The tiny book on basic stock valuation unlocked by Ang Bayan ni Juan

The Tiny Book of Basic Stock Valuation A Basic Value Investing Guide for the Beginner Investor in the Philippine Stock Market The Investing Engineer PH www.investingengineer.com

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The Tiny Book of Basic Stock Valuation

Table of Contents Introduction .................................................4 Why Should You Read This Book .......................6 What is Value Investing ...................................7 How to Value a Business ................................ 10 Knowing How a Business Works ................... 10 Determining the Right Price ........................ 15 The Stock Price and Its Relation to the Companyâ&#x20AC;&#x2122;s Value .................................................... 17 How to Value Stocks Using the Price to Earnings Valuation Method ........................................ 20 Finding the Intrinsic Value........................... 21 What is a Discount Rate ............................. 22 Using a Margin of Safety ............................. 24 How to Value a Stock Using Return on Equity Valuation Method ........................................ 26 What is Return on Equity............................ 26 Using Return on Equity to Value a Stock ......... 28

The Tiny Book of Basic Stock Valuation Constructing the Return on Equity Valuation Model ................................................... 29 Warren Buffett’s Durable Competitive Advantage . 32 My Final Message ......................................... 35 Glossary of Terms ........................................ 38 Ebook Disclaimer......................................... 49

The Tiny Book of Basic Stock Valuation

Introduction Hi! I’m Mark, an Electrical Engineer by profession and the creator of the Philippine Value Investing Blog www.investingengineer.com! When I first started investing, it took me a while to learn the most common mistakes and failures that every investor makes. Learning from the mistakes and experiences of others has led me to understand what Value Investing is all about. Most investors fail to realize the importance of a value-based approach strategy once they start making huge losses. These mistakes came simply because most of them lack the ability to make accurate estimates of the stock’s intrinsic values. When I started, I don’t have any idea how to make stock valuations. No one taught me what to do and I had to figure this out on my own. Eventually, after reading a lot of books about Value Investing, I learned what to do and started investing based on my own analysis.

The Tiny Book of Basic Stock Valuation After I started learning the basics, I applied these principles and the right mindset in my investment decisions. I invested heavily during the 2015 market selloff which started on the 2nd week of August. During those times, the PSEI tanked but that didnâ&#x20AC;&#x2122;t stop me from continuing my investing activities. After a year, I managed to make a 20% return. I realized that a value-based approach strategy really pays off. Today, the personal challenge I want to achieve is to make consistent returns of 20% or more every year. I hope I make it! I hope that the basic techniques that I will teach in this book will help you consistently earn above average returns in the stock market. Happy investing! Mark The Investing Engineer PH www.investingengineer.com

The Tiny Book of Basic Stock Valuation

Why Should You Read This Book Value Investing is a pretty cool thing to do especially if you love crunching numbers. If you’re pretty confused and overwhelmed of the plethora of information out there, then this book is right for you. This book aims to teach you how to invest using a value-based approach strategy. I have transformed many of the complex ideas I’ve learned from all the value investing resources out there into a simple and easy to understand book that’s easy for a beginner to comprehend. Now, if you don’t have any clue how to invest in the stock market, I recommend you get started now. I’ve written a separate guide just for that in my blog and here’s the link that you can use to get there. LINK: GET STARTED! I hope that you’ll learn a lot from this book and I hope that this book will serve you well. Thank you and good luck!

