Sunday, May 13, 2007

Valuing Companies - A Simple Business Model Approach

Valuing a company isn't really as difficult as most people think, but neither is it easy ! It's one of those things where you have to exert some effort initially but once you get the momentum, it feels much easier as you go along. It's a little like rock-climbing, once you get over the initial difficulty, scaling the rest of the wall seems easier (though this analogy does not ring true for me, cos I have a fear of heights !).

Let's look at a company using a very simple business model approach. What this means is that we look at what a company is essentially doing (i.e. its industry), its core strategy, its target markets, potential customers, suppliers and stakeholders. From these aspects, it is already possible to eliminate the "potential" companies from the downright avoidable ones. What I can surmise from my limited investment experience is this: some industries just do not have the margins and are too competitive, lending credence to the fact that getting decent earnings growth is tough ! Even the best company is a sunset industry may not be making much profit, thus it may not qualify as a good investment using value investing screening criteria.

A few of the hot industries right now include oil and gas, palm oil (alternative fuels) and also properties ! The not-too-good sectors right now include China pharmaceuticals industry, plastics industry and semi-conductor industry. When I say "hot", it means popular but not necessarily a good investment because what is popular may not be profitable (take the boom as a good example). I shall attempt to elaborate below.

Oil and gas companies are enjoying the boom in the exploration of oil right now, and most companies in the sector are seeing high margins and high ROE. Palm Oil companies like Wilmar are also enjoying tremendous attention and are touted as the next big thing, which we will have to wait 2-3 years to see. Properties are in a boom cycle right now, and prices for private properties have been hitting stratospheric levels. When one looks at such industries, one inevitably feels like dumping their money in cos it seems so enticing !But wait, assessing each company within the industry is important too, because when it comes to value investing, the company must have a durable competitive advantage and sustainable growth based on recurring earnings. Next, assess the strategy for each company and see if this can ensure good growth in 3-5 years time. Sometimes, a little business sense is helpful here as companies may like to hype up their products/services to the public, and it is up to us laymen to decide if the CEOs and analysts can be trusted.

Just remember that some business models may work much better than others, from a simple common sense point of view. Just to take a rather glaring example, recently Rowsley went through a RTO with a China company Perfect Field which will guarantee a profit of S$300 million each year for FY 2008 through FY 2010. The company is currently only making about S$4 million a year, thus this would represent a 7500% increase in profits, in just ONE year. Call me a skeptic but which product in the world can give a company a 7500% increase in profits ? Even if the company could actually achieve this, is it sustainable ?

Another example I see of a strange business model is selling gemstones on TV, for the company on SGX called GEMS TV. Let's see, when was the last time my mum went shopping for jewelry through the TV.......*thinking* so far none ! My wife, sister and mother love going to the physical shop to choose jewelry, and they have a whale of a time trying on this and that. If GEMS TV chooses to penetrate Asian markets, then they must see this as a big obstacle. Also, they are competing with traditional jewellers as well as TV Channels for advertising space, and this all adds up to higher COSTS. Over time, they would have to scale up their revenues significantly in order to recoup their investments. It would seem that the company is expanding into foreign markets too aggressively without building up their core earnings, and such over-extension can hurt profits in the long-run. The worst-case scenario would be for the company to overuse its cash, and not have enough sales to replenish it (slow cash conversion cycle). This could potentially be detrimental to the survival of the company.

I have highlighted 2 business models which I feel cannot work under current circumstances. Perhaps if the model was revamped or revised, it may stand some chance of being successful. Sometimes, when we are presented with a business proposition, we need to coolly evaluate it in the light of the competition, industry, expenses, revenues, customer base and cash flows. It may not be simple but it's not rocket science either !

OK, back to the not so hot industries. China pharma is undergoing a turbulent phase as the government insists on regulation. Asiapharm, C&O and Reyoung have thus not done as well as they should have (but Sihuan did put up a commendable set of results). Plastics and PCB industries are essentially too commoditized and companies like Jadason, Eucon, Fu Yu and Meiban will find it very tough to maintain margins and keep costs under control, as there are so many unlisted competitors giving them a run for their money. Chip and semicon industry is also too dependent on the IT industry, which is too volatile. Companies like Global Testing, UTAC and Chartered are not having it easy, and the capital intensive nature of the industry ensures that cash will always have to be used up for expansion/upgrading of facilities while margins remain razor-thin.

In summary, look at a company and its business model before deciding to invest. If it sounds too hyped up or downright weird, it may be good to go wash your face and come back with a clearer mind to analyze the situation. When things seem too good to be true, they are usually not (true).

No comments: