Is there value in using dividends to valuate a company?

In my previous post, we challenged the long-held belief in looking at annual rate of return on investment as a measure of investment success. Maybe there is another way to rethink the notion of investment success by looking at how fast one accumulates his investment capital over a period of time (his rate of accumulation of capital)? On this same note, perhaps there is some value in seeing dividends serving this purpose of capital accumulation by reinvesting the earned dividends back to increase one's portfolio value and also work on the principle of compound interest growth to further receive more future dividends upon a larger portfolio with the reinvested dividends.

It is no wonder that compound interest growth is the 9th wonder of this world - principle of interest received upon interest reinvested. The higher the amount of interest in consideration and the higher the rate of interest received, the faster this 9th wonder of the world works to double the original capital value. One may have already heard of the principle of 72 in calculating the number of years needed for one's capital to double by compound interest growth. Just divide the number "72" by the compound interest growth rate and one will know how long it takes for an original capital sum to double. E.g. if one can receive a consistent compound interest rate of 10% annually, it will take approximately 7.2 years (72 / 10 = 7.2 years) for one's original capital sum to double assuming all dividends received from one's portfolio are reinvested.

If one started with a $100,000 capital sum, 7.2 years later he will have approximately $200,000 by compound interest growth at 10% compounded interest rate. One can imagine the effect is enormous when dealing with larger capital sum. A starting capital of $500,000 in the same case with be worth $1 million in approximately 7.2 years time.

The two important factors here will be the amount of start-up capital and compound interest rate. Many of us are limited by our start-up capital. Not all people start on the same equal footing. Some start on a more substantial capital sum while others start with a smaller sum when embarking on this journey of investment. Since one is limited by his start-up capital, the second factor (compound interest rate) now plays an important role in determining how fast one can keep doubling his capital.

How nice if one can continue to receive year after year dividends that grow at a rate faster than inflation? The higher the annual rate of growth of dividends, the higher the compound interest rate one receives if one can successfully reinvest all the dividends consistently at high yields. Therein lies the importance of dividends, especially dividends that prove to be consistently growing at high rate annually.

However, there is another perspective in some investors preferring the company not to provide dividends but instead reinvest it's earnings to grow it's business competitive moat and assets so as to generate even more future earnings and potentially increasing the share price. If the company can do a better job at reinvesting it's earnings to generate better future returns for it's shareholders than they receiving the dividends which they can only reinvest at lower returns, it maybe better for the company to do so. The future is unknown, so the merit of whichever choice be it for a company to provide some dividends out of it's earnings or to reinvest all it's earnings is known only on hindsight.

Since dividends may be considered as important and a consistently growing dividends at high yield annually is desirable, one can use dividends as a means to valuate a company's intrinsic value per share.

The relevant equation adapted from dividend discount model (DDM) to estimate a company's intrinsic value per share is as follows:-

R = Cost of capital

G = Compounded growth rate of dividends

Just a simple case study for estimating the intrinsic value per share for one of my invested companies, Keppel Corporation. Keppel Corp has seen it's dividends grow at a compounded rate of around 11% over the past 7 years. It's most recent dividends is $0.42 per share. I shall use a cost of capital of 14% as my opportunity cost in investing in Keppel Corp.

Putting all the information into the equation gives:-

= $14

Intrinsic value per share is only at best an estimate. If one uses a higher cost of capital (e.g. 15%) in the equation, the estimated intrinsic value per share now becomes $10.50. The current market price for Keppel Corp's share is $11.40 per share. So, if one uses a higher cost of capital (15%), the estimated intrinsic value per share is lower at $10.50 and now Keppel Corp's current market share value seems to be overvalued. But, if one uses a lower cost of capital (14%), Keppel Corp's current market share value of $11.40 per share will now seem to be still undervalued compared to estimated intrinsic value of $14 per share. Thus, estimation of intrinsic value per share is only a subjective fuzzy guide. The investor needs to invest at a valuation much lower than the estimated intrinsic value per share to ensure a margin of safety.

The value in looking at dividends in estimating intrinsic value per share for a company is that one is also looking at the track record of the company in giving dividends. A good track record is always welcomed. A company like Keppel Corp that has provided a good 7 years of dividends that grow at a compounded annual rate of 11% may have a fair chance of continuing it's track record. Of course, in everything due diligence is needed to also look at other aspects of a company and not it's track record in dividends alone.

In conclusion, is there value afterall in using dividends to valuate a company? Is dividends valuable to an investor? Yes, it is valuable to a certain extent as long as the company can continue to provide a reliable stream of dividends that grow at a high annual compounded rate. Even better is the investor that continues to receive that stream of dividends at a high yield (more than 10% annually).

Determining intrinsic value of some stocks in my portfolio - Do not overpay for stocks!

The Singapore stock market has rallied over the past few months on the news of gradual recovery in the global economy. All stocks in my portfolio have seen gains, some more than others. Though I am satisfied by the gains in share prices of stocks in my portfolio, I still do not feel comfortable with a few stocks in my portfolio because I found that I am holding them at average share price higher than their estimated intrinsic values. Thus, I will seek to discuss on the mistakes I may have made in holding a few stocks in my portfolio at higher than their intrinsic value per share. Intrinsic value is very important to me as a focused value investor as it provides a guide to me as to whether I am overpaying for a particular stocks. By overpaying for a particular stocks (even if the stocks is supported by good underlying business), it will diminish long term returns and does not provide any margin of safety in case the business does not fulfill the intrinsic value as judged by the investor. As such, I am not comfortable with overpaying for any stocks.

Before I seek to estimate the intrinsic value per share, I will first present some financial statements for a few companies I have invested in. The statements include net cash from operations, capital expenditure and free cashflow. Then, I will provide a simple analysis on these companies based on their financial statements. Also, I will provide a sample on how I estimated the intrinsic value per share for one of the company.

Please bear in mind that I am not a qualified accountant nor analyst. I do not guarantee the accuracy of the financial statements presented here. Also, the opinions expressed here are my own personal judgments. So, please take my sharing with a pinch of salt. The purpose of my discussion is to provide a training and discussion ground for the exercise of evaluating a company's cashflows and determining their intrinsic value per share based on their present value of projected cashflows. All figures presented are just estimates and may not be accurate.

Recap:- Free cashflow = Net cash from operations - Capital expenditure

Keppel Corp

Keppel Corp's net cash from operations have been fairly stable for 10 years. It has grown steadily over the years to the current level of around $ 2 billion. This indicates consistency and stability in generating cash from its operations.

The capital expenditure has remained fairly constant over the years and is not excessive. This results in positive free cashflows for most of the years. The free cashflows has also risen slightly over the recent years.

Thus, I peg a consistent growth of around 2% compounded annual growth (CAGR) for its future cashflows as I think the company is mature and its future cashflows may not outperform its current cashflows significantly which is already steep. As the company is able to generate consistent cash from operations with positive cashflows, I see this as a stable company going forward. So, my discount rate used in the calculation of DCF is 10%, a fairly conservative discount rate to account for my opportunity cost in investing in this company and also my risk premium (see earlier post for details on DCF model).

I have created an excel spreadsheet incorporating the calculations for DCF. The estimated intrinsic value per share for Keppel Corp based on my spreadsheet after taking into account the 2% CAGR for future cashflows, 10% discount rate on future cashflows to their present value, total number of shares, and a long term rate of growth on its cashflows of 3% beyond the 10 years is $13.04 per share.

As this is just an estimate on what each share of Keppel Corp is worth, this intrinsic value may not be accurate. To account for any misjudgments, it is always wise for the investor to invest at below the estimated intrinsic value. Investing at below the estimated intrinsic value per share allows a margin of safety to account for possible errors in estimating the intrinsic value. The lower the share price an investor buys its shares below this estimated intrinsic value, the better safety margin to account for any errors in misjudging the worth of a company's shares.

My current average holding price for Keppel Corp's shares is $4.05 per share (see earlier post on my stocks portfolio). Thus, my margin of safety is around 221% which is very significant. Even if I overestimated the intrinsic value per share for Keppel Corp, I should be well buffered against my misjudgment since my holding price for Keppel Corp's shares is very low.

Sample of the Excel spreadsheet I use for estimating intrinsic value per share

SembCorp

Fairly consistent net cash from operations with only two years showing negative values. Fairly consistent capital expenditure over 10 years. Most years with positive free cashflows.