The Tiny Book of Basic Stock Valuation

What is Value Investing Value Investing is an investing strategy wherein you seek and buy stocks that trade below its intrinsic value and have a huge upside potential. To quickly understand this definition, I’ll introduce you to Juan. Juan is a value investor. He only invests in undervalued businesses that have high growth. One day, he saw a business named Pedro’s Buko Stand listed in the Philippine Stock Exchange. He wanted to know if the business is undervalued so he went on to the company’s website and downloaded the financial statements. He started studying them digging out all the vital information he could find. Based on the financials, he found out that the company’s stock is worth P10 per share. Now, he looked at the stock’s market price and saw that it’s trading at around P5 per share. He realized that this is a bargain. He knows that the business is doing great and earnings are increasing year on year. So he decided to buy 10,000 shares worth P50,000 (let’s exclude taxes and commissions for now to simplify the math). After a year, the stock rose to P15 per share. After seeing this, Juan realized that the stock is now overvalued ©Copyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation and decided to sell his position making him P150,000 including the initial P50,000 he initially invested. Pablo on the other hand, has also P50,000 that he’s willing to invest. Unlike Juan, he saw this other business, Maria’s Isaw Stand. He also found out that the value of the business is P10 per share and the stock is trading at P5; same as Pedro’s Buko Stand. He decided to buy 10,000 shares just like what Juan did. But after the 1st half of the year, the stock fell to P2.50 per share. Although this was the case, Pablo didn’t panic. Pablo thinks that if he liked the stock at P5, he should like it even more at P2.50. So instead of cutting losses, he bought another 10,000 shares worth P25,000 bringing his total investment up to P75,000. This purchase lowered his average price to P3.75 per share but increased his shares to 20,000. Pablo believes that the business is strong, stable and that the stock will rise back. And he was right! After a year, the stock now trades at P15 per share. Upon seeing this, Pablo thought that the business is now overvalued so he sold his shares making P300,000 including his initial investment of P75,000.

The Tiny Book of Basic Stock Valuation This is what Value Investing is all about. You buy stocks that you believe that is less than its true worth then wait a couple of years for the market to realize that value so that you’ll make money from it. Value Investing is pretty simple right? You really don’t need an extensive background on finance and you don’t need to study charts all day long. What you’ll need to be successful in this strategy is a lot of patience, money and willingness to learn the very basic principles and fundamental concepts which I will discuss in the next chapter.

The Tiny Book of Basic Stock Valuation

How to Value a Business Knowing How a Business Works What most investors fail to realize is that when you buy a stock, you are simply buying a portion of the business itself. So let me explain this simple concept in detail. Mina wants to start a Halo-Halo business. Let’s call this business Mina’s Halo-Halo Stand. But Mina doesn’t want to get physically involved in the day-today operations of the business so he hires Jason to run it for her. Jason’s job is to make sure to sell a lot of Halo-Halo every day, monitor and replenish inventories, account all the income and expenses, keep the store clean and orderly and all other things required to ensure the smooth operations of the business. So the business opened and operations started. On the first day, a customer bought a glass of HaloHalo for P50. This is what we call Revenue. To make a glass of Halo-Halo, Mina needs crushed ice, milk, sugar and a lot of toppings which costs ©Copyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation around P10. This expense is what we call Cost of Revenue. Some books call this Cost of Sales or Cost of Goods Sold. Besides the cost of revenue, Mina needs to pay Jason’s salary. She also needs to pay rent for the shop’s location. There’s also the utility bills that needs to be paid. So for every glass of Halo-Halo, Mina pays P5 to Jason and P10 for the rent and P5 for the utility bills for a total of P20. This is what we call Operating Expenses. So let’s recap. Mina made P50 revenue. Subtract the cost of revenue from the revenue and we get P40 Gross Profit. Subtract the operating expenses worth from the gross profit and we get an Operating Income of P20. Let us also not forget that Mina needs to pay her taxes. I’m going to assume that she pays P10 taxes for every glass of Halo-Halo she sells. Doing the math we arrive at a Net Income of P10. This is the number that we see at the bottom of an Income Statement. From here, Mina has two choices. She can choose to pay herself a Dividend of P5 and the other half to be ©Copyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation reinvested back into the business as Retained Earnings to buy more inventories, hire more people or improve the shop; or she can reinvest all the earnings back into the company to speed up the growth of her business. Now, let’s assume that for one year, her business made P100,000. She decides to pay herself a nice P50,000 of dividends. The other half, she then puts back into the business. So let’s see what happens to the business’ Balance Sheet. The balance sheet consists of all the Total Assets and the Total Liabilities of the business. Subtracting the two, you get the Equity of the business. To understand this in the simplest way as possible, consider this example. Mina’s Halo-Halo business has total assets of P100,000. This consists of the following below; Cash Halo-Halo Stand Refrigerator Inventories Total Assets

