Is this a good time to buy stocks? 8th April 2009

THE current financial crisis is making it hard for some investors or analysts to derive the intrinsic value of a company.

Some long-term investors intend to accumulate stocks during this period.

However they are not too sure whether this is the right time to buy stocks even though the share prices of some companies are much lower than analysts’ computed intrinsic value. They wonder whether the current share prices have already factored in all the incoming bad news, like poor revenue, earnings or further write-down on inventories, debtors or other assets.

Some investors may argue that the stock prices are real and truly reflect the value of certain companies – the very low stock prices for these companies may imply that they will go bankrupt soon.

Investors always ask why different analysts compute different intrinsic values for the same listed company. Sometimes they wonder which one should they rely on. Besides, they are unable to comprehend why some analysts keep changing their intrinsic values for certain companies. It may appear that the value changes according to the market and economic situations.

Investors notice that whenever the market recovers, analysts start to revise upward the intrinsic value of some companies, much higher than their market prices.

However, whenever market sentiment turns negative, they start to revise downward the intrinsic value, much lower than the current market prices. This has created confusion among investors and they wonder why analysts cannot provide a fixed intrinsic value for each listed company.

As a result, one common question arises from most investors: can we really rely on analysts’ intrinsic value to buy stocks? Some may even argue: can we really trust analysts’ research reports?

To answer the above questions, we need to understand the meaning of intrinsic value. According to Benjamin Graham, the father of value investing, intrinsic value is the value of the company to a private owner. It is the price of a company that the owner will sell, which should reflect all the facts, including the value of its assets, earnings, dividends as well as potential future prospects.

We need to understand that it is an estimate rather than a precise number. It changes according to market valuations as well as the economic outlook. Besides, analysts’ computed intrinsic values are only valid on the research reporting dates.

They are not valid even a day later because the estimation of the intrinsic values will change whenever the market receives new information on the companies, new economic outlooks or new market conditions.

The movement of interest rates, currencies, commodities, introduction of new stimulus packages, overseas market movement can affect the estimation of the intrinsic values. Furthermore, those variables change every day. Hence, we need to be careful on the reporting dates whenever we read any research reports.

Different analysts use different methods to derive the intrinsic values. Warren Buffett suggests that the intrinsic value is derived from discounting all future free cash flows of the company to present value. He named these free cash flows as owners’ earnings. This method is commonly used in most business appraisal reports and being taught in investment valuation courses.

According to Graham, intrinsic value can be determined by the earnings power of a company. It is the earnings capacity of a company in a normal year – the earnings that it can earn year after year during normal business conditions.

He suggested that we should use normalised earnings and normalised market valuation to derive the intrinsic value. Examining the company’s past earnings trends as well as future average expected earnings will provide us a clue to its normalised earnings. We can use historical market valuation to derive the normalised market valuation.

Hence, we notice that different investment gurus use different methods to derive the intrinsic value. This explains why different analysts compute different intrinsic values for the same company.

As long as they have reasonable basis, supported by appropriate research and investigation, we can accept those values. Nevertheless, we need to pay attention to the assumptions they used as well as the suitability of the valuation methods during that period.

Unfortunately, investors with limited financial training will have difficulties to evaluate the quality of those research reports. We suggest investors read more research reports on the same listed company before coming to a conclusion to buy or sell.