'The Price is Right' is the next in a series of articles on the basics of evaluating company shares.
Previous articles in the series included:
1. Director Dealings
2. Supply and Demand
4. The Trend is Your Friend
5. Annual Events That Influence Markets
This article delves into several ways that Warren Buffett uses to value shares and how to gauge when: "the price is right". I will cover, not for the first time:
Pay attention: I do not repeat a lot of these ratios for fun. They are the very basics that Warren Buffett uses in his calcs, except he knows them inside out and back to front - so should you.
If I were to define the two types of people who place their hard-earned into the market place, then I would badge them as: investors and speculators.
Some people like to call themselves "traders" but for me, that's just another fancy word for speculator. Some might even call it "gambling."
By my definition: true investors are those that are in the markets for the long haul. Maybe months, or even years. Warren Buffett likes to call the type of share he buys: "forever" stocks. He has known to be in the same stock for 30 years and more.
Speculators, on the other hand, are in the market for the short term - sometimes only minutes, perhaps for the day, or for just for a few weeks - but certainly not long term.
Speculators are always looking for the "ten bagger." Where a share price increases ten-fold in the shortest possible time. It happens. But it's rare.
In my opinion, and indeed in my experience, it rarely happens. Most specultors lose money. Of course, there are "professional traders" who spend an enormous amount of time in front of their screens. They can make money. But at what cost?
Their philosopy of "winning" is being right more times than they are worng.
Contrast all that with the Warren Buffett philoposhy.
Here is a man who has dedicated his life to investing. Even as a kid he used to play around with figures and set up money-making ventures. A true entrepreneur.
But from an early age he decided what he wanted and knew how to get it. Fast forward 70 years or so and he has amassed a fortune of over $90 Billion - and still rising.
Can anyone argue with that?
This website is all about investing for your retirement.
Should it therefore be for "investors" like Warren Buffett? Or for speculators like Jesse Livermore or W.D. Gann (past market speculators).
I won't even wait for an answer on that one.
Investors may categorise themselves in to four groups, but our hero Warren Buffett, would choose but one of these groups.
For completeness, here are the four groups:
The Economic Cycle and Business Cycle are very similar (see Stock Market cycle).
Different sectors will do well in the early part of the cycle (recovery) - such as Consumer Goods and Services, Leisure Goods, Household Goods, Travel and Leisure, Media, Life Insurance, General Retailers, and Autoobile and Parts.
During the Growth phase the Sectors that might do well are: Aerospace and Defence, Industrial Transport, Oil Equipment and Services, Mining, Oil and Gas Producers, Technology Hardware, Software and Computer Services, and Real Estate
During the third stage of the Business Cycle, sometimes called the Recession phase it is the following Sectors that may perform well: Chemicals, Banks, Electrical and Electronice Engineering, Banks, Forestry and Paper, General Industrials, Industrial Metals, Construction and Materials, General Financial, and Support Services.
And in the final stage of the cycle, often termed 'The Slump Phase' it might be: Electricity, Fixed Line Telecoms, Mobile Telecoms, Beverages, Food Producers, Food Retailing, Utilities, Healthcare Equipment, Non'Life Insurance, Personal Goods, Pharmaceuticals, and Tobacco that do well.
This is just a rough guide but if, for example you were interested in one particular pharmaceutical company (e.g. GSK) you might pay particular attention as the business cycle enters its final stage.
The trick of course, will always be to recognise what part of the cycle the market is in at any given time. Easy in retrospect - not so easy in real time.
Also ...you may be surprised to know that Warren Buffett would discard about a half of theSectors mentioned above.
Some because he simply doesn't understand them, and others because he regards them as "bad" businesses.
"Bad" businesses are those that are competitive on price (see below for a more detailed explanation).
"Good" businesses are those that don't have to compete on price - they sell products that are in demand (see below for more details).
Warren Buffett ove the years has devised a plan for the type of company he is prepared to invest his money and the type of company he is not going to invest in.
He has painstakingly identified two types of businessess:
With the former, a good example may be a steel producer. He has recognised that this industry is extremely competitive on price and uses very expensive machinery which, from time to time, wears out and has to be replaced.
Such re-fits are not cheap.
Buffett is vindicated in his analysis because he has pored over dozen of such company financial reports and discovered over the years that their figures are sposmadic. One year their earnings are up, the next year they are down. The next year they may even make a loss. In short - their results can be eratic.
Furthermore, before their results fluctuate and their machinery has to be replaced regularly, they usually carry a high amount of debt.
Consumer Monopoly companies, on the other hand sell branded goods that are used day-in, day-out by their loyal customers. It may be a food product, it may be a kitchen utensiil, it may be some other everyday used piece of equipment with a recognised company logo. They are trusted. Their customers are loyal.
When Warren Buffett scrutinises their financials, he expects to find a solid record of earnings growth, profits, high margins, strong cash-flow, and a history of rising figures over the years and the expectancy for that to continue.
He would find little or no long-term debt. Such companies generate plenty of cash so they do not need to borrow money. And if they did, they would be able to pay it back in a matter of a few years.
The management of each type of company is different too.
Consumer Monopoly type businesses have stable, experienced maagement whereas the tendency for Commodity type busineeses is to chop and change management.
