1. The Reputation of the Management Team and Board of Directors
Before you dive deeper into the quantitative aspect, ensuring management quality and transparency is crucial to long term investment success.
If the people running the organization aren’t accountable to its shareholders, then sooner or later, this phenomenon will be reflected in the company financials and their stock price.
Phil Fisher, a long-term advocate of management quality, was famous for the depth of his research on companies in which he would invest. He relied on personal connections (what he called the “business grapevine”) and conversations to learn more about a business before buying its stock. His first and most important book, Common Stocks and Uncommon Profits, published in 1958, devotes careful attention to this concept of networking and gathering information via business contacts. This step ensures complete transparency with regards to understanding company management and testifies the numbers found in the book of accounts.
2. The Financials and Business Model
Financial metrics and how the business makes money are the first two quantitative elements to look at. On rare occasions, I have discarded a few stocks just after this step. My logic to do so depends on the three criteria listed below.
- Absurd Valuation: If the P/E and P/B ratios are unbelievably high, it could signal that either the stock is overvalued or that the markets themselves are overvalued and all the corresponding stocks are riding on the same rally.
The only exception to this rule is technology stocks since it’s extremely difficult to forecast their earnings and correlate their growth with any ratio whatsoever. A perfect example can be Amazon, which has had P/E ratios of above 40 for months now, but despite that, the company continues to soar in the stock market. Ratios are not a one-size-fits-all kind of parameter, so they should be used with thorough judgment.
- Economies of Scale: If the unit economics does not scale, then the chances of a company continuing to be profitable decline in the long run. The exception to this rule again is technology stocks. Stocks that redefined the gig-economy, for example, Uber, Airbnb are prime examples of this phenomenon.
- Unreliable Book of Accounts: When analyzing financial statements, each line item must make sense to you as an investor. If more than three or four line items do not add up or make perfect sense for their allocations, try reading the footnotes. If the management is trying to hide any piece of information, the approach taken in the footnotes will clearly help you decipher such anomalies.
Image: Morning Brew at Unsplash
3. Competitive Advantage
“A condition or circumstance that puts a company in a favorable or superior business position.”
Warren Buffett believes in investing in stable, durable businesses that have a huge competitive advantage and business economics so strong that they’ll be able to weather out any storm. His portfolio consisting of Coca-Cola, Apple, and a select list of top US banks depict his ideology and is a live proof of the testament, “practice what you preach.”
Competitive advantage can take any shape or form. Here are a few ways one can try and understand what to look for, and what can springboard a company to the next step of the process:
- ‘The network effect’: Mainly a focus on identifying potential software apps that could become a billion-dollar unicorn, a network effect is when every incremental user makes the experience better for every other one. A strong network effect of creators and users draws in additional users at lower costs and dries up the competition faster as the years’ progress.
- Brand: One of the toughest ones to decipher as an investor and build as a company, but one that can lead to phenomenal returns. Brands give companies a unique “moat.”
Similar to moats that used to defend medieval castles, a strong brand protects a company by ingraining the product in the customer’s mind so strongly that they resort to seeking the product every time they have a need which has to be fulfilled. No substitute or complementary good can replace the product due to the emotional leverage the company has managed to acquire in the form of an “addicted consumer.”
- Tackling Industry Competitors: Whether the company is part of a growing target segment or whether it is doing business in a highly competitive and dying industry will be critical as you progress throughout the years. Holding the stock of a company that has declining profit margins due to increasing competition and declining market demand can sometimes be the “sell” signal one needs to completely exit a stock.
There are plenty of other ways companies can build “moats,” but the fundamental idea of having one is crucial in ensuring long term success.
The ideal scenario is when a stock you own has little to no competition. This is rare, and usually only happens with smaller market opportunities, but can lead to fantastic results. Warren Buffett calls these businesses “consumer monopolies” as they can often get away with price discrimination, cartels and collusions without even losing customers due to competition or regulatory affairs.
4. Analyzing Trends
The key trends to focus on are:
· An increase in the trend of earnings (preferably use the dataset for the last 10 years)
· An increase in the dividend payout ratio (or dividend per share)
· An increase in operating cash flow per share
· An increase in the consumer base
· An increase in the asset base
· A decrease in long term debt
Any company that is highly leveraged, will encounter solvency issues as the debts pile up. An increase in assets or a decrease in debt is a good sign showing the companies commitment to pay off its debts and commit the remaining profits to its shareholders.
In cases where the net profit can be manipulated by overstating expenses, it’s a lot harder to manipulate operating cash flow, hence the two metrics should be assessed simultaneously.
A growing demand, consumer base, and asset base shows the company’s commitment to ensure it keeps its focus on gathering more users and making sure that they have a sufficiently strong asset base to keep on increasing production.
5. Calculating the Intrinsic Value
A prima-facie conclusion for the above steps all lead to a calculation called “DCF.” Discounted Cash Flow (DCF) involves discounting the future stream of cash flows one expects from holding the stock and finally discounting it’s terminal value in addition to the other cash flows to arrive at a number that may or may not accurately depict the stock’s “fair value.”
In other words, calculating the intrinsic value involves computing the stock’s fair value to gauge whether or not the price we pay today to acquire it is “too much or too little.”
Nobody knows for certain whether a company will beat the indices or whether the stock they select will beat the market. The DCF approach very simply tries to quantify a rather mysterious random walk component which is a “stock’s price.”
Using a few conservative predictions for revenue growth, operating/cash flow margins, buybacks/dividends, and any other future valuation metrics to estimate whether a company could beat the market is in my opinion “completely irrational,” but it is the best approach to the worst possible kind of dilemma we have, which is trying to decipher fear and greed.
It is no easy task quantifying human emotions, just like I mentioned in the beginning, that the models we base our calculations on have numerous factors that need to be taken into consideration.
Every industry is different. Analysts use the Dividend Discount Model (DDM) to compute valuations for banks, for example, since the stream of cash flows generated by banks isn’t really quite predictable in regards to the stream of dividends it pays year-on-year. Similarly, for technology stocks in merger models, we look at accretion/dilution to gross margin per share. In addition to multiples like EV / Revenue, EV / EBITDA, and P / E, as well as the DCF analysis.
Each industry is valued differently when the intrinsic value is being considered, thus the average investor should ideally bare the basics in mind, in addition to applying the optimal ratios to gauge under/ overvaluation.