Valuation Matters

In my previous article, “Investing in Bursa; Have the cake and eat it” as in the link appended below, we talked about in order to have a better chance of earning good return from the market, we first need to identify if a company is a “good stuff” first before we even consider if we should invest in it.

http://klse.i3investor.com/blogs/kcchongnz/45693.jsp

This is because you could purchase the best stock in the world, but if you buy it at a lofty premium, it is a bad investment. Vice versa, the stock could be the worst company in the world, but if bought it cheap enough, it could work out to be an excellent and profitable investment. The question is how would you determine if the stock is cheap?

Seth A. Klarman in his book “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” stated that, “To be a value investor, you must buy at a discount from underlying value. …. While a great many methods of business valuation exist, there are only three that I find useful.” (Margin of Safety, pg. 121).

The three methods Klarman was talking about for estimating the value of the stock are:

1. Net Present Value Analysis
2. Liquidation value
3. Stock Market Value

In the previous article mentioned above, we did touch on value using the third item above; the stock market value when we used Price-earnings ratio and Enterprise value-earnings before interest and tax ratio. We have also touched on one of the valuation methods for item 2 above, Liquidation value (a balance sheet based valuation) when we used the Graham net net as well as the negative enterprise value on Kuchai Development Berhad which may not satisfy most of the criteria of a good company as an example as shown in the link below:

http://klse.i3investor.com/blogs/kcchongnz/45296.jsp

What about item 1, the net present value analysis, an earnings based valuation above?

Yes, we have also briefly touched on this valuation method when we attempted to estimate the intrinsic value of Padini Holding Berhad as shown in the link below:

http://klse.i3investor.com/blogs/kcchongnz/45203.jsp

Please note that this is just one of the various methods available for earnings based valuation.

Valuation is an Art

I have emphasized on this phrase numerous times and would continue to do so. Yes, valuation is more of an art than a science. All valuation methods involve choices of data and assumptions. Each valuation method may only be suitable for certain type of companies, with its individual strengths and weaknesses. None of the valuation methods is infallible. However, they are the best of what we got. Frequently investors will want to use several methods to value a single business in order to obtain a range of values. In this case investors should err on the side of conservatism.

Without knowing the estimated value of a company or stock, I just find it extremely difficult to make the decision of whether to invest (read not punt) that stock or not, even though it is a great company. Hence I strongly believe that knowing some valuation methods is essential to improve the investing experience of an investor.

KC Chong (12^th February 2014, still in Chinese New Year mode)