InvestAcademy Session 2: Relative Valuation

Author (s): Grace Chan, Gordon Ong

Invest Academy Session 2 | 25 January 2018 | LT-3

So, how does one objectively determine the investment potential of a stock beyond Technical Analysis (TA)? The second session of InvestAcademy’s lesson had its focus on the qualitative valuation of stocks and the markets. This evening, two speakers, Benjamin and Nataniel, spoke about how to evaluate stocks using different valuation techniques, valuation price multiples and a good qualitative understanding of the company one invests in.

“The value of the stock is not what you pay for,” said Nataniel, the first speaker of the night. “Many do not know how to value assets. Valuation is to put a price on what [the assets] are actually worth.” He introduced several valuation techniques: Discounted Cash Flow (DCF) is a method that calculates the present value of all predicted future cash flows of a company, helping you determine its intrinsic value and whether to purchase it; Sum of the Parts (SoTP) is used after a valuation technique has been applied to a company’s different business segments, to add the separate values together and arrive at the ‘true’ value of the entire company.

The most important technique tonight, however, is Trading Comparables. “Trading Comparables are about comparing a firm…not against the market, but against its peers,” said Nataniel. He presented to the audience several financial ratios such as Price-to-Earnings (P/E) and Price/Earnings to Growth (PEG), which helps the investor determine a company’ current value by comparing it with other companies of the same industry or nature, thus enabling Trading Comparable and relative valuation to take place. “For instance, Netflix,” Nataniel suggested, “The ratios are off the charts. Everybody is crazy about tech[nology] stocks now. In comparison with its fellow media markets, [its result] is amazing, but against other tech[nological] firms such as Facebook, it is normal.”

While Nataniel believes that predicting the future performance of any stock is very difficult to do, “as everything are forecasts”, he posits that the P/E ratio is one of the most underappreciated ratio in evaluating companies. The P/E ratio is very dependent on the industry. For instance, you do a stock screening* and place P/E < 20 as your criteria. If you are screening for technological companies, you would need to adjust your P/E ratio to the industry’s standard instead (about 40-100+ for technology-related firms). It is exceedingly difficult to find technological companies at a P/E of 20. However, at a P/E of 20, you may be able to buy stable consumer stocks, or stocks that are not doing very well.

*Stock screening: filtering of stocks based on a certain criterion or metric

P/E is a beautifully simple indicator because there is literally only one variable input: net earnings. However, the problem also lies in its simplicity – net earnings might not reflect what you wish it to reflect, which is the company’s overall performance. There are non-cash and non-recurring items and certain accounting practices that may skewer the earnings number.

In fact, you may consider adjusting the companies’ financial statements to obtain a more accurate ratio. For instance, you can reverse non-recurring items from the income statement to get an adjusted net earnings number instead (adjusted P/E). There are also intangible assets which may not be able to be liquidated at the value stated in the accounting books. Hence, the Price of Tangible Book Value** might be a better reflection of what an investor can get when the company goes into liquidation.

**Price of Tangible Book Value: Net book value of all physical assets minus net book value of all liabilities

Benjamin, the second speaker for the night, then introduced other ratios such as PEG and the Price-to-book (P/B) ratio, emphasizing repeatedly the importance of using different ratios to make investment decisions, for no ratio has enough predictive value on its own.

He also introduced the concept of enterprise value to the audience, where a firm’s market value is adjusted for its debt, depreciation, interest tax and other costs. The idea is that enterprise value differentiates between companies even when they are in the same industry. He raised the intriguing example of him owning two apparel companies. The first sells Louis Vuitton shirts and is mature. The second is less known but has quick growth and many talented designers. How then do you compare the companies with only P/E when they are so different in nature? Considering their enterprise values would be more useful.

The audience was then asked to look at the case studies of the top five technology stocks before the Dotcom crash–Cisco, Intel, IBM, Oracle and Microsoft. Benjamin brought everyone onto an investigative journey on how ratios can or cannot predict the fates or fortunes of these firms, and the importance of understanding the market dynamics, management decisions and the company before investing in it.

Benjamin stressed, “No one would expect that the iPhone could overtake the smartphone market…Valuation changes, when the heart of the asset changes.” This rang true with the audience as they listened to him explain how cultivating a macro-outlook is crucial to predicting the market. “Put yourself in a management role to evaluate the market,” he said, “to see if the hype will last, and whether the market price is justifiable.”

To allow the audience to experience the thrill of investing, the session also included a live demonstration by Benjamin and Umar, a NTU-IIC main committee member, of investing platforms such as Finviz and Capital IQ, amongst others. Many members of the audience opened their laptops and attempted the various platforms throughout the demonstration, creating heat maps and adjusting stock screeners alongside Benjamin.

Finally, the session ended off with a live sharing session. Two investors, William (freshly minted investor) and Nataniel (investor with 4 years of experience), went up on stage to share their investing experiences and mistakes. As the audience was made up of both seasoned investors and beginners, the sharing session was very beneficial and enlightening, chronicling a beginner investor’s concerns and impulsiveness as well as a veteran’s reflections on past stock-buying decisions.

Benjamin further shared about his first trade. He was reading ‘Common Stocks and Uncommon Profits and Other Writings’ written by Philip Fisher when he walked by Starbucks at Jurong Point. He was hit by a sudden realisation that the number of Starbucks outlets was increasing in Singapore and inferred that it was expanding its operations, which led him to buy his first stock. Benjamin’s advice is to always look around you, because the trends you see may lead you to new insights in your investing decisions.

Both William and Benjamin further agreed that the demo account would be useful for a beginner to get accustomed to a brokerage account. Benjamin tearfully shared that he had once lost $15 when he tried to sell a stock, because he panicked and clicked on a wrong button, resulting in a double commission fee. If you are interested in opening a trading or demo account as a NTU-IIC member, do approach us through our email for any queries.

As Benjamin laughs, ‘It would be good to live life on your own terms, and may investing be the tool to bring you on your journey there.’ The second IA session thus came to an end, with much new learnings and investing principles to try out and live by.


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