Focusing On Return On Capital Investment Success: Methods & Illustrations

Equity Valuation Methods

Discuss about the Focusing On Return On Capital Investment Success.

The equity valuation is considered as one of the important things to do in the field of finance. It is necessary to be aware of all the methods of equity valuation. The Warren Buffett Methods are most popular methods for equity valuation. The concept of Warren Buffett Formula also plays an important role in the same. The following are the details of the aforesaid topics.

The following are some of the valuation methods for the equity valuation;

Balance Sheet Methods; this method is used to utilize the balance sheet data for the valuation of the equity. The main focus is given on the books of accounts of the company for a particular accounting period.

Book Value Method: In this method, the book value of the business considered from the value of the equity mentioned on the balance sheet of the company. The term book value means the worth of the company. The book value is computed by application of the following formula;

Net Worth = Equity Share capital + Preference Share Capital + Reserves & Surplus – Miscellaneous Expenditure (as per B/Sheet) – Accumulated Losses.

Liquidation Value Method: In this method, the liquidation value of the business is considered for equity valuation. The formula for the calculation of Liquidation value is provided below:

Liquidation Value = Net Realizable Value of All Assets – Amounts paid to All Creditors including Preference Shareholders.

P/E Ratio Formula: This formula provides the market per share and earnings per share of the company. The formula for calculation of P/E Ratio is equal to Market Price per Share / Earnings per Share. For example if the market price per share of a company is Rs. 100 and the earning per share is Rs. 25 the P/E ratio will be P/E Ratio = Rs.100 (Market Price) / Rs.25 (Earnings) = Rs. 4.

The following are the two Illustration basing on the formula provide by Warren Buffett;

To determine the per share investment amount and per share pre-tax earnings the below mentioned formula has to be implemented. According to the details mentioned on the annual report the per share investment amount and per share pre-tax earnings of the Berkshire company for the financial 2010, it was $94,730 and $5,926.04 respectively.

Pre-tax earnings are considered as operating earnings which are found mentioned in income statements of the company. It is the earning before the taxes and interests. If any companies stock prices are presently have pre-tax earnings of 10. Then for the illustration, we have to use 10 as the multiple for the application of the pre-tax earnings.

The Warren Buffett Formula

Considering the same formula, if the pre-tax earnings are $5,926.04, then we have multiply it with 10 ($5,926.04 x 10 = $59,260.40) which equals to $59,260.40. After that we have to calculate the per-share investment amount which comes up as $94,730 + $59,260.40 = $153,990.40

Likewise, we can apply multiple pre-tax value earnings of $5,926.04 to arrive at the estimated intrinsic value. For example if we use a multiple of 12 instead of 10 then the per share investment will be $5,926.04 x 12 = $71,112.48. Considering the per-share investment of $94,730 to $71,112.48 the intrinsic value of the company at the end of the financial year will be $94,730 + $71,112.48 = $165,842.48.

The following are the details of the methods and formulas for the calculation of the equity valuation;

Constant Growth Method

D1 = expected annual dividend per share for the following year

K = the required rate of return

G = the expected dividend growth rate

Intrinsic Value = D1 / (K – G)

Price Earnings Ratio Formula

P/E = Stock Price Per Share / Earnings Per Share or

P/E = Market Capitalization / Total Net Earnings or

Justified P/E = Dividend Payout Ratio / R – G

R = Required Rate of Return

G = Sustainable Growth Rate

Price to Book Value Method

Price to Book Value Formula = Price Per Share / Book Value Per Share

The details of the company wise calculation of the equity value under the aforesaid three methods are provided below:

Energy-Beach Energy Limited

Intrinsic Value = D1 / (K – G) = 1.78/(

P/E = Stock Price Per Share / Earnings Per Share (1.78/ 1.36)= 9.18

Price to Book Value Formula = Price Per Share / Book Value Per Share (1.78/1.75)=1.017

Caltex Australia Limited

Intrinsic Value = D1 / (K – G)

P/E = Stock Price Per Share / Earnings Per Share (30.81/1.81)= 17.022

Price to Book Value Formula = Price Per Share / Book Value Per Share (30.81/ 18.14) =1.663

Oil Search Limited

Intrinsic Value = D1 / (K – G)

P/E = Stock Price Per Share / Earnings Per Share (8.55/0.04)=213.75

Price to Book Value Formula = Price Per Share / Book Value Per Share (8.55/3.18)= 2.688

Whitehaven Coal Limited

Intrinsic Value = D1 / (K – G)