P5,000 P65,000 P20,000 P10,000 P100,000

The Tiny Book of Basic Stock Valuation Mina’s business has a bank account and that account contains the P5,000 cash. Let’s assume that the HaloHalo stand and the refrigerator is worth P65,000 and P20,000 respectively. Then she keeps an inventory worth P10,000. Adding all that up, we get the total assets amounting to P100,000. Her business has total liabilities of P80,000 which consists of the following; Halo-Halo Stand Refrigerator Salary Total Liabilities

P55,000 P15,000 P10,000 P80,000

Mina took out a loan to buy the Halo-Halo stand. From what we see here, it seems that Mina has only paid P10,000 out of the P65,000 which explains why the liability is listed at P55,000. Same is true with the refrigerator. She has only paid out P5,000 out of the P20,000 loans. She also hasn’t paid Jason yet his salary amounting to P10,000. Adding all that up, we get the total liabilities amounting to P80,000. Subtracting both of these figures, we get the total equity of the business which is P20,000. ©Copyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation So what do all these figures mean? You can see that the business is making P100,000 a year in profits but the equity in the business is only P20,000. If Mina fails to find a buyer and decides to liquidate her business, she would only get P20,000. Why? It’s because she has to sell all her assets to pay all her debts. Now think about this, if she decides to sell her business to you that earns P100,000 a year but is only worth P20,000 in equity at P250,000, would you buy it? Before you answer that question, let’s go back to again to Mina. She said that she will reinvest the other half of the earnings back into the business. She decides to pay her loans and keep some of the cash. Her balance sheet would now look like this Cash Halo-Halo Stand Refrigerator Inventories Total Assets

P15,000 P65,000 P20,000 P10,000 P110,000

Halo-Halo Stand Refrigerator Salary

P25,000 P5,000 P10,000

The Tiny Book of Basic Stock Valuation Total Liabilities

P40,000

Total Equity

P70,000

So what we have here is that she paid her loans amounting to P30,000 for the Halo-Halo stand and P10,000 for the refrigerator bringing down her liabilities to P40,000. She also added P10,000 to her business’ bank account bringing up her assets at P110, 000. Her equity now is worth P70,000 compared to the previous P40,000. Now she again decides to sell her business but this time, she’s selling it for P500,000. Would you buy it?

Determining the Right Price At this point, you now know that her business makes P100,000 a year with P70,000 of equity in it. Assuming the business has little to no risk, how much are you willing to pay for it assuming that you don’t need to do anything just like what Mina is doing? Are you willing to buy it for P250,000? What about P500,000? How about P1,000,000?

The Tiny Book of Basic Stock Valuation This is where everything starts to become confusing. But don’t worry. I’ll explain it in detail below. Based on the income, if you buy the company at P250,000, you would expect a one year return of 40%. If you buy it at P500,000, you would expect a return of 20%. And when you buy it at P1,000,000, you would expect a return of 10%. Based on equity, if you buy the company at P250, 000, you risk losing P180,000 if the company becomes unprofitable and liquidates. If you buy it at P500,000, you risk losing P430,000. If you buy it at P1,000,000, you risk losing P930,000. If you’ll notice, the higher you buy the company, the lower your expected returns will become and the riskier it gets. It will also take a longer time to make a return on investment. In the first example, it would take you 2 ½ years to gain back your initial investment. In the second example it increased to 5 years. In the third example, it will take you 10 years. Now what does this tells us? If you overpay for the business, your returns diminishes, risk of losing money becomes higher and it will take you a longer ©Copyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation time to gain back your initial investment. In conclusion, the price you pay for the business determines how much money you are willing to make, the amount of risk you are willing to take and the time it will take to get back your initial investment.

