Hi Hei123, very good question from u.

There are constraints in every valuation model. Pe model basically measure the relationship between price change n it' s eps, it doesnt take into account of what is happening to the balance sheet. if we add in provision we will distort the pe ratio n they will become volatile. As I have mentioned in my post yesterday when bank increase their provision it will push down the eps n resulted to higher pe ratio n once the bad debts are settled they will write back the provision n thus resulted to a low pe but these accounting entries have no direct relation to its core performance becos the provisions are already accounted in the balance sheet. 

Hence to safe guard ourselves against any unexpected contraction in business activities (example further rise in provision) which will lead to downward revision of valuation we will need to apply a margin of safety from its valuation when  we buy. 

What I suggest is after u have applied the pe model on DBS u can try it on scb (standard charted bank), a more risky bank n u will see the correlation between stock price n operating earning. Becos when u look at scb, it' s last year operating earning contract by about 50% (net profit loss) n u will see how it' s valuation move in line with its operating income. 

Another way to value a firm is the cashflow n balance sheet method which I share quite a number of time. We will still add back/exclude (depending on the item) the provision, non cash items, non recurring items to its cashflow but the provision will be deducted from its balance sheet. Reason being is apart from being a non cash item provision is also considered as a non recurring item becos as I mentioned we can have the bank increasing their provision for this year due to bad economy n they can also write back their provision in the following year. 

However, when we deduct the provision from the bank balance sheet it is not advisable to take the provision amount given by the bank. Not becos that we can' t trust them, it is for conservative reason, just in case there are further bad debt down the road. Thus my own practice is whatever amount the bank provide I will increase it by 100% n this amount is referring to the accumulated provision stated in the balance sheet n not the new provision for the year stated in the income statement. Thus it is a very conservative scenario.

to summaries what I just said in case I have confuse u..for the pe method becos of it' s constraint of not able to take into account of the balance sheet we can provide a margin of safety to protect ourselves in the short run just in case more bad news arises n pushes down the stock price further but over time the valuation will move in line with its operating income. As for cashflow n balance sheet method it is more straightforward, increased the bank provision n deduct it from the balance sheet but add it back in the cashflow otherwise u will over or understate the valuation which I have xplained in my post yesterday.

feel free to write to me if u have further queries :)

​

Hi guys, I have received private messages from some members n there were some questions raised which I think are quite interesting n I have followings to share with everyone

1) what happen when the stock price did not fall enough to give us the margin of safety to buy n rebounded north, thus lost of opportunity?

I guessed I have been writing quite a number of posts in sj however if u notice I have never talk about the stock mkt, movement of stock price, macro factors n etc. as I have mentioned before in investment there are two mkt/economies, the real economy where the companies are doing their physical business n the illusion economy (stock mkt) which is like an mirror that will reflect the real economy given time. Xample, when we have a white hair we may want to remove it from our real self than trying to do it on the image reflecting from the mirror.

Hence, when we set a margin of safety to buy it is not only trying to buy at a price that is safe (over time) from the stock mkt, it is also a buffer for provision when the real business activities contract That will lead to downward adjustment of valuation  (most of the time we buy when mkt are bad). For example, if u run a business, u may like to estimate the buffer needed in case your revenue fall but still keep u profitable, this is margin of safety. 

By looking at a single investment prospect will made us worried that we may lose the opportunity. However if u keep a pool of prospects (as revealed by warren buffett, his pool consisted of 2000-3000 stocks) there is no worry to lack of opportunity. thus when we invest, the first priority is to buy at a price to protect our capital (over time) In case there is downward revision of valuation n once our capital are safe, making profit is just a matter of time. No need to hurry...

2) when we invest n hold while waiting for the valuation to realize, are there opportunity cost involved while we are waiting?

this statement is true provided that the business we invested in are ideling. While waiting for the valuation to realize, the company that we invested in continue their day to day operation n likewise continue to make profit everyday. While we are waiting n the firm continue to generate earning growth, likewise their valuation will also increase. Example, DBS valuation in 2014 was sgd18 plus, last year was sgd19 plus n till date is sgd20 plus (operating earning continue to increase year by year). Of cos there will also at time when the earnings are down that can lead to lower valuation becos we are talking about real business but we r looking at its long term business n not day to day operation. 

Thus the valuation we have currently are not stagnant, it will vary from the result announce in every quarterly report. Hence, only we as investor are waiting but not the business that we invested in. 

Some may realize the questions post are coming from the angle of the stock mkt but the replies are looking at the real mkt n that' s the difference between trading n investment..

thank you :)