How do I value a stock?

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There are 3 different methods of doing a stock valuation.

  • Simple Price / Earning (PE) Ratio & PEG
  • Discounted Cash Flow (DCF)
  • Discounted Earning Per Share (EPS)

Simple PE Ratio & PEG
As a general guideline, a company is at its fair value if the PE is about 15. If the PE ratio less than 15, it is considered under value, and vice versa. I also do a quick comparison of current PE versus the average PE historically. I will pay special attention to the stock price movement if the current PE is more higher than the historical PE average.

PEG refers PE ratio divided by company growth rate. PEG = 1 means that PE growth rate is the same as the company growth rate (measured by either EPS growth rate or net operating cash flow growth rate)

If PEG < 1, the stock price is under value.
If PEG > 1, the stock price is over value.
If PEG = 1, the stock price is at its fair value.

Discounted Cash Flow Model (DCF)
This model is to estimate the company next 10 years net operating cash flow (Future Value, FV) and re-calculate to the Present Value (PV), and add all ten years PV together. The intrinsic value can be calculated after dividing the total number of shares,. The assumption made is the company must be able to generate cash growth consistently with a CAGR (Compounded Annual Growth Rate) which computed from the past history of net operating cash flow.

Net Operating Cash Flow information can be found from the company annual reports, under the Cash Flow Statement.

Discounted Earning Per Share Model (EPS)
Similar to the DCF model, but this time Earning Per Share is being looked into. EPS information can be found at the Income Statement by getting the Net Earning number and divided by the total number of shares. By looking at the historical EPS, a CAGR for EPS growth can be calculated.

By bringing all the 10 years FV of EPS to PV, adding them together give an intrinsic value of the stock.

Valuation of a stocks need some financial background and need some practice. Two key areas to pay attention to:
(1) Where to find the information? All the financial statement can be found from the annual reports by going to the company web site. Another way is to get the summarised information from the website like Shareinvestor (for Singapore Stocks), Morningstar & MSN Money (for US Stocks)
(2) Understand the Financial Fundamental & Definitions like Present Value, Future Value, Discount Rate, CAGR and also practise how to use them. I use the financial calculator to calculate the CAGR and instrinsic value calculator to calculate the intrinsic value of the stocks. I got those simple software (formula in excel form) from my investment course.

I found that DCF model is a better model although it is a little more complicated because Cash Flow is not easily manipulated by the company accountant and cash is always easily be audited. If the company business model is solid, the net operating cash flow grows consistently every year. On the other hand, good EPS numbers do not mean the company is increasing the sales revenue and gaining competitive advantage to expand the market share. EPS can be manipulated easily as the company accountant can add whatever provision they want, using different amortization or depreciation method or using different revenue recognition method. Furthermore, the company can make the EPS more attractive by buying back shares, doing all sorts of cost cutting internally (like selling company fixed assets) to make the number looks nice.

After the intrinsic value is calculated, I compare the current stock price with the intrinsic value. If the current stock price is at least 20% discount to the intrinsic value, I will put the stocks in my watchlist and wait for the right time to buy. I will share in the next post on how I time my entry. 

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Selection Criteria Checklist (Financial Perspective)

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GROWTH

  • Sales Revenue YOY Growth > 10%
  • Net Profit Margin YOY Growth > 10%
  • Cash Flow > 10%
  • Operating Cash Flow is growing YOY

FINANCIAL HEALTH

  • Net Profit Margin > 10%
  • Low debts or Net cash
  • Long Term Debt < 3 x Net Profit
  • Current Ratio > 1

OPERATING EFFICIENCY

  • ROA > 10%
  • ROE > 15%

# YOY = Year Over Year
# The company has to meet the criteria consistently YOY
# Please check the link on the right under Education & Tools for financial ratio explanation & definition

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How do I select a stock?

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I analyse stocks in two perspectives:
(A) Business Perspective 
(B) Financial Perspective

(A) Business Perspective

1. What business the company is doing?
I will not buy the stock if I don’t like their business, regardless how good the rating given by the analysts or how frequent the recommendation from my friends. I will never analyse the company in detail or pay attention to the related news if I don’t have any interest in the business or the industry the company in.

2. Does the company has certain core competency and sustainable competitive advantage to have a wide economic moat?
I don’t invest in those companies which business model is to compete in cost and without any product differentiation. These kinds of companies face fierce competition in the industry with low entry barriers and very unlikely to be sustainable in the long run. So, why bother to waste time to analyse and monitor these companies whether they will survive eventually? Furthermore, these companies are very unlikely to have consistent and nice profit margin year over year. Some examples are EMS companies (Electronics Manufacturing Services), low end plastic injection company.
 Companies with niche technology or solution (e.g. Intel – every computer need microprocessor, Microsoft – every computer needs operating system), reputable global brand name (e.g. SIA – airline), niche environmental solution provider (e.g. Hyflux – water treatment), monopoly business (e.g. SPH – media, SGX – Stock Exchange), companies that backed by Temasek Holding (e.g. Chartered Semiconductor), companies that forms the pillar of Singapore’s economy (Banks & Finance, Property), are the stocks under my monitoring portfolio.

(B) Financial Perspective
1. Does the company have consistent growth in Sales Revenue, Net Income & Cash Flow?
I read the company financial statement to check whether the company has minimum 10% annual growth in Sales revenue, net income and cash flow. I also check whether the company has minimum 10% net profit margin year over year as this number give me a rough idea whether the company has certain competitive advantage in their business. Operating Cash Flow is also another key thing to check because I want to make sure the company is generating positive cash flow from their operation due to business expansion year over year. Although some companies are making money in certain years but not necessary they are making money from their core business. Creative Technology is losing its competitive advantage and its business has shrunk significantly. However Creative Technology still reported profit a few quarters ago but when I deep dived to analyze Creative P&L Statement & Cash Flow statement, I found out that Creative Technology made profit by selling its headquarter building & won $100M patent lawsuit from Apple MP3. I have to watch out for any abnormality in one time profit reporting or  one time write off as this will distort the financial statement and mislead me in the analysis.

2. Does the company have lots of debt or lots of cash? Does the company liquid enough to pay off its short term liabilities obligation?
I look for the company with low debts or have lots of cash, Current Ratio (Current Asset / Current Liabilities) > 1, Long Term Debt < 3 x Net Income.

3. How efficient is the company?
I use ROA & ROE to judge the efficiency of the company.
ROA (Return On Asset) measures how the company uses its asset to generate profit.
ROE (Return on Equity) measures how the company uses the money from shareholder to generate profit.
My criteria for ROA is > 10% and ROE > 15%.

Besides analysing the stocks from Business & Financial Perspectives, I also pay attention to whether any insiders (Chairman, CEO, COO, CFO, Board of Directors) are buying or selling the stocks. Insiders know the company inside out as they are managing the company daily. They have the most updated company information, financial status and future business plan compare to other peoples. I have to be very cautious if the insiders start selling the stocks in a massive way although the stock is still meeting all the criteria. It is better to avoid the stock than buying blindly base on the selection criteria.

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