I peg a CAGR of 5% for its future cashflows and a 10% discount rate on future cashflows to present value on the consistency of its cashflows generating ability.

The estimated intrinsic value per share I arrive at is $4.55 per share.

My current average holding price is $3.35 per share. This provides a margin of safety of 35.8%.

Tat Hong Holdings

Its net cash from operations is a bit inconsistent with some years having a significantly lower net cash from operations. Its free cashflows is also inconsistent with negative free cashflows for some years.

I peg a 5% CAGR for its future cashflows since this company is still growing and expanding its operations in China. However, I peg a slightly higher discount rate of 12% on its future cashflows to present value because of its inconsistent cashflows to account for a higher risk premium that its cashflows may not materialise in future.

The estimated intrinsic value per share is $0.65. My average holding price is $0.658 per share. Thus, I do not have any safety margin for this stocks.

Parkway Holdings

Net cash from operations has been growing steadily through the years. Capital expenditure has also grown throught the years. Free cashflows has also grown steadily through the years expect for negative free cashflows in latest year. The high capital expenditure in the latest year could be due to its aggressive expansion overseas resulting in a negative free cashflows.

I peg a 5% CAGR for its future cashflows on the consistency of its ability to generate free cashflows based on the defensive nature of its healthcare business. As such, my discount rate on future cashflows to present value is also lesser at 8%.

The estimated intrinsic value per share is $1.29. My average holding price is $1.758 per share. I have invested at a higher premium than its estimated intrinsic value (fatal mistake for a value investor). This would have been risky saved for the fact that the nature of its healthcare business is defensive and provides stable stream of cashflows. Thus, I am still willing to hold my shares to allow the intrinsic value of this company to grow beyond my holding price per share.

Discussion points:- The exercise of estimating intrinsic value per share for a company is both science and art. The estimated intrinsic value is by no means an absolute since it is difficult to forecast the future cashflows of a company accurately.

Valuation of a company (estimating its intrinsic value per share) is only part of the game. An investor has to analyse more parameters apart from just cashflows from a business to determine whether a business is worth investing in.

A value investor always seeks to invest at a margin of safety below the estimated intrinsic value per share. This is to account for any misjudgments in the intrinsic value per share of a company.

An investor may still invest at a slightly higher premium to the estimated intrinsic value per share of a company if he is convinced after sound analysis that the company is able to grow its intrinsic value in future beyond the investor's current holding share price.

More discussions on my experience with analysing the fundamentals of the companies in my portfolio in later posts.

Determining intrinsic value per share of a stocks (Part 2 of 2) - A company is worth the present value of all its future cashflows?

I shall now follow through the discussion on how to calculate the present value of a company's future free cashflows. Before I continue my discussion, please be cautioned to take my sharing with a pinch of salt. This is because I am by no means a qualified accountant or analyst. I am just an average retail investor doing my own research into investing methodologies and principles from reading investment literature and attending investment seminars. However, I believe in constant learning and correcting my mistakes so as to become a better investor with time. One has to start off somewhere to fall and pick oneself up and fall again and repeat the whole process of falling and picking oneself up constantly in order to grow no matter in which areas of life, not just in investing.

An old traditional method - Looking at present value of future cashflows to determine investment value

Early economists more than 60 years ago like Irving Fisher and John Burr Williams proposed that the value of a stock is equal to the present value of its future cashflows. In my earlier post, we have seen how free cashflows are important to a company as it is the freed up cash that can be taken out of a company yearly without harming its business. Portions of free cashflows can be reinvested into a business, paid out to shareholders as dividends or be used in share buy backs to increase the % ownership of each shareholder.

There is a need to calculate the present value of future free cashflows a company is projected to generate. This is because the future cashflows investors would expect to receive is worth less than the current free cashflows. Two reasons abound regarding why future cashflows is worth lesser than current cashflows. Firstly, money we receive today can be invested immediately to start generating returns, but we cannot invest future money until we receive them. This is also called the opportunity cost of receiving money in future compared to receiving money today. Money at hand always has better immediate investment value than future money as it can be put into investing straight away to start compounding returns. Secondly, there is a risk an investor may not receive a company's future projected cashflows, and there is a need to compensate this risk taken, also called the risk premium.

Risk premium also depends on the nature of the business, whether its free cashflows is consistently stable or unstable. A company where its free cashflows keeps fluctuating through the years with no stability makes it difficult to predict its future cashflows with certainty, thus such company carries a higher risk premium.

Due to opportunity cost of receiving money in future compared to now and also risk premium, there is a need to discount the future cashflows a company is projected to generate by a discount. The higher the opportunity cost and risk premium an investor has to absorb, the higher will be the discount on a company's future cashflows to calculate the present value of the future projected cashflows.

As such, this simple idea of discounting a company's projected future cashflows to a present value is called the discounted cashflow (DCF) model for valuing a company's intrinsic value.

No investing methodology is perfect and an investor has to understand the possible limitations of every methodology. DCF assumes that a company's intrinsic value depends solely on the present value of future cashflows it is projected to generate. So, this method places importance on valuing a company based on free cashflows. If an investor is convinced a company's value is tied strongly to the amount of free cashflows it can generate for a period of time and he is willing to only pay for a company's free cashflows, then this method will make absolute sense for him. If an investor is not convinced by DCF model, it maybe better for him to adopt other ways of valuing a company (e.g. looking at P/E ratio).

Mathematical calculations behind Discounted Cashflow (DCF) model

It is not my wish to bother with complex calculations when doing investment. After reading some literature on Warren Buffett's investing wisdom, I remember one quote from this master investor which mentioned that investing is not a simple exercise, neither is it meant to be a complex exercise requiring intense mathematical calculations that it is not attainable by many without a relevant degree of certification. So, a high IQ investor with ability to crunch complex data and financial figures may not necessarily make a better investor than one with some basic financial and investing knowledge. As more variables and factors are considered in assessing an investment, it may not necessarily make an investment sound as an investor has a chance of misjuding each variable being considered. So, the more variables being considered in assessing an investment means more chances of misjuding the investment.

Thus, I will try to keep the discussion of the DCF model simple. My hope is not to provide a rigourous discusssion over this model but rather to bring out only simple appreciation on the required calculations and later to discuss this model's usefulness and limitations based on the context of its required calculations.

CFn = Free cashflow generated for nth year (e.g. CF1 means free cashflow generated for first year),

r = discount rate (depends on opportunity cost and risk premium)

Step 1: We have to forecast the free cashflow (FCF) a company can generate for next 10 years. For simplicity (since I am not an analyst trying to be as accurate as possible; anyway I don't think analysts can be perfectly accurate or else they would have make millions themselves in forecasting a company's future prospects so perfectly if they are really able to do so), I forecast a stable company should grow its free cashflows over 10 years at a pre-determined fixed compounded annual growth rate (CAGR). The compounded annual growth rate to use is rather subjective depending on individual investor. I use the same compounded annual growth rate based on a company's past cashflows.

For calculations of future cashflows for 10 years at my pre-determined annual growth rate, I use the formula Future cashflow = Present cashflow X (1+ r/100)^n, where r is the compounded annual growth rate and n is the number of years.

E.g. Company A's current cashflow is $100. It can grow at 10% compounded annual growth rate. At first year, company A can generate cashflow CF1 of $100 X (1+10/100)^1 = $110. At second year, it can generate cashflow CF2 of $100 X (1+10/100)^2 = $121. The calculation goes on until the 10th year.

Step 2: After forecasting all the future cashflows, we have to discount each cashflow by a discount rate to account for the opportunity cost and risk premium. Again, determining an appropriate discount rate is subjective. An investor can consider the yield he will receive on an alternative risk free investment (e.g. government bonds) had he not considered this current investment which is being assessed. Let's assume Singapore government bonds over a 10 years maturity period provide yields around 3 to 6% annually. So, an investor can have a discount rate of at least 3% over here. An investor can consider a higher discount rate than 3% (say 12%) if he perceived the company is risky and he should be compensated at higher discount rate on the future cashflows to calculate the present value of these future cashflows. So, a more conservative investor considers a higher discount rate when discounting future cashflows to their present value.

Step 3: Now, we have worked out the sum of all discounted cashflows for 10 years period (based on steps 1 and 2 plugging in the various values like current cashflow of a company, its cashflow compounded annual growth rate and its discount rate). We still need to determine discounted perpetuity value. Discounted perpetuity value is necessary to account for present value of a company's projected cashflows beyond 10 years. It is not feasible to compute all discounted future cashflows to infinity number of years, so a discounted perpetuity value estimates the present value of future cashflows far beyond 10 years.