But because Warren Buffett doesn't invest in that type of company does not mean that they don't have their followers. They do. Just not Buffettologists.
I just gotta start with another quote from the man himself. His words of wisdom are well worth paying attention to, and this one is no exception:
"Price is what you pay, and value is what you get."
Of course the two companies I am going to demostrte are in completely different niches, I will just use their figure to make the point.
BATS are just about as "Blue Chip" as you can get. Their latest price was 2922p with estimated earnings of 327p giving a P/E ratio of 8.93
Hays on the other hand, were recently trading for 138p with earnings of 5.42p and a P/E ratio of 25.4
Which of the two is "cheaper"? Which is the better value?
On the face of it, Hays is the more affordable - you can pick them up for a mere £1.38 per share. To get your hands on BAT shares will set you back £29.22 per share. Wow, that's expensive isn't it?
You cannot judge a share on price alone.
If you were to dig deeper into these two companies you would soon come to the conclusion that BATS would be the better investment. And digging deeper means investigating the company finanicals, management, and operations.
By value. It's the only way.
A lot has already been said about P/E ratio, which, hopefully you have read. So what I'll try and do in this small space is try to express it slightly differently.
Normally you would take the share price and divide this by the forecast Earnings Per Share (or prospective earnings).
A shorter way to calculate the P/E is to divide the market capitalisation by the estimated future net earnings - this also explains what the P/E really means - and that is the number of years it would take for a company to earn its market valuation.
As you have learned so far, the lower the P/E ratio the more value is the stock. Right?
Not necessarily. A falling P/E ratio could be the result of a falling share price. And the share price could be falling because earnings are about to slow down.
That's why using the P/E ratio as a valuation tool must never be used in isolation, it is all part of your due diligence.
And also be aware that a P/E ratio can be negative. Which to my understanding means that the company has made a loss. Again, when used along with other indicators, it could still mean that the particular share is a buy - there may be a very good reason for the loss - such as Covid-19
Enterprise Value can be ascertained by adding its forecast debt and substracting its forecast cash position from its market capitalisation.
This figure then tells the investor what it would cost to acquire the company, thus providing a useful benchmark valuation which can be measured against aquisitions made in the same sector.
EV multiples are often used by predators such as trade buyers and private equity companies when they decide what to pay for a company.
The EV can then be divided by sales (EV/Sales), earnings before interest, taxes, depreciation, and amortisttion (EV/EBITDA) and operating free cash flow to give a range of valuation multiples which can be used to compare stocks with each other.
Unlike the P/E ratio, the EV approach gives full credit for a net balance sheet and takes more rigorous account of a heavily indebted one.
On a P/E basis, a stock with lots of cash can look expensive, as record low interest rates mean returns on that liquidity will be of little value. On an EV basis, it might look cheap, as the cash is subtracted from the market cap and the earnings before interest and tax (EBIT) and EBITDA multiples provide insight based on core operating performance rather than any return from financial assets.
In short, not conclusive. But worth looking at.
A discounted cash flow (DCF) calculation is in theory the most scientific way of valuing a company, although this method is disliked by many. The idea of a DCF is to establish how much a company's future cash flow is worth in today's money. This is referred to as 'intrinsic value,'
The four key elements of a DCF:
Net Asset Value (NAV) or Book Value, is assessed by dividing Shareholders' Equity by the number of shares in issue.
The share price, if divided by this figure results in the P/NAV or P/BV
The Shareholders' Equity is the company's total assets minus its total liabilities (the net worth of the company).
If this figure is below 1 it suggests that the shares are cheap.
If above 1, it is considered that the shares are expensive.
The above simple ratios are a few more tools to assist you in trying to find if the price of your chosen share is high or low. They are very simple ratios but a very quick way to give you some idea about the company under study.
If you sincerely want to be a success with your stock investments, then you MUST think long-term. Get out of your head any notion of "get-rich-quick"
You are investing and NOT speculating. Who would you rather follow: Warren Buffett or some tipster in your morning broadsheet?
I thought so!
Think about the words of wisdom that Warren comes out with. Build your own set of rules around him. As you know by now, his number one rule is NEVER lose money. You must know by now what his number two rule is!
He is a financial genious and us mere mortals can only grasp his principles. But we will not go far wrong if we simply select shares using his criteria and buy them when the price is right.
I make no apologies on this website for repetition. If Warren Buffett places such high regardon simple ratios such as the Price Earnings ratio, then so should we.
If Warren Buffett places high regard on future earnings - then so should we.
If Warren Buffett only invests in Consumer Monopoly type businesses - then so should we.
If Warren Buffett identifies a share and then waits patiently until the price is right - then so should we.
However, a word of caution is reqired, as it must be with all things. You may have found what you consider to be a cheap share -wonderful. But tat share may remain "cheap" for a long time, and could even get cheaper.
Something must come along to "unlock" that cheapness - it may be new management, a new technical process, or something as simple as the company having a really good year. Always be alert and never tke your eye off the ball.
Chris and Clem Meet Up - hopefully, the last time before lockdown easing
Chris and Clem Meet Up - at last! They can meet in the beer garden
Chris and Clem Meet Up and it is Chris' turn to do most of the talking. Chris' little windfall has allowed him to widen his portfolio. Chris vows of more.