The Basics Of Valuation - Picking out Value Traps

Fundamentals 02: A framework for analyzing and valuing companies.   This post was originally published on 28 May as "The Basics of Valuing A Company".  This has been updated to include among others special situations in valuation.   Note that there is a PowerPoint presentation of this article on SlideShare under "Baby steps in valuation".  Revision date: 15 Nov 2020

Price vs Value
"Price is what you pay, value is what you get" Warren Buffett

Everyone loves a bargain. If you are offered a price for something you want that is at a significant discount to what it is worth, I am sure you will be thrilled. 

This is the heart of value investing – to buy an equity stake in a company at a price that is at a discount to its value. The question then boils down to how to determine what the company is worth.

At the same time. you have to be wary of value traps. How do you tell what is cheap for a reason (a value trap) vs what is undervalued (a bargain)?  Valuation is the key to picking out value traps.

There is no one answer to what a company is worth. You have to triangulate from several angles. Yet you want to keep it simple so that you do not lose the forest from the trees. 

Big picture. Simple yet insightful. Come from several perspectives. 

To do all of these you need a framework. I have one that came from many trials and tribulations.

I am assuming that you have the skills and interest to analyze and value companies.  If you don't have the interest or skills yet want to invest based on fundamentals, you can still do so by relying on experienced analysts. Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can access their business analysis, valuation, and risk assessment.

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  • What to consider at the start?
  • How I approach valuation 
  • Strategic insights
  • Analyzing Asset Value
  • Analyzing Earnings Value
  • Handling special cases
  • What do I assume in my valuation?
  • Pulling it all together

What to consider at the start?

If you are a beginner, company valuation is more than just knowing the mechanics of valuation. 

Valuation is part science and part art. To be able to value companies under various corporate structures you need to understand the principles. 

I believe the key questions that every beginner should ask are
  • What is value?
  • Why value companies?
  • What are the main valuation methods?
  • How to learn valuation?
  • How to pick out value traps?

There are many types of business organizations - start-ups, private companies, partnerships. While the general valuation concepts apply, there are certain considerations for different structures. 

For this article, I will just focus on valuing listed companies

What is value?

If you look at the Buffett quote it is clear that price and value are not necessarily the same thing.

“Value can mean a quantity or number, but in finance, it's often used to determine the worth of an asset, a company, and its financial performance.” Investopedia

The process of calculating and assigning a value to a company or an asset is called valuation. 

Technically the price of a stock is determined by supply and demand. It is the price that buyers and sellers agree to transact. This is also commonly referred to as the fair market value. 

“The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” Wikipedia

If you belong to the Efficient Market school, you would view that market price as the fair market value.

However, if you are a fundamental investor, you would view the worth of a company as the discounted cash flow generated by the company over its life. This is commonly referred to as the intrinsic value. 

To the fundamental investor, intrinsic value and market price may not be the same.

Why value companies?

Why value companies?

Not everyone investing in the stock market is concerned about the value of a company

If you are a trader buying and selling pieces of paper based on technical indicators, you are probably not concerned about the value of the company. Your buy and sell signals are dependent on market price and volume rather than the fundamental performance of the company

If you are a smart beta investor or even an indexer, individual company performance may be less important than macro indicators eg interest rate, economic performance. 

But if you are a value investor whose buy and sell signals are based on comparing the market price with intrinsic value, then valuation is key.

The investor is not the only person interested in knowing the value of a company. 

But there are other situations where valuation is important
  • If the company wants to raise funds by issuing additional shares, then knowledge about the value of the company is important.
  • A company undertaking a share buyback programme should also be interested in the value of the company. Management should not be buying back overvalued shares.
  • Valuation is also important for companies undertaking a merger or acquisition exercise.
  • Knowing whether the value of a company has increase may also be an important component of senior management compensation.

Methods of valuation

There are 3 general ways to value companies
  • Relative valuation
  • Asset-based valuation
  • Earnings-based valuation

The simple way to understand them is to use the analogy of how properties are valued. 

