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VALUE INVESTING MADE EASY FOR NEWBIES

A Basic Value Investing Guide in the Philippine Stock Market for Beginners

The Investing Engineer PH

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Value Investing Made Easy For Newbies

Table of Contents

Introduction

 

4

Why Should You Read This Book

6

Your

Stock Market Journey

Awaits

7

Why Should You Even Bother to Invest in the Stock Market?

8

How Can Compound Interest Make You Rich?

10

Important Things You Should First Do Before You Start Investing in the Stock Market

4

12

How Much Money Should You Invest in the Stock

Market?

15

Introduction to Value Investing

18

Basic Value Investing Principles That Most Investors Neglect

2

21

How to Look at Stocks the Right Way?

22

How Does a Business Work?

23

How to Determine the Right Price?

29

Stock Price vs. Company’s Value

32

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Value Investing Made Easy For Newbies

How to Value Stocks Using the Price to Earnings Valuation Method

35

How to Find the Intrinsic Value?

36

What is a Discount Rate?

37

Using a Margin of Safety

40

How to Value a Stock Using Return on Equity Valuation Method

42

How to Use Return on Equity to Value a Stock? 44

What Does Warren Buffett’s Durable Competitive Advantage Mean?

2 Powerful Resources That Will Improve Your Stock

Market Gains

48

51

Invest by Using the Strategic Averaging Method. 52

Find Undervalued Stocks by Getting Professional Stock Advice on PinoyInvestor

53

My Final Message

55

Glossary of Terms

56

E-book Disclaimer

72

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Value Investing Made Easy For Newbies

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Value Investing Made Easy For Newbies

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.

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Value Investing Made Easy For Newbies

Eventually, after reading a lot of books about Value Investing, I learned what to do and started investing based on my own analysis.

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 2 nd week of August. During those times, the PSEI tanked but that didn’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.

I hope that the basic techniques that I will teach in this e-book will help you consistently earn above average returns in the stock market.

Happy investing!

Mark

The Investing Engineer PH www.investingengineer.com

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Value Investing Made Easy For Newbies

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 e-book is right for you.

This e-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 e-book that’s easy for a beginner to comprehend.

I hope that you’ll learn a lot from this e-book and I hope that it will serve you well.

Thank you and good luck!

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Value Investing Made Easy For Newbies

Your Stock Market Journey Awaits

Before anything else, let me ask you some questions before reading further in this e-book.

How much money can you invest? Investing in the stock market requires capital. Be sure you can afford to invest by looking closely at your personal financial situation.

How much emergency cash do you have in your bank account? Are you clear of bad debt? These are the questions you need to answer before moving on.

How much risk are you willing to tolerate? How much risk are you comfortable taking on? A large loss to a small investor has a much larger impact than the same amount to a wealthy investor with deep pockets.

Do you naturally enjoy taking chances, or do you tend to be more risk adverse? It’s essential to success to know your comfort zone.

What are your financial objectives? Are you interested in investing to maintain capital or to get the highest return in the shortest amount of time?

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Value Investing Made Easy For Newbies

Consider the amount of time, money, and risk associated with each scenario.

Lastly, do you have what it takes to be a stock market investor? Investing in the stock market requires a lot of learning and the ability to apply it in the real world.

If after considering these questions you are still interested in investing in the stock market, then congratulations on choosing one of the most rewarding ways in building wealth.

Why Should You Even Bother to Invest in the Stock Market?

Did you know that investing in stocks is one of the most effective ways to build wealth and be financially free? But the sad part is that a lot of Filipinos put off investing in their lives.

They come up with all sorts of excuses. Some say, “Why should I invest? Investing is risky. I would rather put my money in the bank than invest in volatile markets.”

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Value Investing Made Easy For Newbies

Others will say, “Stocks are boring and take too much time! I’d rather spend my money elsewhere.”

Let me tell you that those people saying these things are totally neglecting their future. Let me explain why.

One of the things that we need to understand why we should invest our money is Inflation.

Inflation is the rate at which the purchasing power of your money falls by if not invested.

So what does this mean?

It simply means that a 100 peso bill way back in the 1970’s is worth P12.85 only today assuming a 5% annual inflation rate.

What do you think will happen if you didn’t invest that one hundred pesos and you just simply stashed it in your treasure vault and waited forty five years to spend it?

Correct!

Inflation will eat up your money’s purchasing power.

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Value Investing Made Easy For Newbies

But what if you saved your money in a bank? Yes you can do that and it’s a very safe and secure thing to do. But relying on the bank’s interest rate returns will not keep up with the rate of inflation.

If you keep your money in the bank, your money will lose purchasing power as time goes by.

In reality, instead of saving money, we actually lose money.

How Can Compound Interest Make You Rich?

