Malaysia Contrarian Investing

A few quick ways to determine the value of a stock

1. Book Value & Return on Equity

Book value is the value of asset sitting in balance sheet. Think of book value as everything sitting inside your room. Most of them are recorded at historical cost. For example that mattress you bought 5 years ago. While others are recorded on market value (mark-to-market), like the gold ring (99.99) lying on your computer desk because there’s an active market for it (http://goo.gl/BiF6Z8).

If you bought that soccer shoes from your friend but you haven’t pay him back, you’ll have to deduct that.

Book value serve as a good anchor for measuring how much a company is ‘worth’, although it can be misleading at times.

Book value = Total asset - total liabilities. Divide that by outstanding shares, you will have book value per share. Private companies are normally bought or sold at book value. For liquidation it will be lower.

Return on equity or ROE for short is the return a company can earn on it’s asset, expressed in %. You can refer to previous post on why it is important. (Link: https://goo.gl/z4g1WE)

Okay, let’s get into this. When you have a stock in mind, look at the past 5-10 years average ROE of the company. If the company has been averaging 10% ROE in the long term, you shouldn’t pay more than the book value. So 10% ROE for the Price to book of 1x. 15% ROE for P/B 1.5x and so on. If the book value is $1 with ROE 10%, you should only pay for $1. For ROE 15% then $1.50 and so on. If past ROE are inconsistent, it is better to err towards the conservative side.

Companies like Public Bank or Hartalega have been able to trade at 3-5x book value is because they have high ROE. The common sense behind this is the higher a company can generate return, the more cash flow they can generate and the more valuable they should be. However one thing to keep in mind is that high ROE is incredibly hard to sustain throughout the lifetime of a company.

That’s also true for companies that have not been able to generate a return enough to cover their cost of capital in the long term. Their share price tend to trade below book value. Therefore when you see a company selling below book, before getting excited you should ask “How can such a wonderful opportunity be waiting for me? Are other investors blind? Is the company making a good return for it’s shareholders?”.

Not all companies have the same cost of capital, but it you do not want to go through the hassle of being precise, 10% is the best hurdle rate you can use. Think it as your minimum required return.

This method suitable for most types of companies except tech or software.

2. Free Cash Flow

Free cash flow is the amount that a company has generated after making all the required capital investment and working capital. How much a company is worth depends on the free cash flow that it can generate over it’s lifetime.

FCF is slightly tricky as in you need to make adjustment rather than take it as it is. Why does Amazon has negative FCF for many years yet trading at sky high price? Because they are reinvesting all their money back into the business rather than issuing dividend. They are sacrificing their FCF now for more FCF down the future (Exponential growth). So negative FCF doesn’t mean the company is worthless. The key is we need to separate maintenance reinvestment (repair/replace existing machinery) from growth reinvestment (buying new machinery to grow the business)

How do we adjust? Depreciation is a good proxy to find maintenance reinvestment.

Operating cash flow - depreciation = Free cash flow.

Preferably you will want to use 3 years average of adjusted FCF. How much multiple should you apply typically depends on the circumstances i.e. quality of the company.

As a rule of thumb for average companies, that I mean 90% of the stocks, 8 times FCF is probably the right price to pay with inclusion of margin of safety. For better quality stocks, 10-12x FCF is fine. So if the 3 years average FCF is 100 mil. You will only want to buy the company with market cap or enterprise value of 800 mil (8x FCF) or less.

FCF is applicable to all types of companies except financial institutions.

3. EV/EBIT or Earnings Yield

(Enterprise value / Earnings before interest & tax) or short for EV/EBIT is similar to P/E ratio but a better measurement as it takes debt into account. Earnings yield is the inversion, EBIT/EV.

A stock with a 10x EV/EBIT will yield 10% (1/10), 8x yield 12.5% (1/8) and 6x yield 16.7% (1/6) and so on.

Enterprise value = Market cap + minority interest + total debts - excess cash

EBIT is self explanatory. Net profit and add back any interest (if there are borrowings) and tax expenses.

The lower the EV/EBIT multiple means the lesser you are paying for the stock. The emphasis here is cheapness. Cheapness protects your downside and increases the upside. That’s why the lower the EV/EBIT, the higher the earning yield is. Earning yield is also one of the key measurement in Magic Formula.

In a broad context, any stock that is selling less than 8x EV/EBIT (EY 12.5%) is definitely worth a look at. Deep value stocks normally trade at 5x or less.

Applying these 3 valuations

Let’s use CBIP as an example and see what we get using these methods.

Method 1

Book value*ROE - CBIP book value is $1.27. Past 5 years ROE has a big range from 9.42% to 55.40%. You will need to exercise plenty of judgement here. We will use a 15% ROE as I consider manufacturing industry average ROE is between 10-20%.

So we have $1.27 x 1.5x = RM1.9

Method 2

Free cash flow - CBIP past 3 years average FCF is 99 mil. Depreciation of around 7-8 mil per year, so we have FCF of 91 mil. Using enterprise value of 1.09 bil, CBIP is selling at 12x of FCF. If we going to buy it at 8x, that will be:

91 mil x 8 = 728 mil or RM1.38

Method 3

EV/EBIT - Current EV/EBIT is 7.84x or earning yield of 12.75%, very close to 8x EV/EBIT. If you use average 3 years of EBIT(120 mil) then it will be 9x EV/EBIT. If you are conservative and use 3 years average :

EBIT of 120 mil x 8 = 960 mil or RM1.83

Looking at these 3 valuations you arrive at 3 value of $1.90, $1.38 and $1.83. So a range from $1.38 - $1.90 or $724-997 mil, against current price of $2.30 or $1.09 bil. The range is a big gap but you have a rough idea or anchor to start with if you are interested to look deeper and make adjustment from there. Does that mean you will lose money if you buy at current price of $2.27? Absolutely not. It only means CBIP is not selling at mouth-watering valuation.

Conclusion

These quick valuation exercise is not a final exercise for you to make a buy & sell decision. If these valuation is all there is for investing, mathematicians and computer scientist will be billionaires.

Rather it allows you to quickly answer “Should I look deeper into this stock?” or “Is the current price screaming a large mispricing by the market?”. These methods have their own flaw but it is far more robust than other screening tools such as P/E ratio.

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