The Stock Price and Its Relation to the Company’s Value Mina has decided to sell her company for P500,000. But the problem is that she’s having a hard time selling it to just one person. Although that’s the case, she knows that there are a lot of buyers out there that are willing to buy her business but don’t have the full amount upfront. In order to solve this problem, she decided to split her company into 100,000 small pieces. These small chunks of her business are what we call Shares of Stock. These 100,000 shares are what we call Shares Outstanding. Mina values her business at P500,000. If you divide it by 100,000 shares, you’ll get P5 per share. We call this the Market Price. This means that if you buy one share of her business, it will cost you P5. Buy all the shares and it’ll cost you P500,000. ©Copyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation The best way to understand this is to look at that one share as a miniature sized business. Think of it as a tiny Mina’s Halo-Halo Stand that sells tiny glasses of Halo-Halo to tiny people to make tiny little profits. If you divide the net income to the number of shares outstanding (P100,000 / 100,000 shares), you’ll get P1 per share. We call this the Earnings per Share (EpS). Now let’s take a look at the equity of the business. Awhile ago, we determined that Mina’s business has P70,000 worth of equity in it. If you divide that equity into the number of shares outstanding (P70,000 / 100,000 shares), you’ll get P0.70 per share. We call this the Book Value per Share (BVpS). As you can see from here, the market price is directly proportional to one share of stock. If you own the whole business, you own all the P100,000 earnings and P70,000 worth of equity. If you only own 1 share of Mina’s business, you own a tiny P1 of the earnings and P0.70 book value of the business. This is the fundamental concept of why buying a stock is the same as buying a business. By knowing how ©Copyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation much a company is worth, you’ll know how much a stock is worth because all of these things are proportional to each other. In the next chapter, I’ll discus some simple techniques on how to value stocks so that you can now start making educated estimates. Keep in mind that there is no ‘magic’ formula in calculating intrinsic values. With that said, let’s proceed.

The Tiny Book of Basic Stock Valuation

How to Value Stocks Using the Price to Earnings Valuation Method The P/E Ratio is one of the most used ratios in finding undervalued stocks. To get the P/E ratio, all you have to do is to divide the market price of the stock to the recent earnings per share or eps. Here’s an example. Ayala Land Inc. (ALI) is trading at P40.60 per share. The recent eps is P1.20. To get the P/E ratio, we divide P40.60 to P1.20. P/E Ratio = P40.60/P1.20 P/E Ratio = 33.83

This number represents the amount of money you need to spend to make P1 of profit one year later. In ALI’s case, it’s P33.83. Let’s take another example. This time, it’s Megaworld Corp. (MEG). MEG is trading at P5.06 per share and the recent eps is P0.32. The P/E ratio is computed at 15.81.

The Tiny Book of Basic Stock Valuation If you compare the two, you’ll see that MEG sounds like a more attractive investment than ALI. You only need to pay P15.81 per P1 of profit in MEG compared to ALI which will cost you more than double the amount. It is clear in these examples that the lower the P/E ratio, the cheaper the company sound. Since MEG is a more attractive investment between the two, let’s find out its intrinsic value.

Finding the Intrinsic Value The first thing we need to do is to get the average historical P/E ratio of MEG for the last 5 years. From my research, I found out that MEG averaged at around 11.42. We also need to find out the latest EpS in the four most recent quarters. This is also called EpS (Trailing Twelve Months) or EpS (TTM). The EpS (TTM) of MEG is 0.33. The last thing we need is the growth rate at which MEG is expected to grow its profits in the next five years. I found this to be 15.24% by taking the 5-yr. ©Copyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation average net income growth. You can also use the 5yr. annual compounding growth rate. It’s all up to you what you want to use. Now that we have all the data, the formula to find the future value (FV) of the stock is; Future Value = EpS x (1+% Growth)^5 x P/E We put in the values; FV = 0.33 x (1+0.1524)^5 x 11.42 FV = P7.66

The future value of MEG is computed at P7.66 per share five years from now. What we want is to find out what the stock is worth today, not five years from now. To do that, we need to use a Discount Rate.

What is a Discount Rate Always remember this; the value of your money today is higher than the value of that same amount of money in the future because if you’ll invest it today, it will earn an interest. This interest is what we call the discount rate. We use this rate to calculate how much the future value is worth in today’s money. ©Copyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation This is the trickiest part because the discount rate that you’re going to use in this scenario will determine your estimated intrinsic value. To demonstrate, let’s try to use the 5-yr. return on government bond rates. Right now, the return is at 2.818%. The formula to calculate the intrinsic value is shown below; Intrinsic Value = Future Value / (1+ % Disc. rate)^5 Computing for MEG’s the intrinsic value, we get; Intrinsic value = P7.66 / (1+0.02818)^5 Intrinsic value = P6.67

According to this calculation, if we choose a minimum rate of return equal to that of a 5- yr. government bond, then the stock is worth P6.67 today. Now what if we use a higher discount rate? Let’s assume a 10% discount rate which is almost equal to the historical long-term return of the stock market. ©Copyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation Calculating, we get; Intrinsic value = P7.66 / (1+0.1)^5 Intrinsic value = P4.76

At a 10% discount rate, we get an intrinsic value of P4.76. I want to point out that when computing for the intrinsic value, the value will depend on how much money you want to earn every year. So if you want to make 15% rate of return every year, then use a 15% discount rate.

Using a Margin of Safety Finding the intrinsic value is not an exact science. Sometimes, we can commit errors along the way. To make room for this, we’ll introduce the concept of Margin of Safety as popularized by Benjamin Graham, the Father of Value Investing. In the previous example the growth rate used is 15.24%. Now let’s assume a safety margin of 25%. Note that it doesn’t have to be always 25%. It’s up to you how much risk you are willing to reduce. ©Copyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation In the example above, we can arrive at a conservative growth rate of 11.43% as shown below; Growth rate = 0.1524 x (1 – 0.25) Growth rate = 11.43%

Using the new growth rate, we arrive at a future value of P6.47. And when we calculate the intrinsic value using a 10% discount rate, we get a value of P4.02. Right now, MEG’s market price is P5.06 per share. Based on our intrinsic value calculations within a 5-yr. period, MEG is no longer undervalued so we leave it for now and look for other stocks in the market. The P/E valuation method is the most straightforward and easiest way of calculating a stock’s intrinsic value. This method is perfect for beginners so right now, I want you to take out a piece of paper and try to compute the intrinsic values of your investments to find out if you have bought them cheap or at an expensive price.

The Tiny Book of Basic Stock Valuation

How to Value a Stock Using Return on Equity Valuation Method What is Return on Equity To understand Return on Equity (RoE) a little better, let me demonstrate why RoE is one of the most important metrics to understand to determine a company’s profitability. Let’s go back to my previous example, Mina’s HaloHalo Stand business. Her business has earnings of P1 per share and a book value of P0.70 per share. Assuming her business continued to operate for another year, she again will earn P1 per share assuming there’s no increase of sales. If she decides to not pay herself a dividend and instead reinvest all that money back into the business (buy new equipment, buy a larger stand, buy her own land), her book value will increase to P1.70 per share or a substantial 147% growth! Now, I’m going to introduce another business for the purpose of comparison. Let’s call this business Trina’s Ice Cream Shop. Trina’s business also earns P1 per share but the book value of her business ©Copyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation is P50 per share. So after a year, she decided to reinvest all of her earnings back into the business. Trina’s book value has now increased to P51 per share or a 2% growth. Here’s what I want you to understand. Both of these businesses made the same amount of money but their RoE’s differ within a mile. Mina made a 147% return while Trina only made 2%. So what does this mean as a value investor? Assuming both companies trade at premium to their book value, if we bought 100,000 shares of Mina’s business at a market price of P0.70 per share for a total of P70,000, our investment is now worth P172,900 or a 147% growth! Compare that to Trina’s business. If we bought 1,400 shares at P50 per share for a total of P70,000, our investment would just gain 2% or worth P71,400. So here’s what you need to remember. A business that consistently shows high returns on equity is a business that knows exactly how to reinvest their earnings to make more money. A business that shows ©Copyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation poor returns means that the business is doing a bad job of reinvesting their capital. Now that we defined what return on equity is and how important it is in identifying good businesses, it’s time to learn how we can use this metric to value a stock.

Using Return on Equity to Value a Stock In order to use this method of valuation, we need to gather all the data needed. For this demonstration, we’ll again try to valuate Megaworld Corporation (MEG). We need the following data below; 1. 2. 3. 4. 5.

5-yr. Average RoE 5-yr. Average Dividend Payout Ratio Recent book value per share 5-yr. Average P/E ratio Discount rate

I calculated the average RoE of MEG for the last five years. As of this writing, I found it out to be 12.22%. The Dividend Payout Ratio for the last 5 years is ©Copyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation 11.12%. The recent book value is 3.67. The 5-yr. average P/E ratio is calculated to be at 9.19. And lastly, we’ll use a 10% discount rate in this example.

Constructing the Return on Equity Valuation Model Now that we have all the data needed, we’ll now construct the RoE model. I’ve shown below the calculated 10-yr. projections.

To demonstrate how this is done, we first get the recent book value of MEG which is 3.67. From that value, we derive the EpS by multiplying 3.67 to the ©Copyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation average RoE. The Dividend per Share (DpS) is calculated by multiplying the EpS and the dividend payout ratio. In the first row, we calculated the values of EpS and DpS to be P0.45 and P0.05 respectively. On the second row, the BVpS, EpS and DpS from the first row (3.67 + 0.45 + 0.05) is added and entered in the second row in the BVpS column (4.17). We continue to do this calculation up to the 10th year. On the 10th year, the earnings are now at P1.60 per share. We then also take the sum of all the dividends paid which is P1.12 per share. To calculate the projected price, we multiply the 10th year EpS to the average P/E ratio. Projected Price = 1.60 x 9.19 Projected Price = 14.70

Add P14.70 to the sum of all dividends and we get a total gain of P15.82. Now, what we need to do is to get the Intrinsic Value by using the 10% discount rate. Weâ&#x20AC;&#x2122;ll use the calculated projected price. ÂŠCopyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation Intrinsic Value = 14.70 / (1 + 0.10)^10 Intrinsic value = 5.66

MEG trades at P5.06 per share as of this writing. So based on our calculations, MEG is now undervalued. Based on RoE valuation, we can now buy the stock.

The Tiny Book of Basic Stock Valuation

Warren Buffett’s Durable Competitive Advantage I’m a fan of this investment philosophy by Warren Buffett. This is one of the things I follow because it’s really just common sense but not everyone is aware of this. According to Buffett, a business with a Durable Competitive Advantage (DCA) has these following characteristics;      

Sell a product or a service that is a basic necessity. Is in an industry with very little competition. Sell a unique product that doesn't change much. Provides a unique service that's difficult to replicate. Is a low-cost buyer and seller of products the public constantly needs. Spends very little or none at all on Research and Development.

The Tiny Book of Basic Stock Valuation If you find a business with these characteristics, the next thing to do is to validate that by digging into the company’s financial statements. Here are 10 things you need to check in the financial statements to qualify a business’ DCA; 

High return on equity

  

High return on invested capital Increasing historical earnings Little to no debt (except for financial companies) Competitive product or service No organized labor groups Product or service increase along with inflation

     

Low operational costs Business buys back its shares Retained earnings are used efficiently thus adding value to the business and therefore increases the market value.