Some people just don’t want to invest because they think investing takes too much time.

These people don’t have the patience to wait for their money to grow.

These people don’t know how to harness compound interest.

The reality is that if you don’t invest your money today, you’ll be working for money all your life.

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Value Investing Made Easy For Newbies

Would it be fun if instead of working for money, money will be the one working for you?

Investing in stocks is like planting a money tree. As time passes, the tree will grow and produce money. The money will grow into more money. Money will now start working for you. Soon, you’ll become financially free.

Let me tell you that the sooner you start investing, the more money you can make through compound interest.

Let’s look at this example:

Let’s say at age 20, you started saving P5,000 a month and continue to do so until you retire at age 65. At an interest rate of 10%, you will retire with almost

P47,500,000.

If you start investing at age 30 with the same amount and interest rate, you’d retire with only P17,900,000.

If you started to invest at age 30 and wanted to have P47,500,000 by age 65, you must save about P13,250

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a month instead of only P5,000 if you started at age

20.

Now think about this, would you rather save money in the bank which gives you 1% to 2% annual returns or would you rather invest your money in an investment vehicle that will yield 10% annual returns?

If you ask me, I’ll go with the 10% annual returns! Unless you need your money sometime in the not-so- future, keeping your money in your bank is a wiser decision.

4 Important Things You Should First Do Before You Start Investing in the Stock Market

There are things that you should first check before you start investing in stocks and one of it is financial stability.

To determine if you are financially stable, you should check for these four important things:

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Value Investing Made Easy For Newbies

1. How much money do you have in your bank account in case of emergency situations?

2. Do you have insurance for protection?

3. How much bad debts do you have?

4. How much money can you put into your investments?

Having money that is readily accessible in case of an emergency is one of the things that are neglected by most Filipinos when it comes to stability.

What do you think will happen if you prioritize investing instead of building up an emergency fund? If you start to invest now without money currently saved for emergencies, you might risk pulling out your money in a falling market and lose money just to cope up with the immediate emergency.

What if you were laid off from your job or you get hospitalized and your medical bills pile up? Do you see what I’m telling you? That’s why it’s important to have a readily accessible emergency fund to provide you with a peace of mind.

Some experts believe that you should save at least 3 to 6 months of salary for this fund. You should keep

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Value Investing Made Easy For Newbies

building this fund because the higher your emergency fund is, the safer you’ll feel.

Now, what if you fell ill with sickness or you got yourself in a serious accident? If you have insurance, it will protect your hard earned saving and investments from all those medical bills and liabilities to pay.

No one would want all of their hard earned money only to be taken away by such unforeseen events. Insurance provides you with the peace of mind to live

a quality and less stress life so make sure to get one if you don’t have any.

Now, if you already have an emergency fund and insurance, it’s also necessary to settle all your bad debts.

Bad debts are those debts from credit cards, personal loans and other debts that make you lose money overtime. This is the most important thing and should be your top priority.

If you have bad debts, I suggest you settle ALL of

them first. Plan a debt-repayment strategy and make

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Value Investing Made Easy For Newbies

sure to follow it. It may take years before you all settle them.

When you’re now debt free, then you can now start to invest.

How Much Money Should You Invest in the Stock Market?

The question now is how much money can you afford to invest each month? This is a relative question considering that we have different income brackets.

Some of us earn big while some of us just make ends meet.

To determine how much money we can invest, we should first make a budget to give us an overview on our spending habits.

Right now, I want you to memorize the phrase below and stick it with your mind. Read this phrase loud and clear 10x:

“PAY YOURSELF FIRST”

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Value Investing Made Easy For Newbies

What does this phrase mean?

Paying yourself first is the only sure fire thing to make a budget plan work because by paying yourself first, it forces you live off what’s left in your salary and thus prevents you from making impulsive purchases.

How does paying yourself first really work? Let me show you an example.

Juan received his salary amounting to P10,000. To pay himself first, he decides that every time he receives his salary, he would automatically deduct 20% of it. That would be P2,000.

Now, Juan must learn to make budget plan on the P8,000 that is left.

How does Juan do it?

He now decides that he would no longer indulge in expensive coffee sessions.

He would also cancel his gym membership.

He also started to ride jeepneys instead a taxi cab to go to work.

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He also cut down his cell phone prepaid expenses and started using those free text and call promos.

He keeps doing it until his next salary.

Guess what happened? He manages to plan a budget, cut off unnecessary spending and was able to save

P2,000.

If he didn’t plan about it, he would just keep doing what he’s doing and would not be able to save. That’s the power of paying yourself first.

I’m not saying that you should live a super frugal life to the point of sacrificing one’s enjoyment. Your budget should allow you to enjoy life at the same time doesn’t compromise your savings and investments which should be your topmost priority.

