Saturday, 31 December 2011

Warren Buffett - My Biggest Mistake

Warren Buffett's Financial Rules to Live By

Warren Buffett - There is Only One Type of Investment Risk

Warren Buffett - Best Hedge Against Inflation

There is no power on earth like unconditional love.


Billionaire Warren Buffett, widely considered the smartest investor on the planet and known for his modest lifestyle despite astronomical wealth, was recently asked the best advice he ever received. Surprisingly, it wasn’t about money, finances or wealth creation. It was about parenting. Here’s what Buffett said about the best advice he’s ever received:

The power of unconditional love. I mean, there is no power on earth like unconditional love. And I think that if you offered that to your child, I mean you’re 90 percent of the way home. There may be days when you don’t feel like it, it’s not uncritical love, that’s a different animal, but to know you can always come back, that is huge in life. That takes you a long, long way. And I would say that every parent out there that can extend that to their child at an early age, it’s going to make for a better human being. – Warren Buffett

Friday, 30 December 2011

Speculative-Growth Stocks - Are Net Margins on the Rise?

Although Yahoo is profitable, many speculative growth companies - including most Internet companies - lose money.

Of course, that is to be expected from a new venture.  It's investing heavily to exploit profit opportunities, and if those investments pay off, earnings will materialize.

But to curb risk, we want to find companies that are making progress toward profitability.

Even if a company is losing money, net margins should be improving, even if that means becoming less negative.  

Yahoo shows an encouraging trend in 1999.

  • After losing money in its first three years, Yahoo made a profit in 1998, with a net margin close to 5%.  
  • Furthermore, it had net margins above 20% in the third and fourth quarters of 1998 and the first quarter of 1999.  
  • Net margins declined over the next few quarters because of non-cash charges resulting from mergers, but operating margins (which exclude such charges) remained solid.
  • Yahoo appears to have left its money-losing phase behind.
Life Cycle of A Successful Company

(My comment:  A great company can still be a bad investment if you pay too high a price to own it.)

Speculative-Growth Stocks - What's the Growth Trend?

Rapid sales growth won't do us any good if it can't be sustained.

We want staying power, not sales growth of 50% one year and shrinkage the next.

Even though it has only been around for a few years, Yahoo has been one of the most consistent Internet stocks around, growing steadily without a lot of wild swings from quarter to quarter.  

  • The pace of that growth has been steadily declining (from 230% in 1997 to 120% in the first quarter of 2000), but that's to be expected as a company gets bigger and grows from a larger base.  
  • Yahoo has demonstrated a lot of staying power, at least by the standards of Internet stocks.
Life Cycle of A Successful Company

Speculative-Growth Stocks - Is Sales Growth Outpacing Asset Growth?

The speculative-growth market is full of companies that are doubling their sales by doubling their assets.

This is a legitimate way to expand.  Investors pour additional capital into the business, which drums up new sales.

Eventually (we hope), the company reaches a critical mass at which it becomes a big moneymaker.

But to limit risk, we can focus on companies that are making more efficient use of their assets as they expand, generating rising sales on each $1 of capital.

Yahoo has done pretty well on this front.

  • Between 1997 and 1998, its sales grew 18%, but its assets grew even faster, at 333%.  
  • In 1999, though, Yahoo's sales started to grow faster than its assets, indicating that it's starting to squeeze more growth out of its assets.  
  • That tells us that Yahoo is growing quickly, but prudently.

Life Cycle of A Successful Company

Speculative-Growth Stocks - Introduction

Speculative-growth stocks can inspire dreams of wealth - and nightmares of poverty.

These companies are often new ventures selling something people want, generating rapid revenue growth, but incurring high expenses as they strive to become a permanent fixture of the corporate landscape.

One might be the next Microsoft MSFT.  Or the next Atari.

Their defining characteristics are rapid revenue growth but slower or spotty earnings growth - strong sales, in other words, but a lagging bottom line.

In fact, many speculative growth companies lose money - lots of it.  That's not much inducement to invest.

Still, corporate America's future heavyweights and best investments may lurk in this high-risk, high-reward corner of the market.

It's possible to curb some of the risk, too.

For example, Yahoo YHOO, the World Wide Web portal was one of the hottest Internet stocks of the 1990s.

Life Cycle of A Successful Company

Buffett: My job is to take advantage of the craziness of Mr. Market; whacking him when he gets way out of line

March 31, 2008

Question: What are your thoughts about the Chinese Stock market?


