Summary of the book “The five rules for successful stock investing” (2/4)

Analyzing a company all around

Analyzing a Company – Management

  • People buy company’s stock without checking management team of that company
  • It is essential to know the folks who are running the business
  • It is important for us to know that whether the management is taking the business as their own and whether they are doing all the activity for the shake of shareholders
  • Let’s do management assessment in three parts

  • Compensation
  • Here, we can first see how much the management are paying themselves
    • You can compare their compensation with compensation of average employees that how many times their compensation is big, use your own judgement and analyze whether it is decent or high
    • You can also compare different firms’ management’s remunerations to set a decent level to analyze companies
  • Pay for the performance
    • It is important to observe whether executives’ pay is truly tied to the company’s performance
    • Company can set a performance goal for executive for their compensations, and if executive can’t reach to the goal, he should be punished by slashing bonuses
    • There is another mistake that paying executives to make companies bigger, not better, i.e. many companies pay outside bonuses to the executives when they consume an acquisition, it is never a good idea to pay them for successfully doing acquisitions, instead, companies should hold their bonuses and pay only if those acquisitions come out as beneficial deal for the company

    • Other red flags to be watched out
      • Many times, company give loan to its senior management at lower rate than market and after few years, it quietly forgives that loan; do not tolerate this kind of activity, if you find company doing this practice, kick-out it from your watchlist
      •  Do check whether management grabs most of stock option granted by company and whether management is excessively using it
      • Management themselves are getting more options is like they need options to motivate themselves, stay away from these folks
      • See whether management have substantial stake in a company; we want companies where management have significant number of shares, which tells they have their skin in the game
  • Character
    • Here are some questions to be asked to test whether management deserves your trust
  • Does management use their position to enrich their relatives?
    • That is whether company is giving more business to its relative parties or any other pattern this side?
    • Big amount of this kind of deals is unfair with shareholders
    • Is the board of directors staked with management’s family members or former managers?
    • Is management candid about its mistakes?
      • It is not wrong to do mistakes, but it is wrong to ignore or burry them; track this kind of things from AR or con-calls to be sure
    • How promotional is management?
      • Management who often says their stock price is undervalued (instead of making business strategy which can lead the price up), are more concerned with the value of their options
      • This management can’t think for the long-term benefit of their shareholders
    • Can CEO retain high quality talent?
      • Often CEO keep rolling their employees to save high salary paying to older employee
      • CEO spending too much time on this is a red flag as long tenure in company give confidence to employee which is most useful thing for the company
    • Does management make tough decisions that hurt results but give a more honest picture of the company?
      • Management who do so – by expense cost like R&D and so rather than capitalize or by using restricted stock grants instead of options – management is interested in running company instead of playing number games
  • Running the business
  • With honest management, you also want management who are capable to run a business, checklist below
    • Performance
      • To judge performance, see the trend of ROA and ROE and must check whether high ROE is generated from leverage
      • Also, we need to see are there any jumps in revenue, it can be because of acquisitions, must check whether they have paid to the company
      • Check whether the outstanding shares are increasing, if it is, company is constantly dilute existing shareholder’s stake, which is not a good practice
  • Follow-through
    • When there is a problem in the company, do check whether management is making effective strategies to overcome it, and whether those strategies are implemented by management or they want or hope shareholders to forget about it
  • Candor
    • Does company provide all necessary information or they are denying to disclose problematic areas

    • Self-confidence
      • Self-confidence is doing something different than your peers which can payoff in future
      • Doing research and development in industry downturn era is also a sign of confident firm
    • Flexibility
      • Has management done something which can provide flexibility to a company, like not taking too much date, do buyback when price is low, issuing equity when share price is high and so forth

Avoiding Financial Fakery

Here are 6 red flags to be observed while analyzing a company

  • Declining cash flow
    • If company’s cash flow from operation is decreasing with increasing net income over the period of time, or it is growing at lower rate than net income’s, it means company is weak at cash collection part, and is a big red flag
    • Rising amount of account receivable and unsold inventory lead to lower cash flows
  • Serial charges
    • If firm is having frequent one-time charges, it means it is correcting its number by them, i.e. income without these charges is unattractive
  • Serial acquires
    • Making numerous acquisitions can be problematic for the company, most of the times, it is like mudding the water
  •   Resignation of chief financial officer or auditor
    • If firm’s CFO or corporate auditor are resigning from a company with accounting issues, this is enough for you to feel uncomfortable
    • And also, if company is changing auditor frequently, again the same red flag to be noted
  • The bills aren’t being paid
    • Some companies boost their revenue by giving more credit to the customers, which may create trouble for a company
    • If growth of accounts receivable is more than growth of revenue, company is booking sales faster than its receiving cash
    • With these two, track “allowance for doubtful accounts”; if it is not increasing with increasing account receivables, company is booting its revenue by being overly optimistic its receivables
  • Look for credit terms for customers and explanation of rising account receivables

