Hi Tactician,
Thanks for your very elaborate reply.
First of all let me clarify that I have not even read your initial posting, and my posting on P/E as a measurement of value was not meant as a response to your posting at all. My posting was rather long and I notice that your response is even longer; even now I have not read it in its entirety. Honestly, I doubt that many people would, even mine.
At the end of the day this is essentially a forum, not an academic conference, and considering the length of my initial posting I did not already expect many people to fully read it, I just wanted to put it out there. Because this is not an academic conference where we exchange dissertations, for practical considerations not every point can be elaborated to the fullest because the longer the post, the less likely people will read it in its entirety, just like how I have only managed to skim through your posting. Practical considerations have to be balanced with the need to be elaborate. Or perhaps as an academic on school holidays you may have more time than I
Because of time constraints, here are my brief responses to your points. I will try to write you a more elaborate response when I have the time.
Why draw the line at 2 years of earnings then? Why not take the entire history of earnings? But then there are many stocks out there that for many years now have been priced at less than the accumulated sum of all historical earnings. Are they all therefore undervalued?
Maybe we could say hypothethically that a stock which got listed for 2 years, earned $4 in the 2 years, and paid out the $4 earnings in its entirety as dividends over the 2 years to investors and then closed down all operations, it would be safe to say it was worth roughly $4 (actually less when you discount the time value of money but let’s keep this for simplicity’s sake).
But that's a hypothetical case. In reality, how much of those earnings can the company pay out to investors? This depends on the company’s cash flow and working capital requirements. If much of these earnings have not been collected in the form of receivables (which in Eratat’s case have been lengthening) and even if and when collected, these earnings have to be primarily used as working capital due to large working capital requirements, and this cycles continues with no sign of shortening receivables and decreasing working capital requirements, how much can they spare to pay in the form of dividends?
Considering Eratat’s management felt they needed the placement in order to fund working capital, if they had not done the placement they may not even have paid any dividends or maybe much lesser dividends. So my question then is how much of these $4 of earnings can flow to investors? If it can’t flow to investors how much value is in there? This is especially so if value hinges on the sum of all future cash flows, not necessarily the company’s own cash flows but direct cash flows to investors in the form of dividends. Will investors ever see that value?
The future component of earnings also surely cannot be omitted. If a company that made $4 over the last 2 years is projected by an investor to make $4 losses in each of the next 5 years, can it still be said to be worth the $4 that it made over the last 2 years?
Regarding the point about the 7 examples I gave they were meant to be questions over the certainty or sustainability of future cash flows with respect to what they achieved in 2011. The crux of my point here was that you can never wait till you’re 100% sure about the positives or negatives of a stock because by that time the stock would either be too expensive or too cheap. For example, we’re all 100% sure now that Enron was a fraud, what is it worth now? What are China Gaoxian or China Hongwei worth now, now that everyone knows for certain they were cooking the books?
My point is that you got to go by probability based on the available ‘clues’. The information we have about Eratat will not tell us with 100% certainty whether it’s a good or bad investment, because there are always a lot of unknowns, you just got to go by the probabilities based on your own judgment. Therefore these 7 points I raised were meant as potential points to consider when looking at the potential negatives of Eratat with regards to future cash flows, hardly meant as statements with 100% absolutes on why Eratat is a bad investment and will fail for sure. Neither you nor I can know with 100% certainty based on the information we have, we merely go by probability, therefore if there is avenue for doubt about its sustainability, these points must be raised. Therefore to knock these points off as superficial based on the fact that they do not show with 100% certainty that Eratat will fail is like trying to knock a scarecrow dead – you would be hardly getting the gist of my point.
A couple more points
1. Eratat is a fashion apparel company. I don’t think anyone would seriously doubt the logic that fashion apparel companies in China are targeting the growing wealth of its populace and consumption growth in China. I find it pointless to elaborate on such an obvious point. There is also no doubt that global fashion companies like Zara, H&M, Gap, Uniqlo, upon entering into China, are also in direct competition for market share in this growing middle class consumption. Or are you implying that Eratat is merely targeting a niche market? No one who buys Eratat in China would be interested in buying Zara or Gap?
2. Of course distributors would only buy if they could they will be able to make profits selling Eratat products. Well apparently quite a few distributors discontinued, were their Eratat products not selling well enough? Again we can’t know with 100% certainty, but once again this falls under the ‘doubt’ segment of the probability argument. What we do know is that overall orders have decreased from 517 million rmb (1h 2011) to 380 million rmb (1h 2012). On the whole, distributors were less bullish about selling Eratat products this year than they were last year.
A few points I would like to address but I’ll do so when I have more time. Also, I don’t want to my post to be any longer than it already is because it’s doubtful how many people on a forum would want to read such long essay-like postings. Thank you for the interesting discussion.