Value Investing Framework

Value investors are investors who invest in companies which are currently trading at a price lower than the predicted future earnings of the company (intrinsic value). These earnings are called “owner’s earnings”. Owner’s earnings are simply earnings after tax plus depreciation and amortization less capital expenditures.

When owner’s earnings are growing year after year, then the company is deemed to do well. For the owner’s earnings to increase and for a company to be worthy of investing, several factors have to be in place. The company has to:

  • Be engaged in a business the investor understands
  • Have a strong and durable economic franchise (wide economic moat)
  • Have an honest and competent management
  • Have financial strength

Even if a company possess the following, one cannot just go and purchase the company’s shares. The investor then has to calculate the intrinsic value of the company and then determine a suitable price to buy at after factoring in a margin of safety. Margin of safety is simply the difference between the current stock price and the calculated intrinsic value. The more the margin of safety, the better it is. Margin of safety is essential as during the research of the company, the investor could have overlooked certain factors and calculated things wrongly. This margin of safety ensures that the risk is minimized even further, making value investing almost risk-free.

The summary of the framework is presented below:

A business you understand

A successful investor evaluates a business successfully. A favourite trick of outstanding investors to be in a frame of mind to be a business analyst is to imagine purchasing 100% of the company (or that they inherited it). In that way, the analysis will be thorough and not slip-shot. Furthermore, they imagine it is their only business asset. This helps them to focus on key questions such as how is the firm going to compete? What are its strengths and weaknesses? Who are the customers? Will the firm be positioned well in 20 to 30 years’ time? To find answers to the above questions, investors can:

  • talk to customers, employees, suppliers, competitors (scuttlebutt method by Phil Fisher)
  • Read annual reports of company and competitors, industry reports, analyst reports
  • Trying the company’s products, quizzing the managers and directors

Basically, investing should be within your circle of competence and not out of it. If you don’t understand the oil and gas stocks, don’t invest in them even though they may be the next big thing.

Strong economic franchise

The company must have a wide moat with a competitive advantage. Think of McDonald’s, Wal-Mart, SGX, Starbucks, Nike. These companies have a wide moat that isn’t very easily penetrated by competitors.

Honest and competent management

If there are no honest and competent managers running the business you invest in, then your money invested in the company would not be safe at all. There are many important indicators of good managers, such as:

  • Owner-orientated. Their aim is to maximize shareholder’s wealth for the long term.
  • Passionate about their work
  • Excellent in both day-to-day operational management and long-term planning
  • Highest integrity
  • Follow a rational dividend and share buy-back policy (repurchase stock when priced below intrinsic value)
  • Ignore even the most enticing propositions falling outside their area of special competence.
  • They don’t allow shareholder wealth destroying mergers
  • Report both bad news and good news
  • Treat staff with respect and fairness
  • Have tight cost control all the time
  • No accounting gimmickry
  • Decent behaviour
  • The management team has depth and breadth.

Financial strength

The company must have:

  • Earnings and free cash flow growth year-on-year
  • Little or no debt
  • Considerable amount of cash in hand but not in excess
  • Low capital expenditures (CAPEX)

Finding of intrinsic value will not be covered in this post as it will take substantial time to explain. I will cover it in future posts.

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16 thoughts on “Value Investing Framework

  1. hi, i am learning to be a value investor as well. This is a tough decision for me, but i choose to believe in value investing.

    hope to see your post on how to calculate instrinsic value soon.

    • Hi Jian Ling,

      Thanks for visiting my blog.

      Why is it a tough decision to be a value investor?

      To start off, you can read books on Warren Buffett like “Warren Buffett Way” and also “The Five Rules for Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market”.

  2. Hi FF,

    nice post. (:

    Hi Jian Ling,

    everyone has their own way of calculating a company’s intrinsic value. this company may look cheap to me, but to FF, it might be way too expensive.

    I believe calculating an intrinsic value depends on one’s risk appetite too.

    E.g. if you’re using DCF, consider how much growth are you projecting in time to come, consider how much discount value you are using and of course how long you think the company will ex-growth.