Seven other pitfalls to watch out for

  • Gains from investments
    • Companies generally invests some amount in financial markets and gain profits from that
    • But red flag is there when companies record that capital gain as revenue and when they hide their expense against these capital gains and reduce operating expense (companies should record that irregular income outside of its revenue)
  • Pension pitfalls
    • Companies are obliged to pay benefit amount called “pension fund” when they retire
    • We as an analyst need to see whether the company have underfunded pension plan – its pension obligation is more than its asset – or it have over-funded pension plan – vice versa
    • If it has underfunded, it has to then pay mismatched amount from its own pocket which will affect profit
    • We need to check these numbers carefully and stay away from accounting tricks
  • Pension pending
    • When company’s pension fund does well, and become over-funded one, company can realize that extra gain (after pension liabilities) in income statement
    • It is beneficial for shareholders but when we want company’s actual earnings, we have to deduct this income from profit
    • This is an income which can’t distributed as dividend and totally rely on share market
  • Vanishing cash flow
    • When employees exercised stock option, it results in tax benefit for the company and add up in cash flow statement, companies with high stock options grants used to enjoy big number of tax benefits which result in higher cash flow
    • But if company’s stock price fall and become lesser than its exercise price, there is very low number of options will exercised, which will result in lower tax benefits and cash flow
  • Overstuffed warehouse
    • When inventories are increasing but sales are not, it creates trouble for the company (generally this happens when company overestimate demand)
    • If it happens, company have to sell unsold inventories on discount or have to write them off, result in charge on earnings
  • Change is bad
    • Depreciation
      • Companies charge depreciation on estimation of how long the asset will last, company can have low charge on its income by assuming its asset life longer
    • Allowance for doubtful accounts
      • If company is not increasing allowance for doubtful accounts with increase in account receivable, company is saying its new customers are more trustworthy than previous ones
    • These practices make expenses lower for the company, which should be watched out by us
  • To expense or not to expense
    • Companies expensed some cost which give benefit only for a year or so, and capitalized some cost which can benefit it for a long time
    • But some cost – like marketing expense – can be taken as either way, here companies play with numbers, and capitalized some cost which shouldn’t be and lower their expense

Valuation – the Basics

  • Till now we saw all the filters for a great company, but even the most wonderful business is a poor investment if purchased for too high price, you need to buy great companies at attractive price
  • The stock market return come from two components
    • Investment return – it is the appreciation of                a stock because of its dividend yield and earnings growth
    • Speculative return – it comes from change in Price to Earnings ratio (P/E)
  • Over the long time, impact of investment return wins by having almost all return part from total return
  • In short time, returns get influenced by change in P/E
  • Paying up rarely pays off
  • By paying lower price for the stock than your valuation or estimate, you are reducing speculative risk for your investment, which maximize your total return
    • Speculative return in your investment can contribute handsome return when market’s mood is good, but it can be worst when market move opposite
    • Being picky about your valuation isn’t fun, it means you are protecting your portfolio from the stocks which may hurt entire portfolio
  • Using price multiples wisely
  • First, we will see how to value a stock using traditional measures
    • Price-to-sales ratio (P/S)
      • Price-to-sales ratio is simply company’s share price divided by its sales per share – i.e. sales divided by total shares outstanding
      • If P/S ratio is 2, that means investors are ready to pay 2 Rs for company’s 1 Rs sales
      • It generally works when company is making loss and it is enable to find P/E
      • We should compare P/S ratio with companies in same industry (due to different profit margin across different industries), low P/S suggests company is undervalue or investors don’t have faith in company’s revenue – sales
  • Price-to-earnings:
    The benefit
  • P/E is most popular valuation ratio and is very useful considering you know its limitations
    • We should always compare P/E of companies in the same industry
    • It makes sense to pay a company with low P/E, high growth and low debt
    • We can’t and shouldn’t make decision about a company by comparing its P/E with market or industry, one good practice is to compare company’s P/E with its historical P/E, and if you found company is growing at same rate as in past but is trading at lower P/E than its long-term average, you should get interested as it is undervalued

The drawbacks

  • Analyzing only P/E on relative basis doesn’t make any sense
    • There are many factors by which P/E inflates, like
      • High growth – high P/E
      • High risk – low P/E
      • High capital needs – low P/E

Keep this question in mind while analyzing P/E ratio

  • Has the firm sold a business or an asset recently? – if company has sold a business or asset like stake in another company, its earing number will increase and that E of P/E will rise and P/E will become lower; don’t get attracted by such low P/E, we need to exclude that earning to reach at analyzable P/E
    • Has the firm taken the big charge recently? – if firm is having big expenses, it will affect its earnings and P/E will become higher, take it out in your calculation
    • Is the firm cyclical? – if you find cyclical company’s P/E lower, don’t get attracted; here company’s earning can fall more, so in this type of case, you are supposed to see company’s recent peak, and make a judgement for the next peak and calculate P/E upon your estimated earning at the time of next peak
    • Does the firm capitalize or expense its cash-flow generating assets? – firms who generally do R&D expensed their R&D cost rather than capitalized, hence for that particular year or company, P/E will be higher (due to lower earnings) than year or company who capitalize
    • Is the E real or imagined? – there is a type of P/E called forward P/E, which analysts calculate by estimating future earnings of the company; companies keep growing and increasing their earning year by year, and by assuming so, its forward P/E will be lower; invest by using this estimate is not really realistic
  • Price-to-earnings Growth (PEG)
    • PEG is P/E divided by company’s growth; it shows whether company’s P/E is priced according to its growth
    • But high growing companies often become high risky, PEG assumes that this growth generated with same amount of risk and same amount of capital
  • Say yes to yield
  • You can also use yield base measures to value stock, like if we invert P/E i.e. divide firm’s earning per share by its market price, we get an earnings yield
  • There is a metric called cash-return, i.e. free cash flows divided by enterprise value (i.e. stock’s market cap plus its long-term debt excluding cash), shows how efficiently a firm is using its capital (equity + debt) to generate free cash flows

Valuation – Intrinsic value

  • Ratios which we show never tell you about the value – stock’s actual worth
  • Estimating intrinsic value of a stock and buying it on discount is how we can get real worth of the stock
  • Cash flow, present value and discount rates
  • Here’s the first step to answer “what’s a stock worth?” – the basic answer we all know is the value of the stock is equal to the present value of its future cash flows
    • Companies create economic value by investing capital, paying operating expenses, reinvesting in own business, generating returns, and rest is called free cash flow (this is money which can be taken out without harming company’s operations)
    • Company can use free-cash-flow to give dividends, do buy backs or reinvest it in business
    • Future cash flows worth less than current ones, why it is so? – the answer is time value of money, i.e. money we receive today is investable, but future cash flow can’t be invested until we receive them; second, there is a chance we never receive that future cash flows, i.e. we need to add risk premium on that future cash flows
    • Here we want discount rate to discount all cash flows, so it is like, risk free return a investment can get plus the risk premium, and we have discount rate
    • Discount rate is rate of return you need to make you indifferent between receiving some money right now versus at some time in future
    • Business with stable and predictable earnings have high valuation because we discount it by lower rate as it has certainty, vice a versa business with unpredictable future have lower valuation because we discount it on higher rate
  • Calculating present value
  • We can calculate present value of cash flow by dividing cash flow by 1+discount rate raised to number of years
    • I.e. Present value = CF / (1+R) ^n

Let’s say 500 Rs we will get after 2 years; discount rate is 10%;
Present value = 500 / (1+0.10) ^2 = 413.22

  • Fun with discount rates
  • Now the point is how to calculate discount rate? – we know the factors like opportunity cost and risk matters there (As an opportunity cost, we can take government bond’s yield)
    • There is not a fixed and exact formula to calculate discount rate, but we have to keep in mind that,
      • As interest rate increases, so will discount rates (opportunity cost)
      • As firm’s risk level increases, so will discount rates
    • Let’s say govt bond’s 10-year yield is 5%, so will take it as s opportunity cost
    • For risk, we can judge it by share price movement and company’s ability to make future cash flows; 2nd option looks practical as share price has nothing to do with company’s operation
    • Here are some factors we think should be taken into account when estimating discount rates
      • Size
        • Smaller firms are risker than larger one because they are more sensitive to adverse events, as they don’t have diversified product line and customer base
      • Financial leverage
        • Firms with high debt are risker than low debt as they have more fixed cost (interest); they earn better in good times but worst in bad times
      • Cyclicality
        • Is firm in cyclical industry or in stable one; as cash flow of cyclical industry are tougher to predict, and they become riskier
      • Management/Corporate governance
        • It is simple! How much do you trust the folks running the company?
      • Economic moat
        • Does the firm have wide moat, i.e. are they able to keep their competitors at bay?
      • Complexity
        • The essence of risk is uncertainty, and its tough to value what you can’t see
        • Business with complex financial structure are riskier than simple because we many times are not able to know or find all the information
        • Even if we think folks are honest, we need to add complexity discount here while estimating its risk
  • So how to incorporate all these factors in discount rate? – as we discussed there is no right discount rate available
    • They key is to pick discount rate you’re comfortable with; we don’t need exact but just estimate whether the company you are analyzing is riskier or less risky than the average firm, and how much
  • Calculating perpetuity values
  • Now we have cash flow and discount rate, last thing we need is perpetuity, as we can’t simply assume company’s life infinity
    • To do this, take the last cash flow you estimate (CF), increase it by growth rate which you expect cash flow to grow on (g), and divide the result by the discount rate (R) minus the expected long-term growth
    • I.e. CF*(1+g) / (R – g)
    • And calculate present value of the result
    • Let’s take an example (DCF model)
  • Margin of safety
  • We have done valuation of stock and estimated its true worth; but any valuation or estimate is subject to error, hence to minimize this error, we should buy stock at discount to out estimated intrinsic value, this discount is called margin of safety
    • In our example, our intrinsic value is 29 Rs, if stock is trading at 23, out return will be difference between 29 and 23 (i.e. 23%) plus our discount rate i.e. 10%, out total return will be booming 33%
    • But what if the stock doesn’t grow as fast as we thought; therefore, margin of safety is necessary to minimize our error (if we set margin of safety on 25%, we shouldn’t buy stock more than 21 Rs)
    • Margin of safety can be different for different firms – like it can be more for unpredictable or cyclical companies or companies with no economic moat and lower for predictable companies and companies with economic moat)
    • Having margin of safety shows discipline in your investing process

The 10-Minut Test

  • We now know whole process of doing fundamental analysis of the stock, but it is not possible for us to do this work on many companies
  • There are many companies in the market, so now we will see how to narrow down our investment list to eliminate poor investments
  • Doing so at start will provide more time to analyze great investments
  • Go through these questions to screen good investments and eliminate bad ones
  • Does the firm pass a minimum quality hurdle?
    • Avoid foreign firms who don’t file regular financial
    • Avoid IPOs because they usually can’t be bargained

  • Has the company ever made an operating profit?
    • It sounds simple but can snatch you from many bad investments
    • Some companies look attractive as they are going to introduce new product or service, but these firms can blow your portfolio as they normally have one or two products and history says this kind of companies mostly fails
    • Only by get attracted with companies’ product, and without analyzing whether company has made operating profit or not, you will put your-self in trouble
  • Does the company generate consistent cash flow from operations?
    • Companies with negative cash flow and positive profits looks good but they need financing option to continue their operation as they don’t have cash flow

  • Are ROE consistently above 10%, with reasonable leverage?
    • Keep minimum hurdle of 10% ROE for financial firms and if company is not making ROE of 10% in four years out of every 5, it is not worth your time
    • Keep this hurdle 12% for financial firms
    • Don’t miss to check source of ROE, i.e. whether it is from high leverage, then it is not an attractive option
  • Is earning growth consistent or erratic?
    • Best companies make consistent earnings growth, if company have volatile growth, it may mean competitors are playing role there or industry is volatile
    • Hence, we don’t want companies with volatile nature for our hard-earn money
  • How clean is the balance sheet?
    • If non-bank firms have financial leverage above 4 and debt-to-equity above 1, ask yourself these questions
      • Is the firm in stable business? (companies in unstable industry usually need more debt)
      • Has debt been going down or up as a percentage of total assets?
      • Do you understand the debt?
  • Does the firm generate free cash flow?
    • Firms with free cash flow – cash available after CAPEX – are more preferable than firms with no free cash flow
    • One exception is here, firms with negative free cash flow are good, if they invest every cent of their earned money right back to their business as they know their business have more potential
  • How much “other” is there
    • Whether company is hiding its charges without any head on its financials
  • Has the number of shares outstanding increased? Markedly over the past several years?
    • If it is, company is issuing new shares to buy another firm or is granting more options
    • As we show earlier, more acquisitions are not good practice
  • Beyond the 10 minutes
  • If companies pass this test, here’s the process how to go ahead
  • Look summary of balance sheet and income statement data for 10 years, you will find how things are working for the company
    • Take latest AR and check MD&A – industry review by management, any legal issues with company and all, and note things which you do not understand; you need to know things which are buried in this part
    • Check latest option-granted by company
    • Analyze latest 2-year income statement and check things are going good or worst; also go for con-calls and see whether management is being defensive for issue raised by anyone
    • Start valuation of stock, compare its multiples with industry and its past ones, if firm has low investment needs, low risk, high return on capital – be ready to accept high P/E; make DCF model and arrive at intrinsic value o for the stock

Previous portion of the book summary : Analyzing a company all around

Further portion of the book : Analyzing Sectors

Published by Aakash and Meet

I am Aakash Raotole I am currently doing Bcom from Dr. Patel and Rb Patel commerce college I am currently studying at finnacle investment academy Recently done distance internship with windrose capital, Pune - for a period of 14 weeks I am Meet Bhatt Completed HSC in commerce Now studying finbridge program at finnacle investment academy and Bcom externals I had completed CFA institute's investment foundation course and distance internship with Windrose capital, Pune - for a period of 14 weeks

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