UNIT Investing For Charity

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UNIT Investing For Charity

Hello I4C Members,

If you are just signing up, make sure you make an account using your real name - i.e. "John Smith". I will be deleting all accounts made otherwise.

You are required to read the "I4C General" forum for an introduction to these forums.

Please treat these forums with professionalism and seriousness, as this is a work forum. If you wish to discuss something freely, we have a General Discussion room for that.

Please contribute to the site, and remember to check for new announcements frequently!

James Miao
Head of IT/Quant Models

UNIT Investing For Charity

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UNIT Investing For Charity

The forum is the official collaboration and work forum for UNIT I4C.

If you have just made an account, read the stickied threads in the I4C General subforum.
Attention Sector Heads - start off your forum sections by adding the threads, "Goals for 2011" and "Team Introductions".

4 posters

    Paladin Energy Limited

    Carl Bromfield
    Carl Bromfield


    Posts : 8
    Join date : 2011-06-05
    Age : 38
    Location : Camperdown, Sydney, NSW

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    Post  Carl Bromfield Mon Jun 06, 2011 12:20 pm

    During the second week of May 2011 some of us interviewed for the role of 'equity analyst', and as a part of such interview we were requested to prepare and present an investment valuation for Paladin Energy Limited (PDN). The concensus from the presentations appeared to favour a strong 'buy' decision. For some, the sooner PDN was added to a respective portfolio the better. In fact, some candidates when questioned impressed upon the panel such confidence if they were to decide upon the parcel size more than 50% of a $100,000 portfolio could be safely placed on a long-position in PDN.

    The presentations possessed a broad range of approaches in justifying the strong 'buy' decision pitched to the panel. Some focused heavily upon technical analysis of an alleged suppport level of approximately AUD$3.30. Others focused upon a comprehensive elaboration as to the underlying fundamental economics of the uranium industry and its undeniable place in the future of global energy. Within this group some took a macro approach and focused upon the broad need to move towards more 'green' energy sources, while others took a micro approach and considered the price of uranium and the structure of PDN itself. Some presentations attempted to postulate the decision quantitatively with a DCF valuation, while others relied upon a more qualitative approach where it was impressed upon the panel that the writing was pretty obviously 'on the wall' where this industry was heading despite the Japan disaster.

    Upon the first day of interviews, 11 May 2011, PDN closed at AUD$3.44. Today, 6 June 2011, PDN closed at AUD$2.99. That's a 13.1% fall in under a month. If I4C had invested $50,000 on 11 May 2011, today the portfolio would be worth $43,459.30 before costs. Furthermore, if the portfolio were to return to par PDN would need to grow approximately 15.1% excluding costs. However, let's remember before the Japan disaster when the price of uranium was approximately USD$70/pound, PDN was closing on average at approximately AUD$5.00. If I4C invested $50,000 today and PDN were to return to pre-Japan disaster levels, the portfolio could grow to a handsome $83,612.04 excluding costs. That would equal a 67.2% increase in the value of the portfolio.

    Questions to any and all: (1) Why has PDN continued to fall an additional 13.1% since 11 May 2011? (2) Under what circumstances will PDN start trending upwards again? (3) Where is PDN going in the next 6 months?

    According to the CEO of PDN, the current industry climate can be summed up as follows: http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2011/05/17/bloomberg1376-LLC04B0YHQ0X01-1C2DT1PLF727RQ56CB6VP17MQF.DTL.

    I like to describe this industry as purely competitive, and by that I mean it's all about the price of uranium. So I'm not surprised to read: http://oilprice.com/Alternative-Energy/Nuclear-Power/Are-Uranium-Prices-Ready-to-Rally.html.

    The purpose of this thread is to encourage discussion and debate. It's also an opportunity for anyone to get involved in collaborating on understanding a company, in this case our good friend PDN. Please note: This is not a criticism of anyone's presentations or recommendations during the interview process. They were all valid and of a high quality. This discussion is about moving forward.

    "A public opinion poll is no substitute for thought." - Warren Buffett

    Timothy Lou
    Timothy Lou


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    Post  Timothy Lou Mon Jun 06, 2011 3:06 pm

    I would agree that the uranium business is a competitive one and as such it's business model is very much based around cost cutting to meet the price of uranium. This would mean that the success of the business is to a large degree dependant on the price of uranium.

