Paying Too Much for the Future

Weird title eh ? Well, actually this title signifies a person who chooses to put in too much of his money into a company when valuations are rich, thus ending up "paying too much". The problem, of course, is in ascertaining how much you should actually pay and how to avoid over-paying.

Let's start off with the basics: say I offer you a cheeseburger. How much will you be willing to pay for it ? $2 ? $3 ? Maybe even $6 if it was from Carl's Jr ? But would you, in your right mind, pay $20 for a single burger ? Not unless it's justified, you might tell yourself. The same thing happens in the stock market on a daily basis. A company is offering $0.10 per dollar of earnings but people somehow pay $0.20 or even more, not realizing that they over-paid. But wait, you again say, perhaps these people are paying for what the company will be worth in future ! Good point, but then how will we know what the value of the company will be in say, 2 to 3 years time ?

This is where value investing and using valuation methods come in. If we want to pay for future growth, we have to be sure we are paying a good price for it. Even for a good company like DBS, SIA or Cosco, one should NOT pay too much for a certain rate of growth; otherwise you will find that it will take years for the company's earnings to catch up with the price you paid. This is also one of the reasons why people start lamenting that they are not making money even though the company is fundamentally strong; this is because they paid too much for it in the first place !

In today's bull market, where the STI has breached the 3,800 mark, this warning will ring very loudly and serve as an alarm bell for people who may think of purchasing part-ownership of a company. Please do note that many analysts are using FY 2008 valuations to justify their target prices (some even use FY 2009 so they can come up with a more inflated number), and the prices they come up with can be based on very optimistic, idealistic conditions. Thus, as an investor, we should be wary of such assumptions and challenge them assiduously so that we do not end up paying more than we should. Business conditions can sometimes be very rough and unpredictable, therefore investors should take note that in the most optimistic projections, there are bound to be some possible misses in terms of revenue targets, profit targets and margin growth. This is part of the normal business cycle which all investors should think about.

So to avoid over-paying, we have to assess if the sustainability of earnings can be continued through into the future. This depends largely on how a company recognizes revenues. Be acutely aware that property companies tend to use % of completion method, oil and has chartering companies recognize revenue on a time charter basis while retail companies like Hour Glass and Sincere recognize revenue on an immediate basis (at the point of sale). One has to do a simple forecast (using a conservative net margin) to see how earnings will turn out in future periods. This will give a fair value for the company. Add in synergies in terms of JV, tie-ups and other beneficial arrangements and you obtain a rough intrinsic value. Make sure you purchase with a reasonable discount to intrinsic value in order to maintain a margin of safety. This ensures you do not "overpay" for the transaction, using a forward-earnings projection.

All I can say is, in today's market, there is hardly any margin of safety for any company on SGX. Therefore, I will sit, wait and build up my cash hoard in anticipation of the next major crash or correction. Patience will always reward the value investor; most people cannot resist the temptation to constantly buy and sell.