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”

Who is Mr Market and why do we care?

9 minutes

 

Mr. Market

The stock market goes up and down every day. If you watch one of your stocks on a daily basis you could see it rise and fall even on the same day. It can be kind of maddening and extremely frustrating.

One of the questions that investors ask is why does the market behave this way? Frankly, there is no easy answer and there are lots of speculations about the real reason.

Stock prices can change daily as a result of market forces. This means that the prices rises and falls due to supply and demand. If more people want to buy or demand than sell it or supply. Then the price goes up. On the flip side if more people want to sell the stock than buying, then there would be a great supply than demand and the price would fall.

Now if only it were that easy, let me assure you it is not.

Who is Mr. Market?

Mr. Market is a creation of Benjamin Graham that he used to explain the vagaries of the stock market.

Benjamin Graham is considered the father of value investing and was a huge influence on Warren Buffett. In 1949 Graham wrote a hugely influential book titled “The Intelligent Investor”. This book is considered by most to be the biggest influence on investing out there.

In this seminal work, he included his character, Mr. Market.

So what does Mr. Market do?

Every day he shows up at your door offering to buy and sell his shares at a different price. Sometimes, the price quoted by Mr. Market seems reasonable, but most times it is ridiculous. The investor is free to agree with the quoted price and do a trade with him. Or to ignore him completely. Mr. Market doesn’t mind either way and tomorrow he will be back to quote another price.

Sounds simple, huh.

Let’s look at an excerpt from The Intelligent Investor, Revised Edition 2005, pages 204-5.

“Imagine that in some private business you own a share that costs you $1,000. One of your partner’s, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest on that basis. Sometimes his idea of value seems plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

“If you are a prudent investor or sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you would be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position. Continue reading “Who is Mr Market and why do we care?”

Value Investing: The Art of Buying Undervalued Companies

11 minutes

 

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

Warren Buffett

In this simple saying, Warren Buffett, arguably the greatest investor of our generation has summed up what value investing is. It is the search for companies that are selling below their intrinsic value, with the hope that we can buy them at a discount and that their price will rise over time.

Value investing, unlike some other investing strategies is fairly simple. It doesn’t require that you have an extensive background in finance. Certainly, understanding the basics of finance will help, but you don’t need to go to Harvard to follow this strategy.

It also doesn’t require an expensive subscription to terminals to help you find companies or how to read very extensive charts. There is also little need for math, but some is required.

The main ingredients needed are patience, common sense, money to invest and the willingness to do some reading and accounting then you have what it takes to become a value investor.

Five Fundamental Concepts of Value Investing

Value Investing Fundamental No. 1 – All companies have intrinsic value. This is what gets most people about value investing. The basic concept is so simple that you probably do it on a daily basis already. The idea is that if you already know the true value of something then you will save a ton of money by buying it when it is on sale.

Let’s use an example to illustrate. Most people would agree that whether you buy a new cell phone when it’s on sale or when it’s at full price, you’re getting the same cell phone with the same screen size and same memory. The obvious assumption that we have to make is that the value of the cell phone will not depreciate with time as new technology becomes available.  

Stocks are the same way, the company’s stock price can change even though it’s intrinsic value has stayed the same. Stocks, like cell phones, go through periods of higher or lower demand. These fluctuations change the price but they don’t change what you are getting.

Most savvy shoppers would say that it is crazy to buy a cell phone at full price when you can buy them on sale many times throughout the year, particularly during the holidays. Stocks work the same way. The only difference is that unlike cell phones, there is no predictable time of the year that stocks will go on sale, such as a Black Friday event. Which is unfortunate. Also, their prices won’t be advertised in a daily mailing like Target. Also unfortunate.

If they did know about the sale price it would create more demand and drive up the price, which means they wouldn’t be a bargain for us to take advantage of.

The trick with value investing, if you are willing to do a little sleuthing work to find these secret sales, you can get stocks at a discount that other investors would be oblivious to.

Continue reading “Value Investing: The Art of Buying Undervalued Companies”

Superinvestors of Graham and Doddsville: What We Learned

13 minutes


picture courtesy of ruleoneinvesting.com

“While they differ greatly in style, these investors are, mentally, always buying the business, not the stock. A few of them sometimes buy whole businesses, far more often they simply buy small pieces of the business.”  

        Warren Buffett, Superinvestors of Graham and Doddsville

In May 1984, Buffett laid out his thoughts on everything you need to know about his investing philosophy.

In a speech at Columbia Business School, which was later adapted into an essay. Buffett introduced what he termed “The Superinvestors of Graham and Doddsville.”

The “Superinvestors of Graham and Doddsville” is a name that Buffett gave to Benjamin Graham and a group of his proteges. The group of money managers once studied under or worked for Graham, Buffett or Munger, Buffett’s partner at Berkshire Hathaway. We will talk about each of them more in depth coming up.

The speech was given in honor of the 50th anniversary of “Security Analysis” which was written by Benjamin Graham and David Dodd. The book was published in 1934 and was the seminal book on analysis business using financial fundamentals that were outlined by Graham and Dodd.

Warren Buffett is arguably the world’s great investor, there have been many books, essays, and papers written on his greatness. I am not smart enough or eloquent enough to improve on them but I will touch on his beginnings for a moment.

Although Buffett’s father was a stock broker he didn’t have his a-ha moment until he read another very famous Graham book “The Intelligent Investor”. It caused Buffett to apply to the Columbia School of Business to study with Graham. To this day, Buffett credits that book with changing his professional life and Warren believes that most of what everybody needs to know about investing come from two chapters in the book.

The chapter on Mr. Market, which outlines behavioral finance concepts before the term even existed. And the chapter on Margin of Safety.

Breakdown of the speech

At the start of the speech he asks the question “is the Graham and Dodd look for values with a significant margin of safety relative to prices approach to security analysis out of date?”

He then touches on the theory of Efficient Market Hypothesis, which states that the market is efficient in how it prices each and every stock in the market. Meaning that the market is taking into account everything that is known about the company’s prospects and the state of the economy in the price of each stock.

The hypothesis states there are no undervalued stocks because there are smart security analysts who utilize all available information to ensure unfailingly accurate pricing.  

He thinks that this is bunk!

Continue reading “Superinvestors of Graham and Doddsville: What We Learned”

Value Investing Advice from the Dhando Investor

12 minutes

51gn-ygw5ol-_sx330_bo1204203200_The Dhando Investor, the low-risk value method to high returns is a wonderful book written by hedge fund manager Monish Pabrai. In it, he gives a comprehensive value investing framework for the individual investor.

The book is written in a straightforward style that is easy to read and comprehend. The Dhando Investor lays out the amazingly powerful value investing framework. Written with the intelligent individual investor in mind.

The Dhando method expands on the value investing principles expounded by Benjamin Graham, Warren Buffett, and Charlie Munger. In this book, we will come across phrases like “Heads I Win! Tails, I don’t lose much”, “Few bets, Big bets, Infrequent bet.”

Other concepts discussed are Abhimanyu’s dilemma, a detailed breakdown of the Kelly formula to invest in undervalued stocks.

So who is Monish Pabrai? I can hear you asking who is this guy and why are we talking about his book?

Let’s dig in a little and learn more about Monish.

Monish was born in 1964 in Mumbai, India and he moved to the US in 1983 to study at Clemson University. After graduation, he worked in the tech world until branching out on his own.

He started his own tech company with $30,000 from his 401k and $70,000 in credit card debt. In 2000 he sold the company for $20 million.

In 1999 he started Pabrai Investment Funds, that he still runs today. Since the fund’s inception, he has generated net returns of 517% versus the 43% return of the S&P 500 for the same time period. We are talking 16 years that he has made these returns.

His focus is long-only equities that are deeply distressed. He looks for two to three ideas a year, which he feels is enough. His portfolio is highly concentrated in that he generally only holds 10-20 stocks at one time. Currently, he has seven positions.

Buying and holding are only part of his strategy, he also looks very closely at his mistakes as well. Investing is a field where mistakes can be very costly and they must be looked into. He is unusual in that he doesn’t gloss over mistakes but rather spends time breaking down what happened so he can learn from the mistake. So he doesn’t repeat it in the future.

He uses a checklist of what not to do in the markets. Pabrai built this list by analyzing investors that he admires and deconstructing their mistakes. As a result, he ended up with hundreds of checkboxes on his investing checklist. This is not his exact checklist but rather an outline of his checklist and how he things about constructing his. He feels that each individual investor should come up with their own checklist as they learn more about investing.

Monish Pabrai’s primary source of investment ideas come from the 13F SEC filings from other value investment managers that he admires. 13F SEC filings are a quarterly filing required of all institutional investment managers with over $100 million in assets. In this filing, they will list all the current holdings for each fund. It will also list the prices purchased or sold as well.

This is a great source of investing ideas and is a whole investment strategy in and of itself. We will dig into this topic in a future post.

Continue reading “Value Investing Advice from the Dhando Investor”