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Posts Tagged ‘Benjamin Graham’

The entire idea of valuing companies using a discounted cash flow method is based on the premise that the value of a company is the value of its future cash flows, discounted by an appropriate rate to the present.

Now, DCF models provide a very elegant solution to the valuation problem. Simply plug in your implied growth rate, your starting cash flow and tadah! You have the intrinsic value of a company.

However, what most people do not realise is that DCF faces several challenges that can potentially overvalue or undervalue a company.

The first challenge is that DCF is extremely imprecise. Put in garbage and you get garbage valuation. Its notoriously hard to predict whats going to happen the next year, much less 20 years into the future. I would be very suspicious of anyone claiming to be able to do so!

Secondly, if you look at a discounted cash flow model, it only shows results getting better year after year (entirely ridiculous!). There is never a down year. Furthermore, high growth rates are impossilbe to maintain over time due to the law of big numbers. For example, its a mathemtical impossilibty that Apple can keep growing at its current growth rate in the long run so it would be suicidal to use a DCF model here.

Finally, there is the problem of choosing an appropriate discount rate. Academics have debated it to the death and still no firm consensus has been ironed out. I have even seen people deriving a discount rate from beta (which I consider to be a ridiculous concept..) which makes no sense whatsoever to me.

That being said, I still feel that Discounted Cash Flows are still the best method in many situations to evaluate companies. It’s really a situation whereby there are a lack of better tools avaliable to do the job. In other to deal with the flaws of the DCF Model, I normally try to do the following:

1) DCF Valuation should be the last step of your entire evaluation process.
2) Look for a company with relatively stable free cash flow throughout a long number of years.
3) Be extremely conservative in your growth rates. If it looks to good to be true, it probably is. As a rule of thumb, companies that post growth rates exceeding 15% rarely meet expecations.
4) Look at the relative valuations like P/E to see if your valuation makes any sense.

The above discussion highlights why Margin of Safety is the most important aspect of investing. Valuation is really more art than science. Benjamin Graham once valued a company to be worth between $15 – 40 – reflecting how imprecise he knew it to be.

Always demand a Margin of Safety no matter what kind of valuation tool you use.

Conclusion:

In the end, DCF is only one of the methods to go about valuing a company. My advise would be to look at different valuation methods to see where yours stands before making an investment decision.

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Hi guys, sorry for the lack of updates.

I been busy with my other projects. I will be updating my site more regularly over the coming weeks so keep a look out! I will be hoping to cover the valuation of more Singapore companies (if you have any requests do let me know) that I find attractive.

I plan to do fundamental analysis on Challenger Technologies next.

Interestingly, something that has struck my attention is the valuation of quality companies in the US. By quality, I am talking about the great brands like Johnson & Johnson, Intel, Microsoft etc. They are selling at extremely attractive valuations. I will be covering more on this in my subsequent posts.

I will also be posting a “guide” on how to open an account with optionsXpress and with my experiences with it so far (its been a positive experience up till now).

Finally, I have been working on a new website dedicated to Warren Buffett. I also posted a fundamental analysis report of his recent acquisition of Lubrizol Corporation.

Do check it out at  http://www.buffett-investing.com/warren-buffett-lubrizol.html

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“In business, I look for economic castles protected by unbreachable ‘moats’.” – Warren Buffett

The best kinds of businesses that I love are the ones with strong economic moats. They are often characterized by supernormal profits and high returns on capital. In this post, I characterize the different economic moats that exist.

Companies with profitable margins are often eroded over time. The bubble tea craze a few year back is a textbook case. Initial start-ups were immensely profitable and its novelty soon became a craze. Competitors soon entered the market and before long, the once profitable industry became over-saturated and profits plummeted.The bubble tea industry is one in which firms possess virtually no economic moat at all. Coupled with the fact that entering the industry was relatively low, pioneers of bubble tea were soon unable to maintain past profit margins.

Industry Without an Economic Moat

You will often find firms with economic moats to be extremely profitable in the long run – provided that their competitive advantage is maintained.

Type of Moat Examples
Intangible Assets Tiffanys & Company, Nike, Coke
Customer Switching Costs Adobe. Microsoft
Network Effect Microsoft, Visa, eBay
Cost Advantages Dell

 

Intangible Assets – Brands, patent and regulatory licences. Patents of drugs drives profits from pharmaceutical companies – one reason why they are so highly guarded. Strong brand names such as Nike or Tiffanys & Co. allow companies to charge much higher premiums as compared to their competitors. If consumers are willing to pay a premium for a brand name – you have evidence of a moat.

