As investors, we usually try to get a feel for the future earnings of the company we invest in.

If we can’t predict future earnings, we can at least find out how a company plans to increase its earnings. There are basically several ways:

1. Expand into new markets (eg new country)
2. Sell more of its products in existing markets
3. Coming out with new products
4. Cut costs
5. Turn around, close or sell off a losing operation

As Peter Lynch says, the word most frequently seen with “earnings” is “surprise”. The truth is that we do not need to predict earnings to be a  successful investor.

If you do not know already, check to see how your company plans to increase its earnings. Keep an eye out from time to time to see if such plans are working out.

A company which I follow more closely is AMMB Holdings. It announced its half-yearly results couple of days ago.

- Decent loan growth of 6.1% during the 6 months period (or 9.2% yoy)
- Cost-Income Ratio of 40% is substantially down from last couple of years
- Net NPL ratio of 2.2%
- NTA / Total Assets Ratio of 8.0% is super strong by any global standards
- AMMB is raising its full year Net Profit guidance now to RM920-950 million for its FY2010

AMMB’s management has told us what they are doing to improve their business and so far things are on track. The story in the banking sector reinforces what they are saying.

Even when AMMB share price nears RM5.00 (PE of around 15x), I’m wouldn’t be too quick to cash in just yet because its earnings growth story is very much in tact. There’s talk of a decent dividend payout policy… certainly the bank has more than enough capital for this.

AMMB’s Quarterly Press Release is always worth a read. You can download here.

Having sank to a low of RM0.73 during last year’s meltdown, its unit price has since gained some 45% to close at RM1.06 yesterday. Even at the current price of RM1.06, Hektar’s distribution yield works out to be 9.6%, a very enticing proposition for yield hungry investors.

Basically Hektar is currently the only Malaysian REIT that is Retail-focused. It is a pure shopping centre play and intends to stay that way. Currently the funds owns 3 shopping centres:

1. Subang Parade, Selangor (NLA 473,611 sq feet)
2. Mahkota Parade, Malacca (NLA 466,527 sq feet)
3. Wetex Parade, Johor (NLA 173,725 sq feet)

In the case of Subang Parade, there are a few lots which are not owned by Hektar but we understsand that Hektar is looking to acquire those lots.

If like me you’ve been to Subang Parade in the 1980s, you will no doubt be amazed at the transformation that has taken place in recent years. Walking into Subang Parade now, you get the sense that it is customer-friendly, well maintained, has a good variety of shops and good access.

This transformation underscores the capabilities of Hektar Asset Management to ADD VALUE to its shopping centres.

Hektar Asset Management Sdn Bhd, Manager of Hektar REIT, shares with us Hektar’s Value Creation Model which we summarize as follows:

1. Tenant Re-mixing – By owning an entire shopping centre or a large part of a centre, a shopping centre owner is in a position to decide what type of tenants should be in the centre to best serve the needs of the customer.

In the case of Hektar, tenancies are continually being reviewed (in fact in Hektar centres, most tenancies are only given up to 3 years). Since acquiring Subang parade, Hektar has introduced a number of key tenants such as Celebrity Fitness, Orlando, Voir, SenQ, Kenny Rogers Roasters, Coffee Bean and Starbucks. This has no doubt made the centre more credible and “happening”. Subang Parade is now a Lifestyle plus Convenience value proposition.

2. Tenant Relocation – For example in Subang Parade, Hektar closed the Food Court, relocated Toys R Us to the old Food Court and relocated HSL Electronics to the old Toys R Us lot. By doing so, the shopping centre traffic circulation was improved between the anchor tenants and HSL was able to build a large “Circuit City” concept store.

3. Asset Enhancement – Increasing Net Lettable Area by capital improvements, reconfiguring low-yielding zones into higher yielding lots (eg re-configuring a low rental space in Mahkota Parade and converting it into a new zone with specialty shops which gives higher rental).

4. Refurbishment – Notice the fancy floor tiles, nicer toilets and improved amenities in Subang Parade? All this makes the shopper feel good and want to come back.

Aligning the Interests of Tenants with Shopping Centre owner….

Hektar’s rental model includes a Base and Turnover Rent. Typically tenants pay a base rental and also an amount based on their Sales Turnover. This motivates centre management to “promote sales” for their tenants – the more the tenant gets, the more rental the owner gets.

Pure Retail Play…

Hektar focuses on regional and neighbourhoold shopping centres in Malaysia. Going forward its acquition strategy is as follows:
1. Acquire turnaround shopping centres and add value to them
2. Acquire stabilized shopping centres which are yield accretive to its portfolio

Shopping centres which are well-positioned are highly resilient in any economic condition.

Research in developed countries have shown that high quality Regional and Neighbourhood Shopping Centres typically outperform other property asset classes such as Office and Industrial properties during economic downturns. Such centres also offer exposure to economic growth. Where consumer spending power is improving, it generally translates into higher retail sales and centres which dominate their catchment areas stand most to benefit.

Based on Hektar’s research, there is a huge retail opportunity in Malaysia especially outside KL, Selangor and Penang. KL is a well-supplied market with NLA (Net Lettable Area) per capita of around 14 sq ft.

Comparatively, Johor is at 3.6 sq ft, Malacca is 3.4 sq ft, Perak is 2.1 sq feet, Sarawak is 1.1 sq ft  while Terengganu is only 0.5 sq ft.

Indeed Hektar is serious in its research. It analyses traffic in its shopping centres and undertakes consumer research periodically, analysing its catchment area, shopper preferences, feedback and so on.
 
More Equity would be Nice…

Current net borrowing position of RM283 million works out to be 70% of its total equity of RM402 million (as at 31-Dec-08). Personally I would like to see gearing at a lower level. Even so, Hektar should have no shortage of options in terms of buying shopping centres with part equity-swap and so on.

Duplication… the Westfield way
Hektar models itself partly on the highly successful Westfield Group of Australia. Westfield is the largest REIT in the world and is a pure retail play. CapitaMall Trust, the largest REIT in Singapore is also a pure retail play, while Link REIT of Hong Kong is also largely retail.

This makes Hektar unique in Malaysia. Looking at other successful centres – Mid Valley Megamall, 1 Utama and Sunway Pyramid – these are great centres but the owners have not been able to duplicate their model across multiple locations.

Hektar has the potential to “make it big” in the next 10 years. There will be a time when the market is more conducive to capital raising and Hektar should be able to access the much-needed firepower to grow its asset base. If Subang Parade is an indication to go by, then we have some exciting things to look forward to!

Snapshot
HEKTAR is the eigth largest REIT on Bursa Malaysia with a current market capitalization of RM340 million.

Disclosure: The author holds units in Hektar REIT.

Cost-Income Ratio is a useful performance indicator we can use to guage the efficiency of a bank’s operations.

In Malaysia currently, the Cost-Income Ratio for our banking sector varies from between 30% – 50%. The most efficient bank in terms of Cost-Income is still Public Bank which last year brought its CI down to just 31%. Here’s a snapshot:

Public Bank: 31%
Hong Leong Bank: 42%
AMMB: 49%
Bumiputra Commerce: 52%
Maybank: 44%
Affin: 50%

Calculation of Cost-Income Ratio
Cost Income Ratio is essentially a bank’s Operating Expenses (excluding goodwill amortization) divided by its Operating Income (comprising of its Net Interest Income, Islamic Banking and Other Income).

=                                 (Operating Expenses – Goodwill Amortization Expense)
      —————————————————————————————————————
        (Interest Income – Interest Expense + Islamic Banking Income + Other Op Income)

Example 1: AMMB 2009 (YE 31/3/09)
Other Operting Expenses: RM1,612.1 million
Amortization Expense: NIL
Net Interest Income: RM1,776.3 million
Islamic Banking Income: RM572.6 million
Other Operating Income: RM922 million

Cost-Income Ratio = 1612.1 / (1776.3+572.6+922) = 49.3%

Note: In its recent quarterly results, AMMB showed a dramatic improvement in its Cost-Income Ratio, bringing it down to under 40% for the June-09 quarter. AMMB attributes the improved figure to higher revenue growth for that quarter.

