Warren Buffett (Trades, Portfolio) is the world’s greatest value investor. One of his memorial lessons is: “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.” Is greed good? According to the book, “Business for the Glory of God” by Wayne Grudem, “Earning a profit is fundamentally good and provides many opportunities for glorifying God, but also many temptations to sin.” Being a little greedy can be good in the sense that it helps people allocate time, money and resources to more important and more profitable investments.
Are Warren Buffett (Trades, Portfolio), Seth Klarman (Trades, Portfolio), or Howard Marks (Trades, Portfolio) greedy? I am not sure, but they sure helped a lot of people with their retirement funds so that is fundamentally good. How do you invest like these great value investors? You invest in good companies that are trading below their intrinsic value and wait until the stock realizes its fair value. This is true, but what does it mean to an average investor.
Like building a house, you start out with a framework and build from there. A framework is the basic structure of something: a set of ideas or facts that provide support for something. A Value Investing Framework I developed is: B.E. GREEDY. It stands for the following:
- Growth of Sales and Earnings
- Relative Value
- Effective Profits
- Efficient Cash Conversion Cycle
- Discounted Cash Flow and other Intrinsic Valuations
How do you recognize a company is a good company when you are reading its financial statements? In this article, I will discuss: 1) some important Fundamental Analysis tools you can use to identify good healthy companies and 2) the principles when to invest in their stocks.
What is Fundamental Analysis?
Fundamental Analysis involves analyzing a company’s financial statements, business model, management, competitive advantages and its competitors along with its markets. There are many Fundamental Analysis tools out there, but I have chosen some of the most important ones to help you find good companies.
Growth of Sales and Earnings
Growth of both Sales and Earnings are important when measuring the financial health of a company. Sales is a top of the line figure, while Earnings is a bottom line figure. What I mean is Sales is the first thing on an Income Statement then after expenses and taxes you arrive at Earnings.
Analyzing Sales Growth is important and can be broken down into two components: 1) Price per unit of product/service increases and 2) Volume of unit sales increases (Sales = Price per Unit * Volume of Units). As a result, companies can be broken into four quadrants.
Unit Price Increase
Unit Price Decrease
Unit Volume Increase
Unit Volume Decrease
Ideally, the good companies could be in quadrants 1, 2 or 3 as long as overall sales is growing. By evaluating how sales have grown, you can identify a company’s pricing power and level of demand.
In addition, you can break your Sales Growth analysis further by analyzing sales per location for a products business (i.e. average sales growth for each restaurant for McDonalds) or sales per employees for a service business (i.e. average sales growth for H&R Block).
Both Sales Growth and Earnings Growth are important and both should almost parallel each other in general (i.e. Sales Growth should translate to Earnings Growth while a decrease in Sales usually means Earnings decline also). Think of Sales and Earnings as the rails on a train track.
A lot can happen from the topline Sales figure to the bottom line Earnings. Management use accounting rules and principles along with judgment in calculating expense and taxes. For example, they may use straight-line depreciation or decide to use a more aggressive double declining balance depreciation method. Other examples, they may choose not to expense an item, but capitalize it and deduct the expense over a number of years. What I am trying to point out is that JUDGMENT and sometimes manipulation are used to massage the final Earnings figures reported on the Income Statement.
If Earnings Growth generally mirrors Sales Growth that is a good sign. In addition, Cash Flow per Share should usually be more than Earnings per Share and move in the same general direction. An exception to the Cash Flow per Share almost parallel Earning per Share rule of thumb is when a company is using its free cash flow to invest in expanding the growing business. For example, Starbucks invested free cash flow into opening new healthy stores and was earning good healthy profits and its Cash Flow per Share was less than its Earning per Share during that time.
A Relative Valuation is a method to value a company based on multiples such as Price-to-Earnings (P/E), Price-to-Book (P/B), Price-to-Sales (P/S), Price-to-Cash Flow, Dividend Yield, and Enterprise Value-to-Earnings Before Interest, Taxes, Depreciation & Amortization (EV/EBITDA). There are two basic categories of Relative Valuations, which are: 1) compared to other companies, industry, or sector (Comparables) and 2) compared to the company itself called Justified Ratios that is based on the company’s internal growth rate, Dividend Payout Ratio, Required Rate of Return, Net Profit Margin, and Cash Flow. One of the best way to learn is through examples. I wrote an article with examples entitled “Relative Valuations: Tips on How You Can Perform Your Analysis Better”, which can be found at the following: http://www.gurufocus.com/news/264521/relative-valuations-tips-on-how-you-can-perform-your-analysis-better/affid/127983
The Relative Valuation process helps you analyze the company’s strengths and weakness compared to its competitors (using Comparables) and also allows you to compare the company to itself (using Justified Ratios). Hopefully, you will identify whether the company is trading at a discount or premium using Relative Valuations.