(I will not present the calculations for discounted perpetuity value since my intention is not to provide a rigourous discussion on the mathematical calculations behind DCF model)

Step 4: Calculate total discounted cashflows (DCF) by adding 10 discounted cashflows for 10 years to the discounted perpetuity value. (Refer to DCF formula above)

Step 5: Calculate intrinsic value per share by dividing total discounted cashflows (DCF) by total number of shares outstanding for a company.

Discussion points on DCF model for determining intrinsic value per share of a stocks:-

1. There are at least two important variables affecting the calculations of discounted cashflows (the forecasting of future cashflows and the discount rate applied to discount the future cashflows to their present values).

2. It is by no means easy to forecast future cashflows. The compounded annual growth rate (CAGR) to use for determining future cashflows is subjective. An investor who is optimistic about a company's future cashflows can use a high CAGR to determine future stream of cashflows. Similarly, a conservative investor can use a lower CAGR. It depends on the investor's assessment of the company's future abililty to generate cashflows.

3. The discount rate an investor chooses can also be subjective. A conservative investor may use a high discount rate to discount the future cashflows to their present value. This is to account for the opportunity cost and risk premium he thinks he has to absorb when investing in the company. The discount rate may go as high as 15% to 20% up to the comfort level of an investor.

Conclusion:- DCF model is not a sure-win magic formula for determining intrinsic value per share of a stocks.

Different investors using the same DCF  model may still arrive at different intrinsic value per share for the same stocks depending on the CAGR they use to determine the future cashflows and the discount rate they use to discount future cashflows to their present value.

As such, DCF model is just one of many tools available for determining intrinsic value per share of company stocks. Valuation by DCF model may not be totally exact science, but it is partly an art since there is no absolute perfect forecast of future cashflows and no one perfect discount rate to be taken in the calculations of discounted cashflows. 

Thus, as with any other valuation tools, DCF model serves only as a guide and is not an absolute way to determine intrinsic value per share. No one can really peg a true intrinsic value to a company. Intrinsic value does change with time also. Therefore, an investor should always seeks to invest at a margin of safety below calculated intrinsic value per share to account for any misjudgment of the intrinsic value of a company. 

More discussions on using DCF model to determine intrinsic value per share for stocks in my portfolio, and I will also seek to discuss some mistakes I have commited by investing at higher than intrinsic value per share for some stocks in my portfolio in later post.

Determining intrinsic value per share of a stocks (Part 1 of 2) - Why free cashflows matters to a business and shareholders?

Why the need to determine intrinsic value per share of a company?

Since I started investing in June 2008, I have not conducted a rigourous determination of intrinsic value per share for the stocks I bought. I understood the importance of intrinsic value per share as it reveals how much the business underlying a stocks is worth. However, due to the lack of discipline to follow through the mathematical calculations behind determining intrinsic value per share, I kept procrastinating on learning this technique. This is an important exercise seeking to determine the true value of a company based on its cashflows. If the stocks market is not to be viewed as a speculative playground whereby securities are bought and sold by the minutes or at best only by the hours, this is where determination of intrinsic value for a stocks comes into play for the serious investor who wishes to invest his money carefully into only prospective stocks that are undervalued for their businesses.

Determining intrinsic value per share for a stocks has its place of importance because whether an investor is aware or not, whenever he is buying shares of a company, he is already having a part-ownership in the business of the company. The returns from his investment in the chosen company is determined by the economic prospects of the company and the price he pays for the shares of the company. If the company does well economically and is exceptionally profitable, the investor can expect bountiful returns from his investment (especially if he has invested at undervalued share prices). If the company fails, the investor may risk losing his invested capital in the company. Even if one is adopting a short-term attitude towards holding shares of a company, it still pays to know some important fundamentals about a company before investing one's money in the company as any unpleasant surprises can catch an ignorant investor unprepared even in short time period. There are already some examples of China concept stocks engaged in bad corporate governance and lack of integrity in management that caught investors unaware short-term before they can react.