P/E = Stock Price Per Share / Earnings Per Share (5.320/ 0.26)=20.461

Price to Book Value Formula = Price Per Share / Book Value Per Share (5.320/10.10)=0.526

Financial- Amp Limited

Intrinsic Value = D1 / (K – G)

Illustration 1

P/E = Stock Price Per Share / Earnings Per Share (3.92/28.0)=0.14

Price to Book Value Formula = Price Per Share / Book Value Per Share (3.92/2.50)=1.568

Anz Bank

Intrinsic Value = D1 / (K – G)

P/E = Stock Price Per Share / Earnings Per Share (28.1/0.95)=29.57

Price to Book Value Formula = Price Per Share / Book Value Per Share (28.10/ 20.23) =1.389

Bank Of Queensland

Intrinsic Value = D1 / (K – G)

P/E = Stock Price Per Share / Earnings Per Share (10.44/0.46)=22.695

Price to Book Value Formula = Price Per Share / Book Value Per Share (10.44/9.89)=1.055

Information Technology

Intrinsic Value = D1 / (K – G)

P/E = Stock Price Per Share / Earnings Per Share (5.25

Price to Book Value Formula = Price Per Share / Book Value Per Share (10.54

Altium Limited

Intrinsic Value = D1 / (K – G)

P/E = Stock Price Per Share / Earnings Per Share

Price to Book Value Formula = Price Per Share / Book Value Per Share

Iress Limited

Intrinsic Value = D1 / (K – G)

P/E = Stock Price Per Share / Earnings Per Share

Price to Book Value Formula = Price Per Share / Book Value Per Share

The investments made a company depend on the financial positions of a company. The following is the list of the investment plans a company can make;

Equities
Fixed Income
Cash
Real Estates
Debentures
Stock Exchanges
Mutual Funds
Share Market
Insurance
Banking Sector

The ranking of the aforesaid sector according to the investment plans. The investment in equity now a days are considered profitable. Thus, I have given the rank one to equity after that it is necessary that the business should investment in some fixed income plans so that it can meet the urgent requirement of funds and pay off the debts incurred in future. Then come the real estates , cash and various financial sectors operating these days in every country.

I would like to invest in the Mutual Fund schemes as this very profitable in the recent business world. Mutual funds are subject to market risks but provide great returns whether it may be long term or short term. The flexibility in return schemes and the lock in period also provides greater opportunity for a business as well as individual to invest in the Mutual Fund Schemes. Now a days many banks are offering Mutual Fund Investment schemes for the investment of money with a good return scheme.

According to Warren Buffet, “Intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover–and this would apply even to Charlie and me–will almost inevitably come up with at least slightly different intrinsic value figures.”Research and summarise some interesting facts about Warren Buffet that you can relate to the companies you have selected from the Financial Review to analyse.

Warren Buffett has invented the “Two-Column Valuation Method” investment process. The aforesaid method was first published on the Berkshire Hathaway’s 2010 Annual Report. Later Buffett also republished the aforesaid method in the Annual report of the Berkshire Hathaway in the year 2011 and 2014 as well. In this method, Buffett mainly focused on the intrinsic value of the company. In the Annual report of the company he suggested that it was Berkshire Hathaway Inc. vs. Intrinsic Value.

Illustration 2

The Intrinsic value of the Berkshire cannot be calculated easily as it has key components that must be considered for the calculation. The first component of the value for the investment is stocks, bonds and cash in hand. According to the annual report, at the end of the financial year the total market value of Berkshire was $158 billion.

The second component of the Berkshire’s is earning from other sources apart from the investments and insurance underwriting. The earnings were obtained by almost 68 insurance business mentioned on the annual report of the company. It can be rightly said that the company focused mostly in the investment schemes. The development of earnings from other sources i.e. the non-insurance business have been continuous since last two decades.

Then , it comes the third component which considered as the most subjective element for an intrinsic value calculation. In the aforesaid case, the intrinsic value may be negative or positive. The impact of the intrinsic value of the earning can be deployed in the future. Now a days, many businesses are expected to retain the earnings in the coming ten years that may equal or exceed the current capital structure. It depends on the management of the business whether to retain the earnings in to fifty cent pieces or two-dollar bills.

According to Warren Buffett,

“Intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover–and this would apply even to Charlie and me–will almost inevitably come up with at least slightly different intrinsic value figures.”

The aforesaid statement can be better understandable with a couple of illustrations. The illustration is provided below;

Ranking of Investment Plans

From the above two illustrations it can be concluded that the Two-Column Valuation Method,” invented by Warren Buffett’s is purely based on the intrinsic value. The intrinsic value of the Berkshire at the end of the financial year is estimated to be between $153,990.40 and $165,842.48. On analyzing the same Warren Buffett gave the following to statements;

“Market price and intrinsic value often follow very different paths – sometimes for extended periods – but eventually they meet.”