The Chinese stock market? I don’t know what markets are going to do.  When I was over in China they were bombarding me with questions about the market and of course you have these A shares, including Petro China, which was going public in China.  Petro China and others were trading at twice the price within China (at that time Chinese people were not permitted to buy shares in Hong Kong or in the United States) than outside China.  This was really extraordinary.  If you knew these restrictions were going to break down it would have been great to short the stocks in China and buy them elsewhere around the world.

But the Chinese stock market has 1.2 billion people waking up to the stock markets and having an investing or gambling urge.  The stock market was becoming wildly popular as we know in China.  Petro China at one time, based on the Chinese prices, was the most valuable company in the world, and was selling for over 1 trillion dollars, whereas Exxon was only worth 500 billion.  This made Petro China twice as valuable as the largest company in the world. 

I have no idea why and where that many people were relatively new to the market and were very excited about stocks.  You do know in the end you have to buy things on a basis of when you get a value for what you pay.  This seemed to lose relevance in a market like China.  They had a situation like that in Kuwait 20 years ago.  When a whole society, and a rich society, (certainly far richer than 15 years ago), a huge market opened up for them.  I have no idea whether the people get friendlier or crazier.  That is not my game.

My game is simply to buy something worth a dollar for 50 cents.  Then if they go crazy in the right direction it helps me and if they go crazy in the other direction I  just buy more.  

My job is to take advantage of craziness.  And that goes back to Ben Graham’s Intelligent Investor chapter 8.  If you are going to invest based on value with a partner (lets say Mr. Market) - let’s say you each own half of a McDonalds stand.  Every day he quotes a price at which he either wants to buy me out or sell me his interest.  If he hears a bad rumour he low-balls it, so I buy.  Other days he is all excited about some Burger King burning down and seeing some line ups and decides to give a high offer, so I sell.

If I’m going to have a partner like that what kind of partner do I want?  I want a psycho.  The stupider he gets the better I am going to do.  I don’t want some cool, calm rational partner.  I want somebody with huge ups and downs - a manic depressive.  Basically that’s what you get in the stock market some times.  As long as you realize he is there to serve you, and not to instruct you, you can make a lot of money.  You can’t listen to Mr. Market and think he must be right.  Only listen to what he says in the context of: when this guy gets way out of line I am going to whack him.  And basically that’s what you get in the stock market.

In China you can’t tell how far the markets will go to extremes.  You can’t tell that, I have no idea where the markets are going to go tomorrow or the next day or the next month or the next year.  I do know that in the end stocks tend to sell for what they are worth.  At least in the range of what they are worth.   They go all over the place in between - but tend to true value in the end.

A Discussion of Mr. Warren Buffett with Dr. George Athanassakos and
Ivey MBA and HBA students
Omaha, NB, March 31, 2008, 10:00 am - 12:00 pm

Only One Warren Buffett: Buffett's investing style is to buy great companies at reasonable prices.

Buffett is often thought of as a pure value investor, buying companies and shares only when they are dirt cheap. He does some of that, and his investments in Goldman and GE last year were an example.

But far and away Buffett's investing style is to buy great companies at reasonable prices. His simple definition of a great company is one which has a sustainable competitive advantage, like a railway, for example.
Price wise, he is not getting Burlington on the cheap. The Financial Times calls Burlinton's valuation "generous", but also says "Buffett is not a man to quibble (on price) when he sees something he likes".

Buffett imitators often try to buy shares in a company because they are cheap. Buffett himself concentrates on buying great businesses. The difference is chalk and cheese, and it's the reason why there's only one Warren Buffett.

