Preface

As indicated by the title, the Investment Analysis section of this website focuses on the analysis of investments, not rational speculations.  As defined in the Philosophy section, rational speculations are  short-term profit opportunities that often turn on one or two isolated factors and entail very different analysis and reaction time than investments as defined herein.  For examples of these more transient opportunities, look to the Trade Archive section.  The trades there highlight the narrower, more transient nature of rational speculations. 

 

Recognizing Rigorous Analysis

Because it is the bedrock of intelligent investing, the analysis of value is critical to the investment process.  Talent for forecasting probable outcomes is useless without reliable underlying financial projections to begin with.  Doing one's own valuation is also critical because authentic confidence is impossible without it.  No investor can have the courage of someone else's convictions.  And to have faith in one's own valuation it must be grounded in actual analysis, not superficial opinion.  It's about numbers, not vague notions.

 

Each investment is unique, so it might seem improbable that a uniform approach would be applicable to all situations, but what we're promoting is more akin to a discipline than a method.  The analysis will of course vary from one investment to the next, but if the rigor is present it always shines through.  Ultimately, we take the same position on robust analysis as Justice Potter Stewart did on pornography - we might not be able to define it, but we always know it when we see it.  

 

In gauging my understanding of a potential investment - particularly when it comes to the purchase of securities as a long-term investment - the first question I ask myself is how many hours I have dedicated to analyzing the situation.  Generally speaking, if I haven't spent at least 30 hours analyzing the company's and competitors' financials, industry, etc., I am certain that my grasp is inadequate.

 

Particularly with respect to long-term investments, if you haven't

spent at least 30 hours analyzing the company, its industry and competitors,

your understanding doesn't even qualify as superficial.

 

Some might assert that spending 30 hours (or more) analyzing an investment simply isn't practical.  The usual protest is "I don't have that kind of time."  But the question of whether one has the time to conduct an adequate analysis is ultimately irrelevant to the amount of time required.  In my opinion, it is simply objectively impossible to have virtually anything relevant to say about a given investment scenario without expending a significant amount of time.  I personally read corporate reports and generate spreadsheets and projections as fast as anyone I know, and I take a lot longer than 30 hours just to develop a basic familiarity.  Reading 5 years' worth of filings and creating spreadsheets based thereon will alone consume the lion's share of 2 days.

 

The 30-hour landmark may seem arbitrary, and to some degree it is - why not 29 or 37?  The point is that, as a solitary intellectual exercise, investing requires that we police and critique our own mental processes very rigorously.  If the average individual's natural subjectivity leaves them particularly ill-equipped to judge the quality of their own analysis, objective benchmarks impose an external accountability that keeps their natural overconfidence in check.  However inclined to self-deception, the investor cannot evade the most basic of questions: Why could I possibly understand this investment so well if I have spent so little time on it?

 

We have all unfortunately read about how Warren Buffett has made multi-billion-dollar investment decisions in the space of minutes.  The reason this is unfortunate is because those articles inevitably fail to highlight that Mr. Buffett is able to make such "snap decisions" because he has spent tens of thousands of hours analyzing swuch businesses and investments.  Anything but seat of the pants, those decisions are the culmination of decades of knowledge and practice.

 

Unless you're Warren Buffett, the investment of time isn't optional;

when you're running a focused portfolio with sizable positions,

you have to invest the effort.

 

Truth to tell, for most of the full positions I've held, I've typically expended a minimum of 150 hours of work.  Because without the proper amount of dedicated research and resulting knowledge, running a portfolio of concentrated positions is suicidal.  Most managers run overly-diversified portfolios precisely because they're trying to diversify their way out of the danger that they know their ignorance about their individual positions inevitably creates.  They're rightfully afraid of how little they know.

 

Don't own what you don't know.

 

The Monograph Approach

The hard-copy culmination of all of my investment analysis takes the form of what I refer to as a monograph.  Merriam-Webster defines a monograph as "a learned treatise on a small area of learning; also: a written account of a single thing."  Practically speaking, as one check on the soundness of my own analysis, I force myself to assemble that analysis into a coherent narrative containing everything I need to know about the industry, the company, the competition, the financials, and everything else that's relevant.  These monographs can run more than 50 pages, but they're extremely useful in gauging the rigor of one's investment thesis because all of the pertinent information is immediately at hand, and - here's the important part - if it doesn't make sense as a narrative, it won't as an investment, either.

 

The discipline of actually putting one's analysis to print and reducing it to a coherent argument forces the analytical flaws to the surface.  Balancing all of the information and analysis in one's head leaves enormous room for error, but when the reasons are laid out in written form, there's no place to hide.  Unfounded assumptions assume an almost glaring quality.

 

 Be able to explain what's driving the creation of value (or destroying it).

 

In addition to the basic financial analysis of a company, the monograph forces one to have a very clear conception of what is driving the creation of value.  There's a term in investing called a "value trap" which is used to describe a company that seems inexpensive compared to similar assets but for some reason never appreciates in price.  A company can be a "good value" but never rise in value because even if the assets are inexpensive, there's no additional value being created in the business. 

 

Summarize the key issues and isolate the catalysts.

 

Even if the investor feels she has a clear grasp of the value of the assets as well as what it is in the business model that's driving the creation of value, there has to be a reason for the share price to rise.  In the process of isolating the defining characteristics of the business and what drives value creation, I always construct a Decision Matrix. The table below comprises the partial decision matrix for an actual investment.

      

Issue

Positives

Negatives

$4.50 per share, ~ $75 mil. cash & securities, NO DEBT

$75 mil. = $3.30 cash/share = approx. downside of $1.20, given no cash burn by company and value of real estate holdings

Given the contractual constraints, distribution of the $3.30 in cash is very unlikely, and the Co. is exploring a credit line w/ an interest in future acquisitions ($50 mil. against property ­ March 10Q)

Inside Ownership: 2 insiders control ~ 50% of the equity

Management’s fate is firmly tied to the shareholders’

Management has also paid itself extremely well, and just because they own half the co. doesn’t mean they won’t drive it into the ground

Property holdings of $125 mil. = $5 per share in real estate

3 properties comprise relatively stable asset values.  One mall is over 90% capacity.

Very unlikely that any of the properties will be monetized

 

The table above is incomplete, but it effectively conveys what the end product should look like.  The goal is to isolate all of the important issues and define the positive and negative aspects attached to each.  Taking all of that analysis into account and reducing it to a binary decision is an imperfect calculus, but by at least going through the process, the odds of losing money for lack of careful analysis.  There are always reasons why one's judgment might be less than perfect, but there's never an excuse for sloppy analysis.

 

Identifying an "Attractive" Investment

What makes an investment "attractive"?  For the answer to that question we turn to Linda Evangelista, supermodel of the 80s, who understood value investing better than 90% of the portfolio managers out there.  She once famously stated, "I don't get out of bed for less than $10,000 dollars."  Just like Warren Buffet and all the other truly great investors cited herein, Ms. Evangelista never took action unless the opportunity was truly worth it - and in deciding what was worth her time, she set the bar very high.

 

What defines attractive when it comes to financial assets?  It's difficult to generalize, not only because every investment is unique, but also because what is "attractive" is very much a function of the risk required to attain it.

 

Anyone can achieve great returns by assuming great risk; that's just blind gambling.  The intelligent investor seeks out circumstances where the investment return is much greater than the risk entailed in capturing it.  This means that not only is the financial upside much greater than the downside, but the likelihood of that upside/downside calculus being wrong is extremely low.  When investing, we first win by not losing.

 

In many respects a great investment is susceptible to the same analogy we drew between great analysis and pornography as defined by Justice Stewart: It might be hard to define, but you know it when you see it. 

