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Monday, July 20, 2015

Some Simple Valuation Techniques for Some Furniture Stocks kcchongnz

Publish date: Fri, 26 Dec 2014, 09:17 PM

“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” Warren Buffett


In the last article, we identified the goodness of some furniture companies and ranked them based on their profit margins and profitability ratios such as ROA, ROE and ROIC as shown in the link below:

http://klse.i3investor.com/blogs/kcchongnz/66908.jsp


From the analysis of profitability ratio in Figure 1 above, we ranked the goodness of the furniture companies according to the following order; 1) Homeritz, 2) Latitude, 3) Lii Hen, 4) Poh Huat, 5) Hevea, 6) Eurospan and 7) Tafi.

However, we must bear in mind that a good company is not necessary a good investment and vice verse. It all depends on the price you pay. We will go on to carry out some simple valuation, which though simple, can provide powerful, quick and dirty ways to determine which company in the same industry is a better buy.

Below describes the valuation metric used and their limitations.

  1. Price-to-Book ratio
The book value, or net asset backing (NAB) is the net equity position left over when everything a company owes is taken away from what it owns.

Book Value = Total Assets – Total Liabilities

Price-to-book = Market Capitalization / Book Value = Price / Book value per share

The P/B ratio doesn’t rely on volatile measures like profits and has a hard accounting foundation in the company’s books, it has often been used as the key barometer of value.

The P/B ratio is tied to return on equity. Taking two companies that are otherwise equal, the one with a higher ROE will have a higher P/B ratio. The reason is clear--a firm that can compound book equity at a much higher rate is worth far more because absolute book value will increase more quickly.


  1. Price-to-Earnings ratio
The P/E ratio is the most accepted valuation metric among investors as it is the most commonly talked about metric. The nice thing about P/E is that accounting earnings are a much better proxy for cash flow than sales. Moreover, earnings per share results and estimates about the future are easily available from just about any financial data source imaginable.

By dividing a company’s stock price by its earnings per share, investors get an instant fix on how highly the market rates it. It is effectively shorthand for how expensive or cheap a share is compared with its profits. 

P/E ratio depends on the growth prospect of the company. Stocks with high P/Es usually have greater future growth prospects, and vice verse.

However, there are some serious shortcomings in using PE ratio as shown in the link below:

http://klse.i3investor.com/blogs/kcchongnz/63417.jsp

  1. Earnings Yield
Investors define the Earnings Yield to be the inverse of the P/E ratio (or E/P) and consider it a great improvement. Why? Because yields can be compared with other investments more easily – for example banks fixed deposit rates. But, given that the P/E (and thus E/P) ignores debt – Joel Greenblatt in the “Little Book that Beats the Market”redefined it to take the debt into account. His definition compares the earnings due to all stakeholders in the firm (the operating profit) to the entire value of the firm, or enterprise value (EV). 

Earnings Yield (EY) = Operating Profit (or Earnings before interest and tax) / Enterprise value

Or after tax EY = Ebit * (1-tax rate) / EV

EV=market capitalization + Total debts + MI – excess cash – other non-operating assets

A company making an earnings yield of 8.3% may be ok, 12.5% good and more than 20% may be fantastic. But still this does not take into consideration of the growth of a company.

  1. Price-to Cash Flow – a good catch all?
The price to free cash flow ratio compares a company's current share price to its per-share free cash flow. Free cash flow is defined as cash that the operation creates minus any capital expenditure to keep it running. It’s the amount of cash left over which a company can use to pay down debt, distribute as dividends, or reinvest to grow the business. The benefits of looking at the price to cash flow versus other ratios like P/E or P/B ratios are several - firstly some companies systematically understate their assets or earnings which can make them harder to isolate with a low P/E or low P/B scan – but secondly earnings and assets can be manipulated by crafty management accountants to make companies appear more profitable or asset rich than they actually are. 

Price / FCF per share = Market capitalization / FCF

As FCF is hard cash, a Price-to-FCF of 16 may be reasonable, P/FCF of less than 12 is good, and P/FCF of below 8 may be fantastic price.

  1. No earnings: Price-to-Sales Ratio
During the Dotcom euphoria in the late 1990s, many new technology companies mushroomed. Their share prices were chased sky high but they had no earnings at all. So the market invented this valuation metric to cater for these new economy stocks.

P/S is a key indicator for isolating potential turnaround stocks. Low P/S stocks, especially compared against their sector, can often be stocks that bounce back very quickly as they return to profitability.

  1. Dividend Yield
Dividend yield is actually one of the oldest valuation methods. It was very popular back in the days when dividends were the primary reason people owned stocks, and it is still widely used today, mainly among income-oriented investors.
Dividend Yield = (Annual Dividends Per Share) / (Stock Price)
The appended link below described the high dividend yield investing strategy employed in Bursa and its shortcomings.
http://klse.i3investor.com/blogs/kcchongnz/62033.jsp

Simple Valuation for furniture stocks
Table 1 below summarizes the market valuations of the furniture companies.
Table 1: Simple Valuation of furniture stocks
Company
Homeriz
Latitude
Lii Hen
Poh Huat
Hevea
Eurospan
Tafi
Price
0.820
3.650
2.700
1.410
1.630
0.810
0.440
PE
8.1
6.2
6.7
6.3
5.2
8.0
25.8
Price-to-book
1.8
1.1
1.0
0.9
0.6
0.7
0.6
Price-to-sales
1.3
0.5
0.4
0.4
0.4
0.6
1.1
EY= Ebit/EV
21%
23%
24%
24%
17%
37%
16%
EV/Ebitda
4.4
4.1
4.0
3.4
3.4
2.2
3.0
Price/FCF
5.9
5.0
23.5
6.4
4.1
4.1
14.5
Dividend Yield
4.6%
1.4%
4.4%
5.7%
1.2%
0.0%
0.0%

Eurospan appears to be the cheapest furniture stock with an earnings yield (EY) of 37% and P/FCF of just 4.1. However, as its “Goodness” ranked at the bottom, and its turnover is smallish, I would walk over on this stock, similarly for Tafi, as they may be hard hit when the economic tides turn.
Latitude, Lii Hen and Poh Huat all have similar low P/E ratio and EY of about 6.5 and 24% respectively. As Latitude has the highest profitability ratios among the three with ROE and ROIC at 19.1% and 23.6% respectively, it is hence my first choice as an investment candidate. My second choice is Homeritz as although the profitability ratio of Homeritz is much higher with ROIC at 42%, Latitude has a much higher turnover and better reinvestment opportunity than Homeritz. Latitude also has a much lower P/S and P/B of 0.5 and 1.1 compared to 1.3 and 1.8 respectively of Homeritz.
My third choice would be Poh Huat with a much lower P/FCF of 6.4 compared to 23.5 of Lii Hen. Both of them have high earnings yield of 24%.  They are both good companies selling at cheap prices except I don’t really like Lii Hen’s low FCF. I stay neutral on Hevea as its profitability ratios and earnings yield are far below the top four picks above, although it has a lower P/FCF ratio..

 Conclusions
All the furniture companies mentioned here are doing very well in their business in the last couple of years with high profitability ratio of ROE and ROIC well above 10%. All of them are also selling at very good price with earnings yield of more than 15%. Basing on a combination of “Goodness” and “Value”, my choice of the furniture companies to invest is first Latitude, followed by Homeritz, Poh Huat and Lii Hen, in that order.  

For queries and feedback, please contact ckc13invest@gmail.com.


K C Chong (On Boxing Day 2014)

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