Buffett's Ratio Says Stocks Are Getting Interesting

17 August 2011
The art of cheap.

One of the hardest things to grasp in investing is that when the present turns the darkest, the future becomes the brightest. Warren Buffett once captured this with a famous and oft-repeated quote: "I will tell you how to become rich: Be fearful when others are greedy, and greedy when others are fearful."
There's another, more specific Buffett rule that gets less attention. In 2001, Buffett wrote an article for Fortune magazine laying out a few investing truisms. In short, you want to buy stocks when the total market capitalization of all public companies looks cheap in relation to that country's gross national product (similar to gross domestic product, or GDP). He called this technique "probably the best single measure of where valuations stand at any given moment."
He even threw around some numbers. "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you."
Tallying up the total market value of all listed stocks isn't easy. Different analysts come up with different numbers. The most widely used method is the full capitalization version of the Wilshire 5000 index, which tracks the market cap of all U.S. companies "with readily available price data." Divide that index by gross national product, and you get Buffett's ratio.
Where are we today? After the market bloodbath of the past few weeks, the ratio of U.S. stocks to GNP recently hit 79% -- just below what I'd call Buffett's comfort zone.
Source: Dow Jones, St. Louis Fed, author's calculations.
Understand what this does not mean:
  • It does not mean stocks are bound to go up in the short run. No metric can predict that.
  • It does not mean stocks won't fall further from here. A ratio becoming mildly attractive doesn't rule out the possibility of it becoming much more attractive. In fact, that's usually how it works. The history of bear markets is that of stocks becoming not just a little cheap, but obnoxiously cheap.
And importantly, other valuation metrics, such as the cyclically adjusted P/E ratio created by Yale professor Robert Shiller, still peg stocks as slightly overvalued.
But Buffett's metric means things start getting interesting. Forty years of data show there's a fairly strong correlation between Buffett's ratio and stock returns two years hence. At 79%, today's ratio is in a range that has historically set investors up for decent future returns:
U.S. Stocks as
% of GNP
Average Subsequent
2-Year Return
< 60%21%
> 100%(4%)
Source: Dow Jones, St. Louis Fed, author's calculations. Data since 1971.
There are no certainties. There are no promises. But investing gets interesting when the odds of success are in your favour. Buffett's ratio suggests those odds are now pretty good. If you were excited about stocks a month ago, you should be thrilled about them today. Indeed, many of us are. 
"The lower things go, the more I buy," Buffett said last week. How about you?

Thursday, 29 December 2011

So which Stock Type do you wish to add to your portfolio?

To highlight fundamental differences between companies, examine each company's historical record, growth rates, cash flows and other financial data.

Based on these fundamental differences, assign it to one of eight groups.  These stock types are:

  1. Speculative Growth
  2. Aggressive Growth
  3. Classic Growth
  4. Slow Growth
  5. High Yield
  6. Cyclicals
  7. Hard Assets
  8. Distressed.
These stock types address the question:   What kind of company is this?

Life Cycle of A Successful Company

Here is a quick overview of these very different companies.

Speculative Growth:  Yahoo YHOO.  The premier Internet portal has become one of the giants of the online world in 1999, with an audience in the tens of millions.  It has become consistently profitable, unlike most of its online brethren, but its track record is still so short that it is definitely risky.

Aggressive Growth:  Starbucks SBUX.   The coffee chain has grown like gangbusters while also showing a healthy profit, the two most important characteristics of an aggressive growth stock.

Classic Growth:  McDonalds MCD.  the fast-food giant is a stereotypical classic growth stock:  A well-known name with an established track record.  It's growing steadily, but not as fast as speculative growth or aggressive growth companies. 

Slow Growth:  Procter & Gamble PG.  The consumer-products giant is a good example of this type; its growth is slower than that of even classic-growth companies, but it makes up for this lack of growth with high profitability.

High Yield:  Philip Morris MO.  The food and tobacco giant's stock was hammered in 1999, but the company still gives back much of its enormous cash flow to shareholders in the form of a hefty dividend.  

Cyclicals:  United Technologies UTX.  This industrial conglomerate is a great example of a cyclical stock.  Its business - aerospace equipment, air conditioners, and elevators - are highly sensitive to the performance of the general economy.

Hard Assets:  Barrick Gold ABX.  This company is one of the most consistently profitable gold-mining stocks, but it also illustrates many of the charcteristics unique to companies that sell hard assets such as minerals or oil.

Distressed:  Silicon Graphics SGI.  This maker of computer workstations and server systems was once a hot technology stock, but it has suffered through a lot of problems since the mid-1990s and has seen its stock price tank.

Using stock types, help you pinpoint where a company is in the corporate life cycle.

Savvy investors know about the corporate life cycle:

  • Companies in their startup phase lose money.
  • If they're successful, though, they enter a rapid growth period, where sales - and eventually profits - shoot upward. 
  • Then, alas, comes the point when the company has exhausted all of the easy growth opportunities.  The low-hanging fruit has been picked.  The company enters a mature phase in which sales maybe growing, but at a much slower rate than before.
  • Finally, in a company's dotage, it's all management can do to grow the company at all.  The company's either in stagnation or outright decline.  

Using stock types, help you pinpoint where a company is in the life cycle.

Life Cycle of A Successful Company

Let's look at semiconductors.
What is the key difference between chipmakers Intel INTC and National Semiconductor NSM?
Or between Broadcom BRCM and Rambus RMBS?