Example 2: HONG LEONG BANK 2009 (YE 30/6/09)
Operating Expenses: RM876.6 million
Amortization Expense: NIL
Net Interest Income: RM1,353.1 million
Islamic Banking Income: RM176.3 million
Other Operating Income: RM569.5 million

Cost-Income Ratio = 876.6 / (1353.1+176.3+569.5) = 41.8%

Example 3: BUMIPUTRA COMMERCE 2008 (YE 31/12/08)
Operting Expenses: RM4,121.8 million
Amortization Expense: RM122.9 million
Net Interest Income: RM4,660.6 million
Islamic Banking Income: RM437.8 million
Other Operating Income: RM2,642.1 million

Cost-Income Ratio = (4121.8-122.9) / (4660.6+2642.1+437.8) = 51.7%

And one message came out loudly.

Everywhere you turn, companies are saying that we are in uncertain times. It’s hard to know what earnings will look like over the next two years.

It is times like this that makes us appreciate companies which are boring and predictable.

I was having dinner with some friends recently. One of my buddies commented (in a nice way) to a female friend that she was “unpredictable”. I don’t think it went down well with her, but being a good sport, she laughed it off and we all had a good time.

I’m not trying to compare women with companies, but PREDICTABLE is GOOD for us investors.

Look at what Warren Buffett says:

“To properly value a business, you should ideally take all the flows of money that will be distributed between now and judgment day and discount them at an appropriate discount rate. That’s what valuing businesses is all about. Part of the equation is how confident you can be about those cash flows occurring. Some businesses are easier to predict than others. We try to look at businesses that are predictable.”
Warren Buffett, 1988

For those who are familiar, you know that Buffett is talking about Discounted Cash Flow valuation (DCF). For those of you who do not know, DCF is a valuation method that works like this:

Say you decide to invest in shares. Your cash flow will include dividends you receive every year and the amount you get from selling the shares later on.

Here’s something useful to keep in mind:

VALUE does not equal MARKET PRICE.

Market price is simply a reference point, what the broader community thinks the share is worth. In contrast, the true value of your share is a function of how much dividends you will receive and how much you will pocket when you exit later on.

And DCF valuation is one way for you to work out the VALUE of your shares.

For example, you may receive 12 sen in dividends in the first year, 13 sen in the second year and so on. But we want to know the value of the shares NOW. In order to work out the current value (or what financiers call Net Present Value), we discount those future dividends and sale proceeds using an appropriate discount rate.

What do I mean discount?
Well if you invest in shares, you won’t actually receive all your cash flows in one shot. You may receive your dividends once a year and every year for the next 5 or 10 years.

Say you expect to receive 13 sen dividend in the 2nd year of your investment. Because of inflation and the fact that you expect to receive a return on your money, the 13 sen you expect to receive in 2 years is actually worth less than 13 sen today.

If you expect to receive 10% return a year on your money, then that 13 sen is only worth 10.7 sen to you in today’s terms. I won’t bother you with the maths but if you need help to understand all this, just email me. Basically that 10% is called the discount rate.

Example: Hong Leong Bank
Say I’m interested in buying HLBANK shares. Currently HLBANK has Earnings Per Share (EPS) of 51.2 sen and it pays 24 sen per year in dividends. Let’s say I expect the bank to grow it’s EPS by 5% per annum for the next 10 years, and I expect the bank to pay out 50% of its earnings in dividends.

If we do the maths, it means that in the first year I would be getting 26.9 sen in dividends, in the second year 28.2 sen and so on, as shown in the table below.

Say I expect to sell the shares at the end of the tenth year, and I expect the share price to be 10 times its EPS then, or RM8.34 per share. Based on all these expectations, the value of HLBANK shares to me is RM5.22 per share assuming I use a discount rate of 10% per annum return.

This value of RM5.22 is known as INTRINSIC VALUE. It is highly subjective based on one’s individual expectations.

HLBANK is currently trading at RM5.15 per share, slightly lower than its intrinsic value.  It is neither too cheap nor expensive.

Putting It All Togather
Warren Buffett’s entire investment concept is based on finding great companies that are run by honest and competent people and selling for less than they are intrinsically worth.

To know whether it is cheaper than its intrinsic value, you need to use the Discounted Cash Flow method explained above. If you wish to get started but don’t know how, here is a DCF Spreadsheet for you to download.

It should be self explanatory. The cells highlighted yellow are for you to change to your own estimates. Cell C18 gives you the Intrinsic Value of the share based on the assumptions in the yellow cells. Hope this help but feel free to email me if you need some assistance.

