The overall process of investing is simple: Buy – Hold – Sell. Unless you’re a buy-and-forget investor, it makes sense to periodically check on the difference between the price of your investment and your estimation of its intrinsic value.
One small complication in this process is the fact that the intrinsic value of every company changes over time. It’s hard enough to come to a sensible estimate of value, and it may be even harder to estimate value once you actually own a company’s shares because behavioural economists tell us that we are more likely to value things more highly once we own them.
Many investors feel the need to re-think their investment’s value almost constantly by following every piece of news and factoring it all into their latest estimate. However, if a company needs that sort of close attention, or has an intrinsic value which is so sensitive to the day-to-day events that happen to all companies, then perhaps it wouldn’t make such a good investment after all.
Alternatively, a large, mature and stable company is more likely to have an intrinsic value which is better insulated against the ups and downs that all companies face.
The intrinsic value of a good business typically takes time to change, which is why the annual report may be the best time to do a revaluation.
Looking at BAE (a company which I’ve owned since early 2011) as an example, I can compare the key numbers which make up my valuation in order to see how they’ve changed in the last year.
- For 2010 the average earnings for the previous ten years was 26.6p. For 2011 it was 28.4p, an increase of 6.7%.
- For 2010 the 10-year earnings growth rate was just under 8%. For 2011 it’s just over 8% after a negligible change.
- For 2010 the dividend was 17.5p. For 2011 it’s 18.8p, an increase of 7.4%.
Using these simple long-term fundamentals, I think it’s reasonable to increase my estimate of BAE’s intrinsic value by something around 7%. Alternatively, I can combine value with price and look at the long-term earnings yield and the dividend yield to see if BAE is good value for money at the moment.
Of course, there are thousands of other factors that can be considered, and after I’ve read through the annual report, I might think about some of them in more detail. However, the truth is that even if I learned more about BAE than the company’s CFO, it’s unlikely that that knowledge would give me much more of an investing edge than just a handful of key long-term metrics.
As I have a military formation I used to understand this kind of companies and to invest in them. Today, I can’t say I understand them anymore, I am under impression there will be higher cuts than we can think of in the defence sectors, from UK to Saudi Arabia. I may be wrong and if Iran makes a ‘mistake’ the defence sector will rerate.
On the positive note, BAE is in the elite UK CROCI index made only of 15 UK stocks. That means it is ‘undevalued’ based on the information it will meet its consensual targets as agreed by its stock analysts. To be part of that index the stock should have some ‘margin of safety’ as those components of the index are chosen based on how deep undervalued the stock is believed to be.
I think you’re not alone when you say you don’t understand them. BAE is a huge company doing a vast number of different things with different clients across the globe. I don’t even begin to attempt to understand it. I think it’s much more rational to just look for long-term stability and buy it when it looks cheap. My assumption is that their products will, unfortunately, always be in demand to a level that is broadly similar to today’s.
See I am different, I like to invest in stocks I understand. I don’t try to copy Warren Buffet who does the same as he is the ‘guru’, I am nobody.
If you base your investments decisions and you value stocks based on their accounts you will get two type of businesses: real value stocks and value traps. To make it work you need to diversify over 60 and even more stocks and you will earn a couple of procentages on top of the market premia. It is worthwhile. The more uncorelated is your mix the better you will perform.
The problem I have there are lots of business I understand but because I understand them I can’t invest in them. For example banks. There are a few problems with them. They should make profits from lending as the yield curve is steep, even if it was steper last year. But here is still a lot of write off to come. Probably there is less write off from loans as there is more from selling assets and they need to sell assets as these banks needs liquidity. Unfortunately they bought those assets (banks in Brazil or Turkey) at inflated prices and now they sell them cheap as chips. So in this case valuing a bank based on their accounts doesn’t make any sense, they may trade at 60% their book value but probably the book is not wortn that much in the first place.
You’re right, valuing companies on book value doesn’t always make sense. Most of my big-cap stocks trade at multiples of book because they are great businesses, or at the very least good solid businesses. However they are cheap relative to earnings, dividends and in relation to their possible future value if ‘normal’ service continues.