It has been said that the price you pay for a stock can determine how much return you can expect from your investment.
The less you pay for a stock, the higher the expected return. The more you pay, the lower the return.
Last week, we discussed in this column “How to invest like Warren Buffett” that one way to find out the potential return of a stock is by computing its future value against its current share price.
The higher the future value of a stock relative to its share price, the greater the expected compounded annual return of the investment.
But how would you know if you are paying the right price for a stock?
Value investing teaches us that if you want to buy undervalued stocks, you must look for companies that trade below their intrinsic values.
If the future value of a stock, as estimated by Buffettology, represents the “true” worth of the company in 10 years, we can compute its intrinsic value by simply discounting the future share price.
Warren Buffett once said that when he saw a company that would do well in the future, he used a government-bond type interest rate as his discount rate to estimate the value of a company.
For example, we calculate that the future share price of First Gen is P45 a share.
We derive this figure by multiplying the stock’s projected earnings per share of P4.11 in 10 years with its historical average P/E ratio of 11 times.
Once we have determined the future share price, we shall use the current 10-year Philippine bond yield of 4.75 percent, as the discount rate, to derive the present value of the stock at P28.34.
Compared to the share price of First Gen at P24.60, we can say that the stock enjoys a 13.2-percent discount to its intrinsic value.
But, as in any investment, there is always the risk that the projected share price in the future will not be achieved.
It is possible that the sustainable growth rate of the company may slow down in the years ahead due to unforeseen factors that may result in lower earnings.
Because of these uncertainties, we need to be compensated with a rate of return that is higher than what the 10-year Philippine bond yield can offer by adding a risk premium.
Every business has a different risk profile. Some companies may have a higher risk premium because they are riskier than the others.
In the case of First Gen, the company is less risky than the other PSE index stocks. With a historical beta of only 0.47, we can compute its risk premium at 2.3 percent, which increases its discount rate to 7.1 percent.
But at a higher discount rate of 7.1 percent, the present value of First Gen’s future share price decreases from P28.34 to P22.70.
Because of the lower intrinsic value against current share price of P24.60, the stock is now trading at an 8.4-percent premium.
As a value investor, you want to buy stocks that trade at a significant discount to their intrinsic value, which is your margin of safety.
Buffett, who is a staunch believer in the margin of safety, used to say that even if you have the knowledge to value a business, you must leave yourself an enormous margin for judgment errors.
In other words, the more margin of safety a stock has, the greater your protection against potential losses.
Presently, about 60 percent of the stocks belonging to the PSE index are trading at an average margin of safety of 37.6 percent.
Among the stocks with discounts of at least 50 percent include LT Group, which has the largest margin of -84.7 percent; Semirara Mining, -73.2 percent and Alliance Global, -52.8 percent.
The other stocks with higher than market average are Security Bank, -47.4 percent; Aboitiz Power, -46.7 percent; Puregold, -46.5 percent; Aboitiz Equity Ventures, -44.6 percent and Metrobank, -41.9 percent.
While these stocks may be fundamentally undervalued, we need to remember that following Buffett’s investment philosophies is just one of the many ways to estimate an intrinsic value, which may be subjective.
Investing in stocks with discounts to their perceived worth does not necessarily guarantee success.