    Thus, in order for us to accurately forecast where the price is going, we need to know where the uranium price is going. However, there are less than 500 nuclear power plants out there and they are the main consumers of uranium. The market for uranium is so small that there is no actual commodity exchange, rather the sale of uranium is done through contracts. It is therefore a very esoteric and volatile market because the information is harder to get and analyse.

    Personally (from experience) I would not invest in uranium unless I am a nuclear scientist.

    To answer the questions:
    -I don't know
    -I don't know
    -I cannot tell

    The volatility in the EPS and ROE figures are too high for any meaningful quantitative analysis (that I know of)


    Last edited by Timothy Lou on Mon Jun 06, 2011 3:11 pm; edited 1 time in total (Reason for editing : Relevance & grammatical error)
    Daniel Man
    Daniel Man


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    Post  Daniel Man Mon Jun 06, 2011 4:02 pm

    Hi Carl and Timothy,

    Good to see you guys are starting a discussion.

    I have not done work on PDN or uranium. I actually feel it falls in the "too hard" basket. Here are my guesses from a layman point of view.

    (1) Why has PDN continued to fall an additional 13.1% since 11 May 2011?
    I think Germany announced they were closing down their reactors. Maybe that is it.

    (2) Under what circumstances will PDN start trending upwards again?
    A political announcement by a major uranium- consuming nation that following a safety review, building of nuclear reactors will re- commence, with additional protections against terrorist attacks and earthquakes. Investors regain confidence that uranium may indeed be a valid long term positive. PDN goes up, without uranium price needing to go up.
    OR
    Fundamentals catch up with the uranium price, as there IS an actual shortage (I still don't know if this is really the case!). Uranium price goes up. PDN goes up, purely as a result of uranium price only.
    OR
    Something positive, firm specific to PDN, occurs. I don't know what is so good about PDN specifically.

    (3) Where is PDN going in the next 6 months?
    I will leave that to the people who have done work on the stock.

    >>>>>

    "The volatility in the EPS and ROE figures are too high for any meaningful quantitative analysis (that I know of)"

    I agree with Timothy.

    However, we have to look at the future. Future free cash flow. Think about cash all the time. Cash inflow, cash outflow.

    Long investing is about what you give, and what you get. You pay money now for the business, you want to get something later from the business. Capitalism!

    Crucial to this is thinking about required annualized return. Must be better than 5%, otherwise I lend it to a bank, guaranteed up to $1,000,000 by Aussie government. Socialism!

    >>>>>

    Anyway, with regard to:
    http://oilprice.com/Alternative-Energy/Nuclear-Power/Are-Uranium-Prices-Ready-to-Rally.html

    "Those 443 operational reactors need about 180 million pounds of uranium. We only produce 130 million pounds of it.

    The other 50 million pounds come from the Russian Highly Enriched Uranium agreement between the United States and Russia. Once that agreement expires in 2013, we need to make up for a missing 50 million."


    That's pretty interesting quote. Except, everyone knew this stuff, even before the 2007 run up in uranium price. Here is a typical example of a pre- 2007 uranium thesis:
    http://www.bromptonfunds.com/funds/gur/pdf/Uranium_fundamentals.pdf

    So plenty of people seem to have done a lot of homework on uranium's long term prospects, and the current undervalued price, if it is indeed low, may well exacerbate a future shortage.

    Back in 2007, everyone concentrated their minds on the following TRUTHS:
    -uranium was under- supplied due to long term demand projections
    -economic feasibility studies of mines are heavily reliant on current price of the commodity: no one dares to forecast future prices that deviate significantly from spot price... both debt and equity investors are stuck to the present. So projects only commence once a uranium price hits a certain threshold. But mines take a long time to come online! Therefore, there will be a mandatory period afterwards of "undersupply."

    In light of the above premises, there is no limit on what the uranium price could trade at for the supposedly mandatory period of "undersupply" See price chart:
    http://www.uxc.com/review/uxc_PriceChart.aspx?chart=spot-u3o8-full

    This same frenzied exuberance occurred with potash/ phosphate/ urea, soft commodities and hard commodities. People get irrational over rational ideas, by taking the rational idea too far.

    But, if the long term uranium story in 2007 was correct, then it remains correct today!
    If it was a sound premise then, then it's probably a sound premise now!


    "You can get in more trouble with a sound premise than an unsound premise." - Warren Buffett.

    While June 2007 was definitely NOT the time to invest in sound premises which everyone knew about, now may be the time to invest in a sound premise. But has the Japan earthquake made it unsound?

    I do note that the uranium price fell, along with the other commodities. However, it did not turn, along with the majority of commodities, in early 2009. Rather, it only started its run in mid 2010, which was cruelly disrupted by the Japan earthquake. Of course, it would be great to take a Pavlovian approach of always buying dips (caused by Earthquake) in a delayed uranium bull run (for some unknown reason, it's turnaround lagged the other energy commodities). But I can't help but feel, that, I don't know what I don't know.

    >>>>>

    Is the current uranium price low? The current uranium price is low if:
    -it is impossible to build new mines that will make an economical return
    -projected supply will be insufficient to meet projected demand

    My preliminary question would thus be, what is the marginal cost of uranium production?

    This article suggests US$70/lb, probably quoted from Extract Resources MD:
    www.intelligentinvestor.com.au/articles/299/Gone-fission-An-investigation-into-the-uranium-sector-Part-1.cfm+uranium+the+intelligent+investor&cd=1&hl=en&ct=clnk&gl=au&source=www.google.com.au" target="_blank" rel="nofollow">http://webcache.googleusercontent.com/search?q=cache:GqxbynEd8nkJ:www.intelligentinvestor.com.au/articles/299/Gone-fission-An-investigation-into-the-uranium-sector-Part-1.cfm+uranium+the+intelligent+investor&cd=1&hl=en&ct=clnk&gl=au&source=www.google.com.au

    Is that right? You see, if I can't make a strong thesis for the uranium price, I'm not gonna to know whether my stock is cheap!

    Even if I thought the current uranium price was low, that, by itself, is not enough to pick a specific stock; it is only barely enough to pick the whole sector to buy. To be honest though, I'd rather just buy the physical commodity through an ETF, because I want a pureplay on the research I did.

    >>>>>

    It is quite hard to "invest" on a "value" basis, in a stock that can magnify a long term commodity price uptrend. You need a qualitative view of the company that can translate into an acceptable annualized return even under conservative assumptions.

    1) So I put in conservative assumptions FIRST. Then I see what my annualized free cash flow return will be at the current price.

    2) I can easily flip it around the other way. Is the uranium stock cheap? It is cheap if the current price of the stock implies an unreasonably high annualized free cash flow to equity return

    3) If I am a lazy bastard in search of a variant perception from the broker report, the stock is undervalued if the broker has assumed:
    -an unreasonably low uranium price, leading to undervalued revenue
    -an unreasonably low annual output, leading to undervalued revenue
    -an unreasonably high cash cost, leading to overvalued costs, and thus undervalued margins
    -an unreasonably low level of surplus realizable assets, leading to undervalued surplus realizable assets

    If I am a value investor, I need a special variant perception of the return that I can get, given the risks. Pretty hard to get a special long term view of a specific resource stock during a resources bull market. Far easier for many people to just trade a bull market. Unfortunately, I don't know how to trade. [Neither do I know how to invest, but hopefully that will come with time]

    Alright, I think I need to study for my exams. Let's hope Carl will teach us how to look at PDN, the company.

    And by the way, I thought the presentations were fantastic, if unnecessarily optimistic.
    Timothy Lou
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    Post  Timothy Lou Tue Jun 07, 2011 1:06 am

    Daniel, what does required annualised return mean? Is it the same as the figure used to discount stocks to know the price to buy it at the desired return?

    How can you look at the cashflows for PDN? I don't understand how you can get any meaningful analysis given the volatility present in those figures?
    Daniel Man
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    Post  Daniel Man Tue Jun 07, 2011 4:16 am

    Hi Timothy,

    1) What does required annualised (free cash flow to equity) return mean? Is it the same as the figure used to discount (equity) cashflows to reach a fair value for the stock at the desired return?

    Yes, to me, the two terms are equivalent. They are also equivalent to the "cost of equity" number in a DCF model which discounts future FCFE (free cash flow to equity) back to the present.

    I don't understand the excruciating cost of equity calculation taught in finance, which involves levered betas, unlevered betas, risk free rates, market risk premiums and even (i think) debt to equity ratios. I am a simple creature. Maybe you can teach me how that works.

    2) How can you possibly predict the future cashflows for PDN? I don't understand how you can conduct any meaningful analysis, given the volatility in the historical figures!

    How much stuff does management say it is going to produce and sell in the future, & at what price? When will the selling begin? Revenue.
    What is the expected cash cost per stuff? Expenses.
    What about expected royalties per stuff? Expenses.
    What about expected future maintenance or expansionary capex? Capex.

    As most people would know:
    FCFE
    = [NI] + DEPRECIATION + AMORTIZATION - CAPEX - (CHANGE IN NON CASH WC) + (CHANGE IN NET DEBT)
    = [EBIT – INTEREST(1-tax rate)] + DEPRECIATION + AMORTIZATION - CAPEX - (CHANGE IN NON CASH WC) + (CHANGE IN NET DEBT)
    = EBITDA – INTEREST(1-tax rate) - CAPEX - (CHANGE IN NON CASH WC) + (CHANGE IN NET DEBT)

    Though you have to normalize everything. That is key. Also, you have to be careful that don't spend the free cash flow on buying something stupid. Unless they can find a superior investment opportunity within their sphere of competence, they should return the free cash flow to you.

    Now to your real question! I think with Paladin, you can't rely on historicals. Coz it doesn't earn much. Does it even pay a dividend? Probably not.

    Instead, you must look at the future. Actually read/ listen to what management says it is going to do. Well that's what nearly all of the interviewees did. Presentations. Annual Reports. Podcasts. AGMs. Broker reports. If you are still confused, email the MD. If not enough, call them. If not, meet them.

    Personally, I don't know how to look at the future.

    We require Carl's guidance
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    Roger Dong


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    Post  Roger Dong Tue Jun 07, 2011 5:05 am

    I want to try to understand why some of you would be willing to pay more than double book value for a company that has made losses in 5 of its last 6 years...
    Timothy Lou
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    Post  Timothy Lou Tue Jun 07, 2011 2:12 pm

    Hi Daniel,

    Regarding Cost of Equity Calculations:
    Off the top of my head at 12am...I think you are referring to the equation where:

    Cost of equity = Risk free rate + Beta[market premium] which is one of the many ways you calculate cost of equity as you know. The good thing about it is that it gives you a cost of equity that has factored in market risk. The bad thing is it is reliant on your estimation of beta and the market rate. I should know more but I don't. I have an exam on it next week, ask me then! I would recommend Fundamentals of Corporate Finance by Ross if you are interested.

    FCFE
    I have no idea about the FCFE...such a steep learning curve ever since I joined I4C...looking forward to the training program!

    Looking to the Future
    At first instance, I disagreed with looking to the future because I thought the Efficient Market Hypothesis would make any publicly available information useless. However, I have given what you said some more thought - by looking to the future, do you mean taking a position as to the viability and success of proposed future projects?

    Timothy Lou
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    Post  Timothy Lou Tue Jun 07, 2011 2:14 pm

    And yes, we require Carl's guidance on this issue!
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    Roger Dong


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    Post  Roger Dong Tue Jun 07, 2011 8:04 pm

    Future assumptions

    Are essential for valuing a business. When you are calculating an equation such as CF/RR you are assuming constant cash flows in every future year.
    It depends on each individual company and situation, but an indepth analysis for the next 2 years then splitting the next segment/s of assumptions into tiered timelines would be worth considering.
    A quicker method would be to scale the factor into annualized chunks using root of n, however it is less accurate due to timing issues in discounting but useful for a quick dirty valuation.

    Discount rate?

    This is crucial to any valuation.(highly sensitive)
    In a nutshell, it is the minimum rate of return the investor requires before undertaking an investment of such risk.
    Just be mindful with the usage of CAPM. In a less than efficient market it would be missing a range of important variables (some opportunity costs for an example) and distorting effects.

    There is no reason to not base some of your assumptions on historicals. They are your first source of information.
    If you have clear bullish or bearish assumptions of the company (as in significantly trending from historicals), these should be supported by quantitative evidence, details or information or you would be speculating and not investing.
    Personally I dont view PDN as investment grade as reflected by my required return (16.2) or being worth close to the $3 range.
    Why has PDN dropped by 16% over the past month? I dont know and it shouldn't matter. Overanalyzing the daily gyrations of prices in the market shouldn't be of much or any priority. We need to focus on business fundamentals from the ground up, and in those terms my valuation of PDN has not changed since last month.
    Carl Bromfield
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    Post  Carl Bromfield Mon Jun 20, 2011 11:12 am

    On 6 June 2011 Paladin Energy Limited (PDN) closed at AUD$2.99/share, which is the day I started this thread. Today, 20 June 2011, the share price (SP) has closed at AUD$2.31, equating the total fall in the SP since 11 May 2011 to 32.85% excluding costs.

    In the case of an equity analyst at Investing for Charities (I4C), the goal with each company we consider is to equate a quantitative, intrinsic value for a single ordinary share and compare it to the current SP. This comparison produces three possible outcomes: (1) the SP is currently trading at a discount; (2) the SP is currently trading at a premium; or (3) the SP is currently trading at fair value.

    A common misconception students tend to apprehend in setting such a goal is the instrinsic value derived from the analysis is meant to represent the single true answer. This is simply not true. Remember, the equated intrinsic value will be underpinned by a series of assumptions made by you, the analyst, and those assumptions will very likely be the derivative of someone elses assumptions. Furthermore, even before the analyst looks at the numbers on the balance sheet and the income statement, those numbers are also a derivative of many assumptions made by the managers of the company. The impression to take from this is the following: You will never be right in pursuing this goal; you will only be right as much as you remain consistent with your reasoned and well argued assumptions. The concluding statement of your analysis will always be as follows: "My conclusion I present is, ceteris paribus, X, subject to A, B, and C." As soon as you fully appreciate the reality of the task at hand, the easier it will be to approach and to succeed.

    Timothy is correct in asking how can we "get any meaningful analysis given the volatility present"? Indeed, as Roger points out, the only thing PDN has been consistent with over the past 6 years is that the company does not make money. However, also over the past 6 years the SP has changed from less than AUD$0.50 to an all-time high of AUD$10.80. However, according to the most recent half-year report, as at 31 December 2010, there was only US$1.54 of net assets per ordinary share and also at the time the SP was last traded at AUD$4.93. Quite the premium considering the other half of a SP is the rights to all future-cash flows and PDN had yet to make any positive ones! Place focus, however, on this point going forward. Remember that a SP contains two parts: (1) the underlying net asset value per share; and (2) the assumption that the company is a 'going concern', that is, all the future cash flows of the company. In more cases than not, the SP fluctuates due to changes in circumstances that adjust the markets assumptions re: (2), while on the other hand changes in circumstances that adjust (1) are less often. Remember, however, that these parts are not mutually exclusive, as (2) eventually transpires into equating (1).

    My guidance for the analysis of PDN is as follows:

    1. I like to analyse any intrinsic valuation with a 'top-down' approach. What are we analysing? PDN. Why? Perhaps because we feel there is an opportunity in the Uranium(energy) sector to make a profit. Why? Perhaps because we feel the Japan earthquake disaster has deflated the price of uranium so much that the companies who trade uranium are currently trading at a discount. Ok, so what companies trade uranium? PDN. What other companies trade uranium?

    2. If we're going to put so much time into understanding the underlying economics of a potential opportunity, let's make sure we pick the company with the best opportunity for a return. I like to analyse companies in groups. In fact, in most cases I feel you can't analyse a company in isolation. So in answer to the final question in (1), Energy Resources of Australia (ERA) trades uranium, and Extract Resources (EXT) explores for uranium. PDN, ERA, and EXT are the three largest companies on the ASX whose core business is uranium. Is three enough companies to perform an analysis? I feel this is circumstantial, it depends on the opportunity, the industry, the economic circumstances, etc.

    3. Once I have identified my opportunity, selected my pool of companies, I perform the following process:

    (i) Perform an industry analysis;
    (ii) Perform a company/strategy analysis;
    (iii) Perform an accounting analysis;
    (iv) Perform a financial analysis;
    (v) Construct a prospective analysis;
    (vi) Perform a valuation using an intrinsic valuation method; &
    (vii) Compare the outcome of (vi) with the current SP for the best return.

    I'd like to leave this post here and ask for some feedback, comments and criticisms. What do you think of this process? How do you see your analysis of PDN developing in this format? Do you disagree (I encourage this incredibly)?