One of the babies of the industry is Rambus, a company that makes devices to speed up computer processing.  The company's sales have grown rapidly, though inconsistently.  Earnings have been spottier.  Rambus has actually lost money over the past 5 years in aggregate.  It is a great example of a speculative - growth company.

Moving up the maturity scale a notch, we find Broadcom, a company about 10 times the size of tiny Rambus.  The company specializes in chips that enable broadband data communication.  Broadcom's sales have grown  rapidly, and although it has had one money-losing year over the past five years ending in 1999, it's generally increased its earnings in line with sales.  That's the sign of an aggressive-growth company:  one that has managed to increase both sales and profits at a rapid clip.

Now we come to companies like industry leader Intel.  Not too long ago, Intel landed in the aggressive-growth group along with firms like Broadcom, but because of slowing growth, Intel has mellowed into a classic-growth company.  Despite the snags of late, Intel has a record of good sales growth and consistently positive earnings.  That's the mark of a classic-growth firm.  Don't expect them to grow sales by double digits every year, but do expect them to generate solid profits - and maybe even pay out a good dividend.  

Even more mature than Intel is Texas Instruments TXN.  The company was busy restructuring itself in the late 1990s and has been shrinking as a result.  The company's trailing three-year sales growth at the end of 1999 was negative, and earnings have bounced all over the place.  Texas Instruments merits a slow-growth tag because of its rather unspectacular record.

The trials at Texas Instruments, however, are nothing like those at chipmaker National Semiconductor.  The company's sales and cash flows have fallen, and the firm has lost money as a result.  The situation is bad enough to land National Semiconductor in the distressed stock type - the nether-zone in which we place firms with a history of serious operating problems.  These are typically companies that have run into growth problems, either because the market is saturated or because competitors have the upper hand.

Stock Types

Microsoft MSFT and Microtest MTST.  They are both technology companies.  Both have "micro" in their names. But that's where the similarities end.

Microsoft is the most successful company of the 1990s with a market value of $450 billion at the end of 1999.

Microtest is a struggling produce of hand-held scanners, is worth a piddling $30 million.

These are two technology companies, two very different stocks.

Inside any sector - whether it is technology or utilities - you will find companies as different as Microsoft and Microtest.

To highlight fundamental differences between companies, examine each company's historical record, growth rates, cash flows and other financial data.

Based on these fundamental differences, assign it to one of eight groups.  These stock types are:

  1. Speculative Growth
  2. Aggressive Growth
  3. Classic Growth
  4. Slow Growth
  5. High Yield
  6. Cyclicals
  7. Hard Assets
  8. Distressed.

These stock types address the question:   What kind of company is this?

What about Microsoft and Microtest?

  • Bill Gates' company lands in our aggressive-growth stock type, the home of the fastest-growing companies.
  • Microtest doesn't fare so well.  Because of declining cash flows and negative earnings, it is in the distressed group.  Hawking handheld cable scanners hasn't generated much growth.

Life Cycle of A Successful Company

Keys to Successful Investing

Know Yourself
Know your investing objectives
Know your time horizon
Know your risk tolerance
Know your financial capacity and reserves

Know your investing philosophy and strategy
Keep it simple and safe (relevant, powerful and focussed)
Never lose money (Rule No 1 and Rule No 2 of Warren Buffett )
Develop and stay with your investing philosophy and strategy (value investing, long term)
Know the difference between investing and speculation/gambling (avoid speculation and gambling)
Avoid market timing (a most dangerous game to play, best avoided)
Selective stock picking (earning power, economic moat, durable competitive advantage, franchise value)
Know your rules for buying (circle of competence, margin of safety, buy quality, great companies at wonderful price)
Know your rules for selling (sell the losers- fundamentals deteriorated permanently or underperformers)
Know your rules for portfolio management (concentrated, defensive and offensive strategies)
Keep good records to guide your investing (an essential to your success in your investing journey)
Reinvest your dividends and dollar cost averaging (take advantage of compounding)

Ongoing activities to invest for the future
Continue to learn and explore.
Continue to master the understanding of all types of businesses
Continue to master valuation of business
Continue to master the understanding of market behaviour and Mr. Market
Continue to master behavioural finance to understand herd and individual behaviour.
Continue to learn, develop, refine and explore investing knowledge, concepts and applications.
Continue to research companies and businesses.
Continue to seek opportunities in good and bad markets.

Invest intelligently by following these three principles of value investing

Invest INTELLIGENTLY through adhering to the following three principles of value investing.

