Happy Hump Day! If what I saw during the Great Singapore Sales is anything to go by, everyone in Singapore loves a bargain. When it comes to finding a bargain in the stock market, the premise can be as simple as this: For our stocks to gain over the long run, we have to buy them at prices that are below what their underlying businesses are worth. There are several ways to put a value on a business. One way to value an investment would be to consider it as the present value of the business’ future cash flows. The…
Happy Hump Day!
If what I saw during the Great Singapore Sales is anything to go by, everyone in Singapore loves a bargain. When it comes to finding a bargain in the stock market, the premise can be as simple as this: For our stocks to gain over the long run, we have to buy them at prices that are below what their underlying businesses are worth.
There are several ways to put a value on a business. One way to value an investment would be to consider it as the present value of the business’ future cash flows.
The problem is, the underlying value is not a static number. After we tag a value on a business, we have to think about how its value can be protected or grown in the future.
Growing value in our investments
To guide us through these thoughts, I will turn to author and investor Pat Dorsey’s book, The Little book that Builds Wealth.
In a previous article, I talked about two factors – growth and risk – that can affect the value of our investment. Today, I will defer to Dorsey for another two factors. Using a landlord’s apartment as a parallel for a common business, he said:
“Let’s think about what would make a building full of rental apartments worth more or less to a prospective purchaser.
You’d also imagine that a higher return on capital would make a building worth more—if you thought you could raise rents in a certain building and essentially get more income with no investment, that property would be worth more than a building with stagnant rents.
Finally, let’s not forget competitive advantage—a building that was the last to go up before a zoning ordinance prevented adjacent new apartment buildings would be worth more than a building that potentially faced lots of new apartments competing with it.”
In other words, if a business requires less upkeep (or capital investments) it may turn out to be a superior investment over the long run. One such candidate would be vehicle testing and inspection firm, Vicom Ltd (SGX: V01).
Source: Vicom’s Earnings and Annual Report
As a business, Vicom’s operations does not involve launching a new type of vehicle test frequently. In fact, the majority of its vehicle tests do not change all that often. It’s this stable nature of its business which translates to lower capital expenditures over time (see graph above).
Dorsey is also concerned about how well a business’s cash flows can be maintained over the long run. In other words, is there an economic moat that we can rely on for the business to fend off other competitive wolves?
Going back to Vicom, the company is practically the only player in town when it comes to vehicle inspections in Singapore. Then, there’s also the fact that vehicle owners in Singapore are mandated to send in their vehicles for inspection every six to twenty four months (depending on the age and type of vehicle). These traits help improve the predictability of future cash flows for Vicom, a trait that Dorsey may like.
For Dorsey, considering the likelihood that the future cash flows of a business can materialize (risk factor), how large those cash flows can be (growth factor), how much additional investment the business may need to keep moving along (return on capital factor), and how long can its cash flows be protected (economic moat) form the foundation for his thoughts on estimating the future value of a business.
It’s the culmination of these four factors that may help us make a better judgement on whether a company’s shares are overpriced or underpriced.
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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 owns shares in Vicom Limited.