Monday, September 08, 2008

Understanding stock valuation 5 comments



(P.S: Sorry for any disturbances the advertisements above may have caused you)
To me, understanding valuation, or why the stock is priced the way it is over an extended period, is one of the, if not THE, key risk management method for the stock investor/trader. This is as opposed to the approach of many traders who use technical analysis, momentum trading, cut-loss etc. Indeed, if I may generalise, the upside gains from an investment comes from astute understanding of business dynamics and growth potential, but management of downside risk comes from understanding of the valuation.

There are several issues on valuation that I'll discuss here. First of all, understanding what type of valuation technique drives the price of a stock is winning half the battle. The favourite technique is PE (price earnings) but I am incredulous when people quote PE for companies which should more accurately be valued by their balance sheet assets eg. property stocks. PE is more relevant for companies which enjoy steady and sustainable growth in their core earnings because it is predicated on projecting a certain level of earnings growth into the future, and hence it's imperative that these earnings are predictable. Indeed, it's worth noting that often the best time to buy cyclical companies is when their PEs are high or even negative, because it will be at the bottom of the business cycle when this happens (ie. the market-timer can catch it at its bottom).

It's also interesting to observe how valuation technique can change at different points in the market cycle. In an up market, PE is often used because earnings are seen to be on a steady growth trend in the foreseeable future. The more cynical individual might also postulate, with some truth, that PE valuation offers a lot of latitude for the market analyst who wants to push a stock to derive a very high target price, through surreptitious methods like using high PE ratios (can anyone honestly explain why a stock should be worth 15X instead of 20X PE?) or using earnings 2 or 3 years later as the basis for the PE calculation. When the market turns, like now, suddenly analysts base target price at NTA (net tangible assets). It's worth guarding mentally against such skulduggery.

An associated issue is the elasticity in price valuation that each valuation technique produces. There is great amount of discretion that has to be exercised with respect to the PE ratio used, whether it should be 5X, 10X, 20X. Hence this method often can be dangerous in the event of a PE compression when liquidity is tight or sentiment weakens, simply because price targets can decline by multiples without earnings even changing. Valuation on the basis of NTA might produce a more solid base, because balance sheet assets don't just melt away; the analyst might decide, however, at different times to assign 0%, 10%, or 30% discount to NTA, or even premiums to NTA, when calculating fair value, depending on his or Mr Market's "mood". That is why one should perhaps buy both asset plays (valuation based on NTA) and growth plays (valuation based on PE) if he wishes to control the degree of price voilatility in his portfolio.

The last issue is to do with assessing the components of valuation. This could best be illustrated with the example of a conglomerate. For example, consider Keppel Corporation. Conglomerates' values are calculated on a SOTP (sum-of-the-parts) basis, where the value of various divisions are summed up. According to a recent GKGoh report on Keppel, I can observe that its offshore division constitutes >50% of the SOTP total value, its property division and Keppel T&T constitute >10% each, with its infrastructure division and SPC stake making up the balance. This provides a general reference for where the main price driver of Keppel lies, whether or not the target price eventually derived overshoots or not. Hence the valuation of Keppel will be most affected by changes in the offshore segment --- this is the one to watch if one is holding the stock.

This approach can be extrapolated to most companies as well to assess what drives their valuation. For example, my Hotstocksnot assessment of Lian Beng in October last year concluded that a large part of its valuation derived from its property developments with its construction segment forming the minority, and this formed the basis for my hotstocksnot conclusion because I felt then that property prices might have peaked which meant Lian Beng's heavy exposure in this segment would render it a substantial victim of a property downturn. Although Lian Beng had hitherto been known as a construction player, an in-depth assessment of its stock valuation would have rendered useful insights and prevented a disastrous entry into the stock.

That is why I consider valuation knowledge probably the most important aspect of an investor's toolkit. At the same time, it is important to recognise and keep in mind the fluid and dynamic nature of valuation approaches, so that one constantly evaluates the market and its interaction with the mainstream valuation approach.

 

 

5 Comments:

Anonymous Anonymous said...

Good article lah.
But rather general. Maybe need more specifics by case studies.
Me too tired by market to comment more.
So busy trying to get it right no energy to write on anything.

9/21/2008 1:10 AM  
Blogger DanielXX said...

alamak so many examples & illustrations in the article still not happy???

9/21/2008 9:14 AM  
Anonymous Penny Stock Newsletter said...

This is a area that so many investors lack knowledge. Many investor chase a few high flying stocks but pay almost no attention to so many of the great unknow value stocks.

11/24/2012 8:38 PM  
Anonymous QUALITY STOCKS UNDER FOUR DOLLARS said...

Value investing is about buying a stock worth 20 dollars for less than ten.

1/03/2013 1:22 PM  
Blogger Lovisa Ellison said...

Great blog. In the present economic climate, many people are searching for ways to boost their income. Penny stocks are a popular investment vehicle. They are company shares, which trade for under one dollar . In certain countries, penny stocks are referred to as cent stocks. But are penny stocks worth it? Click this link and get all your answers about this.

visit our site

12/23/2013 4:12 AM  

Post a Comment

<< Home