First, we think of stocks in the same way that a business person would think of a business.

Second, we do not follow, but instead try to take advantage of the manic depressive Mr. Market.

Third, we always look for a margin of safety.

Mr. Market

“Common stocks have one important investment characteristic and one important speculative characteristic. 
Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the reinvestment of undistributed earnings. 
However, most of the time common stocks are subject to irrational and excessive price fluctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble”.

- Benjamin Graham

Wednesday, 28 December 2011

What is Value Investing?

The style of investing developed by Benjamin Graham in the early 1930s, referred to as Value Investing.

Benjamin Graham
            What is Value Investing?
Value Investing - "An approach to investing best summed up by Benjamin Graham, a veteran American investor, who urged others to seek a 'margin of safety'; the opposite of growth investing. Value investors ferret out the stocks of companies (that is value stocks) which have solid businesses and balance sheets but which, for one reason or another, are out of favour with the market. Such investors aim to buy low and sell high. Their techniques vary. Warren Buffett, one of the most successful investors of all time, values companies on the basis of the present value of their future cash flows. Others look for companies whose price/earnings ratios are below the average for the market as a whole. Most take a long-term view of investment."
   from Essential Finance, by Nigel Gibson, p.305.

When choosing a stock to buy, don't overlook the PEG ratio

The figurative earnings can indicate a bargain


Dollars & Sense

April 02, 2000|By Laura Pavlenko Lutton | Laura Pavlenko Lutton,MORNINGSTAR.COM
Bankers are sticklers for the details. It's their business to invest money in loans to individuals and businesses, and they expect to be repaid, on time and in full -- no excuses.
As stockholders, we should think like bankers. When we buy shares in a company, we're making an investment, and we should be paid back, too. The payback for shareholders is figurative, of course, but consider how much a company would have to earn before its cumulative earnings equal its current stock price. That period is called the PEG payback period, and it's based on the PEG ratio: a firm's price/earnings ratio divided by its expected growth rate. The PEG payback period is the time it would take a company to pay back its investors with earnings.
Take Schlumberger, the oil- and gas-services company. It has a PEG payback period of 15.3 years, so at the company's expected growth rate, Schlumberger would have to add up its earnings per share for 15.3 years straight before those earnings would equal its current stock price. (Morningstar includes each stock's PEG payback period in the "stock valuation" portion of its Quicktake report.)
The PEG payback period is good for gauging whether a company's expected earnings justify its current stock price. A high PEG payback period generally means shareholders are paying for a company with relatively low earnings. Stocks with low PEG payback periods aren't risk-free, but they're cheaper based on expected future earnings.
For this week's analyst picks, we stayed with companies that have PEG payback periods of less than 11 years. One company worth noting is Alltel, the nation's fifth-largest wireless telephone carrier. The Little Rock, Ark.-based company has a PEG payback period of 10.6 years -- a figure that has increased recently with Alltel's stock price.
Alltel's appeal comes from its growing wireless network. The company recently inked a deal to buy wireless assets from Bell Atlantic and GTE, two companies that have been forced by regulators to divest some assets in conjunction with their merger this spring.
The deal will give Alltel customers inexpensive access to Bell Atlantic and GTE's wireless networks so Alltel phones may "roam," or operate on the other companies' infrastructures, at a low cost. Alltel's sales growth has been outpacing the telecommunications-industry average. The company has also posted strong profitability ratios, which earns it B-plus grades from Morningstar for profitability.
Another PEG-payback qualifier is Tyco, the conglomerate that fell out of favor last year due to questions about past accounting practices. Those still-unproven accusations tarnished Tyco's reputation, but with a PEG payback period of 8.1 years and an otherwise solid track record, this company may be worth a look.

The Longer the Payback Period, the Greater the Risk

The most useful thing about payback periods is that they give a good (albeit rough) idea of how risky an investment is. 

We may feel fairly confident in our assessment of a company's earnings potential over the next year or so, but that confidence usually diminishes as we peer farther into the future. 

Thus, the longer the payback period, the greater risk we run that we won't get the return we expect. 

That is especially true if the company we're looking at is a young firm without an established market position or is dependent on a rapidly changing technology.

Take Qualcomm QCOM, for example. This digital-wireless-communications powerhouse was the hottest stock on Wall Street in 1999 after appreciating 12-fold in 11 months. Its PEG payback is 12.4 years--not too bad considering its $350-plus stock price. But compare that with Allstate ALL, which watched its stock drop about 30% in 1999. Its PEG payback is 6.6 years. 

Qualcomm may be the sexier company and certainly has had upside for its investors, but sometimes the cheaper stock looks like a better deal.

After all, stocks with longer payback periods aren't just riskier, they also have lower rewards. 

Remember that the payback period is the amount of time it takes to double your money. 

If a stock has a payback period of five years, that means it doubles the amount of the original investment in five years. An investment that doubles in five years has an average rate of return of 15% per annum (on a scientific calculator, take the fifth root of 2, subtract 1, and multiply by 100). 

A payback period of 10 years implies a rate of return of a little more than 7%. At 20 years, the rate is less than 4%. And so on. 

The longer the payback period, the lower the rate of return.

Payback Period = Double Your Money

A payback period is the amount of time it takes for a company to accumulate enough in earnings to equal the amount of your original investment. 

That sounds complicated, but in simple terms, it is the time it would take you to double your money based on the profits a company is generating. 

There are a couple of payback periods to consider, and one of the simplest can be determined by looking at the stock's P/E, or the ratio of its price to its earnings per share. 

P/E is one way you can estimate how many years it would take for the company to accumulate earnings equal to its share price. 
  • Imagine a $10 stock with $1 per share in earnings. 
  • Based on its P/E of 10 ($10/$1), if the company continues to earn $1 per share every year, it would take 10 years for all those dollars to add up to the original $10 stock price. 
  • So a stock with a P/E of 10 has a payback period of 10 years, assuming its earnings are the same each year.

But most companies don't make the same earnings year after year. As an investor, you're hoping the earnings will grow. 

To account for growth, there is something called the PEG payback period, which is based on the price/earnings growth (or PEG) ratio. 

The PEG ratio relates a company's price/earnings ratio (P/E) to its earnings growth. 

It is calculated by dividing a stock's forward P/E, or its P/E based on consensus analyst earnings estimates (what Wall Street analysts expect the company to earn over the next 12 months), by its forecasted earnings-growth rate (the rate at which analysts expect the company to grow).

PEG ratio = forward P/E / expected growth rate

Like P/E, the PEG ratio tells you how many years it will take for earnings to equal the stock price. But unlike P/E, it assumes earnings will grow at a certain rate.

Take our $10 stock with $1 per share in earnings. 
  • If analysts' consensus estimates say the company will grow at a rate of 10%, we would increase each year's earnings by 10% before adding it up. 
  • Therefore, the first year's earnings would be $1.10 (that's $1 times 1.1), the second year's would be $1.21 ($1.10 times 1.1), and so on. 
  • Based on a 10% growth rate, it would take seven years before earnings added up to the original stock price. 
As you can see, the PEG payback period for any growing company will be shorter than the P/E payback period.

PEG and Payback Periods

If you own a home or a car, you are probably all too familiar with what happens when you take out a loan.

  • A bank lends you a certain amount of money that you must pay back at a specified rate, such as one payment per month for five to 30 years. 
  • In exchange for taking a risk that you won't repay the loan, the bank earns some revenue on top of its investment, based on the interest rate it charges.

 As a shareholder in a company, you're a lot like a bank. 

  • When you buy stock, you're in essence lending a company your money so it can buy what it needs for its business and (hopefully) grow. 
  • You get paid back as the company's earnings grow and its stock appreciates. 

But whereas a bank clearly establishes its profit margin and a timetable for being repaid, shareholders aren't that lucky. (It's a different story for bondholders, who literally loan the company money and do get scheduled interest payments.) 

It is possible, however, to estimate what you may earn on your investment and when you'll earn it by examining a stock's payback period. 

Valuing Stocks - Absolute or Intrinsic Valuation

The two basic method of valuing stocks are;

  • Relative valuation
  • Absolute or Intrinsic valuation
Usually, absolute value is estimated by calculating the present value of the company's future free cash flows (cash flow minus capital spending).

The present value of that future-income stream is the theoretically correct value of the stock.

This method has its own difficulties and is less frequently used, but absolute value deserves a place in every investor's arsenal of valuation tools.

Calculating the absolute value of a stock isn't easy.  It is tough to forecast:
  • how fast a company's free cash flow will grow, 
  • how long they'll grow, and 
  • at what rate they should be discounted back to the present.  

We estimate stocks's absolute values by inputting our estimates of a company's growth rate, profitability, and the efficiency with which it uses its assets into a discounted cash flow model.  The result is an analyst-driven estimate of a stock's fair value in absolute terms.