Customer Switching Costs – Adobe has come to become the gold standard for image editing software.  Most designing firms run using its propriety software not because it’ cheap but because were trained using Adobe Photoshop. Switching to cheaper software doesn’t make sense as any savings made will most likely be offset by the loss of productivity (not to mention the risk involved).

Network Effect- Credit card companies are a prime example of this economic moat. You’ll find that shops readily accept cards like AMEX or VISA. Competitors who try to enter the market will be hard pressed to competing against well established networks.

Cost Advantages – Dell, famous for their optimizing and reducing cost in the process flow has done exceedingly well compared to its competitors. By cutting out the middle-man and selling directly to consumers, they have a comparative advantage against well established players like HP.

This list is by no means exhaustive but merely acts as a good reference point.

I recommend reading “The Five Rules for Successful Stock Investing” as a great primer for learning more about economic moats in different industries.  I also recommend “The Little Book That Builds Wealth” as a secondary reading.

I will be covering economic moats of locally listed companies in my next post. Look out for it!

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As part of a series of introductory posts, I decided that making clear my investment philosophy would best serve my readers (or lack of).  Drawing inspiration of Benjamin Graham and David Dodd, I follow a value based approach to investing. I have summarized the key tenets of my philosophy as:

Safety of Capital

“Rule No.1: Never Lose Money

Rule No.2: Never Forget Rule No. 1”

- Warren Buffett

Preservation of capital is of paramount importance to me. I am extremely rise adverse, and choose to invest only after making a substantial time and effort to run through my investment thoroughly.

Margin of Safety

Suppose you were an engineer building a bridge. You estimated that 150 tons of vehicles passed through its roads at any given time. How much weight would you design the bridge to withstand? 150 tons? I doubt it. 200 tons? Now we are getting somewhere. How about 400 tons just to be safe.  That’s more like it.

The additional weight is the margin of safety (MOS) that engineers give themselves in case their calculations turn out to be wrong. Similarly, the same applies to investments. Suppose you calculated that the intrinsic value of a company was $0.30 a share. How much would you pay for it? The buffer that exists between the Intrinsic Value and the actual price paid is the Margin of Safety. I will provide a more in-depth discussion on this in subsequent posts.

Take Time To Mark Out Your Circle of Competence

Circle of Competence

Understanding what you know and what you don’t is essential in getting your investments right.  Never buy into anything that you can’t understand, no matter how appealing or attractive it looks.  Despite my extensive effort, I have yet to figure out how to analyze financial companies like UOB or DBS; hence I have never considered investing in them. We all have our specific areas of expertise. Getting our circle of competence right will play great dividends in future investments.

Mr. Market

Mr. Market suffers from wild mood swings; he might be on a manic high one day and depressed the next. The most important thing to realize is that you are free to ignore him if you chose to do so. Treat him as your friend if need be, but always realize that he’s serving you and not the other way round.

In short, exploit the tendencies of the market to swing from extreme high to record low. The market is just like a pendulum swing from one side to the other. Accepting it as part of the business cycle will give you conviction when others forecast only doom and gloom.

PE Ratio of the S & P 500. Don't be a slave to the market - Exploit it to your advantage.

Do note that this list is not exhaustive. I do hope that it’s a useful guide to get you started.

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Merry Christmas everybody!

Over the coming months, I will be posting up articles about Value Investing in Singapore. Among the topics covered are:

  • Core Concepts of Value Investing
  • Reviews of Value Investing Resources
  • Detailed Analysis of Companies in Singapore
  • And more to come!

I draw a great deal of inspiration from the Value Investing legends: Benjamin Graham, Graham Dodd, Warren Buffett, Pat Dorsey and more. Full credit goes to them for paving the way for us. As Issac Newton once said – “If I have seen further it is only by standing on the shoulders of giants.”  To those that are willing the effort, the rewards are great. I still remember reading my copy of “The Intelligent Investor” as if it was yesterday.  Even though the book was first published in 1949, I still recommend it to those who are unacquainted with the subject. The simple truths that it espouses remain stunningly relevant even today.

Warren Buffett - Value Investing Legend

To those who are doubtful or cynical (and I don’t blame you), I implore you to explore the subject with an open eye. I have enclosed a link below, an article from a benefactor of Value Investing – Warren Buffett; I hope it will lend some credence to the subject if I have failed to persuade you of its merits.

The Superinvestors of Graham and Doddsvilles

This journey ahead is both intellectually fulfilling and emotionally rewarding. I wish you the best of luck and hope that you will enjoy it as much as I have!

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