Sunday, February 6, 2011

Valuing an investment

When we buy shares in a publicly company, one of the most difficult things to do is determining its value. This is, in part, because there are so many ways or perspectives that may lead to putting a value on a company. Take Microsoft and Apple. In terms of assets, profits and revenue Microsoft outperforms Apple: Earnings in 2009 were $18.8 billion versus $14 billion and in 2008 Microsoft made $14.5 billion while Apple made only $ 8 Billion.

In terms of Assets, Microsoft owns $86 billion and Apple owns $65 billion. Yet in the stock market you buy $1 earnings of Apple for $13.3 while those same $1 earnings by Microsoft go for only $10. So it is a matter what price the buyer is willing to pay for a company. Let's look at the other high-tech giant, Google. You pay $26 for $1 dollar's earning of this company. Its profits are 'only' $8.5 billion on a whopping $57.8 billion in assets but its return on equity is only 20.7% compared to Apple's 35% and Microsoft's 43.7%. If Microsoft is the most profitable then why is its profit least valued?

Why are companies like Apple and Microsoft valued less than the average Canadian Bank, where investors pay $15 dollar for $1 earnings/year? Why do investors pay for $1 earnings in Canadian Oil Sands $15.6 and $10.6 for Encana's? Ah… you may say it's because Encana owns mostly gas (and who wants that these days) and COS owns oil. Oh yeah? Then why does Canadian Natural, one of Canada's best oil and gas operators and owner of the Horizon's oil sand mines and numerous SAGD and CSS projects, get only valued at $10.5 per $1 dollar earned?

Why is a typical Calgary homebuyer willing to pay $250,000 for a typical two-bedroom condominium and why would a rental property investor not want to pay more than $200,000 for that same property? It is because the value lies in the eye of the beholder. One buys the condo to provide its owner with a certain life style, the other buys it strictly for income and profit.

Investors in the stock market obviously do not buy stocks for lifestyle, but often it is bought based on perception rather than facts. Apple makes sexy gadgets and it has iconic leader Steve Jobs. Steve is perceived to be a super-designer who is nearly infallible. Microsoft is considered an underperformer with a monopoly and a habit of strong-arming its competition. Yet it is Steve Jobs who bans software developers from Apple equipment. Microsoft provides most flexibility. If Steve sneezes, Apple's stock tanks, while no-one cares about 'arrogant' Bill Gates who gives billions to his charity foundations. Google's revenue is growing less than Apple's (20.7% vs. 39%) so why do many perceive Google as the Hi-tech growth engine and not Apple?

Do you buy your stocks based on how a company is perceived, or do you buy it based on earnings, profitability and growth prospects? If you do the first, like many stock market investors, you are basically gambling on horse races, even worse, you're gambling on how other investors may perceive the stock value of a company and based on what? If you buy based on fundamentals you look to buy value at the right price, but how do you correctly tell how much a company is worth and when will you be able to cash in on your profits?

Investment books on Warren Buffett tell us, that Warren only buys what he (and Charlie) understands. Warren doesn't understand 'hi-tech'. Well that is not entirely true. Warren loves to play bridge on the computer. He is close friends with Bill Gates for years. I bet he knows a lot more about that business that you and me. What is meant is that Warren doesn't understand how to value a high-tech company. In particular, he didn't understand how you could pay thousands of dollars for shares of .net companies that didn't make any money. What is the business model?

When you buy a company like Coca-Cola, you know what it makes, you know how much profit it will make, and you can extrapolate its earnings way out into the future. So you can calculate the Net Present Value (NPV) of the earnings and cash flow stream of such a company. If you want to earn 10% over the long haul, then you can calculate how much you can afford to pay for a share based on its NPV. If cheaper than NPV it is undervalued; if you have to pay more than NPV it is too expensive.

Organizations such as Canadian Shareowner collect this kind of data and members are provided with the software and data to calculate the fundamental value of a share. But many companies cannot be valued as a 'gadget' producer because apart from a cash flow stream they own assets that rather than depreciate, appreciate! Yes a factory has buildings and equipment that go down in value when they get older and this depreciation is deducted as costs from revenue. But what if the assets increase in value or if the company ADDS value to its assets?

What about service companies? How do you value SNC-Lavelin, an engineering contracting company? Yes it has an income stream, but it has no assets. Tomorrow its work contracts may be cancelled; its personnel may rebel and leave for better pay somewhere else. Once SNC loses it staff, the company is worthless. Where is its expertise? Along with the staff its worth is out of the window. It has to acquire new expertise or it is out of business.

In its rawest form, a fundamental investor looks at the expected cash flow stream of a company and uses a discount rate to determine what that income stream is worth. The big question is, what should the discount rate be? The same as you get on a GIC? A big manufacturer will likely not go under in the foreseeable future (unless your name is GM or Ford), so the predictability and reliability of that income is not much worse than that of interest income from a Government of Canada bond. Thus the discount rate may equal the bond's interest rate. On the other hand, SNC's income is a lot less reliable and predictable, it may change by tomorrow. So, maybe SNC-Lavelin's discount rate should equal that of a 'junk-bond'

But how then do you valuate an oil and gas company or a mining company? A resource company produces oil or gas or ore – its earnings are a function of how much it produces and how much it costs to produce it. So, although commodity prices are volatile and depend on the overall state of the economy as well as the supply of the commodity in question, you can generate a profit stream and calculate its discounted value. But does that reflect the true value of such a resource company?

Not really. The profit statement of a manufacturer assumes that the costs of equipment wear and tear are built into the profits. For an oil company, that would be the depletion value of its reserves. However, an oil company also buys new land (mineral rights) to drill on and it drills wells to prove reserves underlying those lands. The reserves added to the company this way often outstrip the amount of oil produced. So the company's assets may have increased in value by its exploration operations; especially when the costs of acquiring the lands and the drilling of the wells was less than the value of the newly added reserves.

A real estate conglomerate, such as RioCan or Brookfield, earns money from its rental operations: the positive cash flow resulting from the rents minus maintenance, administration, property taxes and debt servicing costs. But the value of the underlying assets: the apartment buildings and land, increase over time. A large portion of such a company's profits lie in the value increase of their buildings and may exceed that of their long term predictable rental operation discounted profit stream. The evaluation of real estate companies and that of resources companies are in some ways more alike than when compared to that of a manufacturer.

This is why investing in the stock market is so complex. You have to know and, as Warren Buffett says' understand a company you invest in. You have to know how to value that investment visa-vie other investment opportunities. Is it better to invest in an oil company than a bank? But even worse, even if you understand a company's business model and you can apply a discounted value on it; the market with its numerous perceptions – real or imagined, may price the company quite differently – sometimes way above your valuation, sometimes below. The market is not 'efficient' and thus you as an investor (not a gambler like many others that run with the herds), will have to decide whether the price you pay is 'right'!

In that lies Warren Buffet's genius. He knows what he 'understands' and he knows how to value the companies he 'understands'. If he does not understand a company, he stays away from it. And… even Warren makes mistakes. So how about you?

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