If you already done all the four things above. You’re now ready to invest in the Philippine Stock Market.

I will teach you one of the most effective ways to build wealth in the stock market that is, Value Investing.

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Value Investing Made Easy For Newbies

Introduction to 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.

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Value Investing Made Easy For Newbies

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 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 1 st 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.

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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.

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 section.

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2 Basic Value Investing Principles That Most Investors Neglect

Value Investing revolves around into two distinct principles;

1. Find high quality companies.

2. Buy them at bargain prices.

Value investing is simple but why isn’t everyone doing it? The reason is that it requires patience, hard work, discipline and the right mindset.

Value Investing is therefore not for everyone.

While other investing strategies are based on speculation, Value Investing is based on common sense.

Benjamin Graham, the Father of Value Investing, explained the Value Investing framework in detail in his book The Intelligent Investor and Security Analysis. Graham pointed out that stock prices often divert significantly from the actual fundamental value of the underlying business.

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Value Investing Made Easy For Newbies

Graham believed that buying stocks of quality businesses when they are undervalued with respect to their fundamental value allows someone to make a good return on investment on a lower risk.

Graham taught all of his investment principles to his student, Warren Buffett who then used this knowledge to amass a fortune of no less than $65B making him the third richest person in the world.

How to Look at Stocks the Right Way?

What most investors fail to realize is that when you buy a stock, you are simply buying a portion of the business itself.

Most investors look at stocks as numbers that move up and down on a ticker screen. This gives the impression that price is the only thing that’s reliable when analyzing a stock.

This is not the right thing to do if you want to be a successful Value Investor.

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Value Investing Made Easy For Newbies

You must look at stocks like a tiny piece of a business.

If you look at a stock as a tiny part of a business, you can therefore say that the performance of the business is closely tied to the performance of your investment.

It follows that to analyze the attractiveness of the stock, you should not look at the price of the stock but instead look how much money the business is actually making.

How Does a Business Work?

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-to-day 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

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Value Investing Made Easy For Newbies

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 Halo- Halo 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 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.

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Value Investing Made Easy For Newbies

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 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.

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Value Investing Made Easy For Newbies

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

-

P5,000

Halo-Halo Stand

-

P65,000

Refrigerator

-

P20,000

Inventories

-

P10,000

Total Assets

-

P100,000

Mina’s business has a bank account and that account contains the P5,000 cash. Let’s assume that the Halo- Halo stand and the refrigerator are worth P65,000

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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

-

P55,000

Refrigerator

-

P15,000

Salary

-

P10,000

Total Liabilities

-

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.

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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

-

P15,000

Halo-Halo Stand

-

P65,000

Refrigerator

-

P20,000

Inventories

-

P10,000

Total Assets

-

P110,000

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Value Investing Made Easy For Newbies

Halo-Halo Stand

-

P25,000

Refrigerator

-

P5,000

Salary

-

P10,000

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?

How to Determine 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

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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?

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.

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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 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.

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Stock Price vs. 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.

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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.

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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 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.

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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.

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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.

How to Find 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.

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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. average net income growth. You can also use the 5- yr. 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

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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.

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

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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.

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.

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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.

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.

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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.

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How to Value a Stock Using Return on Equity Valuation Method

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 Halo- Halo 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.

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Trina’s business also earns P1 per share but the book value of her business 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

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business that knows exactly how to reinvest their earnings to make more money.

A business that shows 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.

How to Use 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. 5-yr. Average ROE

2. 5-yr. Average Dividend Payout Ratio

3. Recent book value per share

4. 5-yr. Average P/E ratio

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5. 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 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.

Now that we have all the data needed, we’ll now construct the ROE model. I’ve shown below the calculated 10-yr. projections.

I’ve s hown below the calculated 10-yr. projections. © Copyright www.investingengineer.com All Rights Reserved

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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 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 10 th year.

On the 10 th 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 10 th year EPS to the average P/E ratio.

Projected Price = 1.60 x 9.19 Projected Price = 14.70

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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. We’ll use the calculated projected price.

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.

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What Does Warren Buffett’s Durable Competitive Advantage Mean?

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.

Are a low-cost buyer and seller of products the public constantly needs.

Spends very little or none at all on Research and Development.

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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.

Buffett said that a business with a DCA is a cash cow. That’s why in my blog, www.investingengineer.com,

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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.

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2 Powerful Resources That Will Improve Your Stock Market Gains

If youre looking for a place where you can find reliable and up-to-date information on your stock investments, these 2 resources that Ive been using will surely get the job done.

I recommend these services because I personally use them in my stock investing decisions and I find them useful and rewarding.

The first resource where I get a lot of financial advice in stocks, entrepreneurship and proper mind setting is the Truly Rich Club Bro. Bo Sanchez.

