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.