Return on Assets: How to Find Banks that Generate Profits

7 minutes

 

return on assets

How do normal investors like you and I invest in a bank? According to Warren Buffett, the answer is pretty simple. Look to the bank’s return on assets or ROA.

“Well, a bank that earns 1.3% or 1.4% on assets is going to end up selling above tangible book value. If it’s earning 0.6% or 0.5% on the asset, it’s not going to sell. Book value is not key to valuing banks. Earnings are key to valuing banks. Now, it translates to book value to some extent because you’re required to hold a certain amount of tangible equity compared to the assets you have. But you’ve got banks like Wells Fargo and USB that earn very high returns on assets, and they at a good price to tangible book. You’ve got other banks … that are earning lower returns on tangible assets, and they’re going to sell — they’re going to sell [for less].”

Warren Buffett

The attraction of return on assets is its simplicity. It captures so much of the essence of a bank, without getting caught up in the complexity of the big bank accounting mess.

In our continuing series of discovering the formulas and ideas to value a bank or financial institution, we will discuss the return on assets or ROA.

Definition of Return on Assets

So what is a return on assets?

According to Investopedia.

“Return on assets (ROA) is an indicator of how profitable a company is about its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings.”

This term is often referred to as return on investments or ROI.

Continue reading “Return on Assets: How to Find Banks that Generate Profits”

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.

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Owner Earnings: One of Warren Buffet’s Favorite Formulas

10 minutes

owner earnings

Earnings season is upon us, as Wall Street chooses which companies to reward for a good quarter or punish for a bad quarter. Wall Streets obsession with earnings happens every quarter, the give and tug of who is rising versus the fallen. As value investors we don’t necessarily play this game, we are much more interested in the long-term outlook, as opposed to the short-term focus of earnings season. Warren Buffett eschews this mania, and instead, he focuses on what he calls “owners earnings.” These earnings to him are a better representation of the true earnings of a company.

This short-term focus that Wall Street has can cause a stock to rise or fall quite quickly, sometimes in the same day. As the bears and bulls of each side of the trade rush in and out to try to get a better position. This volatility can be maddening, and certainly, test the will of many people.

Buffett rises above this madness and instead chooses to hold a long-term approach that focuses more on the fundamentals of the business as opposed to the short-term earnings of one single quarter. These earnings that everyone places so much focus on can, and have been manipulated before, sometimes to great effect.

Many investors have been blindsided by this manipulation and have lost a ton of money because of the greed and deceitfulness of others. One way to avoid this is to do your research, and another is to adopt a long-term view that focuses on the fundamentals of the business and to see that they are doing the right things to grow the business.

What are Owners Earnings?

In the 1986 Berkshire Annual Shareholder Letter Buffett outlined his thoughts on owners earnings.

“If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c). However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)” 

Hubba, what? That was a mouthful, wasn’t it? Ok, let’s break this down a little bit. I liken it to eating a pizza, you can’t eat it all at once, as much as you would like, but eating it one piece at a time –

Owners Earnings = Continue reading “Owner Earnings: One of Warren Buffet’s Favorite Formulas”

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

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Return on Invested Capital in Two Easy Steps

12 minutes

Warren Buffett

“A truly great business must have an enduring “moat” that protects excellent returns on invested capital.”

Warren Buffett, 2007 Shareholder Letter

Return on invested capital is one of the best ways to calculate whether or not a company has a moat. Finding a company with a moat that gets a great return on its invested capital makes investing easy, not that this is an easy thing to find. The reason this makes it easy is the company can grow their value over the years and you can compound along with it. Helping grow your wealth as they continue to add assets and grow their business.

The trick to finding a company that is a great allocator of capital is finding a company that has had success in the past getting a great return on invested capital. The higher the percentage the better allocators they are.

Today we are going to look further into return on invested capital. We will take a look at what it means and how to calculate it, along with examples for you to follow along.

Let’s dive in.

Definition of Return on Invested Capital

What is a return on invested capital?

“Return on invested capital (ROIC) is a profitability ratio. It measures the return that an investment generates for those who have provided capital, i.e. bondholders and stockholders. ROIC tells us how good a company is at turning capital into profits.”

Investinganswers.com

“We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year.”

-Charlie Munger2008 Berkshire Hathaway Annual Meeting

Another great thought from Charlie. I love this explanation and this is a great idea to strive for, finding a business that is conservatively financed that can write us a check every year. Better yet, would be a company that in addition to giving us a dividend would be fantastic compounders.

Continue reading “Return on Invested Capital in Two Easy Steps”

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”

Intrinsic Value Formula for Beginners

14 minutes

 

Stock Market

“The newer approach to security analysis attempts to value a common stock independently of its market price. If the value found is substantially above or below the current price, the analyst concludes that the issue should be bought or disposed of. This independent value has a variety of names, the most familiar of which is “intrinsic value”.

– Ben Graham, Security Analysis (1951 Edition)

Trying to determine the intrinsic value of a stock, car, home and iphone is an art form. There is no specific formula that can help you find the actual value of an item that does not have any error in it. There are many different formulas that can be used to determine the intrinsic value. But, unfortunately, there is no spreadsheet that you can plug numbers into that will give you that hard fast, rigid price.

Definition of Intrinsic Value

“A general definition of intrinsic value would be that value which is justified by the facts—e.g. assets, earnings, dividends, definite prospects. In the usual case, the most important single factor determining value is now held to be the indicated average future earning power. The intrinsic value would then be found by first estimating this earning power, and then multiplying that estimate by an appropriate ‘capitalization factor’”.

Ben Graham, Security Analysis

Or this from Joel Greenblatt,

“Value investing is figuring out what something is worth and paying a lot less for it.”

Finally this from Investopedia.

“The intrinsic value is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value. Additionally, intrinsic value is primarily used in options pricing to indicate the amount an option is in the money.”

All of these definitions say it pretty well. Intrinsic value is used for many things. It is mostly associated with buying stocks but it can be used for just about anything. Cars, homes, iphones, a loaf of bread. You get the idea.

Value investors use this theory and formulas to determine what the value of a company is. They use it to help find out what price they need to pay to achieve a margin of safety.

Notice that I haven’t mentioned price much? This is because intrinsic value focuses on what a company is worth, not how much it is trading for on the stock market. Price does not equal value.

“Price is what you pay, value is what you get.”

Warren Buffett

This is the first line in the value investing manual. Well, maybe not. But it should be. Price is a function of the vagaries of the stock market. Mr. Market has a field day with the price.

Value is something much more valuable than the price you pay for something. Can you put a price on your home? No, but you can put a value on it.

In the stock market world finding the intrinsic value is of utmost importance. This gives us the ability to determine a margin of safety. Which is critical to determining whether or not this is a company we want to invest in.

Why does intrinsic value matter?

In a broad sense using an intrinsic value formula to calculate that value gives you the opportunity to decide whether or not to buy or sell a company.

Continue reading “Intrinsic Value Formula for Beginners”