Most Basic and Conservative (probably) Way of Valuing a Company

This may contain many pictures for discussion purposes. Simple math knowledge is needed.

If you have read this before scroll down to the last part and read through the ADDENDUM for updates made on 9/19/2015.

Start

Seeking the value of a company may be a struggle depending on the person looking for it. It can be some form of trying to solve a maze or a math problem too-elementary math that is.

One may rely on drawings (technical analysis) and put most, if not, all his savings in that drawing; others may decide for themselves and learn more about the company their interested in. If not satisfied with the company of interest, then you’d learn to move on.

Anyhow, so much for lecturing.

Seth Klarman (The Baupost Group, a $6 Billion hedge fund-world’s 11th largest) once said, “Since investors cannot predict when values will rise or fall; valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.”

I assumed (after studying and applying most technical drawings etc. for years) that NO ONE can predict the market price tomorrow, the following two days, the following month, etc. Only upon through mergers and acquisitions (M&A) that a specific market price may reflect and catch the spread (difference between the offer price and market price) depending on the date of execution (this may be another worthy article) and other contributory aspects of the deal, unless the deal itself fell through the cracks.

Anyhow, never mind all that.

If you can predict and can prove to anyone that you had been consistently able to predict the market price of any company, bond, gold price, etc. in any given point of time requested, then STOP READING this article. Maybe you can set up your own hedge fund and get the smart money to invest with you.

There are plenty of ways in seeking the valuation of a company.

Terms are also interchangeable: fair value, intrinsic value, discounted cash flow value, (author’s name) value, Graham’s number, and the list goes on. For simplicity, we will use valuation/value in this article/blog.

What we’ll use is the price to earnings (PE) way of valuing a company.

I’m sharing this as this is what I use most of the time, there may be tweaking here and there when I use it, but generally this is the most basic and conservative (probably) of all the methods I have encountered so far.

What do we need to get this value of the company?

  1. The company’s current market price (MP)
  2. The company’s earnings per share (EPS)
  3. An assumed number (we’ll discuss this later).

First, MP.

In the Philippines, a person can easily find the PE ratio in the website (http://pse.com.ph/stockMarket/home.html) or from Bloomberg website.

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Type in the company’s name then search (For simplicity, we’ll just use the first company listed in the All shares index and that is the 2GO Group (2GO).

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Now, you get the MP from the Last Trade Price. Interestingly PSE already provided its PE ratio at 25.

On our checklist,

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There are two ways in finding the EPS of a company. One is the easy way (calculator), the other one is looking it up from company filings.

First the ‘hard’ way, go to (http://edge.pse.com.ph/)

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Look for the company’s filings.

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You can then easily browse through the company’s description to get a better understanding of its operation.

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Next, go to Financial reports. Yes, you are now an ‘expert’ =)

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Now, you are finally able to get the company’s EPS for this year’s and previous’.

That had a lot of mouse clicks in it, right?

Other (easier) way to figure it out is pulling up your computer’s calculator and simply solve for EPS from the already given values of PE and MP.

This is the Formula:

Price over earnings equals PE.

Ergo, with given

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This is the formula to solve for the EPS.

8.5 divided by EPS equals 25.

Simple transposition (or whichever term the elementary math teacher’s use). Solving for X (EPS), results into the following:

8.5 divided by 25 equals EPS.

So, EPS is 0.34.

Scroll up, it’s almost the same with company’s report-just differs with 0.01 cent. I wouldn’t care for such a small discrepancy, would you?

Now we have,

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There’s no stopping you figuring out what’s the most simple/conservative way of figuring out a company’s value once you have the EPS number. Because the only thing left that we need to figure out is the ASSIGNED NUMBER. This is usually called the Multiple.

You’d hear this often in Bloomberg or CNBC or whichever you tune in to to get your daily news. Pundits would state, “the current price of Netflix is trading at 220 multiples of its earnings.”

This just means that, if you multiplied (hence multiple) 220 to Netflix’s EPS, you’d get its current price. Let’s sidetrack for a little bit and apply the elementary math on Netflix. (http://www.bloomberg.com/quote/NFLX:US)

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Solving:

Price divided by EPS equals PE

Price divided by 0.44 equals 220.

So, when solving for Price, we should (transpose) 0.44 and multiply it with 220.

Price equals 0.44 x 220.

Price = $96.8 per share

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Almost the same, right?

Now,

What is the assigned number/multiple??

YOU’RE THE ONE WHO WOULD GIVE THAT NUMBER.

YES, you decide what MULTIPLE you’d give a company.  It can be 1, 2, 3, 4, 5, heck 220 for NETFLIX—which I say is just RIDICULOUS.

Personally, I use the numbers between 10 and 15.

