Lately, I received a question from Jess, a fellow subscriber of DividendVault.com on the subject of valuation via email. She asked, ‘How could stocks that possess solid fundamentals become undervalued?’
The question is valid and interesting and thus, I’ll like to pen down my thoughts on this. Of which, I’ll expound why stocks could be undervalued and how we, as investors, could use this knowledge to build our stock portfolios.
To begin with, I believe the concept of valuation could be better explained from the perspective of a real estate investor. Personally, the concept applies to both as the thought process I use to invest in both stocks and properties is the same. Hence, let’s side track a little to talk about real estate.
How to Compound Wealth via Real Estate?
Let’s say, I’m a property investor based in the Klang Valley.
I found a decent 800 sf apartment in a nice and matured neighbourhood, which is closely accessible to most necessities. The rental rate of the apartment unit is around RM 1,000 per month. The recent average transacted price of apartment units in that development is about RM 300,000. Hence, I would say that the fair value of the apartment unit is estimated as follow:
a. Average Gross Rental Yield = 4% a year
(RM 1,000 x 12 months / RM 300,000 x 100%)
b. Average Price per Square Foot = RM 375 psf
(RM 300,000 / 800 sf)
Let’s say, I bought mine at RM 300,000, exactly at its fair valuation and from it, I managed to raise my rents twice a year. Ten years later, I’m now renting my unit out for RM 1,500 a month. In that 10-year period, the average gross rental yield of apartment units in that development has remained at 4% a year. As such, my apartment unit would be revalued upwards to RM 450,000 and its calculation is as follow:
Below Market Valuation (BMV) Properties
Is it possible for investors to pay RM 270,000 for a property worth RM 300,000?
Why do you think sellers would sell their properties at below market valuation?
Well, there are many reasons. For instance, they include:
So, here are some questions:
If you bought your apartment unit at RM 300,000 and are making RM 1,000 per month in rental income from it, will you sell off your property for RM 270,000 if you found out that your next-door neighbour is selling off his at RM 270,000?
Also, what if you know that your neighbour is facing financial difficulties and he is selling off the property to keep himself afloat? Will you join him to sell off the property you have bought at RM 270,000?
Also, what if you know that his unit is tenanted and his tenant is paying him RM 1,000 in rental income? Will you be interested to buy over his apartment unit if you can afford it? Can you see that it makes more sense to buy over the unit for RM 270,000 from your neighbour instead of selling yours at RM 270,000? Why?
This is because the gross rental yield for your new property is 4.44% per annum which is higher than the average of 4% per annum.
a. Your Gross Rental Yield = 4.44% a year
(RM 1,000 x 12 months / RM 270,000 x 100%)
b. Average Gross Rental Yield = 4% a year
(RM 1,000 x 12 months / RM 300,000 x 100%)
If You Understand the Logic Above
Then, why not use it on stocks?
Take Public Bank as an example. The bank has grown its shareholders’ earnings, up from RM 3.0 billion in 2010 to RM 5.5 billion in 2019. As such, this enables it to grow its dividends per share (DPS) from 45.5 sen in 2010 to 73.0 sen in 2019. It is likened to you who can raise your rents gradually from your apartment unit from RM 1,000 a month to RM 1,500 a month in 10 years.
But nevertheless, the average dividend yield of Public Bank has remained at 3% per annum, despite its gradual increase in DPS over the 10-year period.
The closing stock prices presented above is before its recent 1:4 bonus issue.
So technically, from the table above, if an investor is interested in buying shares of Public Bank, he may aim to get Public Bank, if he gets above 3.0% in dividend yields per annum. After all, why would he get Public Bank at below 3% a year as it completely makes no sense?
How Short-Term Guys Buy Public Bank Stocks?
In 2018, Public Bank was trading at around RM 25 a share.
The short-term guys saw that Public Bank Bhd’s share price had jumped by 25% from RM 20 to RM 25 at a short span of time. Seeing its rise, they came right in, buying shares of Public Bank as they believe that it could rise higher and higher to RM 30, RM 35 … etc. Their eyes are on fast profits.
Chances are, they are not into the business. Certainly, they’ve failed to consider the dividend yields that they will get from owning Public Bank’s stock at RM 25, which is only 2.44% a year based on 2017 DPS of 61 sen. It is overvalued for the current dividend yield at that time was below its average of 3% per annum.
Short-term guys went in while long-term investors chilled.
How Long-Term Investors Invest in Public Bank Stocks?
In 2020, Public Bank was trading at RM 12-15 a share, 40%-50% below where it was in 2018.
It was MCO 1.0. There was fear, panic and uncertainties. Short-term guys who’d bought Public Bank would dump their shares as they had lost their belief that it could reach RM 30, RM 35 … etc in stock price in the future. They cut losses.
Meanwhile, for business-like investors, they begin calculating what is their yield from investing in Public Bank if they invest into it at RM 15 a share. In 2019, the bank has paid out 73.0 sen in DPS and thus, it could offer 4.9% in dividend yield per year. It is attractive for the current dividend yield at RM 15 a share was a lot more than its average of 3% per annum.
Hence, the short-term guys went out while long-term investors stepped in.
So, What’s the Result?
As I write, Public Bank is trading at RM 4.10 a share after adjusting for its bonus issue of 4 bonus shares for every 1 ordinary share.
It means, for people who bought Public Bank at RM 25 and still held onto it, the person will have 5 shares of Public Bank worth RM 4.10 each for every share he bought in 2018. His capital loss is 18% in 3 years.
Meanwhile, for people who bought Public Bank at RM 15, he would also have a total of 5 shares of Public Bank worth RM 4.10 each for every share he invested in 2020. His capital gain is 37% in 1 year.
Short-term guys lost. Long-term investors win.
Both achieved different results despite buying the same stock.
As you can see, it would do investors a lot of favour if they would view investing in stocks the same way as investing in properties. It is not really about stocks vs properties to see which of the two asset classes are better investments. Rather, it is about how you think and operate as an investor that makes the difference.