Find out the Value

Last week, I had a very engaging conversation with a colleague who was leaving the company in pursue of greater aspirations. We sat down for tea one last time as it was his last day at work. We spoke about almost everything under the sun – philosophy, investing, leading a contented life, entrepreneurship etc. Before we know it, we chatted for almost two hours and honestly it was one of the most valuable moment of my week.

Indeed, we derive value from many things in life, from helping someone with the groceries to finding a bargain in the shopping mall. Altruistic or egoistic, we are constantly seeking value in life which creates happiness. Therefore, it might seem that value is rather subjective.

The Importance of Valuation in Investing

However, this cannot be further from the truth in investing. Finding value in investment is all about the numbers. It is purely quantitative and nothing subjective about it. Any perceived subjectivity is often a result of creatively constructed financial accounts or blatantly misleading figures.

In the previous post, we shared about 4 financial numbers to judge the financial health of a company. With that sorted out, we move on to the valuation of a company’s stock. This step was deliberately left to the last because you should never consider investing in a bleak business or financially ill company. You should assess the company’s business and finances first before looking at the valuation. If the business or finances are ugly, don’t bother with the valuation even if the low prices may seem like a bargain. It could be a value trap.

Yet, if you are satisfied with the business and finances, you must look at the valuation before investing in it.

Value investing is all about investing when there are loads of fear and negativity in the stock market. Such pessimism will often provide bargain prices for value, which is the most crucial piece of value investing (yeah the name is kind of a giveaway right?). It doesn’t matter how great a company may be if it is overpriced. Any investment is a bad investment when you paid too much for it. Therefore, understanding valuation is the center-piece of every investment strategy out there. The stock market have taught us that the less you pay for it, the more likely you will earn from it.

The Valuation of Choice

If you have dabbled with investing, you would have heard of the ratio of Price to Earnings (P/E ratio). For some unknown reasons, this is the most referred-to ratio. However, from the previous post, we have explained why earnings alone can be subjected to manipulation, and mislead investors.

We will use an example to further illustrate the point.

Now, back to the story of two candy stalls, Sweetie and Toothache. In a similar scenario, let’s assume Sweetie bought a box of sugar for $10 and used up all to make candies. The candies were then sold for $100. This would mean $100 of sales, $10 of cost and result in $90 of earnings. In terms of cashflow, an actual cashflow of $90 too. Toothache, on the other hand, bought 4 boxes of sugar for $40 but only used 1 box of sugar to make candies. The candies were also sold for $100. In accounting terms, Toothache would have also made $100 of sales, $10 of cost (cost of the candies sold) and result in $90 of earnings. However, Toothache’s cashflow was only $70 because of the extra boxes of sugar bought.

This is a typical example of how earnings may be manipulated while cashflow is more likely to reflect the truth.

Therefore, in finding the valuation of a company’s stock, we very much prefer the ratio of Price to Operating Cashflow (P/OCF). Operating cashflow refers the cash generated from the business of a company, excluding the investment or financial activities.

What is the ideal ratio?

Well, the ideal answer is as low as possible. However, when you set the P/OCF ratio to 1, most companies will fall through the filter. Therefore, it is really a question of “How conservative are you?”. Personally, I have been using a P/OCF ratio of less than 10 as a benchmark, and it has generally produce a balance between a number of companies to choose from and a good return of investment. In another sense, the P/OCF ratio also means that the company will be able to generate enough cashflow to meet the current market prices in 10 years or less. In my opinion, that’s also a good measure because any higher, the company is taking too long to meet the market expectations.

Now of course, there are other valuation methods out there such as Discounted Cashflow, Discounted Earning, Price to Sales and Price to Net Asset, etc. You are welcome to try other methods too or combine them for potentially better results. Just remember the main tenet of value investing: “The less you pay, the more you may earn”, and you won’t be too far off from success.

This brings us to the final piece of the selecting value stock series. I hope you have enjoyed it as much as I have writing it. Let me know your comments below and I hope to provide more value next time!

See you soon!

Investing Always,

Pete

p.s. Mav, thank you for the friendship! I wish you all the best in your future endeavours and a wonderful investing journey ahead! Keep in contact, you know where to find me.

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