Tuesday, March 31, 2009

Views on Balance Sheet and Valuation

My views on analyzing the B/S, P&L and Cash Flow Statement:

1. On the B/S. A B/S that is well-structured or well-proportioned supporting the underlying business and its further growth, is certainly superior to a B/S with a big overall size and/or big key B/S items. It is also very important to verify that the asset items in a B/S are of sufficiently good-quality, and their values properly or conservatively recorded. Given a choice, I will much prefer to have the body of a healthy athlete, than an 'inflated' body or one carrying 'diseased' parts!

2. On the P&L. It is crucial to first critically assess whether the profits are real, fair and sustainable. To just fall for big and nice profit numbers is obviously quite dangerous. It certainly pays to remind ourselves that profits on the P&L are merely numbers derived by accountants using accounting rules; and it is quite foolhardy to assume that the accountants and management are honest and knowledgeable in accounting, and the auditors are always diligent and never make mistakes. In this regard, having a good-enough understanding of the underlying business activities and the industries concerned, will certainly help in the interpretation and analysis of the P&L and financial accounts.

3. On the Cash Flow Statement. It is only good, if the profits in the P&L and the current assets in the B/S are both good. The primary additional value-add from analyzing cash flow is to be able to value the underlying business based on its capacity to generate free cash, which is superior to just relying on accounting profits.

For valuation of a business or a stock, I like to make it simple. My own views and approach:

1. I will only rely on my own valuation to decide on my own purchase price, after factoring in an appropriate margin of safety.

2. My primary basis for valuation of a business is a reliable estimate of its current aftertax FCF, before adjusting for WC changes or capex. Depending on the stabiity of the underlying business and quality of the financial accounts, I can accept the numbers in the latest P&L, or take a simple average of the relevant numbers over the most recent accounting periods to adjust for volatility.

3. Having determined a reliable estimate of a business' current aftex FCF, I would apply an appropriate multiple - based on my own judgement - to derive my own estimate of the fair or intrinsic value of the entire business. The appropriate multiple will take into account the quality aspects of the business, including its profitability and sustainability, volatility and growth potential, management quality/competence, intangible assets (like brands and goodwill), business/industry risks, long-term capex requirements, working capital/capex requirements, etc. The derived estimate of the fair or intrinsic value of the entire business will be used to determine the fair value of the unit share, after adjusting for any existing derivatives like warrants or stock options.

4. Depending on whether there are additional 'reserve-type' assets - e.g. investment properties, 'hidden' value (vs. realisable current market valuation) in key assets, large cash reserve, etc. - in the company, I will usually attach additional value in my estimate of the fair or intrinsic value of the entire business.

These are comments extracted from Wallstraits Forum. I find it to be of value in my understanding of how others value their stocks.

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