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Start with the End in Mind

December 08, 2008 | About:
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 (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


Rating: 2.9/5 (10 votes)

Comments

Dr. Paul Price
Dr. Paul Price premium member - 5 years ago
You forgot to take out the huge fees the bankruptcy lawyers will extract from the shareholders.

DaveinHackensack
DaveinHackensack - 5 years ago
Let's stick with your example for a moment, Guruek. Let's say you have stock that you've determined has a terminal value of 60 cents. Let's give that figure a haircut to cover the bankruptcy lawyers, as per Stockdoxc, and call the TV 45 cents. Now, how much would you be willing to pay per share for that stock? Unless you pay less than that terminal value, aren't you still at risk of losing money? Or do you limit your investments to stocks trading for less than their terminal values (essentially, Graham's net-nets)?
Dr. Paul Price
Dr. Paul Price premium member - 5 years ago
Krasimir,

What would be a few examples of stocks that would meet your criteria?
ConsumerMonopoly
ConsumerMonopoly - 5 years ago
What do you think the Terminal Value for American Express is?
karamfil
Karamfil - 5 years ago
DaveinHackensack,

No, I don't limit my investments to stocks trading for less than TV. Those are very, very hard to find, if they exist at all. I use TV as an indicator of a company's asset strength. For example, Google's TV is around $45.00, which is one of the highest I've ever seen. Are Google's assets solid? Yes. Once I know that, and if all the other investment metrics are solid, I wait for Google to hit the right price before I buy it. TV is just one number, but important one, that I consult before buying.

Thanks for your comment.
karamfil
Karamfil - 5 years ago
Stockdocx99 and ConsumerMonopoly,

Unfortunately, I don't give stock recommendations. I believe each investor should do their own thinking. I've learned that what makes sense to me may not make sense to other people.

Happy investing.
DaveinHackensack
DaveinHackensack - 5 years ago
Karamfil,

You are Guruek? Why the two usernames? Regarding your comment addressed to me:

"No, I don't limit my investments to stocks trading for less than TV. Those are very, very hard to find, if they exist at all."

A stock I've mentioned here before may meet your criteria of trading for less than TV at its current price, USEG.

"Once I know that, and if all the other investment metrics are solid, I wait for Google to hit the right price before I buy it."

Which is what, in your opinion? Do you use a certain multiple of TV as a screening criteria? If so, what is it?
DaveinHackensack
DaveinHackensack - 5 years ago
Care to respond to the questions on this thread before starting another three new ones?
karamfil
Karamfil - 5 years ago
DaveinHackensack,

What's Guruek?

I'm glad that you're finding stocks that trade below their TV. More luck to you.

As per Google, stating the buy price I've arrived at in my research would be against my policy.
DaveinHackensack
DaveinHackensack - 5 years ago
"What's Guruek?"

Look at who wrote the first post in this thread. It was either you, writing under another username, or Guruek is a fan of yours.

"As per Google, stating the buy price I've arrived at in my research would be against my policy."

A little coy, no? Forget about Google for a moment. What's the point of discussing the importance of a metric such as TV without tying it back to price? It would be as if you wrote about how important trailing earnings are as a metric without saying whether you prefer stocks trading at 5x trailing earnings or 50x.

Please leave your comment:


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