High value is not the same as low price

There was a recent blog post by Seth Godin that describes value from a marketer's perspective. Similarly, high value cannot be extrapolated from low price when investing.


The lower the price of a stock, the harder it is to find value. I define what is 'low price' by looking at the price of a stock with respect to say other stocks within the same sector in the same time period. There is often a reason for every low price - especially if the price stays persistently low for years. It could be due to no growth or slow growth of the business, it could be due to a lack in profitability, it could be due to high liabilities or simply a lack of business moat. Just like an item on sale, it is either that it is not durable, expiring or not in high demand. We all know that a gem won't stay cheap for long right?


What to know about PE and Free Cash Flow


Stocks that are selling at a premium and has high P/E, on the other hand, may not necessarily mean it's bad value for investors. High price can go higher as long as there is earning growth. Investors have priced in the future payoffs and expected earnings, therefore the P/E is higher (they expect the future P/E to be even higher!). We can see from the share prices of Amazon, Google, Alibaba etc.

Having said that, it does not mean we should be blindly chasing those 'in demand' hot stocks. Do remember that most fundamental metrics can be tweaked (one way is via shares buyback as what I mentioned in the previous post). In uncovering whether there is real value, we have to also take a look at how the business innovates and improve upon its products / services (which lead to more potential earnings), other figures on balance sheet such as net income, margin, cashflow and leverages.

That is also why the the Discounted Cash Flow method is often used to estimate the present value of a company. It uses Free Cash Flow (FCF), projected growth rate and a discount rate (to adjust for time value of money) to derive at the so-called 'intrinsic value'. However, there are limitations.

Free Cash Flow is a powerful figure and is somewhat independent of shares buyback, as we generally disregard the cashflow from financing activities. It is calculated as follow:

  1. FCF = Cash Flow From Operating Activities - Capital Expenditures
  2. FCF = Net Operating Profit After Taxes - Net Investment in Operating Capital
  3. FCF = Revenue - Operating Costs and Taxes - Required Investments in Operating Capital
Where:
Net Operating Profit After Taxes = Revenue - Operating Costs and Taxes
Required Investments in Operating Capital = Net Investment in Operating Capital

If calculated properly with all the same inputs, all three equations should produce the same result for FCF. 
[Formula reference: Investopedia - Free Cash Flow]

Note: Cash flow from operating activities excludes the use of cash for purchases of capital expenditures and long-term investments, as well as any cash inflows from the sale of long-term assets. Cash paid out as dividends to stockholders, and cash received from bond and stock issuance are also excluded.

If you want to find out more about cash flow, Kyith from InvestmentMoats has a very impressive piece of write-up talking about Net Profit, EBITDA, Operating Cash Flow and Free Cash Flow in Dividend Investing. He even gave details of the calculations, illustrations and the advantages / disadvantages of using each type of cash flows. Scroll to the last part to zoom in on Cash Flow.

I particularly like the last segment "What are signs of Healthy and Unhealthy Cash Flows?" summarized as follow: (My remarks are in pink)

1. Dividend payouts, Repayment of debts, Buy Back of shares should be less than Free Cash Flow or Investor’s Cash Flow. These 3 are healthy business decisions that rewards the share holders. (To look at sustainability)

2. Net changes in Working Capital (current assets minus current liabilities) should be Low. But working capital should be high.

3. Company should be conservative in paying out of depreciation (for dividends or?). Depreciation should be matched by Maintenance Capital Expenditure.

4. Company should pay off debts instead of satisfying investors thirst for dividend. Some companies know that investors like high yield, so they pay out and roll over debts or interests. (So don't only look at ROE and dividend yields when choosing a good company.)

5. Cash Flow from (core) Business should be growing. Do not get suckered by one time large dividend payout.


Just like any other figures on paper, cashflow can also be manipulated to look good. Read Cashflow on Steroids


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Brief book review on The Millionaire Next Door


I have finally finished reading The Millionaire Next Door. It has many case studies pertaining to how Americans lead their lives (contrasting the UWA and PWA, read to know more about these acronyms) and their backgrounds which I don't find very relevant to my lifestyle in SG.


The gist of it is that millionaires are always frugal and prudent in managing their money, they do not show off their wealth (you wouldn't even suspect them to be millionaire if you are their neighbour), they do not encourage their children to be big spender nor routinely give them monetary rewards / care, they would limit consumption (liability) and always try to create value out of their money. I recalled one example about getting a low-mileage, second-hand Mercedes instead of some latest trendy model when choosing a vehicle.


I would rate this book as 2/5 as many of the concepts are not new and there wasn't any extraordinary stories.
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I shall sum up this post with a quote,

"Price is what you pay, value is what you get." - Warren Buffett

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