    For anyone with final exams, best of luck, and try not to stress.

    - "There seems to be some perverse human characteristic that likes to make easy things difficult." - Warren Buffett
    Timothy Lou
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    Post  Timothy Lou Mon Jun 20, 2011 11:42 am

    Carl,

    What is the justification for taking the top down approach? Would it not incorrectly eliminate possibly profitable companies in bad industries?
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    Roger Dong


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    Post  Roger Dong Sun Jun 26, 2011 8:01 am

    A top down approach is suitable for many reasons, here are the main two:

    - Saves time
    - PDN is a commodity firm, not a franchise. It has very few long term competitive advantages, therefore an analysis on the entire uranium industry is quite suitable.

    Our role as analysts are to find the BEST quality business trading at significant discounts after careful and conservative analysis. Reason being, higher quality businesses are easier to value (PDN is not easy to value, therefore higher margins of safety are needed) and large discounts are for the purpose of prudency.

    Of course the more sensible and intelligent your analysis and assumptions are (from greater understanding of business, scuttlebutting, sleeker and more precise variables) the closer you will be to the true intrinsic value, however you need to consider these things:

    - Your IV will rarely be exactly precise.
    - The market generally follows long term efficiency. However, this could take years and years of time which could work strongly against your favor. Paying a lower price, lowers your risk and increases your margin of safety.
    - All variables follow probability distributions that are outside of your control.
    - Dodgy accounting, misinformation. eg. misleading reports of companies in China (fraud).

    So what can we do? What are our competitive advantages?

    - No market cap bias, we can look at smaller companies that are not covered.
    - Greater freedom of expression. No obligations to analyse using certain industry metrics, we have a diverse group of people and have the opportunity to debate freely and critique one another.
    - No obligations to invest. We can hold cash until we find superior businesses at good value.

    How should we approach things?

    - Cut out junk. Each sector head allocates 5~ companies per team member and asks them cull that subset down to 1-2 companies, just a quick dirty valuation and analysis. (Thats 25~ companies covered per sector or around 100 in total)

    eg.

    PHASE 1
    Sector head: Cull from 200-300 companies down to 25-30~
    min (ROE last 3 years) >= 15%
    EBIT margin min last two years >= 10%
    Interest coverage >= 5:1
    ROA >= 10%
    PE < 15
    etc.

    PHASE 2

    Sector analysts: culling from 5-10 --> 1-2
    - Qualitative analysis (High quality? Growth? Where will the company be in roughly 10 years? Understandable?)
    - Quick quantitative valuation using conservative values.
    - Chooses their best 1-2 companies for next stage.

    PHASE 3

    - Present findings to sector heads. Around 5-10 companies to look at more closely.
    Split into groups of 2-3 analyst to analyse 1-2 individual companies in greater depth (Eg competitors, required return derivation, proper pro forma statements) and repeat process until most suitable investment out of group is identified.

    PDN:

    Id personally ignore spending additional time on the company. It is extremely difficult to value for one, and is a low quality business. That would already tick the NO boxes for me, but my valuation is still sitting considerably lower than the current price of $2.5.
    There are 1900+ listed companies on the ASX, do we really want to take PDN on another candlelight dinner?!
    Timothy Lou
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    Post  Timothy Lou Sun Jun 26, 2011 9:18 am

    Thanks Roger!
    Carl Bromfield
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    Post  Carl Bromfield Wed Jun 29, 2011 1:43 pm

    Hi everyone,

    Any comments re: the following Article?

    In particular, Roger, the company is now tipped as a buy for Citigroup, and many of your fellow equity analyst colleagues did strongly propose a buy recommendation during the interviews. What do you think is the key differential between their opinions and your own considering you are the strongest supporter of the hold/sell option at the moment on the forum thread?

    Timothy, do you agree with the article as per the key catalyst for the fall in the SP of PDN?

    Question to all, in your opinion how important is the Namibian issue to the fundamental analysis of PDN?

    This is an ongoing story and it would be of great value to continue following this through as many people consider the uranium industry a heavily discounted opportunity at the moment.

    "The chains of habit are too light to be felt until they are too heavy to be broken." - Warren Buffett
    Timothy Lou
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    Post  Timothy Lou Thu Jun 30, 2011 8:33 am

    Which article?

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