Why Valuation Can Help You “Buy Low and Sell High”

Ideally, every investor would like to “buy low and sell high.” But, that’s easier said than done. After all, can we really tell what is “low” for a share?

To get a better sense on what a “low price” is, we can try valuing the underlying business behind the ticker.

And to do so, we can look to Professor Aswath Damodaran from the Stern School of Business in New York University. He is a well-regarded voice on the subject of valuation, corporate finance, and investment management, and he posts regularly on his blog here on various investing matters and more.

Here’s how Professor Damodaran thinks about valuation.

The numbers person

“When most people think about valuation, they generally visualize dense financial statements and elaborate excel spreadsheets, and those coming into my valuation class are no exception.

They expect me to immerse them in accounting rules and the building of models and are either deeply disappointed, if their background is in accounting or banking, or relieved, if it is not, to find out that the only thing I know about accounting rules is that there lots of them and that I am not an Excel Jedi Master.”

The above snippet from Professor Damodaran’s blog highlights the characteristics of a “numbers person.” To the numbers person, the financial statements of a company provides the raw materials to be input into a spreadsheet which would in turn cough out precise figures on the value of a company.

In theory, that sounds useful. But, the business characteristics of a company is often lost in the translation to numbers.

For instance, if we went by numbers alone, Keppel Corporation Limited (SGX: BN4) and SembCorp Industries Limited  (SGX: U96) might look quite similar in terms of their amount of revenue.

However, if we dig a little deeper, we would see that SembCorp Industries has a stable utilities business underpinning the company while Keppel Corporation is much more dependent on its relatively more volatile Offshore and Marine segment to provide revenue.

This dynamic is seen in the graphs below:

SembCorp Industries Revenue Chart

Keppel Corporation Revenue Chart

Source: Company’s Earnings Report    

The Story Person

“If one extreme of the numbers/narrative spectrum is inhabited by those who are slaves to the numbers, at the other extreme are those who not only don’t trust numbers but don’t use them. Instead, they rely entirely on narrative to justify investments and valuations…

… without constraints, creativity can carry you to the outer realms of reason and into fantasy”

On the flip side, the story person is interested in painting a compelling picture of the future possibilities of a company to the point of ignoring the underlying numbers. As Professor Damodaran points out, at the extreme, the story can go way beyond reasonable assumptions.

Bringing it together

In Professor Damodaran’s view, the meeting place between the “numbers person” and the “story person” would be the act of valuation. It takes understanding of the business and its opportunities to be able to test the quality of our assumptions that goes into each valuation input. On the other hand, no company can live on a story alone, and has to eventually deliver the numbers to justify its story.

Check back for more musings on valuation of companies!

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.