Don’t Use DCF for the Palm Oil Companies
DCF Analysis only works on companies which are predictable, like HLBANK for example. It will not work for Palm Oil companies like IOI Corporation, KLK, Sime Darby etc because the earnings (and hence dividends) of these companies are highly unpredictable.

That is why PREDICTABLE is GOOD for us investors.

I’ve always found the standard Cash Flow Statement hard to read especially for big companies. They pack it with so much detail and it’s hardly presented from an investor’s perspective. Most investors I know simply don’t bother with cash flow because it’s so complex.

If you are using the Cash Flow tool in our Investor Database, you may notice that we present it in a different format. From an investor’s perspective, what we want to know is:

• How much cash the business is generating from “earnings”, taking into account working capital movements (debtors, inventory and creditors)
• How much it needs to spend on capital items (eg. plant and equipment)
• How much it is paying shareholders by way of dividends
• How much it is investing (non capex related)
• How much borrowings it is repaying as a result of its cash surplus or incurring as a result of its cash shortfall.

One of our readers mentioned Evergreen Fibreboard last week, so I’ll use Evergreen as an example. Evergreen manufactures building material products and its sales and profits have been increasing for the past few years. Let’s take a look at their cash flow:

Notice that Evergreen’s profits are eaten up by capital spending and unfavourable working capital movements. They have been in expansion mode, possibly building new factories or adding production capacity, and possibly growing sales by extending more credit lines and so on.

The bottom line is that there is hardly any Free Cash Flow from its operations. In fact Evergreen has to borrow money to pay dividends.

But negative Free Cash Flow is not in itself bad.

It could be that the company is investing for the future. If the investment can generate more cash, it has the potential to pay off in the longer run. In a situation such as Evergreen, it is crucial for an investor to keep track of its working capital movements, particularly Receivables and Inventory. If these items keep building up, it shows that the new production capacity is not converting into cash.  This is undesirable over the long term.

Ultimately as investors, we want:
a. More and more dividends; and
b. Our share price to keep going north

Free cash flow is important because it allows a company to pay dividends and to pursue opportunities that create shareholder value. Without cash, you can’t develop new products, invest in acquisitions, pay dividends or reduce debt.

In fact our Cash Flow format ranks shareholders ahead of creditors

Below is the cash flow for IOI Corporation, notice that dividends paid appear just below Free Cash Flow. After deducting dividends, we arrive at “Residual Cash Flow” which is what the company has leftover for repaying loans or doing more fanciful things like acquisitions, share buy back etc.

(Dividends paid to Minority Interest in this case refers mainly to minority shareholders in IOI Properties Bhd, a subsidiary of IOICORP).

Residual Cash Flow
1. If  it is positive - a company can use excess cash to buy back its own shares, make investments and acquisitions.
2. If it is negative – a company has to find a way to cover the shortfall. It may have to sell its investments, issue more shares or borrow more from its lenders.

Cash flow from operations is important. But how a company manages excess cash or covers cash shortfall has a huge bearing on whether shareholder value is created or destroyed.

Earnings can be puffed up with fictitious accounting transactions. The telling sign is usually this…

While the company reports seemingly healthy profits, its debt level continues to rise.

So with a bit of effort, we have compiled a Cash Flow Statement for each of the Top 50 Bursa Malaysia companies covered (excluding banks). To access this, click on the Cash Flow link in the Investor Database.

The approach we have taken is different from the statutory format which I actually find confusing. What we have done is to work out the company’s Free Cash Flow and Residual Cash Flow.

Free Cash Flow is something like the cash earnings of a company. To get this figure, we take the accounting profit and adjust for several items including:

1. Depreciation and Amortization
These expenses do not reduce cash, so we add it back to earnings.

2. Capital Expenditure
Eg. Purchase of equipment. Say a company buys a machine – it usually does not expense the whole amount but will book it as an asset. Subsequently it will incur a depreciation expense against the asset every year. But in terms of cash flow when the company buys equipment, the whole amount is a negative cash flow. Therefore capital expenditure drains cash.

3. Working Capital
Receivables: When a company sells something, it may not collect cash immediately. The sale is booked and a profit is recorded. Without collecting cash that profit is meaningless. So to work out Free Cash Flow:
1. If Receivables Increase: Earnings – Increase in Receivables
2. If Receivables Decrease: Earnings + Decrease in Receivables
Basically the more you collect, the more cash flow you will have.