1) Relative valuation is valuing your house based on the comparable value of houses in your neighbourhood. You might scale it to account for some of the differences in the properties. 

For example, if your neighbour’s house is worth $ X on 2,000 sq ft of land, you may conclude that since your house is on 3,000 sq ft of land, it is worth $ 1.5 X. 

If comparable companies are trading at 10 times their earnings, your company should also be worth 10 times earnings. Other common bases of comparisons are book value, net tangible assets and revenue. 

2) Asset-based valuation is valuing your house based on what it cost to buy the land and build the house. You might use the historical cost to serve as the floor value or you might use the current cost. 

There are several ways to determine the value of companies when using this approach. For example, we could use the book values, the revised net asset values, and even the reproduction values.

3) Earnings-based value for your house is the present value of all the net rental income over its life. You will of course have to decide on the appropriate discount rate to use in order to compute the total present value. 

In the context of valuing companies, we have the discounted cash flow method. The variables to consider are then what to use as the cash flow, which discount rate to use, and how to account for the life of the business.

How to learn valuation?

How to learn valuation?

There are 2 key steps in learning how to value companies
  • Understand the concepts and method
  • Practice, practice, practice

Valuation is like driving a car.

There are only a few concepts in driving a car. Thereafter it is all about practice and experience so that driving becomes second nature.

Learning valuation is the same. 

When learning the concepts and principles, you should do many worked examples so that you understood them correctly. I am a firm believer that understanding the principles is more important than remembering any formula.

Then it is all about valuing different companies. Real-life situations do not always fall neatly into textbook examples. This is where having a strong understanding of the valuation principles is important. Furthermore, you would be able to see the nuances when you have done a lot of valuations. 

I shall not attempt to teach you about the concepts and mechanics of valuation as there are far better resources for you to learn from.

Rather what I hope is to share with you here are:
  • Some of the pitfalls I experienced so that you can avoid them.
  • The steps in my approach so that as you can have a better understanding of the valuation covered in the various case studies

Picking out Value traps

You face a value trap when a company that appears cheap in comparison with some valuation metrics turns out to be actually cheap.

So instead of buying a bargain, you bought a value trap.

The key to picking out value traps is then valuation. You face value traps if there are issues with valuation. 

This can happen due to
  • Errors in the valuation. This could be due to having the wrong assumptions, misunderstanding the concepts, or even computation error.
  • Unforeseen circumstances that eventually lead to a deterioration in the business fundamentals. There is then a corresponding decline in the intrinsic value

To mitigate against the former, you need to have a strong valuation methodology and be skillful in applying it.

To mitigate against the latter, you need to adopt a host of mitigation measures. These could be having a margin of safety, a conservative approach, diversifying, etc.

I have also come across articles where value traps have been defined by comparing the current price with historical prices. This is wrong and you should not make this type of mistake.

How I approach valuation

When I first started to invest in equities about 15 years ago, I knew that valuation was going to be an important element in my investment process. 

If you search the web, you will find many articles about how to value companies from rules of thumb, market multiples to complex formulae. I started from using market multiples to more sophisticated techniques as I learned more about valuation. 

I have an engineering background so working with figures and formulae is something I do easily. 

But with different techniques giving different answers, I started to think of having a framework to hang all the numbers.

What I have today then is a valuation framework that is a synthesis of several techniques. I determine this intrinsic value of a company using 2 basic approaches:
  • Asset-based valuation (AV) 
  • Earnings-based valuation (EV)

In the AV method, I rely mainly on the Balance Sheet of the company in order to determine the intrinsic value. In many instances, the intrinsic value of the company equals the Total Assets minus Total Liabilities 

In the EV method, the value of the company is determined by both the Residual Earnings method and the Free Cash Flow method.  The information extracted from the Profit & Loss as well as the Cash Flow statements.

I then compliment these with several metrics from academics and investment thought leaders. These included the Acquirer's multiple and the Magic Formula. 

