Start with the End in Mind

I have a writing degree. OK, it’s not a real writing degree. It’s more like a MFA in Screenwriting. Anyway, that’s not important. I mention it because, as I was earning that very expensive MFA, I learned the first rule of writing: Start with the end in mind.

What does that mean? In a story, it means that you know who dies at the end and who survives before you start writing a story.

In stock investing, it means that you know that you’ll get some of your money back before buying a stock.

When I say “money back,” I don’t mean that you’ll receive a dividend. What I mean is that before you buy a stock, you should know that even if the company goes belly up, dies, or gets liquidated, you’ll get some of your invested money back.

Here’s a worst case scenario: A company’s business fails and the company has to be liquidated. It lays off all its employees and it sells all its buildings and equipment. With the cash from these sales, it pays the company creditors, the preferred stock holders, and finally the common stock holders.

So, as common stock holders, I recommend we estimate the terminal value (TV) of every company before buying its stock. I tell this to my friends and they look at me like I’m from Jupiter. “Just buy the damn stock. It’s a bargain. Look how low the market is” they say. I just smile and don’t move a penny before I know the TV of the company.

Estimating the terminal value of a business before buying a stock is like having fire insurance on your house. There may never be a fire in your house, but if it happens one day, you know that you’re protected somewhat.

Now, as my friends said, the market is low. And, yes, it looks like there are a lot of bargains. But are they bargains, really? Is American Express (NYSE: AXP) a good buy at $21.36? Is Macy’s (NYSE: M) a good buy at $9.47?

If you are a speculator, you’ll think that American Express is a great buy at $21.36. How could it not be when it trades around $60 in a bull market?

This is the false line of thinking a lot of investors use. They think that future performance can be predicted from past performance. It can’t. Don’t even try. Instead, get fire insurance on your money by buying a stock that has a positive (>0) terminal value. You won’t regret it. If a company has a negative terminal value, don’t buy it. Simple.

How do we estimate terminal value?

When a business is terminated, its assets are sold, based on their book value. Let’s look at them one by one:

Cash – It retains its face value, so we don’t sell it, right? We retain 100% of cash.

Investments – They can be higher or lower than their cost, but for our estimate we’ll assume that some went up and some went down and take them at cost. We retain 100% of investments.

Receivables – Some of the businesses that owe money to our company will default, so we’ll take 85% of receivables.

Inventories – They will yield no more than 50% of their value, so we take 50% of inventories.

Property & equipment – This is tricky because, usually, equipment depreciates in value in time, and most real estate appreciates. We’ll take the conservative road and estimate 45% of book value for this category.

Once done with this simple math, we add up the discounted assets and get a number, say $1 million. We subtract total liabilities (the creditors), say $400,000, from the asset number ($1 million) and get a new number ($600,000). Then we divide that new number ($600,000) to the number of shares, say 1 million, and get the terminal value per share ($0.60). If total liabilities are more than the discounted assets, we get a negative terminal value per share.

I personally don’t invest in companies with a negative terminal value. I know that this is a ballpark figure ant not scientifically precise, but the power of Investing Rule #1 (“Don’t lose money.”) always prevails in me.

Source: Krasimir Karamfilov

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