Inventory: Companies manufacture or buy stock with the aim of selling it for a profit. When things are not going so well, inventory starts to build up and this is a drain on cash.

Payables: Most companies buy things from suppliers on terms and will only pay for them 30-60 days later. Often the telling sign of a failing company is where is keeps stretching suppliers to conserve cash.

Below is an example Cash Flow Statement for Air Asia Berhad:

Air Asia is a company that claims to make money but its borrowings keep increasing. As you can see from above, most of the cash outflow is in capital expenditure. Air Asia says that it buys aeroplanes and what you need to decide is whether you believe their story or not. It operates in an industry where most companies are scaling back and price competition is cut-throat. Is Air Asia really doing what it says it’s doing? Does it have to keep spending on capital expenditure? Can it fill capacity at a profitable price? Is there a time bomb waiting to explode?

Look at what Warren Buffett had to say about the airlines business:

The airline business has been extraordinary. It has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in. You’ve got huge fixed costs, you’ve got strong labor unions and you’ve got commodity pricing. That is not a great recipe for success.
Interview in 2002, The Age

The worst sort of business is one that grows rapidly, requires significant capital, and then earns little or no money. Think airlines.
Berkshire Hathaway, 2007 Annual Report

The purpose of Bollinger Bands is to provide a relative definition of high and low. By definition prices are high at the upper band and low at the lower band.

Bollinger Bands are akin to envelopes on the upper and lower side of a moving average line. They consist of three curves:
Middle Curve: usually a simple moving average (SMA) of the stock price
Upper Curve: SMA + 2 standard deviations
Lower Curve: SMA – 2 standard deviations

For the moving average calculation, a period of 20 days is usually used.

Standard Deviation
Standard deviation is a statistical concept that is often used to measure stock price volatility. It also shows the spread of the stock price around its mean (or average). In the Central Limits Theorem (a Statistical Theory), a set of data will form a Normal Distribution Curve and 95.4% of the values in the data set occurring within 2 standard deviations of the mean.

Expressed in another way, there is a 95.4% probability in theory that the share price will occur within 2 standard deviations of the mean price.

The interval between the upper and lower bands and the middle band is determined by volatility, typically the standard deviation of the same data that were used for the average. The default parameters, 20 periods and two standard deviations, may be adjusted to suit your purposes.

Using Bollinger Bands
Some important concepts are used in Bollinger Bands:

1. Band Width

= (Upper Band – Lower Band) / Middle Band

The bands will expand and contract as the price action becomes volatile (expansion) or becomes bound into a tight trading pattern (contraction).

2. The Upper and Lower Bands can be used to determine price targets

Bollinger Bands can help determine overbought and oversold levels. As seen above, statistical theory has it that 95.4% of the values in a data set will occur within 2 standard deviations of the mean. When the share price move closer to the Upper Band, it indicates that the share is overbought. Conversely as the prices move closer to the lower band, it becomes oversold. Basically there is 95.4% chance that it remains within the band.

3. %b – This is a measure of where the stock price is in relation to the bands.

%b = (Price – Lower Band) / (Upper Band – Lower Band)

4. If the price deflects off the lower band and crosses above the 20-day moving average, the upper band represents the upper price target. In a strong uptrend, prices usually fluctuate between the upper band and the 20-day moving average. When that happens, a crossing below the 20-day moving average warns of a trend reversal to the downside.

Simple Illustration
A Price and Bollinger Band plot for Bursa Malaysia share price. The brown line is the 20-Day Moving Average. Notice the share price became more volatile from early-mid October. The lower most chart showing the band width also starts to move up.

The share price nears the Upper Band in early November and but the RSI does not confirm the upward move (moves closer to 70) - a sell signal is generated.

Our share price data goes back around 1.5 years. You can plot share price and technical indicators such as Moving Averages, RSI, MACD, Stochastics and so on.

To get started, just click on Chart at the top of the page (duh):

Select the counter from the “Ticker Symbol” drop down at the top. In this case I’ve used AMMB as an example.

On the left you will see controls for Chart Type, Price Band and Moving Averages. This controls the top half of the chart. You can plot closing price and candlesticks. And use indicators such as Bollinger Bands and Moving Averages to compare against. If you use Moving Average, please set the number of days you wish to use for your calculation.