Free cashflows is the lifeline of a business

Since I seek to be a focused value investor, determining intrinsic value of a business should be one important skill to master. Determining intrinsic value per share of a business depends on the present value of  future free cashflows a business can generate over a period of time (usually taken to be 10 years). Free cashflows are the lifeline of a company. The ability to generate continuous free cashflows ensures survival of a business. A business needs to generate free cashflows continuously as free cashflows can be used for purposes such as further investing in the business or payout as dividends to shareholders. A business that is unable to generate free cashflows consistently is destined for failure in a matter of time (as this suggests the business is basically not profitable at all).

Free cashflows = Net cash from operating activities - Capital expenditure 

To arrive at positive free cashflows, a company needs to have positive net cash from operating activities. The figure for "net cash from operating activities" can be directly taken from an annual report under the section, "consolidated cashflow statement". A positive net cash from operating activities is important as it shows that the business can generate cash from its operations. A consistent negative net cash from operating activities for a few years maybe a red flag signalling problems with the ability to generate cash from a business's operations. Who wants to invest in a business that cannot even generate cash from its operations? On the contrary, a business that shows consistent growth in its net cash from operating activities over the years shows its excellent business characteristics that allows continued generation of more and more cash from its operations.

Capital expenditure refers to money a company needs to spend on items to keeps its business running and growing at its current rate. Such items include plants, properties and equipments. As such, capital expenditure is a basic necessity to allow the business to maintain its operations and growth. For example, a biscuit making company needs to expend capital to buy a production plant to produce biscuit. It cannot produce biscuit without the necessary production plant with its equipment, so capital expenditure is necessary to produce biscuits. A company that can keep its capital expenditure to a minimum and yet maintain a good rate of growth in business is a good one. An investor can refer to the subsection "cashflow from investing activities" under "consolidated cashflow statement" and look for items such as "investing in/aquisition of plant, property and equipment" to have an idea on how much capital expenditure a company puts into its business.

Thus, free cashflows is whatever free cash left over after necessary capital expenditure is deducted from the net cash produced from a business's operations. An excellent company can produce large amounts of net cash from operating activities while keeping its capital expenditure to its lowest. This is the kind of business an investor will want to invest in, especially if a company can consistently produce significantly large amounts of free cashflows.

Free cashflows can be reinvested into a business to further its growth or to be paid out to shareholders. So, free cashflows is the lifeline of a company, it cannot do without.

More further discussions on determining intrinsic value per share of a company in later posts. I will also seek to critique my own investment portfolio to point out mistakes I committed in purchasing shares of companies that are overvalued based on their intrinsic value per share.

Discussion points:- Free cashflow = Net cash from operating activities - Capital expenditure

It is important to look for companies that shows consistent growth in net cash from operating activites while maintaining low capital expenditure, and yet has high return on equity (ROE).

The ability to consistently generate high free cashflows from a business allows the cash to be reinvested in the business or to be paid as dividends to shareholders.

Waiting for the perfect pitch - Looking at yield on one's investment

I shall discuss 2 sections here. First section is on the concept of "waiting for the perfect pitch". Second section is on recognising the perfect pitch, on when to invest based on looking at long term yield on one's investment.

First section:- "Waiting for the perfect pitch."
Warren Buffet describes wise investing as having a punch card with limited number of lifetime investment decisions (20 times perhaps). Each time a decision is made, the card is punched once. One can only excecute at most 20 investment decisions in one lifetime (each decision maybe a single buy or sell order). Once exhausted the 20 limited number of decisions, one cannot carry out any more investment actions. Though unrealistic, this really paints a strict investing principle of "one should only invest when it is wise to do so, otherwise do nothing". It also makes one thinks very carefully before making each investment decision.

Further to the punch card example, a more suitable demonstration of "waiting for the perfect pitch" describes a baseball batter who needs to constantly decide when to swing his bat at the ball. Warren Buffet describes a famous baseball batter who divides the batting range into many smaller square sections where the ball can fall into when flying towards him. This baseball batter only swings his bat when the ball is flying into a few particular square sections that give him a very high probability to hit the ball for a perfect pitch. Otherwise, he does nothing.

Investing is wise only after it is given thoughtful and careful consideration as shown in the punch card and baseball examples. One only invest when there is a high probability of winning (making excellent returns) and low probability of losing one's capital. As such, Warren Buffet also has two golden rules for his investment:- First rule is never to lose money. Second rule is never to lose money too.

A point to note is that this concept of "waiting for the perfect pitch" cannot be misinterpreted and wrongly applied. For example, a contra player in the stock market may buy heavily into the stock of a particular company after a good news is released about the company thinking the stock price will soar on short-term. He thinks he is betting heavily since he has a perfect pitch. However, Buffett's intention for using this concept of "waiting for the perfect pitch" applies mainly to a long term nature of investing (e.g. he makes his perfect pitch to buying a company stocks not for a short-term speculative gain). His investments are mostly held for long term compounding returns, and his idea is to buy particular stocks when it is most attractively priced for its value with great long term potential for excellent returns.


Second section:- "Recognising the perfect pitch - when to invest based on looking at long term yield on one's investment."
There are many ways to determine whether a stocks is most attractively priced for its value to make good one's investment. One can look at price-earnings ratio (P/E), price-book ratio (P/B), intrinsic value (which is subjectively determined). Traditionally, the lower the P/E ratio (10 and below) and P/B ratio (1 and below), the more attractively priced is a stocks for its value.

Through my reading of investment books, I came across a book based on Buffett's wisdom of recognising when is the perfect pitch. One can look at the long term yield on one's investment. E.g. One buys a share of a company (e.g. XYZ company) at $1 and the company has a earnings per share (EPS) of $0.10. This means for every $1 dollar invested, one expects to receive $0.10 returns on the $1. The current yield on this investment will be ($0.10/ $1) X 100% = 10%. Is this a good deal?

If shares of another company LMN is priced at $1 per share and EPS is $0.20, the investor gets $0.20 for every $1 invested. The current yield is 20%. This is definitely a better deal than the earlier one. Of course, the investor does not get the full $0.20 returns per share physically on his $1 invested per share. Only dividends is given back to the investor and all remaining earnings of a company is usually used as retained earnings to further grow its business. However, as long as the investor remains invested, he still has interest to the full earnings (dividends already given to him plus any earnings not given to him but retained by the company).

It gets a bit tricky when we look at the growth of earnings per share (EPS). EPS of company XYZ is projected to be growing at a compounded rate of 20% per annum while EPS of company LMN is growing at compounded rate of 5% per annum. After 10 years, the EPS of company XYZ will be $0.62 while that of company LMN will be $0.33. So, an investor with company XYZ will have a future yield after 10 years of 62% on his initial $1 per share invested getting $0.62 on every dollar invested. On the other hand, an investor with company LMN though starting with a higher yield of 20% will only end up with a yield of 33% in 10 years time (not a significant increase in yield of returns).

In conclusion, one can look at current yield and future yield to determine whether a company is worthy of being a "perfect pitch".

I bought into the shares of Keppel Corp during March 2009 @ $4.05 per share. Illustrated below is the 6 years record of EPS for Keppel Corp.

2003: $0.511,     2004: $0.603     2005: $0.721     2006: $0.954      2007: $0.715       2008: $0.69

Therefore, my current yield based on year 2008 EPS is ($0.69/ $4.05) X 100% = 17.0%
Based on the 2003 EPS and 2008 EPS, the annual compounding rate of growth in EPS over this 5 year period is 6.19%. Assuming Keppel Corp keeps growing its EPS at this compounded rate per annum, its EPS after another 10 years will be $1.258.
My future yield will be ($1.258/ $4.05) X 100% = 31%.

31% yield may not be too impressive. However, it is still a decent figure getting 31% future yield per annum and growing still. Some stocks were trading at even higher yield based on their EPS and share price (more than 20 %) during March 2009. To an astute investor who can recognise high yielding stocks (current yield more than 20%) that can grow their EPS at high compounded annual rate (10% or more), it may not be too surprising to see the future EPS of such company may even reach the initial share price an investor paid for. By then, the investor that holds onto his shares may get a 100% yield ($1 returns for every original $1 invested).

Discussion points:- Wait patiently for the best chance to invest which is waiting for the perfect pitch. Otherwise do nothing.

One of the way to recognise the perfect pitch is to look at current yield and future projected yield. Buy stocks only when their current yield is high (more than 20%) and their EPS is projected to grow at high compounded annual rate (more than 10%). Thus, one should expect to get a high future yield on one's original invested capital (assuming one holds the shares long term and the company is still performing well).