The Tiny Book of Basic Stock Valuation I do valuations and stock reviews using financial statements to find these hidden gems in the Philippine Stock Market. You can read more about how Buffett identifies these types of businesses by reading books and articles about this topic on the Internet. Now, if you find an interesting company that you think has a DCA, then use the P/E and RoE valuation methods I taught in this book to identify the best price to buy the stock.

The Tiny Book of Basic Stock Valuation

My Final Message I’ve explained in this book the definition of what Value Investing is all about and how you can value stocks using two basic methods; the P/E Ratio model and the Return on Equity model. I’ve also discussed briefly how Warren Buffett finds companies worthy to invest by looking at a company’s Durable Competitive Advantage. These methods require a lot of different assumptions and therefore, are not perfect. But knowing these kinds of calculations will give you trust and confidence in making investment decisions. Just don’t forget that investing is more common sense than elegant mathematics. Don’t heavily rely on the figures that you’ll get but instead, use them to justify what’s really happening in the real world. Thank you for the time reading this book. If you like it, please share it to people who you think will benefit from it. Happy investing!

The Tiny Book of Basic Stock Valuation

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The Tiny Book of Basic Stock Valuation

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The Tiny Book of Basic Stock Valuation

Glossary of Terms Note: All definitions are taken from www.investopedia.com. I give the site credit where credit is due.