You will note that I have not used the relative valuation method as it is not an intrinsic valuation. 

i4value: How to value companies

Strategic insights

OK, you now have the AV and EV to tell you how much a company is worth.  Wouldn't it be nice to have other uses for them since you have spent so much effort to derive the numbers? Think of all the annual reports you have to run through and the Excel model you have to create!

Honestly, it was many years later that I found somebody who showed what else I could do with the AV and EV. 

It was Professor Bruce Greenwald, Columbia Business School who inspired me on the next step. I analyzed the AV and EV together in comparison with the market price to get a sense of the margin of safety. He also opined that an analysis of the AV relative to the EV provides some insights into how well the company has deployed its resources. 

There are 3 possible scenarios when comparing the EV with the AV as illustrated below.

AV = EV ; competitive position
Scenario 1: EV = AV. This is the most common situation where the return is equivalent to the cost of capital. In a competitive environment, a business with high returns would attract competition. Eventually, any excess returns would have competed away so that the company just earn its cost of capital.

AV > EV : Under utilized
Scenario 2: EV < AV. In this case, the assets are under-utilized possible due to some issues with the business.  This could be due to poor management, or that the business in an industry in secular decline

EV > AV ; compounder
Scenario 3: EV > AV. In this case, the returns generated by the business far exceeds the cost of capital. I would expect the company to have some form of an economic moat in order for it to continue to enjoy a return that is higher than its cost of capital

In practice, as it is unlikely to have a situation where the AV exactly matches the EV.  So I have assumed that AV = EV is when the computed difference is within +10% or -10% of each other.

Although I favour looking at both AV and EV, there are certain sectors where due to the accounting treatment and/or nature of the assets, the AV approach should be the main valuation approach. 

Examples of these are companies in the financial services sector. Here most of the assets are financial in nature and where the accounting rules require such assets to be marked to market value. 

Another example is the property sector. Except for these, because many in the market use PE-based metrics, I favour the EV as the primary valuation approach compared to the AV. 

Is this the end of the story? Of course not as I found that if you build up a picture of the AV and EV, you can get other insights into the company. 

It will get a bit textbook-like here onwards but don't skip as I think it is worth the effort

Analyzing Asset Values

You can build up a picture of the total asset value based on the four components as illustrated below

Asset value composition

Information to determine the Graham Net-Net, NTA, and Book value is generally extracted from the Balance Sheet.  If the company has adopted the fair value accounting rules in preparing its accounts, the values are reflective of the market price. However
  • There are instances where the value of properties has been captured at historical costs.  In such instances, if the value of the properties is significant, I do make an adjustment to reflect the current market price.
  • Do not be surprised if occasionally you come across negative Graham Net-Net. In such cases, I treat this as zero.
  • The most challenging to determine is the Reproduction Value.  You are trying to estimate what it takes to re-create the company with all its customers' relationships, product branding, and any R&D that have been charged out.  For some sectors, you may actually have to reduce the value of its Plant, Property, and Equipment as it is now possible to build a new plant cheaper due to technological progress.
  • For property-based companies with significant landbank, many analysts estimate what is known as the RNAV – the Revised or Re-valued Net Asset Value. The most reliable way to estimate the RNAV is to base the property value on a professional valuer’s assessment. 

However, I have seen many analysts estimate the RNAV based on the projected earnings from developing the land. This is different from what property valuers would do when they use the earnings method. So I have doubts about some analysts' RNAV approach as they include the profit element as well. How I will value property developers is a story for another day.

What can go wrong?

Information for Asset-based valuations is picked up mainly from the Balance Sheet.

So, if there are reliability issues with a particular Balance Sheet, there would be problems with the Asset Values

Over the years, I have had some personal bad experience with using Asset Values

1) Nam Fatt.  This is a construction and property company with an NTA of RM 2.15 per share in 2007 when I purchased it for RM 0.81 per share. You would have thought that the book value would provide an ample margin of safety.  

It reported EPS of RM 0.08 in 2007 and RM 0.04 in 2008.  There were some RM 937 million of trade receivables a significant amount of which were from its construction works in the Middle East. 

Unfortunately, in 2009 it reported that it had problems collecting the Middle East trade receivables. The end result is that its 2010 Annual Report showed a negative NTA of  RM 0.30 per share. This wiped out completely my investment in this company. 

2) China Stationery. This is a mainland Chinese stationery company that was listed on Bursa Malaysia.  I bought it in 2013 at RM 0.22 per share based on its NTA of RM 2.35 per share. It had cash of RM 1.90 per share.  

Unfortunately, the majority of the cash is in China. After a series of incidents including a factory fire and questionable actions by the CEO, the company was delisted. Cash with banks in China does not offer asset protection. 

Analyzing Earnings Value

You can also build up a picture of the total earnings value as illustrated below.
Earnings value composition

What are some of the challenges I have found in using the Earnings-based valuation method?

  • Growth does not add value unless the company's return is greater than its cost of capital. If you work out the numbers for such a case, you will find that the value with growth would be less than the value without growth. In such cases, I ignore the value with growth.
  • Some companies retain a significant amount of cash. I have occasionally come across cases where the market price is around the value of cash and other non-operating assets. Yes, these are prized findings.
  • If there are significant differences between the value from the Residual Income method compared to that from the Free Cash Flow method, I choose the Residual Income. You will meet such situations if the company has an expansion programme. It will then require significant capital expenditure that will affect the value using the Free Cash Flow method. 
  • If you are valuing a conglomerate operating in several different sectors, the risks and hence the cost of capital will be different for the various sectors. In such cases, you have to do more work to first value the various sectors independently. Then add them all up to get the value of the conglomerate – the sum of the parts valuation.

What can go wrong?

Information for Earnings-based valuations is picked up mainly from the Income Statement.

So, if there are reliability issues with a particular Income Statement, there would be problems with the valuation.

We are not talking about judgemental errors in the valuation process.  Rather it is about misrepresentations by companies.

Examples of these among Bursa listed companies include

1) Megan Media. This is a CD manufacturer with a top rating by a Malaysian rating agency. I bought it in the first quarter of 2007 at RM 0.65 per share based on its past 6 years' average EPS of RM 0.38 per share. 

At that juncture, my valuation was based only on relative valuation.  Less than a year later, a forensic accounting team reported that the company had created fictitious trading creditors and debtors to overstate purchases and sales. The restated financial statements wiped out the shareholders’ funds. The company was subsequently delisted. 

2) Transmile. This is an air express service company with several aircraft as its assets. In 2004 it had grown its EPS to RM 0.27 per share from RM 0.15 per share in 2001.  

As stated in its 2006 Annual Report, a special audit team found that there was an overstatement of revenues, trade receivables and property, plant and equipment. This effectively wiped out all the earnings for the past 6 years.  

The RM 130 million retained earnings in 2005 was adjusted retrospectively to be a retained loss of RM 401 million even before accounting for the 2006 losses of RM 126 million.  It is no surprise that the company was subsequently delisted. 

Handling special cases

When textbooks teach you about valuation, the focus is on specific concepts.  Examples used to illustrate the concept tend to show idealized situations.

Rea-life is a bit messy. Items do not necessarily fall into place like the textbook examples.

That is why understanding the principles is important so that you can make the appropriate interpretations.

I list below the common real-life problems that I have encountered over the 1,000 valuations I have done. 

Valuing companies with a large cash balance

Valuing companies with a large cash balance

All companies maintain a certain level of cash for working capital purposes. Generally, you treat these as part of the operating assets especially when you use the Earnings-based valuation.

However, there are some companies that retain a large amount of cash.  You compare the cash with the working capital to get a sense of the excess cash. 

In such cases, you treat the excess cash as non-operating assets

In other words, if you use a discounted cash flow method, you add the excess cash to the computed discounted value to arrive at the value of the company. 

The challenge then comes to determining the value of cash
  • If the cash has been invested in marketable securities, I would consider the market value of the securities.
  • I have seen arguments that the value of the cash should be less than the face value of the cash if the company has a poor track record of investing its cash.
  • If cash is deposited with the bank and earns interest, should you value it taking into consideration the interest earned?

