When looking at PE ratio, make sure that you look at the historical PE
and make sure
that you don’t buy it at the high. If you do buy it at the high, you
have to be confident
of the company’s outlook. More often than not, it is overestimating
growth prospects.
DISCIPLINE + CONSERVATION in figuring out the prices.
When should you sell?
1) Did you make a mistake
2) Have the fundamentals deteriorated?
3) Have the stock risen too far above its intrinsic value?
4) Is there something you can do better with the money?
5) Do you have too much money in one stock? – Don’t make sense to have
too
much egg in one basket
Chapter 2
7 mistakes:
1. Swinging for the fence
2. Believing that it’s different this time: not knowing market history
is a major
handicap
3. Falling in love with products
4. Panicking when the market is down
5. Trying to time the market: Stock market returns are highly skewed-
bulk of the
returns (positive or negative) from any given year comes from relatively
few
days in that year. This means that the risk of not being in the market
is high for
anyone looking to build wealth over a long period of time.
6. Ignoring valuation: the reason you should buy a stock is that you
think the
business is worth more than it’s selling for- not because you think a
greater
fool will pay more for it down the road. Buying the stock based on the
expectation of positive news flow or strong relative strength is asking
for
trouble.
7. Relying on earnings for the whole story: cash flow not earnings. This
statement of cash flows can yield a ton of insight into the true health
of a
business, and you can spot a lot of blowups before they happen by simply
watching the trend of operating cash flow relative to earnings. Watch
out
operating cash flows stagnate or shrink even as earnings grow, it’s
likely that
something is rotten.
Chapter 3
The bigger the profit, the stronger the competition.
To evaluate moat:
1) evaluate the firm’s historical profitability. Has the firm been able
to
generate a
solid return on its assets and on shareholders’ equity? This is
the true litmus test of whether a firm has built an economic moat around
itself.
a) Does the firm generate FCF? How much? Divide FCF by sales
(revenues), which tell you what proportion of each dollar in revenue
the firm is able to convert into excess profits. If a firm’s FCF as a
percentage of sales is around 5 percent or better, you’ve found a cash
machine - as of mid-2003, only one-half of the S&P 500 pass this
test.
Strong FCF is an excellent sign that
a firm has an economic moat.
b) What are the firm’s net margins? ROE? (Chapter 6)
c) ROA: 6-7%
d) ROIC and estimating a weighted average cost of capital (WACC)
2) If the firm has solid returns on capital and consistent
profitablility, assess
the sources of the firm’s profits. Why is the company able to keep
competitors at bay? What keeps competitors from stealing its profits?
a) We need to determine why a firm has done such a great job of holding
on its profits and keeping the competition at arm length. The strategy
pursued at the company level is even more important. Research shows
that a firm’s strategy is roughly twice as important as a firm’s
industry
when it’s trying to build an economic moat.
b) Key is never stop asking, “why?” why aren’t competitors stealing the
firm’s customers? Why cant a competitor charge a lower price for a
similar product or service? Why do customers accept annual price
increase?
c) Look at it from the customer’s perspective.
5 ways firm can build sustainable competitive advantage:
1. Create real product differentiation through superior technology or
features
2. Creating perceived product differentiation through a trusted brand
or reputation: not enough to look at whether consumers trust the
product or have emotional connection to the brand. The brand has
to justify the cost of creating it by actually making money for the
firm and sustaining a powerful brand usually requires a lot of
expensive advertising.
3. Driving costs down and offering a similar product or service at a
lower price: Low cost works well in commodity industries. Identify
the sources of these cost savings. Create cost advantages by either
inventing a better process or achieving a larger scale. Look at
business model.
4. Locking in customers by creating high switching costs
5. Locking out competitors by creating high barriers to entry or high
barriers to
success: regulatory exclusivity
3) Estimate how long a firm will be able to hold off competitors, which
is the
company’s competitive advantage period: economic moat – width and
depth
4) Analyse the industry’s competitive structure. How do firms in this
industry
compete with one another? Is it an attractive industry with many
profitable
forms or a hypercompetitive one in which participants struggle just to
stay
afloat.
Analysing a company:
Growth: sources and sustainability, sales growth drives earnings growth.
Profit
growth can outpace sales growth for a while if a company can cut costs
or fiddle with
the financial statements. So look at sales growth. To grow sales: Sell
more products,
raise price, sell new goods or services, acquisition( management can use
the fog
created by constant acquisitions to artificially juice results, and this
financial tinkering
can take a long time to come to light because its buried in the
financial rejiggering and
true growth is impossible to figure out because cant determine organic
growth)
Profitability: What kind of a return does the company generate on the
capital it
invests. Look at revenue. Instead of profit. Look at RRP.
Financial health: How solid is the firm’s financial footing
Risks/bear case: Look at full story
Management: Who’s running the show
ROA: Asset turnover, sales divided by assets
Financial leverage: Assets/shareholders’ equity
ROE: net margin x asset turnover x financial leverage
2 caveats:
1) Banks always have enormous financial leverage ratios, so don’t be
scared off by a
leverage ratio that looks high relative to a nonbank. In addition,
because banks’
leverage is always so high, you want to raise the bar for financial
firms-so look for
consistent ROEs above 12% or so.
2) Concerns firm with ROEs that look too good to be true, >40% is a
no no. Firms
that have been recently spun off from parent firms, companies that have
bought back
many of their shares, and co that have taken massive charges often have
very skewed
ROEs because their equity base is depressed.
FCF: any firm that’s able to convert more than 5% of sales to FCF-just
divide FCF by
sales to get
this percentage- is doing a solid job at generating excess cash.
Putting ROE and FCF together:
One good way to think about the returns a company is generating is to
use the
profitability matrix, which looks at a company’s ROE relative to the
amount of FCF it
is generating. High ROE+ High FCF
ROIC: puts debt and equity financing on an equal footing: removes the
debt related
distortion that can make highly leveraged companies look very profitable
when using
ROE. ROIC uses operating profits after taxes, but before interest
expenses. Again, the
goal is to remove any effects caused by a company’s financing
decisions-does it use
debt or equity?-so that we can focus as closely as possible on the
profitability of the
core business.
ROIC= net profit after taxes/ invested capital
Invested capital= total assets-non interest bearing current liabilities
(usually account
payable, accrued liabilities and other current liabilities)-excess cash
(and maybe
goodwill if it is a large portion)
Financial leverage of 4,5 is risky.
For every $ of equity, there is $4/5 worth of assets. Means borrow $3/4.
After assessing growth, profitability and financial health, your next
task is to look at
the bear case for the stock you’re analysing. List the potential
negatives so that you
will have the confidence to hang on to the stock during a temporary
rough patch as
well as the savvy to know when the rough patch might really be a serious
turn for the
worse.
Look at the customers of the business as well.
Chapter 7: Management – 3 parts: compensation, character and operations.
Compensation: bulk of information is found in proxy statement. First
look at how
much management pay itself. See if bonus driven, raw level of cash
compensation to
see if it’s reasonable. $8m cash bonus is silly no matter what. Also,
look at competing
firms to see what their CEOs are paid.
Other red flags
Were executives given ‘loans’ that were subsequently forgiven? (loans of
this sort are
usually disclosed in the ‘other compensation’ column of the executive
compensation
table in the footnotes.)
Do executives get perks paid for by the company that they should really
be paying for
themselves?
Does management hog most of the stock options granted in a given year,
or do rank
and file employees share in the wealth? Generally, firms with more
equitable
distribution schemes perform better over the long run. Most firms break
out the
percentage of options granted to executives relative to the total
granted in the proxy
statement.
Does management use stock options excessively? Even if they are
distributed beyond
the executive suite, giving out too many options dilutes existing
shareholders’ equity.
If a company gives out more than 1 or 2 percent of the outstanding
shares each year,
they are giving away too much. Better if firm issues restricted stock
instead of
options. Restricted stock has to be counted as an expense on the income
statement
(options don’t, as of this writing), and restricted stock also forces
the recipient to
participate on the downside if the stock falls.
If a founder or large owner is still involved in the company, does he or
she also get a
big stock option grant each year?
Do executives have some skin in the game? Do they have substantial
holdings of
company stock or do they tend to sell shares right after they exercise
options? Large
unexercised option positions are cold comfort. You can find this
information in the
footnotes of the proxy. Companies indicate executives percentage
ownership
including options prominently in a table labeled ‘security ownership of
certain
beneficial owners’, but they declare only how many actual shares are
owned in the
footnotes.
Does management use its position to enrich friends and relatives?
Look for a section called ‘related-party transactions’. Does it pay
money to family
members’ business.
Is the board of directors stacked with management’s family members or
former
managers?
Is management candid about its mistake?
How promotional is management? Care about stock price or company?
Can CEO retain high-quality talent? How often do officers turn over?
Does management make tough decisions that hurt results but give a more
honest
picture of the company? Management teams that use restricted stock
grants instead of
options-because the former has to be expensed, while the latter
doesn’t-or who
expense rather than capitalize items such as research and development or
software
costs are the kind of folks who are more interested in running the
business than
playing number games. Those are the people that you want.
Running the
business
Dig out past M&A activity. Look at the share count over a long
period of time. If the
number of shares outstanding has increased substantially because of
aggressive
operations programs or frequent equity issuance, the firm is essentially
giving away
part of your stake without asking you.
Follow-through: does it implement the plan?
Candor
Self confidence: do something different from their peers or from
conventional
opinion.
Flexibility: has management made decisions that will give the firm
flexibility in the
future? Like not taking on too much debt and controlling fixed expenses
(even in
good years), as well as issuing equity when the stock is high. Attaching
call options to
debt, retiring high rate debt when the opportunity presents itself, and
buy back stock
at low prices.
6 red flags
1) Declining cash flow: if cash from operations decline even as net
income keeps
marching upwards or if cash from operations increase much more slowly
than
net income. AR increased to a large percentage of sales. Inventories
increase
2) Serial chargers: frequent chargers are an open invitation to
accounting hanky
panky because forms can bury bad decisions in a single restructuring
charge.
Poor decisions that might need to be paid for in future quarters all get
rolled
into a single one-time charge in the current quarter, which improves
future
result.
3) Serial acquirers: acquisitive firms don’t spend as much time checking
out their
targets as they should.
4) CFO or auditors leave the company: If a company fires its auditors
after some
potentially damaging accounting issue has come to light, watch out.
5) The bills aren’t being paid:
One way to pump up its growth rate is to loosen
customers’ credit terms, which induces them to buy more products or
services.
If they don’t get paid, it will come back to haunt them in the form of a
nasty
write-down or charge against earnings. Track how A/R are increasing
relative
to sales. On the credit front, watch the ‘allowance for doubtful
accounts’. If
the amount doesn’t move up in sync with A/R, the company may be
artificially boosting its results by being overly optimistic about how
many of
its new customers will pay its bill.
6) Changes in credit terms and account receivable: Check the company’s
10-Q
filing for any mentions of changes in credit terms for customers, as
well as for
any explanation by management as to why A/R has jumped. ( Look in the
management’s discussion and analysis section for the latter and in the
accounting footnotes for the former.)
7) Gains from investments: an honest company breaks out these sales,
however,
and reports them below the ‘operating income’ line on its income statement.
The problem
arises when companies try to boost their operating results-
performance of their core business-by shoehorning investment income into
other parts of their financial statements. Finally, companies can hide
investment gains in their expense accounts by using them to reduce
operating
expenses, which makes the firm look more efficient than it really is.
8) Pension pitfalls: If assets in the pension plan don’t increase
quickly enough,
the firm has to divert profits to prop up the pension. To fund pension
payments
to future retirees, companies shovel money into pension plans that then
are
invested in stocks, bonds, real estate, and so forth. If a company winds
up with
fewer pension assets than pension liabilities, it has an underfunded
plan, and if
the company has more than enough pension assets to meet its projected
obligations to retirees, it has an overfunded plan. To see whether the
company
has an over-or underfunded pension plan, go to the footnotes of a 10-K
filling
and look for the note labeled ‘pension and other postretirement
benefits’,
‘employee retirement benefits’, or some variation. Then look at the line
labeled ‘projected benefit obligation.’ This is the estimated amount the
company will owe to employees after they retire.
Second key number is ‘fair value of plan assets at the end of year’. If
the
benefit obligation exceeds the plan assets, the company has an
underfunded
pension plan and is likely to have shovel in more money in future,
reducing
profits.
Pension padding: When stocks and bonds do really well, pension plans go
gangbusters. And if those annual returns exceed the annual pension
costs, the
excess can be profits. Flowing gains from an overfunded pension plan
through
the income statement is a perfectly legal practice that pumped up
earnings at
GE. You should subtract it from net income when trying to figure out
just how
profitable a company really is.
To find out how much profits decreased because of pension costs or
increased
because of pension gains, go to the line in the pension footnote labeled
either
‘net pension/postretirement expense’, ‘net pension credit/loss’.
Companies
usually break out the contribution of pension costs to profits for the
trailing
three years; therefore, you can see not only the absolute level of
pension profit
or loss, but also the trend. Won’t see these numbers in the income
statement.
9) Vanishing cash flow: you can’t count on cash flow generated by
employees
exercising options. The amount is
labeled ‘tax benefits from employee stock
plan’ or ‘tax benefits of stock options exercised’ on the statement of
cash
flows. When employees exercise their stock options, the amount of cash
taxes
their employer has to pay declines. If the stock price takes a tumble,
many
people’s options will be worthless and, consequently, fewer options will
be
exercised. Fewer options are now exercised, the company’s tax deduction
gets
smaller, and it has to pay more taxes than before, which means lower
cash
flow. If you are analyzing a company with great cash flow that also has
a high
flying stock, check to see how much of that cash flow growth is coming
from
options-related tax benefits.
10)
Overstuffed Warehouses
When inventories rise faster than sales, there is likely to be trouble
on the horizon.
Sometimes buildup is just temporary as a company prepares for a new
product launch,
usually exception.
11) Change is bad: another way firm can make themselves look better is
by changing
any one of a number of assumptions in their financial statements. Look
skeptically on
any optional change that improve results. One item that can be altered
is depreciation
expense (see if extend depreciation period). Firms can also change their
allowance for
doubtful accounts. If it doesn’t increase at the same rate as accounts
receivable, a firm
is essentially saying that its new customers are much more creditworthy
than the
previous ones-which is pretty much unlikely. If the allowance declines
as AR rises,
the company is stretching the truth even further. Current results are
overstated. Firms
can also change things as basic as how expenses are recorded and when
revenue is
recognized.
12) To expense or not to expense
Company can fiddle with their costs by capitalizing them. Any time you
see expenses
being capitalized, ask some hard questions about just how long that
‘asset’ will
generate an economic benefit.
Valuation- The basic
Stock market returns come from two key components: investment returns
and
speculative returns. Investment returns is the appreciation of a stock
because of its
dividend yield and subsequent earnings growth, whereas speculative
return comes
from the impact of changes in the PE ratio.
Using Price Multiples wisely
Price to sales: current price of the stock divided by sales per share.
Price-to-sales is
used for spotting recovery situations or for double checking that a
company's growth
has not become overvalued. It comes in handy when a company begins to
suffer
losses and, as a result, has no earnings (and no PE) with which
investors can assess
the shares. Retailers, which typically have very low net margins, tend
to have very
low P/S ratios.
Price to book: stock market value vs equity value. For service firms,
P/B has little
meaning. Also can lead you astray for a manufacturing firm such as 3M,
which
derives value from its brand name and innovative products. Another item
to be wary
of is goodwill, which can inflate book value to the point that even the
most expensive
firm looks like a value. Be highly skeptical of firms for which goodwill
makes up a
sizable portion of their book value, The P/B may be low, but the bulk of
the B could
disappear in a hurry if the firm declares the goodwill as
‘impaired’(firm admits that it
grossly
overpaid for a past acquisition) and writes down its value. PB is also tied to
ROE in the same way PS is tied to net margin. Higher ROE will have a
higher P/B
ratio. P/B is very good for valuing financial services firms because
most financial
firms have considerable liquid assets on their balance sheets. Financial
firms trading
below book value, investigate just how solid that book value is before investing.
PE ratio: A firm that is expected to grow quickly will likely have a
larger stream of
future cash flows than one that is growing slowly, so it’s rational to
pay more for the
shares (thus, higher PE ratio). On the flip side, a firm that is riskier
has a good chance
of having lower future cash flows than we originally expected, so it’s
rational to pay
less for the stock.
Has the firm sold a business or an asset recently? If the firm
has recently sold off a
business or perhaps a stake in another firm, it’s going to have an
artificially inflated E,
and thus a lower P/E. You need to strip out the proceeds from the sale
before
calculating the P/E.
Has the firm taken a big charge recently? If the firm
is restructuring or closing down
plants, earnings could be artificially depressed, which would push the
P/E up. For
valuation purposes, it is useful to add back the charge to get a sense
of the firm’s
normalized P/E.
Is the firm cyclical? Calculate a PE based on the
current price relative to what you
think earnings per share will be at the next peak.
Does the firm capitalize or expense its cash flow generating assets? Firms that
expenses assets (R&D) will have lower earnings and thus higher PE in
any given year
than a firm that capitalizes assets.
Is the E real or imagined? Forward PE is almost always lower
than the trailing PE
because most companies are increasing earnings from year to year. Cannot
count on
that.
PEG
Don’t just look at the lower PEG ratio. Look at the capital that needs
to be invested to
generate the expected growth, as well as the likelihood that those
expectations will
actually materialize.
Say yes to yield
Earnings yield- used to compare with bonds.
Cash return- more useful than PE. Divide FCF by enterprise value.
(Enterprise value
is simply a stock’s market capitalization plus its long term debt minus
its cash). The
goal of the cash return is to measure how efficiently the business is
using its capital-
both equity and debt-to generate cash flow. Essentially, cash returns
tell you how
much FCF a company generates as a percentage of how much it would cost
an
investor to buy the whole shebang, including debt burden. Cash return is
a great first
step to
finding cash cows trading at reasonable prices, but don’t use cash returns for
financial or foreign stocks. Not meaningful for banks and other firms
that earn money
via BS.
Intrinsic value
As interest rates increase, so will discount rates. As a firm’s risk
level increases, so
will its discount rate. Risk increase, discount rate will increase too.
Some factors that should be taken into account when estimating discount
rates.
Size
Smaller firms are riskier than larger firms.
Financial leverage
More debts are generally riskier than firms with less debt.
Cyclicality
Tougher to forecast and level of risk increases.
Management/corporate governance
How much do you trust management?
Economic Moat
The wider the moat, the more likely it will be able to jeep competitors
at bay and
generate a reliable stream of cash flows.
Complexity
More riskier companies higher discount rate. (13-15)
Perpetuity values
We need perpetuity value because it’s not feasible to project a
company’s future cash
flow out to infinity , year by year, and because companies have
theoretically infinite
lives.
The most common way to calculate a perpetuity is to take the last cash
flow (CF) that
you estimate, increase it by the rate at which you expect cash flows to
grow over the
very long term (g), and divide the result by the discount rate (R) minus
the expected
long term growth rate.
CF (1+g)
(R-g)
After that discount it to PV. Then add this discounted perpetuity value
to the
discounted value of our estimated cash flows in years 1 through 10 to
find total equity
value, and divide by the number of shares outstanding.
MOS
Say Clorox is worth $54, and the stock is trading at $45. If we buy the
stock and
we’re exactly right about our analysis, the return we receive should be
the difference
between $45 and $54 (20%) plus the discount rate of about 9%. That would
be 29%,
which is darn good return. If you are not confident about a business,
have a large
margin of safety before buying the shares. Great businesses are worth
buying at
smaller
discounts to fair value
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