Phase II – Financial Analysis

This phase of lesson sets explains intrinsic value and financial analysis. There is no single formula that is universal; there are at least six common formulas to calculate intrinsic value. The various formulas require the user to understand the five different financial statements and how to properly interpret them.

Intrinsic Value – Balance Sheet Fundamentals

Intrinsic Value - Balance Sheet Fundamentals

Novice and unsophisticated investors place greater reliance on net profits over the balance sheet to determine intrinsic value. However, most so-called experts forget what intrinsic value means; intrinsic value refers to the universally accepted core value of a company. In many cases, this can be easily derived from the balance sheet. If not derived from the balance sheet, the balance sheet can act as additional assurance that certain intrinsic value formulas are superior and best suited given the balance sheet information.

Understanding how a balance sheet is laid out, works and reports this information greatly assists value investors with determining intrinsic value. Gaining knowledge about balance sheet fundamentals takes a value investor to the next level of comprehension of value investing.

This is the second part in a series about intrinsic value. It is the first in a four-part series about the balance sheet and different intrinsic value formulas that are tied to the balance sheet. The next lesson in this balance sheet series delves deep into analysis of asset matrixes and proper interpretation of that information. It also includes how to tie the asset matrix to the liability layout. Understanding this relationship allows the value investor to apply certain intrinsic value formulas which are explained and illustrated.

Intrinsic Value – Definition and Introduction

Intrinsic Value

Intrinsic value has several different definitions when used in the business context. The word intrinsic refers to ‘innate’ or ‘inherent’. Whereas value refers to the exchange mindset between two or more parties. Thus, intrinsic value refers to the core understanding between parties of the worth of something. When looking at the market price for a security, having knowledge of the intrinsic value prevents over paying for an investment. The key is determining this price range for the security. The primary rule for intrinsic value is straight forward; it is a RANGE and not an exact dollar value.

With value investing, the goal is to narrow this range to a set of values that are REASONABLE and OBJECTIVELY verified. Therefore, rule number two, intrinsic value must be reasonable and objectively determined. Finally, all users of intrinsic value must understand and appreciate that intrinsic value is not static. It changes every day and for highly stable companies, it should improve every day in a predictable manner with a high level of confidence.

Value Investing – Industry Principles and Standards (Lesson 25)

Business Principles Pyramid

Shifting from economic wide factors that impact market price to industry wide standards is essential with understanding and creating decision models for investment with a pool of similar companies. Industry standards are a part of the spectrum of business principles. This spectrum starts with tenets, universal rules that can not be broken by anyone in business. With value investing, the focus is on the primary business tenet of buying low and selling high. It is an undeniable requirement to increase one’s wealth. The spectrum moves towards core business principles that sometimes are not universally applicable. The final set are industry standards. Each industry has its own unique set of principles it must follow to be successful. Some are a function of law, others are driven by consumer expectations or the culture of the industry. For value investors, understanding this dynamic set of standards for each industry drives the holistic thinking of effective investing.

Value Investing – Concepts of Economics and Business Models (Lesson 19)

Concepts of Economics and Business

There is no single statement or overriding concept that equates to defining economics. There are about a half dozen or so concepts that the average person would state as a definition of economics. The most commonly accepted definition of economics is the balance of supply and demand. In effect, it refers to determining the relationship between needs/wants against limited resources. With value investing, understanding the concepts of economics allows for a more comprehensive elevation of thought related to financial analysis. There are literally hundreds if not thousands of forces at work at any given moment impacting the market price and of course a value investor’s intrinsic, buy and sell value points.

The study of economics is done at two levels. The macro level refers to the study of economics as a whole. It focuses on how different characteristics impact the overall ability to efficiently produce and delivery goods to consumers. Think of the impact the federal government has related to laws that in turn affect production and consumption of goods and services. For value investors, there are many different macro level decisions that affect financial analysis. These include decisions made by the Federal Reserve, specifically related to interest rates. Others include unemployment, tax rates, and governmental expenditures especially for capital improvements.

The second level is called micro economics. This brings in all those macro level changes and their respective impact on individual businesses and industries. As an example, a simple increase in the interest rate by the Federal Reserve affects the interest rate related to long-term leases. In the immediate short time period, there is very little change as leases have cycle time frames before they the lease’s interest rate changes. But, in due time, it will affect the interest rate which in turn impacts certain industries. A single railway leases thousands if not tens of thousands of railcars. An interest rate increase will in turn up how much cash outflows for leasing purposes. Ultimately, the railroad will raise their revenue per mile of tonnage which increases sales to offset the outlay of money for a lease.

Intrinsic Value – Application of Discounted Cash Flows

Discounted Cash Flows

Every student of investing is taught the core principle of discounted cash flows. This business principle is also used with intrinsic value. Application of discounted cash flows assists value investors in determining intrinsic value. Academia, major investment brokerages and the majority of investment websites place unquestionable belief in this single formula to equate value for a security. The problem here is that all of them forget or ignore the underlying requirements to use and rely on the outcome of the formula’s solution. In effect, with intrinsic value and the application of discounted cash flows, there is a very narrow set of highly defined parameters whereby this tool is applicable. Used outside of this framework, the result’s reliability quickly drops to nearly zero, like either side of the bell curve.

This article starts out by identifying the highly restrictive requirements to apply discounted cash flows. There are at most 20% of all marketable securities where this formula succeeds in determining intrinsic value. Secondly, the formula is explained to the student and why it is so important to apply it properly. There are several terms and values the user must include in the formula; this section explains them in layman’s words.

The third section below goes into the corporate financial matrix to explain how to determine cash flows. Furthermore, cash flows are just not the past year or years; it is really about future cash flows. How do you equate something in the future?

The final section puts it together when determining intrinsic value. Unlike what others state, intrinsic value is not a definitive value; it is a range. The job of the value investor is to narrow that range to a set of values that are reasonable and effective with generating gains with the value investor’s mindset of ‘buy low, sell high’.

The overall goal of value investing is to buy a security at less than intrinsic value, commonly referred to as creating a margin of safety; then waiting for the market price to recover to a reasonable high and then selling that security. The depiction here illustrates this concept well.

The most popular and improper method to determine intrinsic value is the discounted cash flows method. It was advocated in the book Security Analysis written by Benjamin Graham and David Dodd, the fathers of value investing. However, most so called experts didn’t read the entire book. Graham and Dodd only used this method under certain conditions. The same conditions as explained in the first section below. They strongly encouraged calculating intrinsic value from the assets valuation perspective (balance sheet basis) and not as a function of earnings plus cash adjustments (cash flow).

Value Investing – Economic Uncertainty (Lesson 23)

Railroad Fund

If you think of the economy as a train pulling a load on the track, you would base its near future position on its current and historical trend. It is unlikely its current speed will change; thus, we can predict its future position with some degree of confidence. The short-term position is easier to determine with greater conviction and accuracy than 3 to 6 time periods out. Why does our confidence decrease the further out in time the train travels? Inherently, we know that there are variables that can impact the outcome. What if the train slows down? What if there is engine trouble? Worse yet, what if the track is blocked and the train must stop to wait for repairs?

In economics, these unknown variables are referred to as uncertainty. Uncertainty is typically measured and reported at the macro level. This is due to vast resources available to predict the economic results in the near future with a high level of certainty. Again, the further out in time the prediction is made, the more uncertain the forecast becomes.

Insolvency – Detection

Insolvency

Insolvency refers to the ability to pay bills in a timely manner. It does not mean bankruptcy but long-term insolvency is a underlying factor of bankruptcy. Many owners and/or managers of small business have no idea of how to determine if the company is insolvent or headed towards the inability to meet their day to day obligations.

Cash Flow From Operations – Basic Formula

n a pure cash only operation, the profit as reported on the income statement would also be cash flow from operations. But modern-day business is not pure in how it is conducted. Companies agree to pay suppliers at a later time, payroll is weekly or monthly, benefits that are paid in the future are offered to employees, credit is extended to customers; the list can go on and on.

Value Investing – Economies of Scale (Lesson 24)

Economies of Scale

Of the basic business principles, economies of scale has the greatest impact on profitability over any other business principle. As an enterprise’s investment is spread over higher volume the cost per unit of production decreases. The differential between sales price and cost changes add to the overall profitability for the company.

Economies of scale exists in two distinct forms. One isn’t reported in the financial statements and is referred to as the ‘learning curve’. The second form is identified in the financial reports and is called ‘leverage’. When both forms exist in a business and tweaked to perfection, efficiency is maximized and therefore profits reach optimum peaks. Once achieved, the business must exercise the same forms of scale as they grow from a start-up to a publicly traded company.

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