Given the various challenges above, I treat all the cash as non-operating assets. I take the face value when I value companies using the Earnings-based method. 

Valuing companies with intangible assets

There are two categories of intangibles
  • Those that are captured in the Balance Sheet
  • Those that are not recognized in the Balance Sheet

Intangibles appear in a company’s Balance Sheet are generally from"
  • Goodwill resulting from some M&A exercises
  • Expenditure for certain services whose usefulness extends over several years.  A good example is computer software.

Examples of intangibles that are generally not accounted for in the Balance Sheet are brand-name, proprietary technology, and customer relationships. 

When using the Earnings-based valuation, intangibles are already considered as part of the operating assets. They help to generate revenue for the company and the earnings and cashflow reflect their contribution.

So even if there are separate assessments of some intangibles, I would ignore them in the Earnings-based valuation.  A good example of this is ignoring the brand value. 

However, under the Asset-based method, I would consider them as part of the intrinsic value. So if there is an independent assessment of some of the intangibles that are not recognized in the books, I would add them to the Book Value.

A common example would be to add the brand value to the Book Value to derive the Asset-based intrinsic value. 

Valuing Companies with negative earnings or cash flows

There are two general situations where companies can have negative earnings or cash flows
  • Companies at the start-up stage
  • Companies undergoing some turnaround

Analysis and investing in start-ups require a different approach from those for listed companies.  

I do not invest in start-ups and hence will exclude them from my valuation discussions.

On the other hand, I do invest in listed companies undergoing turnarounds. These are companies that have been profitable in the past but are facing some issues that had led to the current negative earnings or cash flow.

Logically the problem is not with the valuation per se.  Rather the challenge is with the company analysis
  • If the problems are due to some structural problems ie long term problems, you should not consider investing in such companies.
  • If the problems are temporary, the challenge for Earnings-based valuation is projecting the turnaround performance
  • Looking at the historical profits can provide one clue. 
  • Another way is to benchmark against industry performance if the problem is not industry-wide
  • The most challenging approach is one where you have to make assumptions about various parameters eg sales, margins

For turnarounds, I tend to favour the Asset-based values rather then Earnings-based ones
  • For such cases, if I am lucky and the Graham Net Net provides the margin of safety, I do not rely on the Earnings-based values.
  • Alternatively, I look at the Asset-based value and build in a few more years of losses and/or impairment. If there is a margin of safety after doing this, I invest
Valuing companies with negative working capital

Valuing companies with negative working capital

Working capital comes into the picture when you use the discounted free cash flow method - one of the Earnings-based method.

Here the free cash flow is computed after deducting among other items, any change in working capital from the after-tax earnings.

When you have negative working capital, it must mean that the company is using suppliers’ credit. For example, Dell with its just-in-time supply system will have negative working capital.

If you assume that the value of a company can be increased with suppliers’ credit, it is correct to include the negative working capital when computing the free cash flow.

The question is whether this is can go on forever especially in the context of the terminal value in the discounted cash flow valuation.

As such, I have taken a conservative approach in that whenever I come across a situation with negative working capital, I set it to zero.

Valuing cyclical companies

According to Prof Damodaran

“Cyclical and commodity companies share a common feature, insofar as their value is often more dependent on the movement of a macro variable…than it is on firm-specific characteristics….the biggest problem we face in valuing companies tied to either is that the earnings and cash flows reported in the most recent year are a function of where we are in the cycle, and extrapolating those numbers into the future can result in serious mis-valuations.”

The advice for valuing cyclical companies under the Earnings-based method is to use the “normalized” earnings and cashflows. 

There are 2 ways to handle this
  • Use the actual average values over the cycle
  • Use the company average margins over the cycle and then apply this to the most recent revenue to derive the normalized earnings.  The same principle applies to capital expenditure and working capital

Personally, I use the actual average values over the cycle.

The challenge then is how do you estimate the growth rate. One way is to compare the average performance of the current cycle with that of the previous cycle.