 

In practical terms, I have very rarely pursued an equity investment that didn't offer an upside/downside ratio of at least 3 to 1 ("3:1").  A 50/50 risk/reward is pointless - any fool can flip a coin - and 2:1 isn't much better.  But when there's a minimum 3:1 upside opportunity that appears highly probable, at that point it's at least starting to get interesting.

 

With equity investments, capturing the upside is of course frequently a matter of the share price appreciating over time, both to close the discount between the purchase price and their intrinsic worth at the time of purchase, and to reflect the increase in the value of the business since time of purchase.  Identifying such opportunities typically entails:

1.  Analyzing the business and financial performance of the company and its competitors; 

2.  Forecasting the financial performance of the company;

3.  Assigning a present value to that performance; and

4.  Comparing that calculated value to the actual value the company is assigned in the

     market. 

It's an involved process, but not as difficult as it sounds.  Beyond understanding what it is that the company actually does, there are a handful of accounting items that provide critical guidance.

 

The Valuation Exercise

The above discussion and decision matrix illustrate how the important issues are effectively organized and weighed, but we still haven't addressed the mechanics of translating financial performance into valuation. 

 

The key to valuation, like investing, is to think like an owner.  Although the shares purchased comprise only a small piece of the company, the price the investor pays should be the same whether she is purchasing 1% or 100% of the company (disregarding certain factors such as the control premium, which are largely irrelevant to the current point).  When an investor decides to buy an entire company, this is typically referred to a "taking the company private," which is why the price that investor was willing to pay is referred to as the private market value (PMV).

 

When an entire company is taken private, the purchaser not only buys all of the equity, but also assumes responsibility for all of the debt.  When the company is purchased from the owners (the stock holders), the debt holders typically have the right to be paid in full; this "change of control provision" protects the lenders in the event that they would prefer not to lend to the new owners.  In practice the debt very often remains in place, although the terms may be altered. 

     

 Company X Amount Price Cost
Equity (Shares) 1,000,000 shares outstanding $10 per share

$10,000,000

(total market capitalization)

Debt (Bonds) $1,000,000 face value $1,000,000 total $1,000,000
Cash $500,000 $500,000 $500,000
Total $10,500,000

 

Every corporate balance sheet is comprised of 3 components: Assets, liabilities, and owners' equity.  Equity is on the liability side of the balance sheet because it represents money raised by selling stock to the public.  Thus, the purchaser of the company takes rightful ownership of whatever assets are present - in this case $500,000 in cash - but is responsible for whatever liabilities exist in the form of owner's equity and debt.  Thus, the cost of the company = Liabilities (debt + equity) - Assets, or in this case, $10.5 mil. 

 

We have calculated the cost of the company in this instance based on the assumption that the underlying financial performance justifies paying $10 per share, or $10.5 mil. total.  To adequately understand that performance, we have to look at some basic financial items: Revenue, net income, cash flow and free cash flow.

 

The definitions of revenue, net income, cash flow and free cash flow can become complicated based on the type of company being analyzed and such issues as revenue recognition, non-cash charges, etc.  But this website is dedicated to a discussion of investing, not accounting, so our focus will remain on the basics. 

 

Keep in mind that much of what the investor is analyzing is accounting artifice, not "real" in any practical sense.  And as an investor thinking like an owner, you ultimately want to know how much cash you could literally take home in your pocket and have the company still maintain healthy performance.

       

Understand the difference between accounting and cash.

Excluding instances of fraud, cash very seldom misleads.

 

Revenue

Revenue is an easy enough concept to understand; it's the money the company makes before anything else is deducted.  It's "sales."  Revenue sits at the top of the income statement.

 

Net Income

At the bottom of the income statement is net income; this is what remains after all other items required to generate the revenue are deducted.  Some of these items are cash expenses - cash going out the door, such as employee wages.  But some are not.  One example is "depreciation", which isn't actually paid by the company in cash, but represents the loss in value of (for example) equipment that the company owns.  Another major non-cash expense is amortization, which is similar to depreciation. 

  

Thus, net income is an important indication of what is actually left over when all of the costs, cash and non-cash, are deducted from revenue.  But notice that it's a creature of accounting - cash is real, but net income is not, and much of what distinguishes the two is a judgment call.  The owner of a business logically wants to deduct each year some amount representing the loss in value of his equipment.  All equipment wears out, and if a given machine has a useful life of 10 years, the logical thing to do would be to plan for the end of that useful life by setting aside enough each year so that when the machine has to be replaced, there are the resources available.

 

Let's say the machine in question does have a useful life of 10 years, and that each year 1/10th of the value of that machine is deducted.  After 5 years, half of the value has been deducted.  But imagine that at the beginning of the 6th year it is discovered that the owner of the company is a little shifty, and that the useful life of the machine - a major expense for the company - was only about 5 years.  What has happened?  Because depreciation is deducted in the calculation of net income, and the depreciation figure was too small, net income was inflated and inaccurate.  It was misleading.

 

Should the investor ignore net income, because it is so vulnerable to manipulation?  No.  The answer, as with most issues regarding investing, is simply to do more work.  Be certain to understand every item that comes between revenue and net income.  If they don't pass the common sense test, there's probably something amiss.

 

Cash Flow

As mentioned above, this website is dedicated to investing, not accounting.  Cash flow can be a complicated calculation, but there's a conceptual short-cut that one can use during the first stage of analysis that can be helpful.

 

If net income is an accounting number that's not "real" in terms of actual cash, how does one translate net income into cash flow?  If net income includes both cash and non-cash deductions from revenue, the answer is to add back the non-cash items deducted from revenue until all that remains are the deductions that comprised actual cash going out the door.  Generally speaking, adding back depreciation and amortization of goodwill is a reasonable proxy for cash flow.  It's not entirely reliable, but it's a good place to start as one gets down to the real work of creating full income and cash flow statements and balance sheets.

 

 Net Income + Depreciation + Amortization = Cash Flow

 

Again, you're thinking like an owner, and if you own a business - it could be a carwash down the street - your most important concern is how much cash you can take home at the end of the year and still maintain the business.

 

Free Cash Flow

How much cash the owner of a business can safely take out of a business is determined in part by how much capital (money) is required to maintain that business, thus maintaining those cash flows.  Cash flow may describe how much cash the business is generating, but free cash flow is the number that indicates how much cash can safely be extracted from it.  It is calculated by subtracting from cash flow the amount of cash required to maintain the business (a.k.a., the "maintenance capital expenditure"). 

 

Net Income + Depreciation + Amortization - Maintenance Capital Expenditure

= Free Cash Flow

 

A capital expenditure is an investment by the company in the assets required to run that business.  Maintenance capital expenditure is calculated by comparing what the business has historically required in capital investment to how those capital needs might fluctuate in the future, and then choosing a number for maintenance "cap ex" that has an adequate margin of error. 

 

Free Cash Flow is the Key.

 

Why is free cash flow an important concept?  Because analysts and money managers can talk night and day about how "cheap" a company is on the basis of price-to-earnings, price-to-sales, etc., and how based on those multiples a company is a "real  bargain" compared to the multiples that competitors are selling for, but cash never lies, and it's the most transparent means for assessing whether a business is truly a good investment.  It's no accident that free cash flow is also a key metric that any private market purchaser is going to focus on.  Unlike the purchaser of publicly-traded shares, the buyer of the entire company cannot rely on the froth and indiscretion of the stock market to bail him out if he overpaid.

 

Free Cash Flow Yield

Without knowing anything about investing, the average individual knows that getting 1% interest on their savings account is much less attractive than 18%.  Using free cash flow to calculate the return on a potential investment enables the investor to measure and rank different investments uniformly. 

 

Again, if you're buying stock in a company, the proper mindset is to imagine you're buying the entire company.  Consider a stable company in a good, established industry niche which could be purchased in its entirety for $100 mil.

 

If that business is generating free cash flow ("FCF") of $1 mil. per year, that would be a return of only 1% on your investment ($1 mil. in FCF divided by the $100 mil. total purchase price).  However, if that business were generating $20 mil. in FCF per year, that would be a 20% FCF yield.  Thus, one could take $20 mil. home each year in return for that $100 mil. investment, effectively earning back the entire investment in 5 years and thereafter earning a magnificent return with none of their original capital at risk. 

 

Not every investment opportunity will offer that kind of FCF yield, but by the same token you don't have to invest in every opportunity, either.  You can let 500 opportunities drift by before you decide to act.  Just like Warren Buffet or Linda Evangelista (imagine their offspring!), don't bother doing anything until the opportunity is genuinely too good to pass up.  And FCF is a great indicator of what is attractive because regardless of what some price/earnings, price/sales, relative analysis might indicate, the investor always knows what's attractive based on FCF.  

  

Present Value and Net Present Value

FCF has a great common-sense appeal to it, and if one's analysis is truly first-rate and the FCF on an annual basis is very attractive, very often one can safely stop there.  If I can make $20 mil. annual cash return on a $100 mil. investment with a very high level of confidence, what more do I need to know?

 

There's another dimension to the analysis that is revealed in the following question: What are those cash flows worth today?  This is the issue addressed by present value, or "PV" for short.

 

Calculating present value is most easily understood as compounding in reverse.  Interest on savings compounds to a larger value in the future, and one can estimate that sum by calculating the interest and ever increasing principal going forward. In the same fashion a future amount, arrived at via financial forecasting, can be "discounted" back utilizing a "discount rate" - it's just like compounding, but backwards.  Discounting effectively removes the element of time from the investing decision, so the amount one is investing today can be compared with the future cash flows presented in today's dollars (i.e., discounted today).

 

Obviously the key decision in discounting is what rate is chosen as the discount rate.  One simple approach is to look at the return one could earn in other available investment opportunities and utilize that as the discount rate.  For example, if one has no concerns about inflation and can invest in a bond paying 10%, the argument could be made that the discount rate should be at least 10%.

 

Once the discount rate has been selected, there are "present value tables" that provide the present value interest factors for calculating the PV of a given set of future cash flows.  It is by referencing one of these tables that one discounts the future sums as shown below.  Note that all of this is also very easily automated by using the NPV function provided in the Microsoft Excel spreadsheet program.

 

Discount Rate 10%
           
Year 1 2 3 4 5
Free Cash Flow $20 mil. $20 mil. $20 mil. $20 mil. $20 mil.
PV Interest Factor .9091 .8264 .7513 .6830 .6209
PV Of Future FCF 18.2 mil. 16.5 mil. 15.0 mil. 13.7 mil. 12.4 mil.
Total PV of Future FCF, Discounted at 10% $75.8 mil.

 

The above illustrates that the next 5 years' free cash flow is worth - discounted to today's dollars at a discount rate of 10% - approx. $76 mil.  That is, at a discount rate of 10% the above cash flows are worth $76 mil. 

 

Now that the PV has been calculated, that number must be subtracted from the investment itself to arrive at the Net Present Value ("NPV").

 

NPV =  Discounted Value of Future Cash Flows - Current Cost

                                                         (the present value of future cash flows)

 

$76 mil. minus $100 mil. is negative $24 mil.  If the NPV of the future cash flows after discounting is lower than the current cost, there's no point in making the investment, is there?  The answer to that question is generally yes, but there is one piece missing from the above breakdown: What is the value after year 5?  This great company doesn't cease to exist after year 5, and may very well be worth more than the $100 mil. investors paid for it.

 

Continuing Value

There are two aspects to this issue which are somewhat related: What is the value of the cash flows after year 5, and what could the business sell for after year 5, given the above cash flows and all other factors?  Those questions are related because the value of the business is anchored in its cash flow-producing qualities, but the future cash flows don't comprise the entirety of its future value.  Merging the two issues, the question becomes: What is the continuing value ("CV") of the company?

 

 NPV + CV = Total Value of Company

 

The task of forecasting future cash flows is tricky business.  One can argue that accurately forecasting the next 3 years would be difficult enough, but extending the effort 5 years into the future is absurd.  On the other hand, one can also argue that the company is being "purchased" to begin with because its financial performance is inherently stable and predictable.  But even if that's the case, how far beyond 5 years makes sense before the calculation becomes unreliable to the point of being useless?

 

In calculating continuing value the investor is surrendering to necessity.  The company and cash flows have to be worth something in the future - even if one can't assert with 100% certainty that the company will even exist in 6 years, it has to be assumed.

 

A popular method for estimating the continuing value of a company is a formula that assumes free cash flow growth in perpetuity.  The formula arrives at a CV by taking the FCF for the first year after the forecasted period ("FCF T+1") and divides it by the difference of the company's Weighted Average Cost of Capital ("WACC", which is the return it must pay to borrow money from the public in the form of debt, stock, or both), minus the expected growth rate of the free cash flow in the future ("g"), or:

 

 Continuing Value  =  FCF T+1 / ( WACC - g)

 

Assuming the company's FCF in year 6 would be $20 mil., but that FCF would grow by 4% thereafter and that the company could issue debt at 8% (which we'll use as a proxy for WACC, which also takes into account the expense of issuing equity), we have:

                                                       Continuing Value  =   $20 mil.  / ( 8% - 4%)

                                                                                 =     20  / ( 4%)

                                                                                 =     20 / (.04)

                                                                                 =   $500 mil.

 

Thus, according to the free-cash-flow-in-perpetuity formula, the company has a continuing value of $500 mil.  Add that to the NPV of $76 mil., and the company's total value is $576 mil.

 

NPV + CV = Total Value of Company

 

$576 mil. seems like a huge number, and it is, but perpetuity is a long time.  Would buying an asset worth $576 mil. for $100 mil. seem like a bargain?  Absolutely.  Is it unusual for the stock of a company to increase five fold?  Yes, but it happens more frequently than one might suspect.  The value of even moderately compounding cash flow growth should not be underestimated.

 

The Dutch bought the island of Manhattan from the native inhabitants for $24 worth of beads in 1624.  If $10 trillion would buy all of Manhattan today (by the way, that's the GDP of the entire U.S.), that means that the original $24 earned an annual compounded return of only approximately 7.5%.  An asset only has to exhibit moderate growth over an extended period for it to be worth an amount so gigantic the mind struggles to comprehend it.

 

In Summation

The rudimentary process above doesn't constitute much.  There's an ocean of information left to the intricacies of accounting, financial forecasting, business analysis, etc.  Inasmuch as investment analysis is a very ad hoc business and can be quite complicated, thorough analysis is nonetheless possible with inexpensive, easily accessed resources.  Consider the process above a modest framework for that effort.

 

Although it doesn't require repeating, success is much more function of doing rigorous research than anything else.  Understanding what constitutes genuinely careful analysis, as well as how to weave one's way through the most basic aspects of business and financial analysis, can carry the investor very far. 

 

By way of example, Enron was a magnificent fraud - and fraud by definition entails deliberate deception.  However, it didn't take much inspection of the books to confirm that Enron was cash flow negative for 9 of the 10 trailing years.  If a company is cash flow negative, that means that it is utterly dependent upon outside sources of cash in order to stay in business.  Now, is a company being investigated for fraud likely to be able to raise outside money by borrowing from banks or selling stocks (or bonds) to investors once it is suggested that the company may have engaged in fraud?  The answer is very probably not.  Thus, even if no one could have imagined the ultimate depth of the fraudulent activities at Enron, in reality it wasn't very difficult to see that owning Enron stock was a bad idea once they ran into difficulties.  People bought the shares anyway.

 

There are myriad mistakes that can be made in the process of investment analysis, which is the best reason for attempting it.  Because absent careful research, mistakes are all but guaranteed.  As the great poet Rainer Maria Rilke once said, "Trust in what is difficult."