    In the above example, in relation to what i mention to depending on one’s risk appetite, to FF who might be more risk averse, might project company A to be growing at 5%, with 2.5% of discount value and may ex growth in 5 years to come. However to me, who might be more risk averse for example, might project company A to be growing at 10%, with a discount value of 2% and may ex growth in 8 to 10 years.

  3. hi all, :D

    hi FF, to me value investing is hard but i believe in 先苦後甜.

    i’ve read 1 of adam khoo book title ” profit from the panic”

    inside it mention a method on calculating the intrinsic value of 1 stock. its formula goes by taking the next 10 years of discounted value of the future cash flow, divide by the total number of shares outstanding.

    it work out for some numbers of some companies, but the question from me is that why does it only work when i take 10 years of value divide by the total shares outstanding? if i take only 3 years then the final value looks way off.

    because if i take the discounted cash flow of the next 50 years, i can say for sure 100% , the value is way higher than current share price, meaning i would most definetely get a result that fit my margin of safety.

    any ideas? :D

  4. Hi Jian Ling,

    Regarding the calculation of IV, you take 10 years as you want to stay invested for the long term. Some take a certain % of growth for the first 5 years and then a lesser % for the next 5 years. Some take the same % for the whole 10 years. There isn’t any hard and fast rule I believe.

    Regarding the 50 years part, any company won’t be able to grow at x% for the next 50 years guaranteed. Therefore, it is unwise to project to next 50 years. Yes, the IV when using 50 years will surely be much higher than if u do a 10 year IV calculation. However, is this being realistic?

    There are other ways to get a higher IV. You can use a higher growth rate or lower discount rate. But, there’s no point doing all these just to get a higher IV. Doing these will just amount to speculation and it is certainly NOT value investing.

  5. Hi Jian Ling and FFN,

    I think 10 years is a little too long to project cash flows reliably. I’d say 5 years is a good guage to begin with; and use a discount rate of 10% to be very conservative.

    I am currently reading a book by Sham Gad called “The Business of Value Investing”. In it he recommends using FCF (Free Cash Flows) for projecting intrinsic value and to compute margin of safety. I think it’s a good idea if you can understand the capex requirements of the business in which you are studying. The words “cash flows” sound pretty generic so I thought I’d better clarify it more clearly here.

    Will share more insights as I read along and post them here.

    Cheers!

  6. Hi all.

    Hi Jian Ling,

    i think what FF mentioned is correct with it being not realistic to project growth of a company up to 50 years. I think when we calculate IV, we would also want to be practical about our results. E.g. changing the amount of years more just to acquire the desired results. To me, i think anytime between 10 years is good, and i’ll usually get the number from govt. bond for discount rate.

    Hi MW,
    Didn’t say hello to me because i’m not 100% value investor? haha. jk. I personally think 5 years with 10% discounted value is very conservative and in order to buy at the projected price, we can only buy it at super bear periods such as what we’ve experienced during the subprime crisis.

    I also realised that you don’t really post on how you valuate your shares when it comes to your analysis. Not sure if you could share what method you use when it comes to valuation.

    I personally believe when STI reached a certain level, e.g. 3000, there are very little meat left for investment. If you concur with my above statement, how do you justify your purchase for SIA Engg who has grown more than 3 times on share prices since the last bear.

    I hope you don’t see my comment as a challenge to your methodology for value investing, I’m still learning as well. (:

  7. Hi MW,

    When valuing shares, I do use FCF instead of just CF from ops to project my IV. However, mine differs a bit. I use latest CF minus off average capex over the years to get average FCF. I use this average FCF to project, to be exact.

    Yes, pls post how you value shares so that we can learn from it too. Hopefully, you will post it when you blog on the latest part of SIAEC analysis.

    Hi CJ,

    I believe there will be undervalued companies in any markets including the super bull market. We just have to look harder (:

  8. yes i agree , in my opinion.. a bear market or a market crash provide a good chance to buy some blue chip, but finding a true super hidden gem will be during a super bull market, as hidden gem are often overlook when others are shining too brightly.

  9. Hi all,

    I could only agree partially because finding a gem and buying a gem at it’s right value is totally 2 different thing.

    For example, you don’t need a super bull to know that TMC is a good company, or you don’t need a super bear to know Genting is debt ridden.

    What i mean in my previous reply is that there is limited upside for investment purposes, but that’s doesn’t mean we still can’t find a gem. For example, Kingsmen in today’s STI closing could still be a value buy to FF or MW.

  10. Hi CJ and JL,

    What CJ has said is very true.

    Kingsmen is still very undervalued even with the STI posting new highs almost every other day. There are still undervalued companies, albeit lesser, in a bull market. We just have to look harder or just be extremely patient enough to wait for a bad news that will temporarily bring the price of a strong company down below its IV. That’s why not many investors prefer value investing because it’s SLOOOW (both in terms of capital appreciation and waiting for opportunity)…. People rather have fast gains like in a get-rich-quick-scheme. This, in a way, is beneficial to us, value investors, as we can sell a company that doesn’t have value anymore (risen too much) to the people who are looking for quick gains.

  11. Ok, wah you guys are fast! So many comments since I posted mine up…..LOL!

    cj,

    Well Part 5 of my SIAEC analysis actually does delve into that aspect – the valuation aspect. While it is true I do not arrive at an intrinsic value per se, I use metrics to determine if a stock is worth purchasing or not. In this case, let’s look at PER and P/B, as well as ROE and FCF. I think when you say the share price has tripled since the bear market, it doesn’t really say much about the value of the business. To quote some examples – Rotary has risen from 19c to $1 (5x) from bear to current; and OSIM has risen from 10c (assume you failed to catch it at the very bottom) to $1.00+ (10x) from bear to current. Such examples illustrate that there are many instances where share prices may double, triple or go up many multiples.

    SIAEC has PER of about 14x (forward) and P/B of about 3x; not exactly cheap yes. I took into account the strong FCF generation capability (including increased dividends from assoc companies/JV as detailed in Part 3); as well as 10-year consistently high ROE of >20% to justify the purchase. In other words, I felt it was justified for SIAEC to trade at the current valuation; and I label it as being “fairly valued”; but with the dividend yield to provide a cushion.

    Don’t worry; you phrased your question very politely so I don’t take it negatively. In fact I am also learning and I want to incorporate some form of number into intrinsic value in future so as to make the analysis more robust; I am working on this as we speak.

    Hi FFN,

    Yes good idea to use OCF minus average capex; that smooths out any anomalies during good/bad years.

    To BOTH:-

    I also feel there’s not much undervalued companies at current valuation levels; hence feel it’s prudent to just accumulate cash and wait. The dividends also help a lot to increase my cash stash.

    As for Kingsmen, it’s still “cheap” in valuation at current closing price of 64 cents; and dividend yield still exceeds 5%! Haha.

  12. Hi all.

    Hi MW,

    While what you have mentioned is true about the price not saying much about the value, wouldn’t it be better if you can get it at the cheaper price?

    I agree with what you mentioned on the latter part of your reply. If i arrived at an IV of 1 dollar for company A and it’s selling at perhaps $1.2, i might give it a shot after getting a conclusion on the good fundaments. However, i’m also only giving a shot because i have done a projection, not just because of it’s good fundamentals.

    Just like FF, i’m curious on how you have determined if a stock is at the right price. Hope you can share with us. (:

  13. Dear all,

    Yes of course if you can find a lower price it’ll be good, but as the saying goes I don’t mind paying a fair price for a good company, and my money can at least compound @ about 4% per annum, so I am OK with it.

    As for assessing if an investment is worthy, I use the ratios as mentioned for BS and PL, FCF indicators, PER and P/B and occasionally NAV. I didn’t use to do DCF; but will consider it in future as a guide as it will only give a very rough approximation (which may be off the mark).

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