Sunday, September 1, 2013

INTRINSIC VALUE AGAIN - Part III

In short, intrinsic value is the value you’d assign to a business if you bought it privately without the emotions of the schizophrenic stock market.  Net Earnings are basically the earnings a business makes after you, the business owner takes your salary. The net earnings are the return on your investment. You also have paid your taxes and expensed the ‘wear and tear’ of your facilities during the operating year. So, what are you going to do with the loot?

Well, you could pay all this net earnings money out to yourself as a dividend. But heck, business is so profitable and with plenty of room for growth, why not re-invest at a similar return or better than last year? So now comes the judgment: pay the money to yourself as dividend and/or grow the company? If you had a partner, you could buy her out – in the public market we call that a ‘share buyback’ program and the result is that after paying out your partner, you can keep the entire company’s profit to yourself. Gosh!
So, really if you see your stock market investment as ownership of a company, rather than a miraculous thing that goes up and down in markets for no clear rhyme nor reason, then owning stock becomes a lot easier. And… if there is a bear market then you’d have the ‘guts’ to buy more of the company at prices far below intrinsic value. But you know that comes rain or shine, the company itself will make more or less its earnings and grow overtime. What do you care if some nut case in the market tells you that he won’t buy your shares for more than 50% of you have paid for You know what the intrinsic value is and that that value is a lot higher than the nut case wants. Really, just because the nut case says he’ll pay 50% of your purchase price doesn’t mean that that is the value of your shares!
That house you bought 5 years ago for $300K and where you and your family live happily, are you going to sell that as soon as some realtor knocks on your door and offers $200K? Of course not, you are happy with your house, why would you sell? Besides, after all the renovations you did, you know the place is worth at least twice that!
But with a company you have always that nagging question, yes there will be good and bad quarters but are those forecasted earnings as reliable as you think? What is the quality of those earnings?
How good is management? Did they play with the earnings numbers? You check the return on assets and it is 5%; next you check the return on your equity and it is 10%. How is that possible? My assets earn 5%, but I make 10% on my investment? Oh, management took out loans at a 3% interest rate. So they borrowed money to buy assets that return 5% at an interest rate of 3% and the remaining 2% goes towards your net earnings and thus increases your return on equity. Smart eh? But….
How much did management borrow to do that?  Oh, you check the balance sheet and find that they borrowed nearly double of what you invested – i.e. they borrowed twice as much as you the owner has invested in the company. What will happen if interest rates rise to 5%? Oops, interest payments would nearly double and the assets won’t earn a dime more than the aforementioned return on assets equaling 5%. That means that you the owner will have a lot less net earnings to show for or worse, you could end up with no earnings and then what would your equity be worth?  Yes it would be worth nothing!
What if you owned Blackberry and the competition, say Apple, Samsung and Microsoft, would be snapping at your heels. Would that give you confidence that your net earnings are save and predictable?

What if the government comes up with a load of new regulations that you have to adhere to at your expense?

These are important issues. Some of these issues you can learn from accounting ratios – especially where it involves debt. Debt/equity ratio and current ratio come to mind. Then you could look at return on assets versus return on equity – with low debt they are virtually the same, while high debt is indicated by a much higher return on equity compared to the return on assets. If two companies have equal amounts of assets and debt but company 1 earns $2 dollars per share and company 2 earns $0.50 per share which one would you prefer? Right company 1 is much more profitable and would be my choice.
We’re talking earnings quality and business model. We’re talking Warren Buffett’s moat. And we need to learn about that too prior to investing. Oh… but that is so much research, I don’t have time for that!  Well, then stick to index investing. BTW I know a basket of 30 stocks that are the best companies in the world why don’t you buy those? I am of course talking about exchange traded funds that own the 30 Dow Jones Industrial Index stocks.
But really, if you do the research as suggested above and you invest in 10 or 20 companies that you really know well and you buy below intrinsic value, chances are you do at least as good if not a lot better than the aforementioned index fund. After all that is basically the way Warren Buffett invests!

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