The point of the book is seeing the connections between the financial statements. That’s so important. And it’s really the only thing I have to say about accounting. It’s about fluency. It’s not about knowing in detail how this or that is calculated. It’s about knowing how things on the income statement and the balance sheet and the statement of cash flows work together to tell the story of a business.
Recently, I’ve written 3 articles that show how investors can use accounting:
Well, reading Richard’s posts finally inspired me to start using Sharelockholmes. It’s a site that screens stocks in the United Kingdom. And it’s very, very good.
It’s also reasonably priced. About $8 a month at the current exchange rate.
Anyway, I was thinking about how I’d just written an article where I said Warren Buffett looks for a good business priced to return 10% a year initially and grow from there. It used to be 15%. But he’s lowered his standards. Berkshire simply has too much cash to invest. It doesn’t help that stock prices aren’t real low right now. But you play the cards you’re dealt.
It shouldn’t be too hard to find the kind of decent businesses at decent prices that Warren Buffett might invest in, right?
This is the quote I had in mind when designing my screen:
If we were working with $25 million – so we could sort of look at the whole universe of stocks – I would guess that you could find 15 or 20 out of three or four thousand that you would find that were A) selling for substantially less than they’re worth, and B) that the intrinsic value of the business was going to grow at a compound rate which was very satisfactory. You don’t want to buy a dollar bill that’s sitting for 50 cents, and it demands positive capital, and it’s going to be a dollar bill ten years from now. You want a dollar bill that’s going to compound at 12%…And, you want to be around some competent people. Just the same thing as if you went in and bought a Ford dealership in South Bend. The same exact thought process goes through your…mind about all the other businesses that are in Standard and Poor’s.
I figured I could do a quick screen and come up with a preliminary list of stocks that looked like they could both start you off with a 10% initial return – basically, a P/E ratio under 10 – and then reinvest future earnings at an acceptable rate.
Well, the preliminary list actually turned out to be quite short.
My requirements may have been a smidge too strict.
I asked Sharelockholmes to find companies with a 10-year ROE of at least 10% and a price to 10-year EPS of no more than 10. I also demanded the Z-Score be at least 3 since that’s the clearly “safe” cut-off.
I then threw out any homebuilders myself, because I couldn’t trust their Z-Scores. I didn’t feel right including them in a list intended for Americans and other investors who might be looking at the U.K. stock market for the first time. Development works a little differently over there. It’s tough to judge homebuilders by their 10-year records since there was a housing boom. So I just felt better leaving homebuilders out of this for now.
There are a lot of ways to calculate return on capital. Whenever, you see me use the term, it means:
Operating Income / (Total Assets – (Intangibles + Cash))
To be completely honest, I don’t look at net income. I look at operating income and I look at free cash flow. As far as I’m concerned – operating income, free cash flow, and comprehensive income make more sense than net income. But net income is the number they print in the papers. So it gets talked about.
Shouldn’t you include intangibles?
I want to know what the business naturally earns on its own assets. The book value of all assets is somewhat arbitrary. The book value of intangibles is completely arbitrary. It’s based on corporate events like acquisitions. It’s not the general manager’s responsibility. Often, the most valuable intangibles don’t appear on the balance sheet. And the least valuable intangibles appear on the balance sheet only to be written off later.
Shouldn’t you count some cash as non-surplus?
I hear people say that all the time. But it doesn’t make much sense to me. Sure, businesses usually have some cash on the balance sheet. But it’s much easier to assume that cash is always an asset apart from day-to-day operations than to try separating required cash balances from surplus cash. That’s being too clever.
If you really want to talk about surplus and non-surplus cash, that depends on cash relative to liabilities. In other words, a totally unleveraged company can always borrow money and get the “required” cash into the coffers that way. While a leveraged company can have plenty of cash on hand and yet not really be holding enough cash to pay its bills as they come due, because it’s got debt repayment to deal with too.