The second resource I use is PinoyInvestor. This is where I get a lot of buy and sell recommendations through stock reports.

Ill discuss them briefly on the next section.

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Invest by Using the Strategic Averaging Method

Investing in stocks is really confusing and overwhelming that’s why people make bad investment decisions.

But if youre a member of the Truly Rich Club, it will make your investing life easier and more enjoyable.

The Truly Rich Club of Bro. Bo Sanchez follows a specific strategy called the ‘Strategic Averaging Method’.

It’s a strategy born out of value investing principles. All you have to do is follow the recommendations in the SAM Stocks Table and the Stock Alerts inside the club and let compounding do the rest!

You can take advantage of this strategy by joining the Truly Rich Club now. You can learn more about it by clicking the link below.

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Find Undervalued Stocks by Getting Professional Stock Advice on PinoyInvestor

Looking for EXPERT advice on what undervalued stocks to buy and tips on when to sell is hard and downright expensive nowadays.

But what if I tell you that there’s a service wherein you can get 24/7 expert advice from several brokerage firms who have been investing and profiting in the stock market for many years now for as low as P399 a month?

This is what PinoyInvestor is all about.

I encourage you to try and become a FREE member to get access to the free stock reports.

The reports contain a lot of information such as buy and sell recommendations which are very important to effectively maximize possible gains.

If you want to have FULL access to the most up-to- date reports, sign-up as a PREMIUM member today.

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You can learn more about PinoyInvestor by clicking the link below.

Take note that if you join using my affiliate links on these two websites, I will earn a small commission if you decide to make a purchase.

I recommend these services not because of the small commissions that Ill make but because they are very helpful in my stock investing journey, and I have good experience with them.

Please dont spend your hard-earned money on these services unless you think you really need the guidance of Truly Rich Club and PinoyInvestor to achieve your financial goals.

If you need help in signing up with these websites, you may send me an email at admin@investingengineer.com and Ill gladly assist you the best I could.

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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 e-book. If you like it, please share it to people who you think will benefit from it.

Happy investing!

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Glossary of Terms

Note: All definitions are taken from www.investopedia.com.

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 company provides. Cost of revenue is different from

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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 Sales.

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 significantly affecting a firm's ability to compete with its competitors.

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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 depreciation, interest, taxes and other expenses. This number appears on a company's income statement and is an important measure of how profitable the

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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 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

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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.

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

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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

of outstanding shares is used in calculating key metrics

such as a company’s market capitalization, as well as

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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 serve 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.

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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.

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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

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attributed to a variety of factors, including cost structure, brand, and 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.

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Thank you for reading!

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E-book Disclaimer

(1)

Introduction

This disclaimer governs the use of this e-book. By using this e-book, you accept this disclaimer in full.

(2)

No advice

The e-book contains information about investing in the Philippine Stock Market. The information is not advice, and should not be treated as such.

You must not rely on the information in the e-book as an alternative to financial advice from an appropriately qualified professional. If you have any specific questions about any financial matter, you should consult an appropriately qualified professional.

(3)

No representations or warranties

To the maximum extent permitted by applicable law and subject to section 5 below, we exclude all representations, warranties, undertakings and guarantees relating to the e-book.

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Without prejudice to the generality of the foregoing paragraph, we do not represent, warrant, undertake or guarantee:

that the information in the e-book is correct, accurate, complete or non-misleading;

that the use of the guidance in the e-book will lead to any particular outcome or result; or

In particular, that by using the guidance in the e-book you will make money in the stock market.

(4)

Limitations and exclusions of liability

The limitations and exclusions of liability set out in this section and elsewhere in this disclaimer: are subject to section 5 below; and govern all liabilities arising under the disclaimer or in relation to the e- book, including liabilities arising in contract, in tort (including negligence) and for breach of statutory duty.

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We will not be liable to you in respect of any business losses, including without limitation loss of or damage to profits, income, revenue, use, production, anticipated savings, business, contracts, commercial opportunities or goodwill.

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Nothing in this disclaimer shall: limit or exclude our liability for death or personal injury resulting from negligence; limit or exclude our liability for fraud or fraudulent misrepresentation; limit any of our liabilities in any way that is not permitted under applicable law; or exclude any of our liabilities that may not be excluded under applicable law.

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If a section of this disclaimer is determined by any court or other competent authority to be unlawful and/or unenforceable, the other sections of this disclaimer continue in effect.

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If any unlawful and/or unenforceable section would be lawful or enforceable if part of it were deleted, that part will be deemed to be deleted, and the rest of the section will continue in effect.

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This disclaimer will be governed by and construed in accordance with the Philippine law, and any disputes relating to this disclaimer will be subject to the exclusive jurisdiction of the courts of the Philippines.

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