In an imperfect world, opting for the much easier - if less pure - method of relative valuation often makes sense.  

However, when the companies you are using as your benchmark are themselves mis-priced, relative valuation can lead you astray; without a reliable measurement tool, your measurements will be off.  That last point is crucial.

If the S&P 500, for example, is trading at a P/E ratio that is very high by historical standards, using it as a benchmark can be hazardous.  

A stock can appear much cheaper than the overall market and still be quite expensive in absolute terms.  So what's an investor to do?  

Unfortunately, there aren't any easy answers.  

The best way to approach stock valuation is by using many different methods, the same way you would if you were valuing a used car or a house.

Checking out what similar houses in a neighbourhood have sold for is akin to relative valuation, and walking through a house you're interested in - looking at the construction and quality of materials - is similar to intrinsic valuation.  

A judicious mix of both methods will serve you well.

Valuing Stocks - Relative Valuation

There are two basic methods of valuing stocks:

  • Relative valuation
  • Absolute valuation or Intrinsic Valuation

The most frequently used method is relative valuation, which compares a stock's valuation with those of other stocks or with the company's own historical valuations.  

For example, if you were considering the relative valuation for a chemical company CC, you would compare its stock's price/earnings ratio (or its price/sales ratio, etc.) with that of other chemicals makers or with that of the overall stock market.  

  • If CC has a P/E ratio of 16 and the average for the industry is closer to, say 25, CC's shares are cheap on a relative basis.  
  • You can also compare CC's P/E with the average P/E of an index, such as the S&P 500,  to see whether CC still looked cheap.  

The problem with relative valuations is that not all companies are made alike - not even all chemicals makers.

There could be very good reasons why CC has a lower P/E than its average peer.  

  • Maybe the company doesn't have the growth prospects of other chemicals companies.  
  • Maybe the possible liability from a product litigation rightly puts a damper on the stock's price.  

After all, a Hyundai has a lower sticker price than a Mercedes, but for very good reasons.

The key is to research your stocks well and be aware of the factors that might justifiably make them cheaper or more expensive than similar stocks.

Common Valuation Ratios

Let's look at the ways in which a stock's price compared with the value of the underlying company can be represented.

Valuations are usually expressed as the ratio of a company's share price to an aspect of its financial performance, such as:

  • price/earnings (P/E), 
  • price/sales (P/S), 
  • price/book value (P/B),
  • price/cash flow (P/CF), or 
  • price/estimated growth rate (P/EG)
We know that a stock's value is a combination of the company's present condition and its future prospects, and it is usually measured by a series of ratios.

But how do we decide if that value is too high, too low, or just right?

This is where things can get tricky, because valuing stocks is sometimes more an art than a science.  

That's why it is not uncommon for two analysts to look at the same company and come up with different conclusions.

Valuing Stocks - What Is a Stock's Value?

The value of most stocks is a combination of the current value of the company and the value of the profits it will make in the future.

In general, the more growth the market expects from a company, the more the company's market value will owe to expected future profits.  

Take online bookseller YY, for example.  By most measures, company YY has little or no current value; it has only minuscule book value and is gushing red ink.  Liquidating company YY would leave its investors with zilch.  But the market thinks the company's future profit potential is so bright that it has pinned a multibillion-dollar worth (the company's market capitalization) on the stock.

Another way to think of a stock's value is that a company's stock price consists of a combination of what you are paying for the company's current level of profitability and what you're paying for its earnings growth.

Since company YY is far from profitable then,  the stock price is based almost entirely on expectations of future growth.  That is one reason company YY's stock is so volatile.

As those expectations rise and fall, so does the price of its stock.

In comparison, the stock price of another stock XX largely reflects the company's current value, not its future growth.  Company XX is quite profitable, but no one expects it to grow terribly fast.

Valuing Stocks

Valuing a stock is a lot like buying a car.

There are lots of great cars out there, but the sticker price may be more than the actual worth of the car.   Some manufacturers command a premium price because their cars have a certain cachet, not because their cars are necessarily more reliable or of better quality than others on the market.

It is the same thing with stocks.

Some stocks are valued much more richly than others because they are hot or popular with investors, not because the companies are more profitable or have better growth prospects,

The ability to decide whether a company's stock price accurately reflects its performance is the heart of stock valuation.

The Risks of Debt-Driven Returns on Equity

The three levers of ROE are:
- net profit margin  (achieve through operational efficiency)
- asset turnover (achieve through operational efficiency)
- financial leverage (achieve through employing high debt)

But does it matter if a company's high ROE comes from high debt and not operating efficiency?

