Sunday, March 24, 2013

What is the INTRINSIC or TRUE VALUE of an investment asset? Part II

Warren Buffett’s Moat around the Business

It is good to compare the Net Present Value of a business’ Net Operating Income (NOI) but what is the QUALITY of these EARNINGS?  You can project earnings until the end of times, but will that projection hold up?  Are the company’s products obsolete by tomorrow?  Think of Yellow Pages or Kodak!  Does the company have to continuously redesign its products and face intense competition?  Think Apple, Blackberry!  Is the brand of its products strong and is the company’s product independent of fashion and cheap to produce?  Think Kraft; Proctor and Gamble; Microsoft! Are the company’s products commoditized and heavily affected by prices set by other parties?  Think of potash, oil, gas or copper producing companies such as Exxon, Encana, Potash, and Agrium! 

To know how big the moat is around your company, i.e. what the quality of its earnings are, you have to understand your company's business.  That is why Warren Buffett sticks with companies whose business model he understands. Once you understand the moat, you can make a better investment choice regarding the quality of its earnings and intrinsic value.

The same for Real Estate investments – you can buy a ‘cheap’ property with a heck of a NOI but does that NOI last?  Where is the property located? Is it in a city with a declining population or in one with a rising population?  What are the factors that makes the population grow?  Is the area a fashionable recreation destination; is it seasonal or is the population growth based on an increasing GDP underlain by a growing solid industry?  For example, Alberta’s population growth is related to a business friendly government with the lowest taxation rates in North America along with growing commodity based industries benefiting from the growing commodity demand in the world and in particular demand from emerging economies. (How is that for a run-on sentence?) Where would you prefer to buy real estate?  In Alberta or in a province with high debts, increasing taxes and a declining manufacturing sector?  Really, once you think about it – this is not rocket science!
UNDERSTAND THE MOAT AROUND YOUR INVESTMENT. If you want to get a better feeling about moats just watch CBC’s Dragon Den – that is all about ‘moats’. Maybe then you’ll understand why these guys are rich and… from time to time quite nasty in their questioning.

Saturday, March 16, 2013

Listen to this BNN interview about the role of shareholders in today's businesses

Apart from being a great communicator Michael Roach is a superb salesman for CGI's services. But that is not the most important message in this BNN interview.  "... they are an important investor but beyond that they play no role in the company", says CGI's Michael Roach.   Thus, the shareholder is not much different that a bond holder (a point also made by Warren Buffett) but rather than receiving interest, the shareholder gets his/her proportional part of the profits. However, management decides how those earnings are invested in the form of re-investment in the business, share buybacks and/or dividends.  (What does CGI do and how does it compare by Canadian tech giant Blackberry)  (Corporate financial strategy and stakeholder roles) (Shareholder rewards)

Sunday, March 10, 2013

What is the INTRINSIC or TRUE VALUE of an investment asset? Part I

By now most of us should know about the psychotic way the stock and real estate markets valuate businesses and properties. There is rhyme nor reason in these markets just a big bundle of emotions. So how can one know what the proper price to pay is – i.e. taking the emotion out of investing? What is the INTRINSIC or TRUE VALUE of an investment asset?

Let’s start with the basics: when we invest we’re buying an asset that provides us a return on our investment (ROI). Basically one would be tempted to say that the higher the ROI the better. That is not necessarily true because often with a higher ROI investment risk increases. For now, let’s not talk about risk because then our discussion will never end. Instead let’s focus on ROI generating assets.
Investing like most complex things can be summarized in a very simple principle:
The big difference between real estate and stock market investing is how the investment return is handled. In real estate the return is used by the investor to pay for financing and the remainder is net- or free cash flow.  When dealing with stocks, the returns are used by the corporate management to pay for financing, re-investment and the remainder is net- or free cash flow that can be used for stock buy-backs and/or dividends for the investor.  This is shown in the next two figures.

                Now ask yourself, what is the real value of the real estate and common share investments? Intuitively one would say for real estate it would be the costs of land and building and for the stock market it would be the costs of the production facilities which may include (if not leased) that of the real estate that the publicly traded company owns. Another way to value these investments is based on how well the assets are being managed, i.e. the investment’s Net Operating Income (NOI or EBIT).  If you project EBIT and NOI over the life of the investment then you could calculate today’s value of the summed incomes using a discount rate such as inflation or the interest rate you make on the money if invested in a ‘low risk’ GIC or government bond.   The result of this calculation is called the Net Present Value of an investment or Intrinsic Value

Intrinsic value refers to the actual value of a company or stock determined through fundamental analysis without reference to its market value. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value (Wikipedia).