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A reminder, if you have your OWN MULTIPLE, you will be able to figure out at what MP the company SHOULD be trading before you PRESS YOUR BUY BUTTON. Or at least, you have performed your research about the company and gave you a compelling conclusion that it is worthy of your investment.

Benjamin Graham (professor of Warren Buffett in business school) was not comfortable buying company/ies with multiples more than 15. Ergo, I personally set a range of 10 to 15.

Let’s do this in MS EXCEL (best tool an investor could have and it’s free-I think).

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Now, this states that the current price of 2GO 8.50 is OVERPRICED in the most conservative terms and speaking in multiples. If you average these market prices you’d get 4.25 Peso per share.

So, how much overvalued? 100% OVERVALUED.

Should you buy 2GO? It depends on you. If you think the company will grow its earnings, continues to run with excellent management, etc. (this would take another article). Then, maybe its market price would then catch up to its earnings (considering other aspects of its business runs well) *I have not assessed 2GO’s management etc. and just used it as an example in this article.

But as was stated in my previous article, “As of June 19, 2015, the forward-PE ratio of the top 30 companies of the Philippine composite is at 19.5. The Philippine composite is considered the third most expensive stock exchange in the world.” (https://perennialinvesting.wordpress.com/2015/09/07/maxs-or-jollibee-which-is-better/)

So, if we use the 19.5 multiple with 2GO’s earnings of just 0.34 cents we get a 6.63 peso/share market price. Giving a 28.21% premium or overvaluation to today’s market price of 8.50. Are you willing to pay that 28.21% premium just to have 2GO in your portfolio?

Remember, the 19.5 is the multiple (average) of the top 30 companies and currently 2GO is at 25 multiple (scroll up). My unsolicited advice is, at least if you would not want to be too much conservative with the 10 to 15 multiple, at least find a company that has less than the current market multiple a country has. That would be less than 19.5 for the Philippines and less than 19.76 for U.S (I used S&P 500’s current multiple, and not DJIA).

In some similar and hypothetical aspect, are you willing to pay 25.64 pesos for a 1.5 Liter Coke Bottle whereby you can find a 20 peso deal in another store (28.21% premium)?

Now,

What are your limitations for the numbers to be used as multiple? NONE. For fun, try NETFLIX’s multiple of 220.

220 times 0.34 equals 74.8 peso per share. Ha! This is exactly how NETFLIX is priced right now (220 times 0.44 earnings = $96.8/share), yet investors are buying in because of the ‘cord-cutting revolution’ that is taking place. According to Google, cord cutting is the practice of canceling or forgoing a cable television subscription or landline telephone connection in favor of an alternative Internet-based or wireless service.

Ergo, more business for NETFLIX, but is this company worth 220 times its earnings? YOU DECIDE.

Anyhow, main goal of this article was to give insights on how to conservatively value a company. I hope it made its point. If anyone would ask me at what value would I then be interested in buying NETFLIX (given it met my extensive checklist). It would be at $5.5 per share.

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Its current price of $97.51 a share is 1,672.91% over this 5.5 valuation that I have. That is why I am not touching its shares even with a 10-foot pole.

My dare for you:

Apply this simple math throughout your portfolio, see which company/ies you have overpaid and see who the undervalued ones are. Finally, you get the sense on how to value a company in the most conservative way (at least for me).

Maybe you can leave your comments here or make your own private list about your most overvalued and most undervalued company. Just for fun.

Disclosure: I do not have shares in any of the companies mentioned in this article and don’t plan to initiate purchase within the next 24 hours. I would not receive any compensation for doing this article. I am not a professional financial analyst. This is just a hobby. Lastly, my work is not error-free, but I strive for it to be. Do not consider as a buy or sell advice. Invest at your own risk.

If you are interested in this similar approach to investing and would seek updates, I wish to invite you to this Facebook group

SEEKING VALUE

(https://www.facebook.com/groups/SeekingValue/?ref=bookmarks)

A quote to go by to finish this article,

In this game, the market has to keep pitching, but you don’t have to swing. You can stand there with the bat on your shoulder for six months until you get a fat pitch.” Warren Buffett

Addendum:

(Addendum 1: sometimes you still cannot retrieve the current year’s EPS data secondary to different filing dates of the company; search in Google fiscal year for better info).

(Addendum 2: On the other hand, I prefer using the DILUTED earnings per share. According to Investopedia, Diluted Earnings Per Share (or Diluted EPS) is a performance metric used to gauge the quality of a company’s earnings per share (EPS) if all convertible securities were exercised. So being conservative, DILUTED is better to be used rather then BASIC EPS. Furthermore, EPS measures the amount of a company’s profit on a per share basis. Unlike diluted EPS, basic EPS does not take into account any dilutive effects that convertible securities have on its EPS.)

Happy investing.

Mark Y.

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