How do you measure if a company has Effective Profits? Warren Buffett (Trades, Portfolio)’s answer is the best!
- Warren thinks that the best kind of business to own is one with high profit margins and high turnover.
- Warren believes the second-best kind of business to own is one with either high profit margins or a high turnover to compensate for lower profit margins.
- Warren is not interested in owning a business with both low profit margins and low turnover.
There are three major margin ratios to consider: 1) Gross Margin, 2) Operating Margin, and 3) Net Profit Margin.
Investopedia’s definition of Gross Margin is: “A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. The gross margin represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services sold by a company. The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligations.” A high Gross Margin means the company makes a high percentage of profit per unit sales. It is calculated as follow:
Gross Margin = (Sales – Cost of Goods Sold) / Sales
Investopedia’s definition of Operating Margin is: “Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt.” Operating Income is Gross Income less Total Operating Expenses (i.e. Depreciation & Amortization, Research & Development Expenses, and Interest Expenses). It is calculated as follows:
Operating Margin = Operating Income / Sales
Investopedia’s definition of Net Profit Margin is: “A ratio of profitability calculated as net income divided by revenues, or net profits divided by sales. It measures how much out of every dollar of sales a company actually keeps in earnings.” It is calculated as follows:
Net Profit Margin = Net Income / Sales
The way you analyze the different margin ratios is by comparing the company’s ratios to: 1) its major competitors, 2) its industry, and 3) its sector.
There are three types of turnover ratios you should focus on: 1) Inventory Turnover for products companies, 2) Service Turnover for services companies, and 3) Asset Turnover for products or services companies.
Inventory Turnover = Cost of Goods Sold / Average Inventory
The Inventory Turnover ratio is a measure of the number of times inventory is sold or used in a time period such as a year. How you can utilize this ratio? You can compare the Inventory Turnover ratio for Target vs. Walmart and see the number of times inventory is sold over the year.
Service Turnover = Sales / (Sales General and Administrative Expenses)
The Service Turnover ratio is something I coined to measure the number of times services revenue is generated per Sales General and Administrative Expenses. A modification of the Service Turnover ratio would include Research & Development Expenses in the denominator. You can utilize this ratio to compare H&R Block vs Jackson Hewitt and see which company generates more sales per employee expenses.
Asset Turnover = Sales / Total Assets
The Asset Turnover ratio compares a company’s sales to its total assets. This ratio gauges how well a business is making use of its total assets. The higher the multiple, the more efficient the company. Like all the turnover ratios, compare the company’s ratios to: 1) its major competitors, 2) its industry, and 3) its sector.
Efficient Cash Conversion Cycle (CCC)
You may have heard the phrase, “Cash is King!” How efficient is the company in generating cash from sales? How is it managing and collecting on its sales? How is the company managing its inventory? How good is the company at paying/financing its bills? These questions can be answered by analyzing how efficient is the Cash Conversion Cycle.
CCC = # days between disbursing cash and collecting cash in connection with undertaking a discrete unit of operations.
CCC for products companies = Days Sales Outstanding (DSO) + Days Sales in Inventory (DSI) - Days Payable Outstanding (DPO)
The Cash Conversion Cycle is a model that focuses on the length of time between when the company makes payments and when it receives cash inflows. A metric that expresses the length of time, in days, that it takes for a company to convert resource inputs into cash flows. The cash conversion cycle attempts to measure the amount of time each net input dollar is tied up in the production and sales process before it is converted into cash through sales to customers. This metric looks at the amount of time needed to sell inventory, the amount of time needed to collect receivables and the length of time the company is afforded to pay its bills without incurring penalties. Also known as "cash cycle."