If a company has a steady or steadily growing business, it might not matter that much.

For example, companies in the consumer-staples sector, where demand is stable, can handle fairly large debt loads with little problem.  And the judicious use of debt by such companies can be a boon to shareholders, boosting profitability without unduly increasing risk.

If a company's business is cyclical or volatile in some other way, though, watch out.

The problem is that debt comes with fixed costs in the form of interest payments.  The company has to make those interest payments every year, whether business is good or bad.

When a company increases debt, it increases its fixed costs as a percentage of total costs.

In years when business is good, a company with high fixed costs as a percentage of total costs can make for a great profitability because once those costs are covered, any additional sales the company makes fall straight to the bottom line.

When business is bad, however, the fixed costs of debt push earnings even lower.  

That is why debt is sometimes referred to as leverage:  It levers earnings, making strong earnings stronger and weak earnings weaker.

When companies in cyclical or volatile businesses have a lot of leverage, their earnings therefore become even more volatile.  

So the next time you're thinking about profitability, make the distinction between the kind that is internally generated (through operational efficiencies) and the kind that is inflated by debt (through leverage).

You can make a lot of money of stocks of companies structured like the latter, but your return is more assured with stocks of companies like the former.

Financial Leverage - Lever of ROE

The three levers of ROE are net margin, asset turnover and financial leverage.

The third lever of ROE, financial leverage, is a measure of how much debt the company carries.

The way in which raising financial leverage increases ROE is a little less intuitive.

If a company adds debt, its assets increase (because of the cash inflows from the debt issuance) and so does its total debt.

Equity = Assets - Total Liabilities
Assets = Equity + Total Liabilities

Since equity is equal to assets minus total debt, a company can decrease its equity as a percentage of its assets by increasing its debt.

= Net Profit/Revenue  x  Revenue/ Asset   x   Asset/Equity
=  ROA  x  Asset/Equity

In other words, assets - the numerator of the financial leverage figure - increases, so the overall financial leverage number rises, boosting ROE.

Net Margin and Asset Turnover - Levers of ROE

The three levers of ROE are net margin, asset turnovers and financial leverage.

Not all the 3 levers of ROE are made equal.

The first two levers, net margin and asset turnover, are measures of how efficient a company's operations are.

Increasing net margins - which means a company is turning a larger portion of its sales into profits - will increase profitability.  

A high asset turnover, which expresses how many times a company sells, or turns over its assets, in a year is also a sign of efficiency.

The product of net margin and asset turnover is called return on assets, or ROA, and it is an excellent measure of operational profitability.

ROA = Net Profit Margin x Asset Turnover

The higher a company's ROA, the better.

Some companies emphasize high net margins to pump up their ROA; others emphasize rapid turnover.  

For example:

Coca Cola KO
Between 1994 and 1998, Coke's net margins averaged 18%.
Coke was able to leverage its strong brand name into higher prices, resulting in fat net margins.

Cott COTTF, a Canadian produce of discount, non-brand-name soda.
Cotts's average net margin was less than 5%.  
Cott, on the other hand, targeted the low end of the market with bargain prices, earning a slimmer profit margin on each sale but (hopefully) moving a lot more merchandise per unit of assets.

Cott's asset turnover during the same period was 1.7, compared with Coke's 1.1.  But that wasn't nearly enough to offset Coke's much higher net margins, and Coke's ROA of 24% trounced Cott's 4%.  

This is not to say that focusing on asset turnover at the expense of margins is always a bad thing.  

Wal-Mart WMT
Wal-Mart WMT has lower margins than most other major retailers because it emphasizes lower prices.  
But Wal-Mart also generates a higher ROA than most of these competitors because it operates so efficiently that its asset turnover is much higher.

In 1998, for example, Wal-Mart''s asset turnover was 2.8, as opposed to 1.1 for old-line retailer Sears S and 2.0 for rival discounter Dayton-Hudson DH.

Levers of ROE

Return on equity, or ROE, is the most common measure of a company's profitability.

But ROE is itself the product of 3 ratios, or levers:

  • net margin (earnings/revenues, expressed as a percentage),
  • asset turnover (revenues/assets), and,
  • financial leverage (assets/equity).
= Net Profit Margin x Asset Turnover X Financial Leverage
= Net Profit/Revenue  x  Revenue/Total Asset  x   Total Asset/Equity
= Net Profit/Equity

Multiplying the three levers together gives us ROE, and raising any one of these three levers will increase ROE.