## Wednesday, December 19, 2012

Investment in share market is by far the most profitable form of investment till date. But still you will find news and rumors going around that share market is very risky. Actually people like me and you have made this form of investment so risky. Share market investment needs at least a basic training before a person can start investing in shares. I would recommend that an investment advisor is a must for a novice to start this most technical form of investment.

An investment advisor will be helpful to make us understand what factors needs to be looked into before buying and selling of shares. The purpose of this article is to work as a fool proof investment advisor for all share market investors. So the starting point of any share market investment will be identification and evaluation of profitable companies suitable for share trading. We will list down here few key logical steps of share market investment that will work as an investment advisor for all new investors.

It might happen at times that a new investor end up buying a share of almost a dead company whose market price of share neither moves up or down. I can tell you this is very much possible. The investment advisor will boldly suggest that investors shall blindly go for the the shares which has the highest ‘market capitalization’. The value of market capitalization can be calculated very simple, multiply the number of shares issued in the market ,Example (10,000,000 shares with market price \$10/share). So ithe market capitalization will be 10,000,000 X \$10 = \$100 million.

Investment advisor use this value of ‘market capitalization’ to judge the “total value” of the company. By total value the investment advisor means that if somebody wants to buy 100% ownership of the company what money he should ideally pay. Suppose after doing financial analysis of a company A, the ‘total value’ of the company comes out to be \$75 million instead of \$100 million as suggested by the market capitalization formulae. In this case the company per share price shall be \$75 million / 10,000,000 = \$7.5 instead of \$10.

This suggests that the present market price of the company’s share is overpriced by \$2.5 (\$10 minus \$7.5). The companies which are not traded very frequently, the market capitalization figures of such company cannot be trusted. But for companies whose shares are traded very aggressively, the market capitalization figures over a period of time (say two years) gives an idea of that what can can be the average “value of the company”. Investment advisor will suggest that all investors shall have a list of top 100 most traded companies and should track the price movements of these companies. As soon as the market price becomes undervalued, go for it and buy.

(2) Investment Advisor will always have a look into the book value of the company and compare it with its present market price.

If we will look into the financial reports (balance sheets) of companies we will find a value called book value per share. Book value is nothing but audited “total value” of company called as its “net worth’. In simple language we can say that the book value is the worth of the company as per its financial managers who run the business. Investment advisor very frequently use book value to know the value of business. Suppose the book value of a company is \$75 million and number of shares outstanding in the market is 10 million.

Then book value per share will be equal to \$7.5; on the other hand if the market price per share of the company is \$10, then it means that the share is over priced by \$2.5. It is a common phenomenon that the companies in the list of top 100 market capitalization list will generally have a market price higher than the book value figures. In case the stock market is seeing a bull phase then the investor can have a general idea about the range of value of business, Market Capitalization will give the Max Value and Book Value will give the Min Value. It is always best to buy shares playing very close of book value. This is the strategy of long term investors.

Book value is a term used to refer to a company's accounting net worth (assets minus liabilities). Book value, or shareholder equity as it is sometimes called, is used to calculate the profitability of a firm using something called return on equity

(3) Investment Advisor will always have a look into the return of capital (ROC) figures.
Why return on capital is important? Investment advisor has already suggested to buy shares of companies whose market capitalization is high and also whose market price is close to or below its book value. High market capitalization ensures that the business is in demand and is among the most preferred shares in the market, whereas market price close to book value helps in deciding that the shares are not overpriced. But these two parameters does not say anything about how the good the business is?

Investment advisor will always recommend share market investors to look into return on capital figures of a business and compare it with risk free return. What is the reference of risk free return in Cambodia ?

How to Calculate Working Capital:

Working capital measures how much in liquid assets a company has available to build its business.
The working capital ratio is calculated as: Working Capital = Current Assets – Current Liabilities
The number can be positive or negative, depending on how much debt the company is carrying. If a company’s current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company’s sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller.
Return on capital can be measured by knowing the following:

(1) EBIT
(2) Net Working capital
(3) Net Fixed Assets

Return On Capital = Operating Earnings Before Interest and Taxes (EBIT) devided by Tangible capital invested in the business (Net working capital + Net Fixed Assets).

or (EBIT)/(Net working capital + Net Fixed Assets).

Generally companies do report and publish their Net Profit or Profit After Tax (PAT) in their Annual business reports

In simple terms, return on capital measures how much capital is need to conduct the company’s operations or business. And like Earnings Yield, we use a simple back of the envelope calculation using free resources. In this case, Net working capital is simply Current Assets -Current Liabilities.

Net Fixed Assets is simply Plant, Property & Equipment or commonly known as “PP&E”.

We will continue with our Lorillard example in which it has EBIT of 1.629 billion. We will then go to the company’s balance sheet to get out necessary data.

Current Assets: 2.504 Billion

Current Liabilities: 1.786 Billion

PP&E: .238 Millions

So our math looks something like this: (2.504-1.786) +.238 = .956 Millions
So now we simply divide our 2 numbers to arrive at return on capital.

1.629/ .956 = 170.40%

A return on capital of 170% is a bit high. From experience, many of the magic formula stocks have return on capital numbers of 20%+ and sometimes in the hundreds but once we get into the 150%+ numbers, we have to ask ourselves why this number is high.

In this example, there isn’t a lot of PP&E invested in the business. 238 million worth of equipment is producing 1.659 billion worth of operating income. Not a bad business to be in. And historically, tobacco companies have been high return on capital businesses. For example, Another large tobacco company Phillip Morris International (PM) has return on capital of 104%.

Putting the two numbers together we arrive at whether the business is worth investing our money into. It tells us how much the business earns relative to the current valuation and how much it earns on tangible capital. The best part about doing these calculations is that you could literally do them on the back of an envelope without using any Greek letters and complicated math.

Conclusion
Investment Advisor would like to conclude with these important words that share market investment is a risky venture but if followed with a bit of investment basics then profits in long term horizon becomes almost certain. Invest with a close watch on (1) market capitalization, (2) Book value per share and (3) Return on capital figures of the company. Investment advisor is sure that these three parameters can help investors to select a good company.

By CAMFinancialmarket
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