The Market Wrap 1-6-12

Down Down Prices are Down.

By Jason Fittler

Everyone loves a bargain except when dealing with shares in companies; most people want to sell when they are cheap.

The small retail investor needs to buy when everyone is selling, take a long-term view and know the intrinsic value of the company.

I suspect this has to do with understanding how to value them and the fact that you cannot touch a share like you can a car or big screen television.

Shares are just number on a screen or on a piece of paper in front of you. They have no texture, you cannot hold them in your hands. But the same goes for the money in your bank account.

So what is the difference? Perceived value!

You know what money is worth, it is written on it; we understand its value and worth… or do we? Money only has value because we give it value, it is system based on trust.

There is not $50 worth of materials in a $50 note, only an implied promise that someone will let you trade it for $50 worth of goods.

Shares however have real value which is backed by money in bank accounts, plant, equipment, stock and buildings. The problem is how you place a value on a company.

Let’s do a quick lesson, this will not answer all of your questions but it will get you on the right track.

Below are a couple of tools we use to value a company;

  1. Net asset value (NAV) is a term used to describe the value of an entity’s assets less the value of its liabilities. The term may also be used as a synonym for book value or the equity value of a business. Net asset value may represent the value of the total equity, or it may be divided by the number of shares outstanding held by investors and, thereby, represent the net asset value per share. 
  2. Discounted Cash Flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs) — the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question. Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives as output a price; the opposite process — taking cash flows and a price and inferring a discount rate, is called the yield. Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.
  3. P/E ratio (price-to-earnings ratio) of a stock is a measure of the price paid for a share relative to the annual Earnings per Share (EPS). The price-to-earnings ratio is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with a lower P/E ratio. The P/E ratio can be seen as being expressed in years, in the sense that it shows the number of years of earnings which would be required to pay back purchase price, ignoring inflation and time value of money. The P/E ratio also shows current investor demand for a company share. 

We use tools like this to value up a company, most broking houses relay heavily on the Discounted Cash Flow model. What this means is that when research houses look at the economic data coming through they change the expected cash flow of those companies if the cash flow is expected to fall this data is feed into the model giving a new value for the company and a sell down of the company shares is recommended.

The problem is the expected cash flow is at best an estimate; the discount figure is another estimate. Small variances can make a large difference to the end value.

As most main stream research houses employ this model there is a fundamental flaw in the valuation of companies. It is also very short-term focuses.

I prefer to look take a longer-term look and use value investing.

Value investing generally involves buying securities whose shares appear underpriced by some form of fundamental analysis.

As examples, such securities may be stock in public companies that trade at discounts to book value or tangible book value, have high dividend yields, have low price-to-earnings multiples or have low price-to-book ratios.

The essence of value investing is buying stocks at less than their intrinsic value. The intrinsic value is the discounted value of all future distributions. However, the future distributions and the appropriate discount rate can only be assumptions.

As such we never recommend using future numbers, only past ones.

This is the fundamental difference, by using the past figures and factoring in the same long term growth you are basing your valuation on what the company has done as opposed to what you think it might do.

It is generally safe to say that long-term a company will continue to perform as it has in the past.

Once we have this intrinsic value we can look to buy companies which are trading below this value for non- fundamental reason. This allows us to pick up bargains and buy companies when the market is falling.

A good way to look at it is Woolworths and Coles sell you your food, alcohol and fuel. Regardless of the economic crises in Europe you are still going shopping this week for food, you are still driving your car to work and most likely you may need that drink after watching the news.

Your habits will not change, sure you may spend less in the short-term and Woolworths and Coles may make a little less profit short-term. But long-term these companies should continue to perform as they have in the past and continue to make profits and pay dividends.

The small retail investor needs to buy when everyone is selling, take a long-term view and know the intrinsic value of the company.

For more information on any of the above please contact us on 07 4771 4577.