Valuing companies with project-based revenue

I tend to classify companies into 2 categories in terms of how they generate revenue

1) Those with a recurring income.  Examples are consumer goods companies and other mass marketing companies
  • The key feature is there are many customers each one buying a product or two. Company revenue is from the aggregation of the many individual small sales
  • Unless the products or services are out-dated, they will continue to generate revenue every year.

2) Those in project-type business. Examples are construction companies, engineering companies, and even property developers.
  • The revenue for such companies is from the projects being executed. It is obvious that their performance will depend on their order books.  
  • Some projects are completed within the financial year while some are stretched over several financial years.
  • The key characteristic is that one project or contract accounts for a significant part of the annual revenue

The one to watch out for are the project-type businesses. 

I treat the project-type business as cyclical ones. I use the same “normalized” principle when using the Earnings-based method.

When using the Asset-based method, I look for historical impairment and order-book. If the current order book is at the historical low and there is a history of impairment, I would reduce the Asset value by some historical amount.

Valuing companies in distress

Valuing companies in distress

Distressed companies are those that are unable to meet, or have difficulties in paying off their liabilities. 

If the company’s obligations are too high and cannot be repaid, or if there is not enough cash to service the debt, then the risk of default becomes significant. 

The Earnings-based method is based on the assumption of the company as a going concern.  As such it is not appropriate to use this method when valuing distressed companies.

Even relative valuations may not be relevant if the peer companies are healthy companies

When a business is under financial distress, it may be worth more “dead than alive.”  

One way to value it is to look at its liquidation value.  The Graham Net Net is one such shorthand.

But estimating liquidation value is a specialized approach.  In practice, I never had to worry about such a valuation as I do not invest in distressed companies. 

Valuing holding companies or conglomerates

Generally, a holding company is a business entity that doesn’t conduct any business operations. Rather, holding companies hold the controlling stock in other companies.

When looking at holding companies, I would classify them into 2
  • The pure holding companies.  These companies do not have operational control of their investments
  • Those with operational control

For those with operational control, they should be valued as an operating group. There are two general ways to value such holding companies using the Earnings-based method
  • Consolidated value. This is looking at the holding company as a group and valuing it based on the consolidated earnings/cash flow
  • Sum of parts value.  If the information for different segments is available, you could value individual segments.  This is especially relevant if the segments have different risks.  The value of the holding company is then the sum of the various segment values

For the “pure” investment holding companies, the income is the dividends it receives from the investments.
  • One way is then to use the Dividend discount model to value such companies. The Dividend discount model weakness is that unless all earnings are paid out, dividends do not represent owners-earnings.  
  • The other way is to use the Asset-based value. The Asset-based method is likely to be higher than the value derived from the Dividend discount model.  It is common to then factor in a discount for lack of control and/or liquidity.

I think the “holding company discount” proponents may have confused intrinsic value with the market price.

In a lot of cases, the market price is at a discount to the net asset value.  Many have taken this to mean that this is an “intrinsic” discount. 
  • I do not think that the discount is intrinsic.  Imagine what happens when the holding company disposes of all the investments and then distribute all the cash.  If the discount is “intrinsic” it would mean that the shareholders would not get all the cash from the sale.  
  • If the net asset value has already accounted for the holding company’s costs this would be double-counting

It is instructive to note that in the 60s many of the US holding companies were trading at premiums to the net asset value or sum of parts value.  They were referred to as “conglomerates” then. 

The idea was that these different businesses would profit from “synergy”.  It implies that the various businesses can work together and be worth more as a whole than as individual companies.

The more appropriate way is to take the net asset value or sum of parts to represent the intrinsic value. 

Then separately gauge the market expectations of the price to net asset value or sum of parts value. 

Valuing options

As part of their corporate exercises, companies some times issue 
  • “warrants” or “sweeteners” to encourage support for the corporate proposals. Such warrants are options.
  • Convertible loan stocks.  In the company’s accounts, part of these are treated as loans and part of this are treated as options

There are theoretical models (Binomial, Black-Scholes) for valuing such options.

The value of such options should be deducted from the value of the company to arrive at the net company value accruing to the shareholders.

