How do we value investments in general? What are the principles and framework for us to value stocks, real estate, private business, etc? Can we, being lay people, confidently evaluate investments to get a good feel of the value and potential of the deal?
The answer is yes. And the following are some guidelines I use and advice my clients to apply too.
1. Revenue of the business
Revenue measures how well the company is selling its products. Higher revenue will mean that the company is selling a large volume of its products or at a higher price. It will mean increased potential profit for the company.
2. Potential market growth rate of the industry
We can do some research on the internet to find out what industry experts say about the future of the industry. We can get a good feel of whether it is a sunrise or sunset industry. We can know its challenges, government interventions, and also the potential growth rate of the industry. We can include this into our financial calculations. Understanding how to use an excel sheet will be very useful to do the financial modeling as there are many user friendly functions to help in calculations.
3. Expenses to operate the business
A high revenue generating business may not be profitable if the cost of doing business is high. An ideal business will be a low cost, low overheads business with high revenue. This will translate to higher profit margins. Costs will typically include labor cost, rental, machinery, raw materials, etc.
4. Inflation rate for expenses
Costs will increase overtime due to inflation. To understand whether inflation will rise in the future, we will have to know the interest rate by the central banks and the monetary policies set by the different governments of different countries.
5. Profit margin
The profit is derived after the cost is deducted from the revenue (Revenue – Expenses). Investors will usually be very concerned about the profit margin. A healthy business will typically have margins of about 30% – 40%. A very attractive business will have margins of 50% and above.
6. Cashflow
If the profit margins of a business are high, it does not mean that the cash flow of the business is healthy. This is because some payments from customers are accrued payments (delayed payments). So even though the revenue is “captured” on the accounts, the actual cash has not come in yet. Thus, businesses can run into cash flow problems, which is dangerous and detrimental to the company. The company can go into bankruptcy if cash flow matters are not handled well.
7. Financial Ratios
Some financial ratios are:
Asset Turnover Ratio = Sales/Average Total Assets
Debt to Equity Ratio = Total Liabilities/Total Shareholder Equity
Current Ratio = Current Assets/Current Liabilities
Return on Assets = Net Income/Average Total Assets
Return on Equity = Net Income/Average Shareholder Equity
There are many other ratios to measure different aspects of the business, depending on the type of business and its particular industry. A good investor will take time to calculate the relevant and significant ratios and have a overall feel of the profitability and value of the business. A strong knowledge of reading financial statements will be very useful.
8. Net Present Value (NPV)
For any investment project, I will make sure to calculate the Net Present Value (NPV) after I have determined all the cash flows of the investment. With the advent of sophisticated and professional Excel spreadsheets, this value can be calculated with a few simple clicks on the mouse. As long as the NPV for the investment is positive, it will be a worthwhile attempt to invest in the particular project. Simply put, the NPV is the present value of all the projected cash flows in the future divided by the discount rate used. The discount rate can be the current real interest rates prevailing in the market.
9. Internal Rate of Return (IRR)
Similarly, when the cash flows of an investment is determined, the excel sheet can automatically calculate the internal rate of return. This return is when the NPV is ZERO. It means the reasonable return to be achieved from the investment. A good project will be one where the IRR is >15%.
10. Other factors
To determine the VALUE of an investment, there are many other factors to consider. Different investors/fund managers will employ different criteria to their investment analysis, depending on their styles and strategy. It will be beneficial to understand who you are as a person, your personality, and your beliefs and select the strategy that best suits you. For myself, I believe that VALUE investing is the way to go.
Value investing truly benefits all stakeholders; the investor, the business owner/entrepreneur, and the economy as a whole. Till date, Benjamin Graham & Warren Buffet has proven that VALUE investing is successful investing.
The Value of Value Investing II
How do we value investments in general? What are the principles and framework for us to value stocks, real estate, private business, etc? Can we, being lay people, confidently evaluate investments to get a good feel of the value and potential of the deal?
The answer is yes. And the following are some guidelines I use and advice my clients to apply too.
1. Revenue of the business
Revenue measures how well the company is selling its products. Higher revenue will mean that the company is selling a large volume of its products or at a higher price. It will mean increased potential profit for the company.
2. Potential market growth rate of the industry
We can do some research on the internet to find out what industry experts say about the future of the industry. We can get a good feel of whether it is a sunrise or sunset industry. We can know its challenges, government interventions, and also the potential growth rate of the industry. We can include this into our financial calculations. Understanding how to use an excel sheet will be very useful to do the financial modeling as there are many user friendly functions to help in calculations.
3. Expenses to operate the business
A high revenue generating business may not be profitable if the cost of doing business is high. An ideal business will be a low cost, low overheads business with high revenue. This will translate to higher profit margins. Costs will typically include labor cost, rental, machinery, raw materials, etc.
4. Inflation rate for expenses
Costs will increase overtime due to inflation. To understand whether inflation will rise in the future, we will have to know the interest rate by the central banks and the monetary policies set by the different governments of different countries.
5. Profit margin
The profit is derived after the cost is deducted from the revenue (Revenue – Expenses). Investors will usually be very concerned about the profit margin. A healthy business will typically have margins of about 30% – 40%. A very attractive business will have margins of 50% and above.
6. Cashflow
If the profit margins of a business are high, it does not mean that the cash flow of the business is healthy. This is because some payments from customers are accrued payments (delayed payments). So even though the revenue is “captured” on the accounts, the actual cash has not come in yet. Thus, businesses can run into cash flow problems, which is dangerous and detrimental to the company. The company can go into bankruptcy if cash flow matters are not handled well.
7. Financial Ratios
Some financial ratios are:
There are many other ratios to measure different aspects of the business, depending on the type of business and its particular industry. A good investor will take time to calculate the relevant and significant ratios and have a overall feel of the profitability and value of the business. A strong knowledge of reading financial statements will be very useful.
8. Net Present Value (NPV)
For any investment project, I will make sure to calculate the Net Present Value (NPV) after I have determined all the cash flows of the investment. With the advent of sophisticated and professional Excel spreadsheets, this value can be calculated with a few simple clicks on the mouse. As long as the NPV for the investment is positive, it will be a worthwhile attempt to invest in the particular project. Simply put, the NPV is the present value of all the projected cash flows in the future divided by the discount rate used. The discount rate can be the current real interest rates prevailing in the market.
9. Internal Rate of Return (IRR)
Similarly, when the cash flows of an investment is determined, the excel sheet can automatically calculate the internal rate of return. This return is when the NPV is ZERO. It means the reasonable return to be achieved from the investment. A good project will be one where the IRR is >15%.
10. Other factors
To determine the VALUE of an investment, there are many other factors to consider. Different investors/fund managers will employ different criteria to their investment analysis, depending on their styles and strategy. It will be beneficial to understand who you are as a person, your personality, and your beliefs and select the strategy that best suits you. For myself, I believe that VALUE investing is the way to go.
Value investing truly benefits all stakeholders; the investor, the business owner/entrepreneur, and the economy as a whole. Till date, Benjamin Graham & Warren Buffet has proven that VALUE investing is successful investing.
Aaron Graham Tay, Certified Financial Planner
Aaron Graham Tay
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