Debt / Shareholder’s Equity
Price to Earnings to Growth ratio (PEG) is a fast and accurate indicator to determine whether a company is overvalued or undervalued. If a sector of all companies have the same growth rate and risk, then using the PE ratio would be fine. Unfortunately, companies in similar sectors grow at different rates from one another. Therefore PEG shows a more complete picture. The formula of PEG ratio is:
PEG = PE Ratio / CAGR of EPS
*Earning per Share , EPS = Net Profits / No. of Outstanding Shares
Last but not least, is to find the Intrinsic Value of the company through Discount EPS Model.
Step 1: Choose the Projection Growth Rate, assumption made from the average past growth rate achieve by the company.
Step 2: Discounting Risk-Free Interest Rate, assumption made based on the latest Fixed-Deposit Interest Rate. The Formula of Discount Factor is=
Discount Factor, DF = 1 / (1+Risk Free Interest Rate)^n
n=number of year
Step 3: Adding the Discounted Earnings to obtain the Intrinsic Value.
It is just a little sharing, Please feel free to visit my blogs at https://stocksbaby.wordpress.com/.
Kindly comment if anything wrong. Thanks.
Discussions
2 people like this. Showing 10 of 10 comments
Buffett also wrote that it is better to be approximately right than to be absolutely wrong. Benjamin Graham wrote you don't need a weighing scale to tell that this person is fat. What can we firther infer from these statements?
2016-03-29 07:34
It is better to buy a wonderful company at fair price than a fair company at wonderful price. Quoting Buffett.
Qualitative margin of safety first, then look at Quantitative margin of safety.
A wonderful company is a bad investment if you overpay to own it.
A fair company available at wonderful discount can be a good investment.
Gruesome companies are better avoided.
2016-03-29 08:02
Essentially, select the best company in the sector or industry. Be disciplined and be patient. When the opportunity presents, have the cash and the courage to buy big. Hold for the long term.
2016-03-29 08:06
Hi Stocksbaby, great effort! Keep it up.
Few comments from me:
1) I presume your 10 rules of thumb for growth companies are entirely based on historical facts rather than estimation of future. Warren once wrote in his classic GEICO article that "the investor of today does not profit from yesterday's growth". This simple sentence has forever shaped my thinking in investment.
You set a pretty high bar of >15% CAGR and I guess you must be hoping the growth to continue in most cases. That can be backfired. Sometimes historical numbers don't tell everything, if not Kodak & Nokia wouldn't have gone down (they had their >15%-growth days). Understanding the business is SUPER crucial.
2) On your discounted EPS model, using a discount rate of ONLY at risk-free rate is, at least to me, too aggressive/optimistic. Your intrinsic value on any company will likely be very high. I normally discount back at 10% because the stock market delivered 10% return a year (including dividends) in the past, so my valuation is tend to be lower, more conservative and sensible.
3) I think your discounted EPS model is wrong. You only discounted 10-year earnings without a terminal value, you should have one.
Intrinsic value = [sum of 10-year discounted earnings] + [(EPS of 10th yr) x (1+{LT growth rate}) / (r - LT growth rate)]
Anyway, the terminal value calculation is widely available online. You can google them.
4) Actually, valuation can be made simple. Like 3iii said "Benjamin Graham wrote you don't need a weighing scale to tell that this person is fat." This Ban Graham quote also inspired me a lot in valuing companies. There shouldn't be any precise intrinsic value on companies, we should always value them in range.
2016-03-29 11:05
The aims of fundamental analysis of a company are to determine its intrinsic value and the FUTURE growth of its business. There is always an element of subectivity in their determination.
2016-03-29 17:06
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3iii
Buffett wrote that the intrinsic value of an asset is the discounted value of all its future cash flow. Charlie Munger turned to Buffett, "I have never seen you do these calculations before." What can we learn from these 2 sentences?
2016-03-29 07:31