Pay a price, get the value
by Ang Kok Heng
WARREN Buffett once said "Price is what you pay and value is what you get." Price is what it costs an investor to purchase a stock. Value is the subjective number that an investor assigns to the stock. Price is visible Different valuation Relative valuation method, however, does not provide an indication to the absolute value of a stock and hence could distract the opinion of long-term investors. Value - sum of future cash flow Then, there is the discount factor R, to be used to calculate the net present value of the future earnings. R is also the expected return of an investor. Although in a lower interest rate environment like now, R should be lower. But, due to the uncertain market environment, risk premium is higher and investors are risk adverse resulting the need for higher returns to compensate the courage to foray into the markets. As a result, the expected return, R, of most investors is very high now. Back to our equation, if we know the average growth, G, of a company's earnings, we can re-arrange the formula of a stock's value as in Formula 1. Price falls more than value In a bear market, when fundamentals deteriorate, the intrinsic value of a stock will also fall. But over a longer term, the basic components that make up the intrinsic value of a quality company will not change much. We have seen how most of the blue chips survived the Asian financial crisis and also continued to grow. Some have grown several times bigger. Main value is management When we invest in a company, we are actually investing in the management who has been entrusted the stewardship to take care of shareholders' interest. They will sail the company through the stormy financial weather. They will take appropriate actions and pertinent strategies to overcome the economic slowdown. Price affects value too A cash call to reduce borrowing will be difficult or almost impossible if the share price falls below the par value. During times of a financial crisis, banks are likely to be more stringent in lending or otherwise borrowing cost will be much higher. Without the new source of financing, some companies may have to sell off valuable assets to pay off the debts and that affects the intrinsic values of the companies permanently. Even a cash call now will dilute the earnings of company due to issuance of larger number of shares at low price. For majority of quality companies, the slowdown of the economy will affect earnings over the next two years and the management will take this as a challenge. Tackling the economic cycles is part of the duties of the management. As long as the management can weather through this difficult period, business will most likely be back to normal after the financial crisis. Most well-managed companies in Asia will be faced with the economic deceleration but they will ride through the storm. Value investing This type of forward looking investment philosophy is well understood by investment gurus like Benjamin Graham and Warren Buffett who always wait for such opportunity to grab "outstanding company at a sensible price rather than generic companies at a bargain price". Margin of safety In a bear market there are many investors who sell due to panic and there are also many who are forced to sell due to margin calls (banks and brokers sell the collaterised shares after the marked-to-market value of the shares fall below a threshold level). Some funds sell to meet redemption by their investors. Unfortunately, the disposals by a handful of investors caused the price to tank and affected the perceived market value of a company. The fear scattered during the current financial crisis deters even those who may have the capacity to buy from entering the market in a bold way. Buy fallen quality stocks Investment must be on quality stocks especially those that have fallen in line or more than the market. Quality stocks which did not fall are definitely not a good choice at this point in time. In fact, investors may want to sell these stocks and switch to other similar stocks which have fallen. Ang has 20 years' experience in research and investment. He is currently the chief investment officer of Phillip Capital Management Sdn Bhd.
Price is visible as it is the transacted value at a point in time. Closing price is the most common figure quoted to denote the transacted price for the day. Few people will use medium price, mode price or volume-weighted average price (vwap). Since closing price is the traded price at the end of day, volume-weighted average price should be more reflective of the total transaction for the whole day. For simplicity, most people use day-end price to approximate the average price for the day. 
Value of a stock is more abstract for it is a subjective figure in the mind of each investor, be it an analyst, fund manager, owner, banker or an ordinary investor who participates in the pricing process directly or indirectly. Every stock has a value which may be unknown to most investors who provide different guesses to the actual value. Due to the different background of investors, each of them will attach a different value to a stock. Furthermore, the value of a stock may also vary depending on the objective of an investor (capital gain or dividend income), the time horizon of investment (short-term or long-term) and the expected return. It also depends on the risk profile of the investors.
Different stocks can be or should be valued differently. An asset-based stock can be valued according to the tangible value of its assets such as cash and properties. Under normal circumstances, these assets can be liquidated and disposed off in the market easily. However, under the prevailing conditions where borrowings from banks are difficult and buyers are more cautious to invest, assets may not be able to fetch the right market value. Under such circumstances, it may be appropriate to give some discounts to the assets which are more difficult to sell. This is especially true for some companies where one or two of the term loans are due and refinancing may be difficult at that point in time. 
DCF method of valuation equates the present value of future cash flow to the present price paid. The method requires projection of future cash flows which could be a daunting task in view of business uncertainties now. Only a handful of companies have a more predictable cash flow. They are those in utilities business especially those with concession where demands are steady and costs of operation are stable. Majority of companies do not have the luxury of having a steady demand and constant cost. With the prevailing uncertain global outlook, profit forecasts become a challenge and the further one tries to predict, the less accurate it will be. 
At any point in time, the price of a stock could be lower or higher than the intrinsic or fundamental value of the stock. Under normal circumstances and when the market is efficiently priced, most of the stocks will be traded around the intrinsic value. For whatever reasons, there may be some overvalued stocks and some undervalued stocks at any one time. The role of market participants is to arbitrage by buying the undervalued and selling the overvalued stocks such that stock prices reflect the true fundamental value.
The main value of a company is the management. As long as it is still the same management running the well-proven company, much of the value of the company is likely to be intact. As an on-going concern, a company has a goodwill which encompasses its brand name, business reputation among customers, financials and creditors, established network of customers, a range of products or services which have been accepted by the market and etc. A proven management will have the ability to manage the business costs, the skills to identify capable employees, the aptitude to produce the right products for the right market, the acumen to determine the market trends and etc. Some of them may even take advantage of the present financial tremor to increase market share or acquire distressed competitors or other companies that are complementary to the existing business.
Unfortunately, for certain companies the collapse of their share price does affect the values of their companies. This is especially true for highly geared companies. The fall in share price may have several implications on a company. When stock price falls excessively for whatever reason, confidence among bankers, fund managers and suppliers will drop. Sometimes force-selling on the owner's stock may also generate unwarranted anxiety among other stakeholders. Even if the company is still operating well, the sharp fall in price will cast some doubts over the sustainability of the company, as the adage goes "there is no smoke without a fire."
As such, the reduction in earnings of a quality company during an economic downturn is only temporary. It may have one or two years of earnings setback, but that will not have much impact on the future cash flow and likewise with the intrinsic value. So long as consumers still consume and there is still demand for the company's goods and services, business will be back to normal after the financial crisis.
By buying stocks at a big discount from the intrinsic value, Buffett is having good margin of safety, a concept which he postulates in value investing. By margin of safety, he means that downside risk is low. So long as he is not buying at the bottom, he may still suffer some losses along the way. But buying a stock at a big discount is probably a one-time chance in a decade. Without the financial crisis, a quality stock will not fall that much.
Obviously in an economic slump, stock prices fall. Some suffered more losses, while some held up quite well. Poorer-grade stocks which most likely have fallen more are only good for trading but now is not the time. Those who buy for a short-term capital gain are only hoping to catch a technical rebound.
theedgedaily
No comments:
Post a Comment