Days Sales Outstanding (DSO) = Accounts Receivables Collection Period = Receivables / (Sales / 360)
DSO is one of the key metrics for analyzing and identifying possible Revenue shenanigans. Days Sales Outstanding is the average length of time required to convert the firm's receivables into cash (to collect cash following a sale). A measure of the average number of days that a company takes to collect revenue after a sale has been made. A low DSO number means that it takes a company fewer days to collect its accounts receivable. A high DSO number shows that a company is selling its product to customers on credit and taking longer to collect money. For example, utilizing this ratio you may be able to spot Lucent booking sales but not collecting the revenue.
Days Sales in Inventory (DSI) = Inventory Conversion Period = Inventory / (Cost of Goods Sold / 360)
DSI is one of the key metrics for analyzing and identifying possible Inventory shenanigans. Days Sales in Inventory is the average time required to convert materials into finished goods and then sell those goods. A financial measure of a company's performance that gives investors an idea of how long it takes a company to turn its inventory (including goods that are work in progress, if applicable) into sales. Generally, the lower (shorter) the DSI the better, but it is important to note that the average DSI varies from one industry to another. For example, this ratio would have help spot the growing inventory problems Coleco Industries had in the 1980’s.
Days Payable Outstanding (DPO) = Payables Deferral Period = Payables / (Cost of Goods Sold / 360)
DPO is one of the key metrics for analyzing and identifying possible Operating Expenses shenanigans. Days Payable Outstanding is the average length of time between purchases of materials and labor and the payment of cash for them. A company's average payable period. Days Payable Outstanding tells how long it takes a company to pay its invoices from trade creditors, such as suppliers. It isn’t always negative if you see this ratio is increasing. For example, Home Depot delayed paying its suppliers and its DPO went from 21 days to 41 days. This move was justified because Home Depot’s competitor (Lowe’s) paid its suppliers in about 40 days at the time. By increasing DPO, Home Depot was able to free up more cash flows.
An alternative for Days Sales in Inventory for service companies is something I coined Days Sales of Service (DSS). For products companies, you should utilizes DSI; however, for services companies you usually don’t carry inventory.
Days Sales of Service (DSS) = Service Conversion Period = Sales / (Sales General and Administrative Expenses / 360)
Days Sales of Service is the average time required to convert employee work expenses and then sell those services. A financial measure of a company's performance that gives investors an idea of how long it takes a company to turn its employee work expenses (including Research & Development expenses if applicable) into sales. Generally, the lower (shorter) the DSS the better, but it is important to note that the average DSS varies from one industry to another.
CCC for services companies = Days Sales Outstanding (DSO) + Days Sales of Service (DSS) - Days Payable Outstanding (DPO)
Discounted Cash Flow (DCF) and other Intrinsic Valuations
Value the Company
Identifying good healthy companies is the first step. The process you learned up to now helps you find good healthy companies (B.E. GREE). The second step is determining if it is a good stock to invest. To determine if the company would be a good investment you need to value the company and compare your valuation of the company’s worth to its current market value. One tool that helps you value a company is the Discounted Cash Flow method.
Investopedia defines Discounted Cash Flow (DCF) as follows: “A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (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 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.”
The idea I want you to remember is that you need to value a company’s intrinsic value. To do so, you can use the DCF method, Gordon Growth Model, Residual Income Model or other value investing methods available to arrive at the intrinsic value. Each model has its strengths and weaknesses. The skill is knowing how and when to use the various models.
Buy with a Margin of Safety
Investopedia defines Margin of Safety as: “A principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. In other words, when market price is significantly below your estimation of the intrinsic value, the difference is the margin of safety. This difference allows an investment to be made with minimal downside risk.”
Your valuation of the company may be approximately right. To cushion the downside risks and improve on your upside growth potential, you should buy with a Margin of Safety (buy below your intrinsic value of the company).
Initial Rate of Return = EPS / Stock Price
Analyze the company’s Initial Rate of Return to determine a yield and compare it to what treasuries are yielding. According to the book, “The New Buffettology”, Warren Buffett (Trades, Portfolio) compares the stock’s value relative to Treasury Bonds (check www.wsj.com) by looking at Initial Rate of Return and Earning Growth Rate. In doing so, he answers similar question of would I rather be in bonds yielding 4% or invest in a stock with an Initial Rate of Return of 3.5%, but also will grow at 10%. By examining the yields, you help determine if you should allocate more of your assets in stocks or bonds.
When you practice using these Fundamental Analysis tools, you can 1) identify good healthy companies and also 2) determine if you should invest in them. So be greedy and use the B.E. GREEDY Value Investing Framework.