Value Investing is an investment strategy where stocks are selected that trade for less than their intrinsic values. Value investors actively seek stocks they believe the market has undervalued. Investors who use this strategy believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with a company's long-term fundamentals, giving an opportunity to profit when the price is deflated. Revenue is the amount of money that a company actually receives during a specific period, including discounts and deductions for returned merchandise. It is the "top line" or "gross income" figure from which costs are subtracted to determine net income. The Cost of Revenue is the total cost of manufacturing and delivering a product or service. Cost of revenue information is found in a company's income statement, and is designed to represent the direct costs associated with the goods and services the ÂŠCopyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation company provides. Cost of revenue is different from cost of goods sold (COGS) because it includes costs outside of production, such as distribution and marketing. Cost of Goods Sold (COGS) are the direct costs attributable to the production of the goods sold by a company. This amount includes the cost of the materials used in creating the good along with the direct labor costs used to produce the good. It excludes indirect expenses such as distribution costs and sales force costs. COGS appear on the income statement and can be deducted from revenue to calculate a company's gross margin. Also referred to as "Cost of Salesâ&#x20AC;?. An Operating Expense is an expense a business incurs through its normal business operations. Often abbreviated as OPEX, operating expenses include rent, equipment, inventory costs, marketing, payroll, insurance and funds allocated toward research and development. One of the typical responsibilities that management must contend with is determining how low operating expenses can be reduced without ÂŠCopyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation significantly affecting a firm's ability to compete with its competitors. Gross Profit is a company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company makes after deducting the costs associated with making and selling its products, or the costs associated with providing its services. Operating Income is an accounting figure that measures the amount of profit realized from a business's operations, after deducting operating expenses such as cost of goods sold (COGS), wages and depreciation. Operating income takes a company's gross income, which is equivalent to revenue minus COGS, and subtracts all operating expenses and depreciation. A business's operating expenses are costs incurred from operating activities and include items such as office supplies, heat and electricity. Net Income (NI) is a company's total earnings (or profit); net income is calculated by taking revenues and subtracting the costs of doing business such as ÂŠCopyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation depreciation, interest, taxes and other expenses. This number appears on a company's income statement and is an important measure of how profitable the company is over a period of time. Net income also refers to an individual's income after taking taxes and deductions into account. An Income Statement is a financial statement that reports a company's financial performance over a specific accounting period. Financial performance is assessed by giving a summary of how the business incurs its revenues and expenses through both operating and non-operating activities. It also shows the net profit or loss incurred over a specific accounting period. A Dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders. Dividends can be issued as cash payments, as shares of stock, or other property. Retained Earnings refer to the percentage of net earnings not paid out as dividends, but retained by the company to be reinvested in its core business, or to ÂŠCopyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation pay debt. It is recorded under shareholders' equity on the balance sheet. The formula calculates retained earnings by adding net income to, or subtracting any net losses from, beginning retained earnings, and subtracting any dividends paid to shareholders. A Balance Sheet is a financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by shareholders. An Asset is a resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit. Assets are reported on a company's balance sheet, and they are bought or created to increase the value of a firm or benefit the firm's operations. An asset can be thought of as something that in the future can generate cash flow, reduce expenses, improve sales, regardless of whether it's a company's manufacturing equipment or a patent on a particular technology. ÂŠCopyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation A Liability is a company's financial debt or obligations that arise during the course of its business operations. Liabilities are settled over time through the transfer of economic benefits including money, goods or services. Recorded on the right side of the balance sheet, liabilities include loans, accounts payable, mortgages, deferred revenues and accrued expenses. Equity is the value of an asset less the value of all liabilities on that asset. A Stock is a share in the ownership of a company. Stock represents a claim on the company's assets and earnings. As you acquire more stock, your ownership stake in the company becomes greater. Whether you say shares, equity, or stock, it all means the same thing. Outstanding Shares refer to a company's stock currently held by all its shareholders, including share blocks held by institutional investors and restricted shares owned by the company’s officers and insiders. Outstanding shares are shown on a company’s balance sheet under the heading “Capital Stock.” The number ©Copyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation of outstanding shares is used in calculating key metrics such as a companyâ&#x20AC;&#x2122;s market capitalization, as well as its earnings per share (EPS) and cash flow per share (CFPS). The Market Price is the current price at which an asset or service can be bought or sold. Economic theory contends that the market price converges at a point where the forces of supply and demand meet. Shocks to either the supply side and/or demand side can cause the market price for a good or service to be re-evaluated. Earnings per Share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability. Book Value of Equity per Share (BVPS) is a ratio that divides common equity value by the number of common stock shares outstanding. The book value of equity per share is one factor that investors can use to determine whether a stock price is undervalued. If a business can increase its BVPS, investors may view the stock as more valuable, and the stock price increases. ÂŠCopyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation The Price-Earnings Ratio (P/E Ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings. The Future Value (FV) is the value of a current asset at a specified date in the future based on an assumed rate of growth over time. The Intrinsic Value is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value. Additionally, intrinsic value is primarily used in options pricing to indicate the amount an option is in the money. Margin of Safety is a principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. In other words, when market price is significantly below your estimation of the intrinsic value, the difference is the margin of safety. This difference allows an investment to be made with minimal downside risk.

The Tiny Book of Basic Stock Valuation Return on Equity (ROE) is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. The Dividend Payout Ratio is the percentage of earnings paid to shareholders in dividends. Dividend per Share (DPS) is the sum of declared dividends issued by a company for every ordinary share outstanding. Dividend per share (DPS) is the total dividends paid out by a business, including interim dividends, divided by the number of outstanding ordinary shares issued. A company's DPS is usually derived using the dividend paid in the most recent quarter, which is also used to calculate the dividend yield. Competitive Advantages are conditions that allow a company or country to produce a good or service at a lower price or in a more desirable fashion for customers. These conditions allow the productive entity to generate more sales or superior margins than its competition. Competitive advantages are ÂŠCopyright www.investingengineer.com All Rights Reserved 2016

The Tiny Book of Basic Stock Valuation attributed to a variety of factors, including cost structure, brand, quality of product offerings, distribution network, intellectual property and customer support. Return on Invested Capital is a calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. Return on invested capital gives a sense of how well a company is using its money to generate returns. Comparing a company's return on capital (ROIC) with its weighted average cost of capital (WACC) reveals whether invested capital is being used effectively.

The Tiny Book of Basic Stock Valuation

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The Tiny Book of Basic Stock Valuation

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