Have you ever wondered how to value a company to get good returns? Or, have you ever wondered how the principles of value investing can be used in the context of Nepal. This is the first iteration of a series of posts I will be writing on the topic of value investing.
Valuing of any material item is very subjective. There is a well-known psychological phenomenon called the Endowment Effect, which says, “we naturally assign more value to things just because we own them.” Let us create a hypothetical scenario. You just bought something that you have been wanting to buy for a year. And let’s say that thing is somewhat rare to obtain. Will you sell it to someone if they gave you 5% more than what you bought it for the very next day. It might be that you would never want to sell it, no matter the price. Hence, what you value is very subjective. We, as human beings, are very irrational about our choices.
After reading this article you will be able to understand :
- Value trading
- An exciting interesting experiment
- Assets vs Liability and Value Investing
- Valuing a small business
- Valuing a large business
To understand this. Let us consider yet another hypothetical scenario. Let’s say you have a paper clip, and people are willing to trade with you, but not with money. Maybe they will give you something else for the trade. Say a feather of a bird. The feather then gets traded for a cloth. The cloth for a book. The book for a map and so on. This is, of course, considering you are trading what you have for something more valuable (trading up in value). If you can continue with this, then there is no limit to how big you can trade. Starting from a paperclip, you might be able to get an island. This is an idea of what value trading looks like.
The moral of the story is when you are investing in something, expecting a return, the amount of risk you want to take to get that return is very subjective (more on this later).
Red Paperclip Guy
Here’s the exciting thing. The hypothetical scenario discussed above is not really that hypothetical. There is a guy named Kyle Macdonald who ran this experiment and was actually able to own a house at the end. Starting with a red paper clip.
But wait before you go down to the darkest hole of your house and try to find the rarest thing that you can find. I advise you to watch his ted talk. Watch the entire video and try to really understand what he is saying. The amount of variables that had to fit perfectly is improbable for anyone. And at the time, it was a new idea, something no one had ever done before to that scale. So, yes, in theory, you can do it. It could be a good experiment. But I will not bet on you to be able to get a house for a paperclip.
Assets vs Liability and Value Investing
An asset is something that can hold and grow its value over time while it puts money into your pocket. Whereas, conversely a liability is something that takes money out of your pocket.
So, a house is a liability, if you are not renting it. Because you will have to put money, into your home, to maintain it. Whereas if you rent the house, you have an asset. Because then the house would hold it’s original value and put money into your pocket. A car, a bike is a liability. As soon as you buy a vehicle, it loses its value. I am not saying it is good or bad. It’s just what it is. There are some liabilities that you have to take on; maybe to increase productivity or to get some sort of personal satisfaction. However, the wealthy stay wealthy by minimizing liabilities and maximizing their assets.
Hence, value investing is an idea of investing in properties that hold and grow in value with time until you want to make the trade.
Valuing a Business
Valuing a business at its core comes down to looking at its financial statements. And through some thorough analysis determining the intrinsic value of its shares. After you have that number, you would look at the market price of that stock (in the stock market) and always try to buy low. As you hold that stock, you will get a return. This is why the market price of a stock does not matter. It is just the matter of whether you are buying a stock at an amount less than the intrinsic value or paying a premium for it, based on hype or a trend. The question that you might be thinking of is, “Why would you try to buy a stock at a price lower than it’s original intrinsic value” if it’s a good company with an outstanding history. ( Keep reading, and this will be made clear).
Benjamin Graham is known to be the godfather of value investing. Warren Buffet, who is one of the wealthiest people in the world, was a student of Graham and still uses the same principles for all his investment purposes. But I do want to make one thing very clear. Often times, I find that books like the “Intelligent Investor” and “Security Analysis” (Both by Graham) are suggested to amateur investors. That is an idiotic suggestion to a starting investor. These books are very technical in nature and are not for beginners. Comment down below if you want my recommendations. I say this because reading these books as a beginner can put you off and ultimately frustrate you into thinking that investing is something you can’t do.
Valuing a small business
Regardless of the size of the business (Big or small), there are always three pieces that exist. They are the owner (Board of directors in a large company), Customers and the business itself. From here on else, I will be using some technical terms, so do try and keep up(Note them if you have to). These are terms you will see in most financial statements.
The total money being paid by the customers that go into the business is called the total(net) revenue. If you go to a shop and pay 100 Rs for an apple then that 100 Rs. For the business is the total revenue (Considering a single business transaction). The total amount spent by the owner to run his entire business is the cost of revenue. The cost may include rent payments, employee cost, cost of acquiring the fruits, and so on. Let’s say the total cost of revenue for the owner for that single piece of apple is 70 rs. Then the net income is the difference between total revenue and the cost of revenue. Hence, the net income is Rs.30 which is the owner’s net income before taxes.
The net income or earnings is the amount remaining after the payment of tax on that income. Say the owner pays Rs.10 in taxes then the net income is Rs. 20. What to do with that net income is dependent on the owner. He can take that money and pay himself, or he can invest that money back into the business (returned as equity to the business, a topic I will discuss in the next post).
Valuing a large business
If you take the model of the small business and change the owner to the board of directors than every other aspect of a large business remains the same as that of a small business. The board of directors are people who hold millions of shares of a company. Those boards of directors represent your vote in the company (Provided you own the shares of that company). When you buy a stock of a company say, NABIL Bank then you are practically, a part-owner of NABIL Bank and that gives you voting rights. But how much of the stocks you hold will decide how powerful your vote is.
That voting power you get is delegated to one of the board of directors. So, there is a fundamental distinction that needs to be made. Just because someone is a CEO of a company doesn’t mean he owns the company. A CEO is the head of the company, but he is like any other; an employee to the board of directors.
How would you go about valuing a business
Earlier I said that the value you put on a business is subjective and is based on the amount of risk you want to take to get an arbitrary amount of return. To understand this, let us consider yet another hypothetical scenario. Let’s take the earlier example for the purpose of convenience and throw in a few zeros at the end.
Let’s say your net income in a year is going to be Rs. 20,000 after taxes. Then the question is, “how much is the shop worth if you can make the same Rs. 20,000 next year (exact) given that the business does not change and you don’t have to do a single amount of work?” Then this is where the valuation of a business becomes subjective.
- If you pay 4,00,000 to acquire the business, you will earn a 5% return on your investment.
- If you pay 2,00,000 to acquire the business, you will earn a 10% return on your investment.
- If you pay 1,00,000 to acquire the business, you will earn a 20% return on your investment and so on.
Hence, as you pay more, your return decreases. This is why you always want to buy a stock below its intrinsic value. Because if you pay a premium(overpay) for a stock, then your return on that investment decreases. This is why you should always pay the money for the return that you are happy with (without being unrealistic, of course).
I want to make something clear. This is not a single article concept. Of course, investments in the real world is not this clear cut. So, in future posts I would like to explain how you can apply these principles in the real world and also how to look at balance sheets, cash flow statements, income statements and also different financial ratios and what they mean. It will probably take me months to explain these ideas. This is a topic that is very dear to me, and I want to take my time explaining these ideas in a way that regular folks like you and I can understand it. So subscribe for future updates.
P.S. How to figure out the intrinsic value of a company will be described in the next post.
For more research: You should check out https://www.theinvestorspodcast.com/ as I am sharing the ideas I learned from his videos. Most of the ideas for these blog articles stem from his explanation of the concept.