Buying the company on the streets (Part 2) - When to buy?

In the previous post, the companies on the streets were discovered in our everyday lives. I have said that even though we have discovered them, we should not buy them immediately. In this post, I'll touch on some simple ways we can value a company.

Knowing the nature of a business is important before anything else. What business does the company engage in? How much does that product contribute to the company's profits? For example, we know G2000 is partly owned by Wing Tai. Wing Tai has a retail business but they also engage in building properties. G2000 is an established brand with good sales record. However, Wing Tai only owns 45% of G2000 and this only contributes to a small portion of its income. The main income comes from its property business. So no matter how successful G2000 may be or how long the queues you see outside G2000, the impact on Wing Tai's profit is very minimal.

Now, even before you start investing, i would suggest you forget about the stock price. The stock price the company is trading at now does not mean anything. You are not buying the stock price but buying a part of the business. Look at the company with the eyes of a business owner.

When to buy?

This is a question a lot of people ask. To be honest, there is no perfect entry point to buy a stock. In fact, most of the time when investors buy the stock, its price will most likely go down. Does it sound shocking to you? Of course you do not want to be buying at the high also and don't want to be paying a high price for what the company is actually worth. It'll be good if you can buy the company at a discount of its fair value.

Now, to determine the value of the company, we can look at 2 things:

1. Intrinsic value
2. Assets the company owns

Intrinsic Value

You might have heard of this term called the intrinsic value. Investopedia defines intrinsic value as "The actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors". So how do we calculate the intrinsic value of a company?

Cash flow can be used in the calculation of intrinsic value. Cash flow is a more accurate measure of a company's worth than earnings. It is the real cash that the company generates every year. To know more about cash flow, read: Understanding Financial Statements (Part 3) - The Cash Flow Statement

The most common valuation that investors use to calculate intrinsic value is called the discounted cash flow model. It factors in the estimated future cash flow growth rate of the company and discount it to the present value. Intrinsic value is therefore the present value of all expected future net cash flows to the company. This will give a rough gauge of how much value the company is worth today based on the predicted cash flow growth. 

Not to worry if you do not understand what i wrote above. I know sometimes it is not easy to understand the finance concepts if you're not a finance student. There is a free intrinsic value calculator you can use provided free by Bigfatpurse.com. You can download the free intrinsic value calculator here. 

Assets the company own

Assets have value and this is especially important for companies that deal with or own properties. We can do a simple valuation of property stocks using the Price to Book(PB) ratio. Book value is similar to what we call Net asset value(NAV). The NAV of a stock is derived by taking the total Assets minus the total liabilities. The NAV shows us the total net assets the company has. The PB ratio is derived by taking the stock price per share divided by the NAV per share. A PB ratio of less than 1 means the stock is trading less than its NAV per share.

Let's say Capitaland stock price is now at $2.50. Assuming it's NAV per share is $5, the PB ratio would be 0.5 ($2.50 divided by $5). If you buy its stock at $2.50 now, you would have bought at less than it's actual value based on its assets. Isn't that a good value that you have found?

Margin of Safety(MOS)

Buying a company below its intrinsic value gives us a margin of safety. This will somewhat limit the downside risk if the market turns bearish. Buying 25% below the company's intrinsic value is a safe margin. However, the stock price can fall even lower and when that happens, it should be good news for value investors like us. This also means that we should always have extra money on reserve no matter what. This is to take advantage to buy at lower prices when Mr market decides to have a bad mood. Unless if i can find many stocks trading at more than 50% lower than it's intrinsic value, then maybe i will be invested fully. When the crash comes it takes courage to invest. Will you be in the game when it happens?

Conclusion

This ends the 2 part series on buying the company on the streets. Next time when you go shopping, remember to look around to find companies which you can potentially buy. Then, research on the company based on its economic moats, profitability of its business, strong balance sheet, intrinsic value and assets. This is what Warren Buffet says to buy good companies at undervalued prices.

It's bad to go to bed at night thinking about the price of a stock. We think about the value and company results; The stock market is there to serve you, not instruct you. -Warren Buffet, 2003 

Like my articles? 
You can Subscribe to SG Young Investment by Email 
or follow me on my Facebook page

Related Posts:
1. Buying the company on the streets (Part 1) - Discovery stage
2. Understanding financial statements (Part 1) - The income statement