The steps to calculate stock intrinsic value, also known as fair value, is by summing up 10 years of future net operating incomes that is discounted to present value. I use 10 years assuming that no company will last forever and remember that present value of money is always more valuable than value of money in future of exact amount. In order to calculate present value of money in N year in the future, we simply multiply the amount by 1/1.04N (to the power of N) where N is number of years. To make thing simpler, think of 1/1.04N as factor of money depreciation over a number of years. Then I assume a risk free interest rate of 4% (the current risk free interest rate is ridiculously low which is less than 1%, so I adjusted the percentage to a more realistic depreciation rate of 4%)

But wait. How do I know the company future operating income if it hasn’t come to past? Good question, we seriously won’t know how the company will fare in the future except looking at the historical performance. From historical data, you can get the compound annualized growth rate, and then use the key figure to derive the estimate operating income for the future 10 years.

Recently Genting’s stock has been beaten down a bit from RM7.60 to RM6.50 now. So I took some liberty to find out Genting stock’s fair price. I plugged some of Genting’s financial key figures into my spread sheet. First I extract their past six years of net cash from operating income:

From year 2004 RM 1,685 millions, the operating income has grew up to RM2,551 million in year 2009. The compound annualized growth rate is 7.15%. I then use 7.15% as the average growth rate to estimate Genting’s future operating incomes, I arrive at:

Remember that, money in the future worth less in the present? So we need to multiply each year operating income by the depreciation factor (1/1.04N), then we arrived at:

Notice that estimated operating income in 2019 before and after depreciation factor has a huge different. RM 3,553 vs. 5,259 millions before depreciation. Now sum up the operating incomes from 2010 till 2019, we get RM 30,752 millions, the total operating incomes of the next 10 years.

Now, in order to get one share’s intrinsic value/fair value, we only need to divide RM 30,752 millions by number of share issued in the public, in this case, roughly 3.8 billions shares. The result is RM8.30, versus current market price of RM 6.5.

By looking at the stock intrinsic value vs. market price, there is a margin of safety of RM 1.80 if we purchase the stock at RM6.50. However, to arrive at RM 8.30, we must assume that the earning will be steadily increasing for the next 10 years, a slightly lower earning in one of those years, we will need to readjust the fair value accordingly. On the other hand, if the earning growth rate jumps higher, then the fair value will be higher as well (such as when Genting Singapore starts to fly). Of course there might be some other factors or developments in the company that could largely affect the fair value per share such as change in number of share outstanding or some other factors that you deem might hurt company’s future prospect, you can always discount the fair price accordingly.

When I did stock investment, I used to pick stock base on the name of the company and whether if i like the company rather than it is a profitable company. Profit From Panic (a book written by Singaporean author) described 8 steps in determining a good stock, i follow that ever since i read the book. I’m comfortable with his analysis techniques because he combines many winning stock picking strategies from some of the greatest investors such as Warren Buffet, Benjamin Graham and Peter Lynch. One of the famous strategies adopted and embraced by Warren Buffet is value investing which was taught to him by his mentor, Ben. Graham.

I extracted most of the stock trading strategies from the book which i think most useful. The information is comprehensive and easy to follow so i think it’s a good to follow that guideline everytime i want to buy stock. Now here is it:

1. Consistant Earning Growth – First criteria of the stock i will be looking at is the company’s earning for 5 continous years (or more if you want to). Of course this will require me to study through the company’s annual report for 5 years (Usually the company’s website will highlight this in financial summary). Well, you don’t need to read everything in annual report considering it is hundred page long. Just some key figures will do, like profit after tax or income from operation. The earnings need to demontrate some consistant growth over these period of time, let say a growth of 10-15% year to year. If a company’s stock demonstrates consistent earning growth of 10-15% every year, then i would it’s a good buy. However we also need to look at other criteria.

Where to get earning figure: Net income/Profit after tax in balance sheet.

2. Sustainable Growth – After determining the company’s consistant earning growth, now i have to consider the sustainability of the growth, after all investing in a company’s share is actually buying into their growth, future prospects and you think the company can do well in the coming years. There are several factors that could interfere a company growth and one of them is competition. In order to overcome this obstacle, the company needs to demontrate either one of these few characteristics such as brand name, large existing market share, economic of scale, etc. For example: Coke is a soft drink brand every one in this world will know, and Genting being the one and only one in casino business in Malaysia.

3. Debt - Profit is only considered as real profit when there is no debt. For example you borrow 100k to start up a business and your revenue is 20k per month. Minus off operation expense, rental, employee and your own salary, you can only pay back 10k every month. You will only be able to break even on the tenth month and started to make profit on the eleventh month onward (This is just an oversimplified scenario, corporate financial is excruciatingly complicated).

But realistically speaking there isn’t much company out there has zero debt, a little leverage is still consider as healthy. There is no sure way to determine how much is too much debt, however as a measure, the figure should show at least something like; the long term debt is no more than three times of the annual net income then the company is still considered as healthy.

In real life, a good company is always in expansion and growth, which is good thing, so most probably there won’t be chance where you will see zero debt. As expansion require borrowing of money, borrowing needs to be paid, and earning to sustain the payment, this constant cycle that can never end. So as long the debt-to-annual net income ratio is not too high, says 3-1 in this case, then it’s only ideal. I personally went through many industry leaders’ company financial statement and their debt-to-income ratio is not as low as described, a lot of them is slightly higher in leveraging. So if that’s the point, it’s very subjective and we need to look further.

Where to get key figures: Non-current liability and annual net income (also call profit after tax) under balance sheet.

4. Return on Equity is another key figure we need to consider when reading a company’s annual report. The calculation looks like this:

ROE(%) = Net Profit After Tax Divided Divided By Shareholders’ Equity

In the result of this calculation we have an idea of roughly how much return is for per share. The book says 15% and above, however, i think the percentage is rather subjective, consider it is very much depended on type of company, or the sector the stock belongs to for example. However 15% is a safe guideline the book can assume.

Where to get ROE: It is included in balance sheet, but a lot of time we need to calculate it.

5. Strong Cash Flow – In difficult times like economic crisis, or natural disaster, cash flow is very important for a company. Consider the company suddenly encounter drop of revenue because of drop in demand, and then income suffers. Excess reverse of cash can be used to fund debts and operation expense before economical rebound or demand recovers. Lacking of cash might result a company to go for desperate measure like issue new shares, retrenchment or even bankruptcy. To measure a company’s cash position, we need key figures; net cash flow from operation, capital expenditure, and revenue . Net the cash flow from operation of the Capital Expenditure we obtain the free cash flow. The percentage margin of free cash flow is to divide free cash flow by total revenue. The bigger the percentage the more cash rich it is.

Where to get the key figures: Net cash flow from operation can be obtained from cash flow statement under operating activities section. Capital expenditure can be obtain from investing activities also under cash flow statement. Revenue can be obtained from Income Statement.

6. Management is Buying Back Shares – The most likely reason for a company’s director or CEO to buy their own share is because they think the market has undervalued the stock and they are picking it up as bargain and they want to make money when the share price goes up.

In contrast, if you know that the management is aggressively selling shares, most probably the stock price is overvalued and a correction is in pending (Correction is term use to refer to adjustment of stock price by the market to it’s so called fair value). Another reason could be that the company is in some kind of trouble and only the management knows that the stock price is in for a big dip!

In the next part i will write about stock intrinsic value calculation. That is the part i spend most of my time in picking a value stock.