Below the top half, you can have up to 3 other technical indicators which are controlled by the bottom three drop downs. There is a wide range of indicators for you to choose from, in this example I’ve used Volume, RSI and MACD for illustration.

Just a disclaimer, I’m NOT a charting expert. Most of these techniques are a bit of an investment “hocus pocus” for me and I am often baffled by the results. Sometimes I would use Bollinger Bands, RSI and MACD to confirm entry points… but only after the fundamentals stack up in the first place. Anyway I will share some of my primitive knowledge in charting next week.

Of course, you are most welcome to share any strategy or just let me know if you spot any errors in the data. Happy charting :)

I am a large cap investor. But while scanning through some of the smaller companies on Bursa Malaysia, I am really amazed at how cheap things have become. I checked out TA Enterprise Berhad and found that it is trading at RM0.62 which gives it a total market value of RM885 million.

Now that sounds like a lot of money… but remember that TA has a nice cash pile. At last count on 31 July 2008, TA’s net cash position was around RM728 million.

TA Enterprise Berhad
I’m sure most of you have heard of TA but if not, it’s basically a financial services (mainly stock broking) and property development company. Its claim to fame started in the 1980-90s during which TA became one of the most profitable companies on the KLSE. The company later hit the wall when founder Tony Tiah was convicted of corporate offences but has since recovered to become a cash and asset rich vehicle.

In a nutshell, TA is SO INCREDIBLY CHEAP that based on the current share price, you can have the whole company and end up with a lot of prime KL properties for free.

Once again this is all theory. Last week I wrote an article explaining the concept of Enterprise Value and using MAS as an example of how to buy a multi-billion dollar company for free.

In the case of TA, its Enterprise Value (Market Value less Net Cash) is around RM160 million. At the same time it has over a billion ringgit worth of business assets and prime properties. Clearly the company is a steal at this price.

If you are a corporate raider this is definitely a prime candidate. If TA was in the US or Canada, people like Carl Icahn and the Reichmann brothers would have swooped on it long ago.

Unlocking Shareholder Value
There has been talk that TA was looking to spin-off its property assets into another listed vehicle. I haven’t been following this and how it’s supposed to enhance shareholder value.

But in the current market environment, the easiest way to unlock more wealth for shareholders is through share buy backs.

TA’s Net Tangible Assets per share is around RM1.60 per share, meaning that if it buys back its own shares at only RM0.62 it is paying less than book value for its own shares. The result is that NTA would go up even further. Let’s see how that can happen:

TA has 1,427.4 million shares in issue. Tony and Alicia Tiah hold 480.5 million shares or 34% of TA Enterprise. Based on the share price of RM0.62, their shares are worth some RM298 million. OK obviously they don’t need any advice from me

But let’s say TA buys back 500 million of its own shares. At RM0.62, that would cost the company RM310 million. Net cash is reduced from RM728 million to RM418 million. Based on 31-Jul-08, TA’s balance sheet would like something like this:

The 500 million shares get cancelled. This reduces total issued shares from 1,427 million to 927 million shares. So the company becomes smaller and has less assets. However the Net Asset Per Share increases. All shareholders who don’t sell are now holding on to shares that are worth more than before. Each share is now worth RM2.08 (in theory) compared to RM1.57 before the buy-back.

Assuming they don’t sell, Tony and Alicia Tiah will now hold 52% of the company. This will cement their control over the company.

Earnings Per Share goes Up
Cash typically earns a return of 3% or less. When a company uses cash to buy back its shares, it is swapping this 3% return for a higher return. In the case of TA, if for example its PE Ratio is 5 times, it means that the shares will return 20% to shareholders (100 divided by 5). This is also known as the Cost of Equity. If the company uses its cash to buy its own shares, it is trading the 3% return for a 20% return. As a result Earnings Per Share will increase. And the share price will eventually increase to reflect this.

Asset Play
Although TA is cheap, just to clarify that I am NOT advocating a buy here. TA’s earnings are volatile and will be impacted by the economic slowdown. Historically this company has been more of an asset play and does not really display attributes of a company that can sustain long term earnings growth.

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Warren Buffett

Yeah right! I hear you say. Don’t believe me eh?

If you had your own airline, you can go anywhere for free right? I’m not kidding! Just buy over MAS and give yourself a free ticket, that simple!