“It’s better to be approximately right, than precisely wrong.”

Compare Warren Buffet’s approach to share valuation and the share valuation methodology and recommend which approach you prefer with one reason;

Warren Buffets has invented the “Two-Column Valuation Method” for the calculation of the per-share investments and pre-tax earnings which are a part of share valuation. The combined study of the two amounts will provide the intrinsic value of the share.

Warren Buffett also introduced the concept if Discounted Cash Flow and Free Cash Flow to calculate the intrinsic value of the business. Some of the past valuation methods of Warren Buffett foe the valuation of the shares are;

Net-Net Working Capital Method
DCF Method,
Four Filters Investment Process,
Two-Column Valuation Method

While considering the valuation method, the following are the few things that Buffett keeps in his mind to evaluate the stock’s level for valuation;

If the company has performed well in the last financial year, this question reveals that the of the shareholders are earning incomes on the shares. For the analysis of this factor Buffett apply the Return of Equity method to check if the company has performed well. The formula for the calculation of Return of Equity is Net Income / Shareholder’s Equity.

The second point which he considers is if the company has avoided the debts. To find out the answer of this question Buffett focus on the earnings growth of the business which is generated from the shareholders equity. The debt equity ratio is calculated as Total Liabilities / Shareholders’ Equity

The third factor which is considered by Buffett is the profit margins of them business is increasing. To find out Buffett calculate the profit margins of the business by dividing the net incomes with net sales. If the profit margins are high it suggests that the business is successful and efficient in managing its expenses.

The fourth factors to be considered are how long the company has been in public. To analyze the same Buffett focuses on the Initial Public Offerings of the company for last decade. It the IPO analysis is necessary to know how long the company has offering its shares to public for subscription. By knowing the offering schemes of the business one can analyze the other factors effecting the valuation of shares. The past performance of the company plays an important role in the valuation of the shares of the company.

The fifth factor which needs to be focused is if the company’s product or service depends on a community. To analyze the same Buffett gave emphasis on the products of the competitors which are similar as that of the own company’s products. It is important to notice that if the company has anything else to offer rather than the things which are available in the market and offered by the competitors. This concept is called competitive advantage by Buffett. It is also known as economic moat.

The sixth factor which needs to be considered is the stock selling of company, if it is being sold on its real value of or at a discounted rate. For this, Buffett mainly focus on to determine the intrinsic value of the business by analyzing the factors such as revenue, assets, earnings etc. if a company has high intrinsic value the company has higher liquidation value.

On analyzing both the methods and methodology of Warren Buffett I will prefer for the methodology he has been following for the valuation of shares as it provides the fundamental and basic details of a company’s financial structure as compared to the methods provided by him. The methods he provides only focuses on the calculation of the intrinsic value while the methodology provides the details of all the factors concerned.

References

(2013, May 19). Warren Buffett’s “Two-Column Valuation Method .

Ferraro, S. R. (2009). Focusing on return on capital may be the key to investment success. The Buffett Approach to Valuing Stocks , 2 (3).

Staff, I. (2018, April 28). Warren Buffett: How He Does It .

Today, B. (2014, August ). Buying At A Discount. Retrieved from https://www.businesstoday.in/: https://www.businesstoday.in/moneytoday/cover-story/investment-lessons-from-warren-buffett-others-and-top-stocks/story/208504.html

(2013, May 19). Warren Buffett’s “Two-Column Valuation Method .

Buffett’s Value Formula . (n.d.). Retrieved from https://www.moneychimp.com/: https://www.moneychimp.com/articles/valuation/buffett_calc.htm

Ferraro, S. R. (2009). Focusing on return on capital may be the key to investment success. The Buffett Approach to Valuing Stocks , 2 (3).

Harper, D. (2018, May 4). Warren Buffett’s Investing Style Reviewed .

Matthew J. Belvedere, Matt_Belvedere. (2017, October 3). Billionaire Warren Buffett says stock valuations make sense with interest rates where they are .

podcast, T. i. (n.d.). Warren Buffett’s Stock Basics. Retrieved from https://buffettsbooks.com/: https://buffettsbooks.com/howtoinvestinstocks/course1/investing-for-beginners/warren-buffett-stock-basics.html#sthash.mBV6JjI4.dpbs

Staff, I. (2018, April 28). Warren Buffett: How He Does It .

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