## Wednesday, August 31, 2011

### How to measure value of shares?

The value of any asset let it be shares, bonds or even business as a whole can be measured by estimating the cash inflows and outflows. These cash flows would then need to be discounted at a rate which is appropriate. The value of bonds are most simple to measure. Government bonds has a fixed maturity dates and a fixed interest rates.

On the other hand shares do not have the advantage of predictability (unless otherwise studied) like that of bonds. A person who wish to measure the value of the share must assume (or estimate) a safe cash flow (cash inflows & outflows) and a discount rate. This combination of cash flows and discount rates will enable the analyst to measure the value of shares.

The value investors always selects investments (shares), which, as per their value measurements are cheaper, or better call them as “undervalued”. Value investors are always after undervalued shares and must avoid overvalued shares under all circumstances. The value measurement technique takes into account all business parameters before declaring its measured value.

The parameters that are often considered are like financial strengths, growth prospects of business, predictability of earning in future & stability of earning in the past.

The best yardstick for value investors to locate an undervalued, quality shares is by checking their balance sheet. Check what is the cost of their capital, if their cost of capital is lower than the returns they are generating then it is a must buy company.

Let me explain, suppose a company lends \$100 to manage its 100% working capital at bank interest rate of say 6.5% per annum. This capital the company will use to generate finished goods (say 10 numbers @ \$10/each). When this finished goods are sold into the market they must be sold at such a rate that they will generate revenue to make decent profits.

Suppose the management of the company decided to maintain at least 5% profit, in this cast the selling price of goods will be (\$100+6.5+5) / 10 = \$11.5 each. This way company will be able to pay back the lended money (\$100) to the bank with interest of 6.55 per annum and also maintain a healthy profit margin of 5%. Here the cost of capital is 6.5% per annum and rate of return (on finished goods sold) is 11.5%.

Estimating and measuring value of shares is not always easy and this is the reason why Benjamin Graham (guru of Warren Buffett) has brought forward the concept of margin of safety. This concept says that value investors should never pay to buy a share at values equal to the “measured value”. He should at least maintain a margin of safety of 2/3 which buying a share.

If measured value if say \$6/share then he should buy only when the price of that share falls to \$6×2/3 = \$4/share. This margin of safety is maintained to protect the investors. As value measurement is not a fool proof way of calculating the worth of the company. But by including the ‘margin of safety’ in the calculations the investors are protected from any potential losses in future.

As per general agreement of all major value investors of the world, it now established that out of all value tenects for measuring the value of a company/ share following will remain at prime importance (in order of priority) irrespective of what others say:

(1)        Balance Sheet
(2)        Income Statements
(3)        Cash Flow Statements

Balance Sheet’s utility in measuring the value of business
The value measuring starts with balance sheet. It is a mother of all financial statements and ratios. The investors must study the list of assets and liabilities to understand what the company owns and what it owes. The most important information that the balance sheet can give to value investors is called book value.

In addition to the book value of shares balance sheets also assets investors to calculate the Liquidation Value of the company. Liquidation value is the money that the company may generate by selling of its assets (remember not all assets are sold easily or at estimated prices).

Companies do this when they are interested to go out of business. If the liquidation value of company per share (say \$5) is less then the current market price of share (\$3) then it means that the company share price is heavily undervalued (but it may also be the case that the business is managed very badly).

When the owner wants to go out of business he will try to sell off his assets which included the companies cash reserves as declared in balance sheet, Cash reserves, account receivables, inventory (finished goods, raw materials, spares etc), property (plant, equipments) and finally the brand name (this does not appear as value in balance sheet).

The most conservative (but easier) way to measure the value of share from balance sheet is to consider only current assets in calculating its worth. Because the current assets are the most liquid capital I hand that can be converted into cash very fast.

Current assets minus all liabilities will give a fair estimate of the financial health of the business. All big business houses always maintains sufficient reserves so that in times of crisis they are at least able to pay back all their liabilities. A company that does not consider this in managing its business (liability management) are the riskier companies to invest in long run.
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