Sounds ridiculous but it’s not. It won’t cost you billions or even millions.

Now you can buy the whole company lock stock and barrel for NOTHING. And here’s the good news… you also get paid some RM100 million for taking it.

Don’t believe me!!!???

OK let’s do the numbers…

Malaysian Airline System Berhad or MAS has a total of 1,671 million shares issued. Multiply that by its share price of RM2.56 and you get a total value of RM4,278 million or RM4.3 billion. That’s the value that the market puts on MAS.

As at 31 December 2007, MAS had around RM4.4 billion in cash (net of its borrowings). So in theory, if you bought the whole company for RM4.3 billion, you could just take out the RM4.4 billion to pay for your purchase. And guess what? You own the whole airline and pocket a cool RM100 million.

You can’t be serious! So what’s the catch?

OK, I know I can’t fool you. You’re too smart for this. Yes there’s a problem with this analysis:

1. You can’t buy all the shares in MAS for RM2.56
When you start buying in a big way, obviously the share price is going to go up and you’ll end up paying too much for it. Besides there are some big wigs in there who control more than 50%.

2. Cash position changes every day
Actually as at 30-Sep-08, MAS Net Cash has reduced to less than RM4.0 billion. Businesses have cycles and sometimes cash is up, sometimes it’s down.

3. You will need a few billion first
Before you can get your hands on the RM4.4 billion cash kitty, you need to find the money to mop up all the shares first. Imagine the look on your banker’s face! Please don’t come looking for me if your name gets blacklisted in the CTOS system

So why am I wasting my time reading this article?
OK wait, before you get upset with me, there’s a lesson here and it’s called Enterprise Value. This is actually a useful concept in company valuation.

Enterprise Value
When you buy shares in the stock market, you are buying the business assets, cash, goodwill, systems, borrowings and whatever else in there. What are really necessary to make money are the business assets, for example:

• Premises & Equipment
• Trade Secrets
• Inventory
• Systems
• Customer Goodwill

We are trying to value the business here. Cash is just cash. A dollar of cash is just that… one dollar. No more, no less. The same goes with borrowings.

So to work out the value of the business, you need to work out this thing called Enterprise Value, which is:

EV = Net Assets – Cash

(No rocket science…  just strip out cash from the business assets, that’s all)

If the business does not have cash but has borrowings, then:

EV = Net Assets + Borrowings

If the business is a listed company, then replace “Net Assets” with the Company’s Market Value (also called Market Capitalization).

EV = Market Capitalization – Cash + Borrowings

So as in the example of Malaysian Airlines:

EV = RM4.3 billion – RM4.4 billion (which gives negative value)

This means the stockmarket places a negative value on the net business assets of MAS – in other words you get paid for buying over this whole company.

So what so Great about this EV concept?
Basically cash and borrowings distort business valuation. There are companies out there sitting on bucket loads of cash way in excess to what they need for their business, for example Resorts World and Petronas Dagangan.

When you look at the PE Ratio of Resorts for example, it’s around 8.6x currently. But the underlying business assets is cheaper than that.

Why? Because Resorts has heaps of cash… around RM3 billion. Cash distorts the valuation. How do I know that? OK let’s do the sums for Resorts…

Market Value = 5,902 million shares x RM2.27 per share
= RM13.4 billion

If in theory you bought the whole company and take out the RM2.9 billion net cash, you are effectively paying RM10.5 billion for it.

EV/EBIT
Instead of PE Ratio, we now use something called EV/EBIT – Enterprise Value divided by Earnings Before Interest and Tax.

EV/EBIT is similar to PE Ratio except we take out the cash element.

Instead of using the Net Profit as in the calculation of PE Ratio, we take out Interest Income because we took out the RM2.9 billion cash when calculating EV. So we will no longer earn interest as there is no cash.

We also take out tax expense because it is another distortion.

So in the case of Resorts, EBIT for 2007 works out to be RM1.8 billion. If we are paying net RM10.5 billion for it, the true Price to Earnings Ratio works out to be 5.9x only. This is called EV/EBIT.

When you work out PE Ratio, just cross check it with EV / EBIT so you get a better feel for how the market values a company’s business assets.

Has this post been helpful to you? Easy? Hard? Interesting? Boring? Would appreciate your feedback so I can better gauge how to write in future.