The world's shortest formula for valuing stocks! - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

The world's shortest formula for valuing stocks! 

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In this issue:
» Will the ECB now take this extreme step to revive economy?
» Survey on cash transfer reveals interesting facts
» Power shortage a huge worry for India
» Subbarao may halt rate cuts
» ....and more!

A gentleman named Frank Singer, who has authored a book on how to value a business, has done a huge service to the field of investing we believe. Now, the fact that he has authored a book on valuation is not what we are giving him credit for. That's because books on valuations are dime a dozen. His achievement lies in the fact that he has written what could possibly qualify as the shortest book on valuation ever. Despite having a measly 30 odd pages, it does a great job of explaining what it had set out to explain. In fact, if the author is to be believed, he could very well have put the whole essence of the book down in just one page!

Well, if the book is short, Mr Singer has done an even better job of reducing the entire exercise of valuing a business to one simple formula. Now, one would wonder there are so many different types of sectors and then businesses in those sectors. Therefore, how can just one formula help in capturing the valuation of all of them. Singer gets around this problem by assigning probability to the earnings of a firm in the formula. In other words, Singer asks us to put any number between 0 and 1 based on how confident we are that the company would achieve a certain level of earnings.

It should of course be noted that the formula applies to a regular business that has a reasonably long history of producing earnings. Still the simplicity and the effectiveness of it cannot be ignored we believe. More than anything else, it helps refute the notion that valuation is a cumbersome process and can be done only by experts. Nothing could be further from the truth we believe.

Valuing a business is inherently imprecise and one can only estimate it within a range. Adding layers and layers of sophisticated formulas to it is just not going to solve the purpose. Simply because running a business entails interactions between so many different humans and numerous other variables that it is impossible to have a firm grip on the outcome. And therefore, it cannot have a precise value. All one can do is study the track record of the business being valued and estimate whether future earnings will follow the same pattern or some major parameters of the business have changed. And finally, assign some sensible multiple to that business. Anything more is simply not required and will only end up wasting time we believe.

If this isn't proof enough, let us tell you something else. Even extremely successful investors like Warren Buffett and Peter Lynch have never advocated complex methods for valuation. In fact, they have been ardent supporters of formulas that can be done even on the back of an envelope. Therefore what matters in valuations is not the complexity of the formula. But the ability to judge the business model of the company and the likelihood of a given level of earnings being achieved.

Do you think business should be valued using the simplest of formulas? Please share your comments or post them on our Facebook page / Google+ page

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01:32  Chart of the day
Are investors investing in gold these days? Well, nearly two third of them are not doing so if one goes by the results of the latest Equitymaster survey where more than 16,000 people cast their opinions. However, what is of some solace is the fact that around one fourth of the total people polled do plan to make some form of gold investments over the coming days/weeks. Then there are the other 37% who are indeed buying gold coins, gold jewellery or gold funds. We are of the view that while gold is good inflation hedge at all times, the need to have small percentage of gold in one's portfolio is even more pressing right now as we are living in the time of one of the biggest monetary experiments ever conducted. Thus, with high risk of paper money suffering strong devaluation, some form of gold investments is a must we believe.

Source: Equitymaster survey

Which one would you vote as the biggest failure of the incumbent government? Is it the inability to push through reforms, check corruption or support infrastructure growth? Without doubt each one of these have ensured that India's growth story remains just that. A story! Not just foreign investors but even domestic ones are now refusing to buy into the logic of slow and steady recovery. After all, several factors that once stood in India's favour have backfired. Large workforce and cheap labour promised a bright future for Indian manufacturing and services. However, poor employment opportunities and unskilled workforce has made India's demographics a challenge. Most importantly, problems like acute electricity shortage has rendered even the productive manufacturing units paralysed!

India's power sector already has a huge backlog in terms of adding capacities. The losses during power transmission are also one of the highest in the world. The government nevertheless plans to add 88,000 megawatts of generating capacity over the next five years. This will be equivalent to about 100 regular-sized power stations. Thus, while government remain ambitious, on paper, India's long term economic prospects remain vulnerable.

What is the value of your money? The question is incomplete if you do not mention when. This brings us to the concept of time value of money. It is said that a rupee today is worth more than a rupee tomorrow. Why? You could take the rupee today, put it to some productive use and earn a return. This is one of the core principles of finance and also the reason we have interest rates. This is the reason why borrowers pay you an interest for lending them money.