For me, cash should always be separated from the return on capital calculation. Cash is part of the solvency analysis. It’s not part of the business quality analysis.
And it’s easier to use just one formula. Otherwise, you get too clever and start letting your personal biases determine the right formula for every industry.
Basically, I want to start by looking at the business alone. The stuff the company actually does and the assets it actually uses. I don’t want to start by worrying about whether it uses common stock, preferred stock, short-term debt, long-term debt, insurance float, whatever. I want to start with the business. Then I move on to the finances.
There is one very legitimate argument against using the return on capital formula above…
Isn’t the return on equity what really matters?
But, when I don’t know anything about a company, I always start by looking at the return on invested tangible assets. Then, if it’s a railroad, or a power company, or a water company, or a bank, or whatever – we can talk about what the appropriate leverage ratio should be.
I never talk to a company’s management before I invest in their stock.
Since I usually invest in micro cap stocks, it’s very easy to talk to management. I just don’t think it helps. In fact, I think it hurts.
It’s psychologically dangerous, because investors who talk to management get confident for all the wrong reasons. You can’t take anything management says at face value. Not because CEOs and CFOs are liars. But because we are all liars. Especially to ourselves. So, if your question is: “are you going to pay a dividend?” or “are you going to do a stupid acquisition?”, they’ll tell you what you want to hear until one minute before they announce they’ve done the exact opposite thing.
They’re probably telling themselves they are committed to a dividend until the second they have the chance to buy a competitor instead. That’s when they think: “This is a once in a lifetime opportunity. We can’t pass up on this. It’s okay. Just this once.”
It’s natural. We all do it. Projections and future plans aren’t something I want to hear about. I look at management’s past interviews, past record, and past behavior. I read old annual reports in order. So, if the company has annual reports on its website for the years 1999 – 2010, I start with the 1999 annual report and read up to the present.
I assume people never change.
That sounds harsh. But it’s an effective way to invest. Serial borrowers will keep borrowing, serial acquirers will keep acquiring, serial share issuers will keep issuing shares.
I don’t believe them when they say they’ll stop. I treat it just like if an alcoholic said: “tomorrow I’m going to stop drinking.” Okay. I appreciate the sentiment. But we both know what’s going to happen tomorrow.
Until you’ve got demonstrated proof of a difficult and unusual change in behavior – not just language – I’m going to smile and nod and not believe a word you say.
That’s why I never talk to management before I buy a stock.
Now, talking to management and studying management are two completely different things. I’m all for studying management. I’m all for analyzing management.
I’m all for observing management. I just don’t believe an observer should speak with his specimens.
And once you own the stock, well that’s a different story entirely. If you want management to do something, you can talk to them. But if you just want information…
I’m skeptical that talking is the best way to get it.
This is something that’s come up in emails readers and I have exchanged. If I was teaching an Investing 101 course, when students walked in on the first day this would be on the board:
Assets = Liabilities + Equity
Assets – Liabilities = Equity
Assets – Equity = Liabilities
This is taught in accounting classes to show how every transaction affects at least two of a company’s accounts and the equation always stays balanced.
I mention it just because it’s useful in situations like the blind stock valuation where I didn’t show the mystery company’s liabilities. Some folks mentioned that I didn’t show the liabilities. Of course, I did show the mystery company’s liabilities because:
Assets – Equity = Liabilities
For balance sheets found in 10-Qs and 10-Ks filed with the SEC, it’s pretty common to just show the total assets and shareholder’s equity at the bottom of the balance sheet without totaling the liabilities.
The reason for this is that for the sheet to “balance” you can’t literally show assets on one side and liabilities on the other. You actually show assets on one side and liabilities plus equity on the other.
If you watched my eyes run down a balance sheet, the first thing I actually do – by force of habit – is race to the assets and equity at the bottom of the page to instantly see how leveraged the company is. Sometimes that’s all it takes to eliminate a stock from further consideration.
