In a 2001 Fortune piece, Buffett outlined a formula that offered the best snapshot of the overall value of the market.
The formula is total stock market capitalisation (as measured by the Wilshire 5000) value divided by US Gross Domestic Product.
3% Treasury Yield
The 3% treasury yield isn’t a valuation metric, but it’s an indicator that the tide is turning on equities. T-bills are largely considered a low-risk investment option. When yields approach 3%, the rate of risk-free return in the marketplace increases for investors.
This means that some market participants could be convinced to leave the market in favour of safer returns.
Debt To GDP
An overall metric for the amount of debt in an economy. This figalonelong might not help much - it functions best when paired with other metrics.
For example, a rapid acceleration in debt in high debt to gdp countries can foreshadow the bursting of a credit bubble, provided the debt is high enough.
Value Investing Metrics
PE ratio shows a company’s price relative to its earnings.
e.g. A company earning $100m per annum with a market cap of $1bn. would have a pe ratio of 10.
PE ratio is a good measure of value for a business generating considerable free cash flow in non-changing industries.
Investors should be careful though because the valuation metric can sometimes be misleading. For example, if a company’s earnings are expected to drop, the pe ratio fo the stock might fall because the market is forecasting the drop. The stock might seem cheap, but it’s pe ratio will jump from really low to really high when earnings are released.
ROIC - Return On Invested Capital
ROIC is the return on an investor’s capital over a particular time horizon. A high ROIC normally indicates that a company has a high quality brand.
If you invest 1,000 in a business and your investment generates $1,100 in a year, the ROIC is 10%.
ROIC is similar to return on equity, except it measures the return on equity and debt. Return on equity just measures equity.
Current ratio tells investors how well a company can pay back its short-term liabilities and short-term assets. If the current ratio is over 1.0, the firm has more short-term assets than liabilities. If the ratio is less than 1, the opposite is normally true - the company could be vulnerable to shocks in the economy.
Discounted Free Cash Flow
This is the metric favoured by most value investors. The discounted free cash flow model gets investors to future earnings over the next 5-10 years.
It is important to select companies with relatively predictable future cash flows and positive cash flows. Most small companies will not meet this requirement, because they usually have larger capital expenditures.
There are three components to the DCF model
Free Cash Flow
The amount of cash a business is generating and can distribute to the share holders.
Terminal value - value of the money at the end of the investing horizon
The DCF gets users to calculate the total cash flow from an investing horizon. This model is then compared to return on treasury bills (considered almost risk-free return).
If you think a stock is worth $20 based on a DCF model and the current price is $10. It is under-valued.
Present value (PV) is the current value of a future sum of money or stream of cash flow given a specified rate of return. Meanwhile, net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
Piotroski F Score
The P F score is named after Professor Joseph Piotroski who devised the investment thesis while at theUniversity of Chicago. Piotrovski identified that value investors were attrcated to companies under temporary stress. Most times investors put capital in businesses that turned around, but sometimes businesses never picked up again and petered out.
The scale is designed to weed out the companies which have a better chance at long-term survival and the companies will fail.
The scale is from 1-9. 9 Represents the best companies. You can read more here (http://www.midf.com.my/images/Downloads/Research/EqStrategy/Earnings/Strategy-Quant-Piotroski-F-Score-MIDF-131017.pdf)
The P-formua was the only stock pickign strategy which yielded positive absolute returns in 2008.
Price To Book Value
The value of a firm’s assets minus its liabilities is the book value of a stock. Value investors can guarantee a margin of safety when they invest in a company trading below book value.
This means that the entire business were to stop suddenly generating cash, the assets on the balance could still be paid off to return money to shareholders.
Value investors will usually calculate the book value of a stock themselves without relying on screeners. Companies have intangible assets which are not counted on the stock’s balance sheet like human capital, or franchise value.
A stricter version of book value is breakup value. This is the value of the assets if the company were to break up.
Dividend Growth History
The growth of a company’s dividend is important for long-term dividend growth investors.
Dividend payouts illustrate a company’s attitude to shareholders. The longer a company has increased their dividends, the more shareholder friendly they become.
Coca cola for example has increased its dividend every year for the past thirty years and probably long before that as well.
FCF To Debt
Indicates whether a company can cover its own debt expenses. A higher number means there is more FCF from operations to cover debt and interest expenses.
PE ratios can sometimes disguise the true nature of a business’ health. The energy sector for example is a cyclical business in which earnings fluctuates.
Generally speaking, the metric means you are spending less money for $1 earnings. Be careful not to get caught in value traps, because there are exceptions:
A high growth company might have very low current earnings but huge upside and therefore will trade at a higher multiple.
Some companies are riskier (however you want to define risk) and thus warrant a lower multiple.
Some companies are cyclical and thus the current multiple is skewed by where the market thinks we are in an economic cycle.
There’s important line items underneath EBITDA such as reinvestment needs (WC needs, Capex, R&D etc). This will skew an EV/EBITDA calc.
The EV metric should never be used on its own, but rather to get a snapshot of the business’ overall health. Investors should
Net Net Working Capital To Net Current Asset Value
An earnings-to-price yield at least twice the AAA bond yield.
A price-earnings ratio less than 40 percent of the highest price-earnings ratio the stock had over the past five years.
A dividend yield of at least two-thirds the AAA bond yield.
Stock price below two-thirds of tangible book value per share.
Stock price two-thirds “net current asset value.”
Total debt less than book value.
Current ratio greater than two.
Total debt less than twice “net current asset value.”
Earnings growth of prior ten years at least 7 percent on an annual basis.
Stability of growth of earnings in that no more than two declines of 5 percent or more in the prior 10 years.
Ten-year track record
No long-term debt
A low price-to-book value ratio
A stock at hear 52 week low
High insider ownership
While studying the footnotes is crucial, the big picture is most important: Earnings yield
and ROIC are the two most important factors to consider, with the key being figuring out
High earnings yield, based upon normalized earnings, is important in order to have a
margin of safety. High ROIC (again based on normalized earnings) simply tells you how
good a business it is.
Independent thinking, in-depth research, and the ability to persevere through near-term
underperformance, are three keys to being a successful value investor.
Worrying about near-term volatility has nothing to do with being a successful value
Think of a concentrated portfolio as if you lived in a small town and had $1 million to
invest. If you have carefully researched to find the best 5 companies, the risk is minimal
(As Charlie Munger says, “The way to minimize risk is to think.”)
Special situations are just value investing with a catalyst.
International investing may offer the best opportunity, at least in terms of cheapness.
Finding complicated situations that no one else wants to do the work to figure out is a
way to gain an advantage. (You have discussed and given examples of many such
situations in your book, You Can Be a Stock Market Genius.)
Looking at the numbers best way to learn about management. What have they done with
the cash? What are the incentives? Is the salary too high? Is there heavy insider selling?
What is their track record?
Focus on understanding and buying good businesses on sale, and don’t worry about the
macro economy. Everything is cyclical, so value can always be found somewhere.
Focus on situations that are not of interest to big players (usually small- and mid-cap,
although currently large caps are cheap; spin-offs may be such opportunities, but the key
is to figure out the interests of insiders; bankruptcies, restructurings, and recapitalizations
may also be such opportunities).
Trust no one over 30, and no one under 30; must do your own work, rather than simply
Risk is permanent loss of invested capital, and not any measurement of volatility developed by statisticians or academicians.
All investing is value investing and to make a distinction between value and growth is
meaningless.) Thus, you understand the context of value investing. The most important step, which you have already completed, is to understand the market in context. If your investments go down, but you have done your homework, then understanding this broader context means that the short-term
under-performance should not bother you. Again, understanding this context is crucial when
things don’t go your way. Buffett on the two things you need:
Jim Chanos - Value Traps
-Cyclical and/or overly dependent on one product (e.g., anything housing related in 2000s. –
-Cycles sometimes become secular (steel, autos)
-Fad does not equal sustainable value (Coleco, Salton, renewable energy)
-Illegal does not equal value (online poker)
-Hindsight as the driver of expectations
-Technological obsolescence (minicomputers, Eastman Kodak, video rentals)
-Rapid prior growth – “Law of Large Numbers” (telecom build-out)
-Marquis management and/or famous investor(s)
-New CEO as savior – ignoring Buffett’s maxim (Conseco)
-The “Smart Guy Syndrome” (Take your pick!) (Lampert/ESL/SHLD? – Ed.)
-Appears cheap using management’s metric
-EBITDA (cable TV, Blockbuster) (EBITDA[anything else] too. – Ed.)
-Ignore restructuring charges at your own peril (Eastman Kodak)
-“Free” cash flow…? (Tyco)
-Anything non-GAAP, industry specific, and/or new deserves special cynicism. – Ed.
-Confusing disclosure (Bally Total Fitness)
-Nonsensical GAAP (subprime lenders)
-Growth by acquisition (Tyco, roll-ups)
-Fair Value (Level 3 assets)
-“A lot of our best shorts have looked short all the way down. Just because something is cheap
doesn’t make it a good value. A lot of times the company can get into distress due to a declining
business. That defines a value trap.”
Buffett - Qualiative Metrics
• Strong And Honest Management - Buffett probably took this from Fisher - it’s a very significant metric for him. When you’re looking at a company, it’s impossible to identify the honesty and integirty of every employee.
But the culture a management team creates peters down through an organisation. If the management are honest, the employees will be too.
• An Easy To Understand Business - Buffett looks for uncomplicated business in his investing areas (something he called his strike zone)
The Zulu principles were coined in Jim Slater’s investing book “The Zulu Principle”. The concept is to buy companies which analysts are forecasting will increase earnings but that are trading at a low price relative to earnings.
• Low PEG (price-earnings ratio relative to the growth rate) .075
• PE ratio of <20
• Strong cash flow per share. The preferred criteria is a pe of 10-20 with a forecasted increase in earnings by 15%-30%.
• Solid competitive advantage (high ROIC and good operating margins)
Scuttlebutt method - Philip Fisher was a famous growth investor and the scuttlebutt was the formula he outlined in his 1957 book - Common Stocks Uncommon Profits.
The scuttlebutt method is a series of criteria for investing in a stock.
Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?
Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have been exploited?
How effective are the company’s research and development efforts in relation to its size?
Does the company have an above-average sales organization?
Does the Company have a worthwhile profit margin?
What is the company doing to maintain or improve profit margins?
Does the company have outstanding labor and personnel relations?
Does the company have outstanding executive relations? Does management hire from within? Are salaries regularly reviewed? Is their confidence in the president and/or the chairman?
Does the company have depth to its management?
How good are the company’s cost analysis and accounting controls?
Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competitors?
Does the company have a short-range or long-range outlook to profits?
Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles or disappointments occur?
Does the company have a management of unquestionable integrity?