After applying criteria for analysis recommended by various books,I have created a checklist before buying any stocks in KLSE.Starting from now,I will elaborate on these criteria under KLSE Security Analysis title in the future.To understand these criteria,you should have medium level of understanding of financial statement.This part has to come from your own initiative.No pain,no gain!
One of the most important criteria in my analysis is to calculate ‘owner earnings’ from a business.This criteria is recommended by Warren Buffet in his letters to shareholders and has been summarized under a book written by Warren Buffet himself and edited by Lawrence Cunningham entitled ‘Lessons for Corporate America’.Make sure you buy 2007 edition. Owner earnings concept is very useful analysis to gauge what the company has left for its shareholders.Rising share prices does not necessarily means the company has added value for its shareholders.When company earns X from business,it can choose to reward its shareholder by paying a dividend or retaining those earnings and reinvesting them to increase the underlying value of the company. If the company employes this earnings efficiently, over a period of time, the company’s underlying value will go up and cause the stock’s price to increase.
This differs from the view most investment professionals hold. They might have a CFA but they don’t consider earnings theirs until the earnings are paid out via dividends. One good example of owner earnings is the stock of Warren Buffett’s holding company, Berkshire Hathaway, Inc. In the 80s,it traded at US$500 a share. Today, it trades around $76,000, and it still never paid a dividend. The increase in the market price of the stock came from an increase in the underlying value of the company, caused by Buffett’s profitable and efficient reinvestment of Berkshire’s retained earnings.If a company believes it can profitably employ the earnings at a rate of return that is better than the investor could get, the management should keep the cash. But most company keeps on feeding shareholders with ‘sweet’ dividend to attract traders. This act is detrimental for long term shareholders and the business but good for traders.When company suddenly declares juicy dividend,a value investor should look further.
If you have attended any AGM before, you will be suprised how most shareholders react when the management announces its dividend policy.For me,unapropriate amount of dividend is like a ‘bribe’ to shareholders to blind them from seeing the management incompetencies and failures.Hence,value investors must really make sure the dividend policy is suitable for the business.Rising dividend amount does not always mean good. In addition,dividend is taxed!
In KLSE, it is common for some security analysts to assign a higher target price to companies that pay a high dividend than to those that don’t. This is true even when the company that is retaining all its earnings is an infinitely better enterprise. Maybe the analysts’ brains are controlled by directive from the top. Value investors should check the quality of management by what it does with its earnings. If it retains them, does it profitably employ them, or does it squander them on dreams of grandeur? By analysing the history of the management performance, we can come to a conclusion whether the underlying businesses will create consistent earnings to allow make its shareholders rich.So, how does an investor calculate owner earnings?
1st , check the ‘cash from operations’ under the statement of cash flows. See whether cash from operations has grown steadily throughout the past 6-10 years. If it has steadily growing, then you can go further.
2nd, calculate Owner earnings = net income + amortization and depreciation – normal capital expenditures. If owner earnings over the 6-10years,then it is a good indication. Owner earnings adjusts for accounting entries like amortization and depreciation that do not affect the company’s cash balances. So, owner earnings can be a better measure than reported net income. If you want to be more conservative,you can go on to subtract from reported net income:
• any costs of granting stock options, which divert earnings away from existing shareholders into the hands of new inside owners
• any “unusual,” “nonrecurring,” or “extraordinary” charges
• any “income” from the company’s pension fund.
3rd, calculate the growth of the owner earnings. If the growth of owner earnings is around 7% or more for the past 6-10 years, the company is a stable generator of cash, and its prospects for growth are good.
But is owner earnings foolproof? It’s not a sole determinant for business of course! For example, when a growth stock is investing heavily in new venture/market, the owner earnings will certainly plunge to negative territory due to losses or charges. If the company has good management and experience, the owner earnings will recover and value investors who hold on through the painful period will be richly rewarded. Investors may also use owner earnings to compare companies in the same industries to gauge their strengths and weaknesses.The value of the business can also be estimated by forecasting future owner earnings and bring them back to present value. This value may be used to check with the calculation of value using Free Cash Flow. More criteria will be introduced under this section. So, stay tune!