But what if you had to pay lenders for depositing money with them? Sounds very illogical, right? But you would be shocked to know that negative interest rates have existed in some parts of the world at some times. For instance, Switzerland had resorted to negative interest rates in the 1970s. The aim was to dissuade investors from pouring in capital in the safe haven. Denmark did the same a year ago.

Now, the word is around that the European Central Bank (ECB) could also go the negative interest rate way. Let us explain. Given that the Eurozone economy is in a severe crisis, banks are wary of lending to businesses. They prefer keeping the money with the ECB. The ECB had kept interest rates at zero to discourage this. But this may not have had the desired effect. Moreover, the demand for cash has been very weak. ECB does not want more cash as it is finding it difficult to lend it out profitably. As such, the ECB President Mario Draghi is apparently open to the idea of negative interest rates.

But such moves are fraught with serious unintended risks not just to the Eurozone but to the rest of the world as well. Given the way the global economy is linked, a change in one area has far-reaching consequences elsewhere.

If the latest data is anything to go by, detractors of the direct cash transfer scheme may have to sit up and take notice. There were many issues raised as far as the success of the cash transfer system was concerned. Some of which were that money given directly to families will not be put to productive use. Rather than spend on food and education, most of it would go towards funding vices of men. But as per an article on Firstpost, a survey based on two pilot projects on cash transfers in 9 Madhya Pradesh villages from June 2011 to January 2012 has revealed otherwise.

For starters, good spending on education, health, food and education increased. There were also other positive indicators such as incidence of illnesses coming down and indebtedness reducing. Further, with better nutrition and rise in standards of living, health indicators also improved. The criticism that cash transfer discourages people from working was also refuted. Here, a comparison made between 2 villages (one of which received cash transfer and other did not) helped in assessing this. Of course, all this is in the early stages. Indeed, it would be difficult to brand the program a resounding success based on the findings of this survey alone. But it does seem like a step in the right direction and the coming months would present a clearer picture of how successful these transfers would be.

We have already seen three successive rate cuts by the Reserve Bank of India. However, if one tries to read the signals sent by Mr. Subbarao, those who are hoping for a further rate cut this June are likely to be disappointed. This may seem an anti growth instance, but we believe he has a point. While inflation is off its peak, it has not sobered yet. With a highly uncertain environment, one can hardly bet on global commodity prices and their impact on inflation. The GDP growth rate has hit a decade low and domestic currency is under pressure. To make matters worse, India's current trade deficit remains high. With elections around the corner, we believe there is a limited room for fiscal reforms. Hence, we will not be surprised with an absence of rate cut, at least in the next review due this June.

Meanwhile, indices in Indian equity markets traded weak today with Sensex lower by around 330 points at the time of writing. Realty and oil and gas stocks were seen under maximum pressure. Other Asian markets closed mixed today but Europe is trading mostly in the negative currently.

04:56  Today's investing mantra
"Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts." - Warren Buffett

  • Warren Buffett - The Value Investor
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    4 Responses to "The world's shortest formula for valuing stocks!"

    akole rajendra vasudeo

    Jun 2, 2013

    I want to try your formula



    May 31, 2013

    Where and for how much is this book available in India?


    vk sharma

    May 31, 2013

    I personally feel we do not require any complicated formulas to spot multi-baggers. During 2009 when the market was down I just spotted two companies-- TTK Prestige (share price was Rs.137) and Hawkins Cooker (Share price was Rs. 200) both producing kitchenware. Today TTK Prestige share is worth Rs. 3300 and Hawkins share is worth Rs.2400. My growth assessment was based on the quality of management and growth prospects of kitchenware in rural and urban markets.



    May 31, 2013

    Simple formula for valuing stocks - Wow all this guru talk sounds fine, but in real world people have to do a lot and complex stuff or hard work to prove that their model/method is reliable.
    You may not agree with me. I did give similar answers or response in interviews at many firms which are well known in the market and comparable to Equity Master. Alas! they all simply doubted my skills or wanted me to create a model and show them. All this sounds good but when talented and skilled analysts including me and several others come up with original analysis its all just diluted because these equity pros dont want outsiders to take away their positions.
    One company stole my model, another company stole my research report itself in the pre-text of giving me a test. Despite being a financial analyst I find it a little difficult to trust or believe any research firm, brokerage, financial institution, etc.

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