In the Malaysian context, almost all the options tend to be listed and traded so market values of these options are readily available.

So instead of using the theoretical values, I use the market values of the options.

What do I assume in my valuation?

What do I assume in my valuation?

If you adopt Professor Bruce Greenwald’ valuation framework you will progress from
  • The most reliable method with minimal assumptions when determining the AV
  • To the EPV with assumptions about the sustainable earnings but without any assumption about growth
  • To the least reliable Value with Growth where you have to make assumptions about the growth prospects.

Most of the information required to determine the AV will be available from the Balance Sheet.  And there are few assumptions to be made about the future of the company. 

So, all earnings-based valuations are based on some assumptions about the future performance of the company.  When I talk of the future, it covers the life of the company. 

To get a handle on the assumptions to make, I categorized companies into 2:
  • Companies operating “steadily”.  These are situations where I can assume that historical performance provides a good sign of the future. 
  • “Companies in transition”.  These can be companies facing some secular decline.  This could be due to the demand for its products, or/and those undergoing structural changes. It could also be those at the start-up stage. Looking at the historical performance here is not very helpful.

The AV and EV methodologies are more suited to those operating “steadily” and hence I shy away from valuing “companies in transition.” 

If there is a need to value “companies in transition”, I rely on the AV.  Or, if I can project the future performance, I will use the EV

To ensure that the estimates are not skewed by an unusually good or bad year, I take the average performance over a business cycle. In the context of Malaysia, I have assumed that a business cycle is equal to 12 years. 

In practice, this meant that I only value companies with at least a 10 years track record as a listed company.  I thus ignore start-ups, IPOs, and companies with less than 10 years of the listed company financials.  I place these into the “too difficult to value” box. 

OK, this is as far as the valuation framework is concerned. I am very sure that there are other angles that I have not thought of. If you have any or see holes in my framework, feel free to let me know.

What is next is mainly for those who want to get a bit more into the technicalities of the valuation. If you are not trying to reverse-engineer my valuation method, you can skip and go straight to the end. 

Key assumptions for my valuation models are: 

1) Typical performance = past 12 years’ time-weighted average performance where the values from the current period are given more weight c/w with those further back in time.

2) The data is first “cleaned up” for any one-off transactions e.g. profits from a one-off sale of assets, one-off restructuring charges

3) If growth is involved, I use the weighted average historical growth to represent future growth but this is then capped at 5% per year. This 5 % represents the long-term economic growth of the country

4) The computed value under the Free Cash Flow and Residual income models is the average value obtained from the perpetual model and the 10 years single-stage growth model

5) Occasionally I use a 2-stage growth model but this is only used if it meets both of the following
  • Revenue growth AND EBIT growth AND TCE growth > 8 %. The 8 % is the average 
  • Correlation for Revenue growth, EBIT growth, and TCE growth > 0.7 i.e. they explain 49 % of the variation
6) In the Free Cash Flow valuation method, there are assumptions for the capital expenditure, working capital requirements, and depreciation as follows:
  • Capital expenditure – I first estimate the capital expenditure as a % of revenue for each year. I then use this together with changes in the fixed assets to estimate the capital expenditure
  • Working capital – I first estimate the net change in working capital as a % of revenue for each year. I then use this together with changes in working capital extracted from the Cashflow statement to estimate the net working capital requirement
  • Depreciation – this comprises all depreciation and amortization
7) In the Residual income valuation method, I compute the annual Residual Income based on the capital charge for the capital employed at the beginning of the year. The capital employed is after deducting the investment in associates/joint ventures whose earnings are not captured as part of the earnings from operations.

8) For the discount rate, I use the WACC that is derived based on Professor Aswath Damodaran's model. (Refer to Definitions for the assumptions used in computing the WACC)

Pulling it all together

There are many ways to value a company, from rules of thumb to more elaborate methods as presented above. The key thing is that they are all based on your outlook on the businesses and their economic environment. You must understand not just its usefulness but also its shortcomings. 


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I am not an investment adviser, security analyst, or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them. 

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