In theory, that bottom most number is liabilities plus shareholder’s equity (which is on the line above it). But, since you know the accounting equation, you know that liabilities plus shareholder’s equity is always equal to assets (Assets = Liabilities + Equity) so the two bottom most numbers are effectively a company’s equity and assets. The difference between them is total liabilities.
So, the two bottom most lines of a balance sheet actually tell you a company’s assets, liabilities, and equity in just one glance.
That one glance also tells you how leveraged the company is. If you see a lot of assets sitting below a little equity, that’s a highly leveraged company. If the two numbers are close together, that’s an unleveraged company.
It can also be helpful to think in terms of leverage ratios.
I have just recently started to use discounted cash flow analysis with owners earnings. You have stated that changes in working capital should be included in owners earnings calculation. However, a lot of value investors on the web seem to think that changes in working capital should not be included…Up until now, I have excluded changes in working capital. But your articles have made me think that I should include it. If you don’t mind, please clarify this for me. I just want to use the right data for my discount cash flow analysis.
Geoff, if changes in working capital is included in owners earnings then would the owner’s earnings formula simply be: cash from operations – maintenance capex? I sure hope so, because having to exclude working capital is very confusing because not all financial sites list it the same way.
Also, what free financial site has the most accurate cash flow statements? I personally have been using MSN MoneyCentral, but I (am) starting (to notice) that sometimes their figures are different than the company’s 10K filing. Any suggestions?
You should include changes in working capital. So, when I say free cash flow I simply mean “cash flow from operations” less “capital expenditures”. Some people talk about separating growth capital spending from maintenance capital spending (including Warren Buffett). They’re obviously smarter than I am or have access to financial statements I don’t. The statements prepared for outside investors – not management – don’t provide enough detail to separate growth capital spending from maintenance capital spending in more than 90% of the cases. Birner Dental Management Services (BDMS) is a rare exception.
If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges…( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included…)
I don’t do discounted cash flow calculations. Charlie Munger says Warren Buffett doesn’t either.
A lot of people do discounted cash flow calculations. And a lot of people don’t wear seat belts.
Discounted cash flow calculations are the most misused tool in investment analysis. I think they’re insanely risky. But, again, most people disagree.
I read the statements at EDGAR. The figures I cite here are always taken from EDGAR and then adjusted as necessary by me.
That’s a total cost of $143.22 to build a complete – for our purposes – Ben Graham library counting only books in print. And $188.21 if you include a used copy of the memoirs.
So you can buy a complete library of Ben Graham’s investment writing for about $200 at Amazon.
A couple ex-library copies of the memoirs have passed through my hands over the years, and they’re usually in good shape. Ben Graham’s memoirs appeal to such a niche audience, it’s likely no one actually read the library’s copy.
The memoirs only touch on investing in spots. But if you’re really into Ben Graham, you should get them. Buying these books is only worthwhile if you both have an appetite for Ben Graham’s stuff and you’re a voracious reader.
I read old books, papers, etc. It’s something I like doing. If you don’t like reading stuff that’s 60 to 90 years old, you probably aren’t going to like reading these books.
Some people can’t get through Graham. I don’t know why. But you might be one of those people. Sample some of Graham’s actual writing first to find out.
If you just want the core “how to invest” stuff by Ben Graham, it’s simply:
The usual caveats for any decades old academic / technical writing applies to these books.
All the information in them is dated. This isn’t what Graham would write today. It’s like reading Keynes or something. It’s a classic. But it’s definitely not the way today’s students are introduced to the field.
Do you know of a place where I can find walk-thrus of valuation work where they actually include important things to look for when getting started? I’ve been looking for a full case study with some answers to questions that a novice might have but haven’t really found a comprehensive source for that type of thing. Find lots of valuation work out there on SumZero etc. But most seems to be for advanced users. Any ideas?
Here are 15 places where you can find valuation walkthroughs: