Efficiency Ratio: Is Your Bank Profitable?

10 minutes

efficiency ratio

Banks are either hated or loved, depending on when you ask customers. If they’ve been approved for that loan or denied a refund of any fee, you will get different answers. As a value investor, banks and financial institutions can be a frustrating experience to try to value. They don’t fall into the same category that other companies do, so therefore they often get ignored. Today we will continue with our series of looking at the different formulas that can help us unravel the mysteries of these institutions. In this post, we will delve into the efficiency ratio and what it means, and how to calculate it.

“In the end, banking is a very good business unless you do dumb things.”

Warren Buffett

The cool thing about learning to value banks is that once you learn how to analyze one, you pretty much can analyze all of them. There are about 500 banks that trade on the major exchanges, so this should give you plenty of options to choose.

Now, don’t get me wrong they can be very complicated with all the financial instruments, heavy regulations, old account rules, macro factors, and the intentionally vague jargon to try to throw you off.

But at their core, all banks are similar in that they borrow money at one interest rate and then hopefully, lend it out at a higher interest rate, pocketing the spread between the two. Which is the main avenue that banks use to make money.

“You don’t make money on tangible common equity. You make money on the funds that people give you and the difference between the cost of those funds and what you lend them out on.”

Warren Buffett

Definition of Efficiency Ratio

The Efficiency Ratio is calculated by dividing the bank’s Noninterest Expenses by their Net Income.Banks strive for lower Efficiency Ratios since a lower Efficiency Ratio indicates that the bank is earning more than it is spending. … A general rule of thumb is that 50 percent is the maximum optimal Efficiency Ratio

Sageworks

Sounds and looks pretty simple, doesn’t it? And as ratios go it is pretty simple and straightforward.

Continue reading “Efficiency Ratio: Is Your Bank Profitable?”

Breaking Down the Two-Stage Dividend Discount Model for Beginners

11 minutes

two-stage dividend discount model

Dividends are the best friend an investor has. They are the gift that keeps on giving and finding a company that pays them consistently over a long period of time is a great way to build your wealth. Finding the intrinsic value of a dividend paying company is paramount to investing with a margin of safety. This helps protect our investments and grow our wealth. Using the dividend discount model is a great way to find that intrinsic value, and the use of the two-stage dividend discount model is a fantastic way to get a more precise view of that value.

Our goal is to find the approximate value of a company, not to quibble about the minor details, we must remember that valuation is an art. What one investor sees as value, another might see as a liability, it can be seen as in the eye of the beholder.

The dividend discount two-stage model is a little more involved than the Gordon Growth model that we addressed last week, but it is definitely doable on our part. We will walk through all the steps to help you calculate it on your own and give you examples to help illustrate what we are doing.

What’s the big deal with dividends, and why do we keep talking about them?

To give you an example of the power of dividends, let’s take a look at our favorite guru, Warren Buffett. Over the years Buffett has grown his wealth by investing in and buying businesses with strong competitive advantage (moat) that have traded at fair or better prices.)

His favorite company to invest in is one that pays him a dividend. Did you know that:

  • Over 91% of his portfolio is invested in stocks that pay a dividend
  • His top 4 holdings, which make up over half of his holdings pay a dividend yield of 2.9%
  • Best of all, most of his stocks have paid a rising dividend for decades.

Continue reading “Breaking Down the Two-Stage Dividend Discount Model for Beginners”

Dividend Discount Model: A Simple Three Step Guide to Valuation

9 minutes

dividend discount model

In our quest to find the intrinsic value of stocks that we are interested in investing in, we have looked at several different types of formulas to help us determine that value. We haven’t considered the role that dividends play in these valuations, and as dividend investors, this is an important fact to factor in. Today we will discuss the dividend discount model to find the intrinsic value of dividend paying stocks.

Dividends are such an important variable to building our wealth, it is in our best interests to continue to add to our toolbox the different methods of calculating intrinsic value. The dividend discount model is simplicity itself and requires only three inputs to determine the value of a stock.

As we continue to strive to find the fair value of any stock that we wish to purchase, it is important to remember that the calculations that we do should never replace other methods of investigation, such as reading the 10-k, looking into other metrics, and doing our research.

In our efforts to narrow down our investing processes and learn more about different formulas to help us find intrinsic value, it is important to remember that we should try not to go down the rabbit hole in search of minutiae. A thought from Warren Buffett on intrinsic value.

“It’s better to be approximately right, than precisely wrong.”

That being said we should strive to be as accurate as we can, to help narrow down our errors in finding intrinsic value.

Dividend Discount Model Definition

Continue reading “Dividend Discount Model: A Simple Three Step Guide to Valuation”

GameStop: Is this Game Still Worth Playing?

9 minutes

 

GameStop

Recently GameStop (GME) has taken a beating in the market with the release of some very unflattering news. As we all know the stock market is a very unforgiving place.

GameStop came across my radar a few years ago when I was doing my regular screening looking for new opportunities. Until recently I hadn’t pulled the trigger on the company, but after digging into it a little more it appeared to be a great opportunity. In the light of recent news, I am wondering if I made a good decision or walked into a value trap.

I admit I was first attracted to the 6% dividend yield, which was very enticing. In addition to the low P/E ratio, it appeared this was a great opportunity, as well as other financial strengths.

In this article, I will take a look at my findings again and re-evaluate my decision to buy and whether or not to stay in at this point or to sell and just cut my losses.

Retail is a brutal environment and the competition can be fierce. With the recent announcement of Microsoft’s (MSFT) Xbox’s subscription service there has been a lot of concern among GameStop investors in how this will affect the company long-term.

Let’s take a look.

Business Overview

Founded in 1994 in Grapevine, Texas. GameStop operates more than 7600 stores now. These stores are located in the U.S., Australia, Canada, and Europe.

Continue reading “GameStop: Is this Game Still Worth Playing?”

How to Find Wide Investment Moats the Easy Way

13 minutes

 

wide investment moat

Finding a company with a strong competitive advantage like an Apple (AAPL) is what every investor is looking for. It is not easy and there are not a lot of formulas that you can use to find them. We are all on the lookout for companies with wide investment moats. Especially value investors. We love these types of companies. Companies with wide investment moats are likely to be around for a long time, not that they are invincible. But they are great companies for growing wealth over time.

“But all the time, if you’ve got a wonderful castle, there are people out there who are going to try and attack it and take it away from you. And I want a castle that I can understand, but I want a castle with a moat around it.”

Warren Buffett from a talk he gave to MBA students at the University of Florida

What is the definition of an investment moat?

Charlie Munger and Warren Buffett are generally accepted as the originators of the term “moat”.

A moat refers to “business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.”

Investopedia

Competitive advantage is going to be any factor that allows a company to provide a good or service that is essentially the same as it’s competitors. But allowing them to beat their competitors in profits.

An example of this would be if you shop online for a product. Chances are you will see many different companies offering the same product but one stands out because they offer a lower price or perhaps free shipping.

This gives that company a competitive advantage over their competitors because of the free shipping, that the others may not be able or willing to offer.

Continue reading “How to Find Wide Investment Moats the Easy Way”

6 Easy Steps to Discounted Cash Flows for Beginners

13 minutes

 

discounted cash flow

In our search for the best way to evaluate a company, we look at intrinsic value formulas to help us determine a fair price for a company. Using a discounted cash flow evaluation is one of the ways we can do this.

Accounting scandals and manipulations of financial earnings have given a rise to the importance of analyzing free cash flows. These numbers are much more difficult to “fudge” and lead to a truer value of the company.

Use of this formula will also give you much greater insight into the company. You will get a better understanding of its growth in operating earnings, capital efficiency, the capital structure of the balance sheet, the cost of the equity and debt, and the expected length of the growth of the company.

Another advantage is this formula is less likely to manipulated by dishonest  accounting practices

We are going to take a look at this formula today and try to break it down and make it as easy to understand as we can. I am not going to lie to you there will be math involved but it is not difficult math.

In the business of finding the best intrinsic value for a company, we will be required from time to time to utilize math to find that intrinsic value.

So what is a discounted cash flow analysis?

According to Investopedia

“DCF analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is then used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.”

What does all that mean?

Simply to estimate the money you would receive from an investment while adjusting the time value of money.

The reason you do this is the value of the dollar today is not what it will be worth in the future. It could be more or it could be less. So to try to adjust for that we use the discounted cash flow model or formula to help us find the closest intrinsic value we can find.

The discounted cash flow formula is powerful, but it can be flawed. Remember that it is just a mathematical tool to be used to find an intrinsic value.

You should never buy a company based on this value alone.

It is only as good as the information you put into it. As my music teacher used to say to me. “Garbage in, garbage out.” Small changes or errors in our calculations can have a huge impact on our value.This is why we don’t base a buying decision on just one formula. Important though it may be.

Last week we discussed the intrinsic value formula that was created by Benjamin Graham. This was a much easier, simpler way to calculate an intrinsic value of a company. The look at discounted cash flows will give us another tool in our effort to find the most accurate intrinsic value of a company we are looking to buy.

There are many different variations of formulas to arrive at an intrinsic value. The Ben Graham formula is one of them and today’s formula, the discounted cash flow is considered a variation of that effort as well.

These are the two most commonly used formulas, but there are others that we may discuss further down the road.

Ok, let’s start.

6 Steps to Find an Intrinsic Value of a Stock Utilizing a Discounted Cash Flow Formula

There are six steps along this path to find the intrinsic value of a company using the discounted cash flow formula. We will take a look at each one and break them down so you can follow along.

For this example, we are going to use a company that we analyzed last week so we can compare our results later.

Gamestop (GME)

The steps we will use will be as follows.

  1. Locate all the required financial data
  2. Calculate the discount rate and use it to discount the future value of the business
  3. Perform a discounted free cash flow (DCF) analysis
  4. Calculate the company’s net present value (NPV)
  5. Calculate the company’s terminal value (TV)
  6. Combine the net present value and the terminal value and come up with the company’s intrinsic value

Sounds simple huh? It is and you can do this. I will be here to help you along the way.

Step 1: Find all the necessary financial information

Before we dive into this we are going to need to locate all the necessary numbers to fill into our formulas as we go along. And then it’s just a matter of plugging them in.

For our calculations, there are 14 financial figures we are going to need to assemble before we can calculate our intrinsic value.

 

  • Current Share Price: Simple, find the current market price of the company
  • Shares Outstanding: Again, pretty simple. Find the total number of shares that are issued and currently held by the company’s shareholders.
  • Free Cash Flow: This number represents the company’s capacity for generating free cash flow, which can be used for future expansion, paying down debt, and increasing shareholder value with buybacks or dividends.
  • Long-term Growth Rate: the expected rate at which the company will grow
  • Business Tax Rate: the business income tax paid to the government.
  • Business Interest Rate: the effective rate that the company is charged for its loans and any borrowing.
  • Terminal Growth Rate: The rate that the company is expected to grow at after our cash flow projection period. We’ll use the country’s GDP growth rate as the Terminal Growth Rate
  • Market Value of Debt: the total dollar market value of a company’s short-term and long-term debt.
  • Market Value of Equity: otherwise known as the market cap. The total dollar market value of a company’s outstanding shares.
  • Stock Beta: Beta is a measure of how much the price of a company’s stock tends to fluctuate
  • Risk-Free Rate: the minimum rate of return that investors expect to earn from an investment without any risks. We’ll use a return of the 10-year Government Bond as a Risk-Free Rate.
  • Market Risk Premium: the rate of return over the Risk-Free Rate required by investors. For calculating the discount rate, you use the market risk premium data from NYU Stern School of Business.
  • Total Business Debt: total liabilities of the company
  • Total Business Cash: the total cash and cash equivalents of the company.

Step 2: Calculate the Discount Rate (WACC)

This is the most crucial part of our of discounted cash flow analysis. If this point is not done correctly it will throw off the future calculations and lead to an incorrect intrinsic value, which will lead to a possible purchase of an overvalued company. Leading to losses in your investments.

The key to this calculation is not assuming the same discount rate for every stock. You need to calculate the rate for each individual company or you could end up in a world of hurt.

Continue reading “6 Easy Steps to Discounted Cash Flows for Beginners”