Return on Equity: Quick and Easy Way to Find Asset Creators

10 minutes

return on equity

In his 1978 Berkshire Hathaway Letter to Shareholders, Warren Buffett stated.

“We believe a more appropriate measure of managerial economic performance to be return on equity capital.”

Measuring the performance of management of a business is a tricky proposition as there are no direct ways to measure it. We have the overall performance of the business, of course. Additionally, we can look to return on invested capital, growth in sales or earnings, or overall business health.

With a return on equity, we have a metric that can help us measure a management’s ability to generate profits from every dollar of shareholder’s equity. After all, creating wealth from the money we invest in a company is what we are all after. We want great businesses that compound our money to generate greater returns.

This formula is great for comparing businesses in related fields, i.e. retail, tech, oil, biotech, etc. One word of caution, this formula is not perfect. There are problems with it, and we need to be aware of those when we are using these numbers to value a company.

Continue reading “Return on Equity: Quick and Easy Way to Find Asset Creators”

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”

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”

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?”

403b: 9 Benefits that Can Help Your Retirement Savings Grow

9 minutes

photo courtesy of borderlessreviewsandnews.com

What is a 403b?

A 403b plan is a retirement plan for certain public school individuals, employees of tax-exempt organizations, and ministers. Individual 403b accounts are set up by employees and managed by eligible employees.

While not as prominent as the better-known 401k, the 403b retirement framework is often used by schools systems, churches, hospitals and may other types of organizations.

The structure of the 403b is as follows.

An individual account within the 403b typically takes the form of a Tax Sheltered Annuity. This is an annuity contract offered by an insurance company. In exchange for a premium, which can be paid in a lump sum or a series of payments. The insurance company agrees to make fixed or variable payments beginning at a future date. This can be either for a specific term or for the rest of your life.

Like a pension, your contributions and your contract’s earnings from investments can consider building up your retirement income stream.

A 403b can also be structured as a custodial account that can invest in mutual funds.

Some 403b plans which are specific to churches can take the form of an account that invests in either mutual funds or annuity contracts.

You can’t contribute directly to your 403b plan. What they do instead is per your salary-reduction agreement they withhold a predetermined amount from your paycheck. This is known as an “elective deferral”. These elective deferrals are exempt from income tax, although you are still responsible for Medicare and Social Security tax on these contributions.

Plan earnings are also exempt from income tax until the participant withdraws them. This is one of the big benefits of the 403b plan and the tax-deferred annuity structure.

One thing to keep in mind is that some plans don’t allow for after-tax elective deferrals. In these cases, the deferral amounts aren’t deductible on your tax returns. Of course.

On top of elective deferrals, your employer can contribute directly to your plan via “non-elective contributions”. Current regulations allow your account to be funded through a combination of elective deferrals and employer contributions.

So how much can I contribute to my 403b?

Continue reading “403b: 9 Benefits that Can Help Your Retirement Savings Grow”

Tools That I Use to Be a Better Investor

6 minutes

 

Photo courtesy of engineerblogs.org

This is a list of the different tools that I use to help me find the stocks that I investigate, track, and purchase. It is an ongoing list and I discover new tools all the time. Please check back from time to time to see what may have changed. I will update as I discover new things. This is the fun part as we discover more ways to learn about stocks and how to invest. It is never over, the learning. 

Stock Screeners:

FINVIZ

This is hands down my favorite screener. It is super easy to use and has great information on all sorts of financial data. It is sortable by rows and you can edit out the data you don’t want. It does have a premium edition that enables you to export your picks into an excel spreadsheet.

One of the things I like about this particular screener is that you can sort by all the financial data I am looking for to weed out the stocks I won’t be interested in. For the value investing metrics that I look for it gives me great flexibility to edit those metrics out to help narrow down the choices.

It also has links to different news sources relating to the particular company you are investigating. Another perk of this site is that if you are looking for in-depth info on a company and need the data quickly it is easy to search for that data on their site.

One last perk, it is free!

GOOGLE FINANCE

This is another great screener that I will use to get additional ideas. I came across this website in general thru Preston & Stig from The Investors Podcast. They use this site for their stock screener. They send out a checklist for signing up for their newsletters that have some great ratios for you to screen for.

One of the things that I like about the Google screener is not only the ability to screen for stocks but also the ability to check on all the news in the financial world.

An additional plus is you can download the app as well so you can access all of these features from your smartphone as well.

Also free.

FINANCIAL DATA:

Morningstar

This is one of the best sites to gather financial data on any company that you are interested in. It has ten years of data, which can be difficult to find on many sites.

Continue reading “Tools That I Use to Be a Better Investor”

Microsoft, Would I buy it again?

14 minutes

 

Microsoft, one of the largest, best-known tech companies out there. They are an interesting mix of trendy and hip. Or old-school tech with their previous reliance on arguably out-dated tech, laptop computers and Windows operating systems. With the advent of cloud computing and data storage, they have recently soared back into our collective conscience with their success in this field.

This company was the first stock I ever purchased so it has a soft spot in my heart. And always will. I have never sold that original purchase and have made additional ones since. I would like to take some time to look at why I bought this stock back then and what I think of the purchase now based on my evaluation of today’s company. Would I have bought it back then knowing what I know now?

Let’s take a look and see.

Business Overview

Microsoft was founded in 1975, and they operate in 190 countries around the world. Microsoft(MSFT) is a technology company “whose mission is to empower every person and every organization on the planet to achieve more. Our strategy is to build best-in-class platforms and productivity services for a mobile-first, cloud-first world.”

Their products include operating systems: server applications, business solution applications, software development tools, video games, and training and certification of computer system integrators and developers. They also design, build and service PCs, tablets, gaming consoles, and of course. Phones.

This is by no means and exhaustive list but a sampling of some of the more well-known products they offer. Of course, the two best known being Windows and Xbox.

For the year ending 2016, Microsoft reported revenues of $85,320 billion which resulted in net income of $16,798 billion. This was a decrease of 9% in revenue from 2015 and an increase of 11% in net income from 2015. The earnings per share increase from $1.48 in 2015 to $2.10 which was an increase of 42%.

Some explanations from MSFT for these changes were in 2016 there was a deferral of net revenue from Windows 10 of $6.6 billion(9%) and an unfavorable foreign currency impact of about $3.8 billion or 4%.

Additionally, the changes in EPS from 2015 to 2016 were due to the negative impact of the Windows 10 net revenue deferral and impairment, integration, and restructuring expenses. This drove down the EPS $0.69 to $2.10. This was an increase over 2015 but not as much as it could have been, obviously.

Some key changes in expenses were:

  • The cost of revenue decreased $258 million or 1%, mainly due to a reduction in phone sales, which was a result of the change in strategy regarding the phone business.
  • Impairment, integration, and restructuring expenses decrease $8.9 billion, due to prior year goodwill and asset impairment charges related to the phone business and restructuring charges associated with changes in the phone business.
  • Sales and marketing expenses decreased $1 billion or  6%, driven by a reduction in the phone business and a favorable foreign currency impact of about 2%.

Some highlights for 2016 were: Continue reading “Microsoft, Would I buy it again?”

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”

6 Proven Ways You Will Grow Rich from Dividend Investing

10 minutes

photo-by-simon-cunningham-follow-flickr-creative-commons_large
photo-by-simon-cunningham-follow-flickr-creative-commons_large

What is a dividend?

According to Investopedia “A dividend is a distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders.”

Dividends can be issued as cash, shares or other property.

So why are we interested in dividends? And how can they help us? Well according to Standard & Poor’s report dividends are responsible for 44% of the last 80 years of returns of the index. I don’t know about you but that caught my eye. Almost half of the returns people earned was due to dividends! I thought this might bear some looking into.

How do stock dividends work?

Dividends are a payout that a company will give back to people that own a part or share of their company. It can be in a form of cash, more stock or other property.

Dividends are usually paid out every three months and are declared before they are paid out. When a dividend is declared they also include the size of the dividend, the ex-dividend date and payment date.

To break these down a little bit. The size of the dividend will be declared which means that for example last quarter Wells Fargo announced they would be issuing a $.37 dividend for the quarter. So each quarter they announce the amount of money they are going to pay out.

The ex-dividend is typically two days prior to the record date, which is the date that you must own the stock. Investors need to buy the stock three days prior to the record date because it usually takes three days to settle any trade on the stock market. Since the ex-dividend date is two days before the record date the investor must hold the stock one day before the ex-dividend to received the payout.

The payment date is pretty obvious. This is the day that we get the money, stock, etc. It will be deposited into your brokerage account on that date. This is our favorite day!

Continue reading “6 Proven Ways You Will Grow Rich from Dividend Investing”