I shall be extremely brief in this post. There are too many, far more qualified people that you can learn company valuation from. So what I will be doing is stating some common practices I've read & applied. I will attempt to add value by demonstrating, with the help of Portfolio 123, how these comon practices add value relative to a simple "buy & hold the S&P500" strategy.
So we are attempting to find easy ways to screen stocks (so using screeners that are free for everyone) that can generate better results over time than just picking up beta (i.e. copying the S&P).
Furthermore, we will attempt to find out exactly where the "alpha" comes from and take it back to real-world reasoning.
2. Financials - how to read them and what they mean
Investing differs from trading. Sure, the final objective is always to generate a substantial return on capital invested, but the time horizon and objectives are different. In trading, you're looking to time the market, attempting to make money whatever the conditions: lateral markets, uptrends or downtrends. Moreover, trading is inherently a short term exercize. Investing instead is based on identifying conditions that should allow you to invest in one or more assets for an extended period of time (3 months, 6 months, 9 months, 12 months or more) and let the market take your equity for the ride up (hopefully!).
So where to start, when attempting to identify longer term "buy & hold" ideas?
Graham would say "buy something that's selling for less than it's worth"
Buffett (his disciple) would say "buy something that's got a sturdy competitive advantage, and that's priced at a discount".
So unifying the two ideas, you get a phrase made popular by Alpha Architect "buy the cheapest, highest quality stocks". And this leads us to the initial questions:
a) how to you identify a "high quality" stock?
b) how do you identify a "cheap" stock?
To answer these questions, we need to dig into the financials, which are held in the Balance Sheet, the Income Statement and the Cash Flow Statement.
Balance sheet checks:
a) Liquidity check with Quick Ratio or Current Ratio. We are looking to see if the company has enough readily available liquidity to cover it's current liabilities.
b) Debt Ratio = Debt/Equity and of course we're looking for a number less than 1, or even better if less than 0.5 (so the company has half as much debt as it does equity).
c) Working Capital = Current assets - current liabilities (more is better)
d) (Inventories/Sales) check over time: if the company's inventory is rising over time, it might mean the good/service is tough to sell and/or the company has issues.
e) Book Value per Share = (total assets - intangible assets - total liabilities)/ N°Shares and we finally have the first measure of the company's net worth, or what it owns above and beyond what it owes. Most companies are able to grow their net worth over time...or at least that's what they try to do. And that's why all analysts and TV reporters focus on "earnings growth", "revenue growth", etc.
But how much growth is sustainable? As a rough measure, companies in the long term revert to the growth rate of GDP + Inflation. If GDP has a historical growth rate of 3% p.a. and inflation is another 3% p.a. on top of that, then we can expect 6% p.a. growth. But on top of that, most stocks also pay a dividend (a part of earnings distributed to investors), which is historically in the 3-4% range. So the total return that a stock investor typically wants, in order to be compensated for the extra risk, is around 10% p.a.
f) Long term debt/ Total assets = is the company accumulating debt to finance it's expansion/growth/current operations or is it able to continue it's course with low debt? Lower is obviously better.
It's best to monitor these ratios over time (at least 5 years) to observe how the company has weathered the ups & downs in the economy. If the company passes these initial checks, then we can conclude that the company has good Stamina, and has the potential to survive over time.
Only if the company passes these initial tests, can we switch to the Income Statement.
Income Statement Checks:
a) Revenue should be growing over time = the company should be increasing it's sales, expanding market share, or increasing the price of it's good/service. If the company has a competitive advantage, it will be able to do this.
b) Cost of Goods Sold / Revenue = measure of how easily the company can pass through certain costs to it's clients. If the company has to absorb costs itself, then there are issues. Either it's losing competitiveness or it's internally losing efficiency. So this ratio shold be stable or lower over time.
c) Gross Profit = Revenue - Cogs, and evidently it should be stable or rising over time.
d) EBIT = Gross Profit - Sales, General & Admin costs, and obviously this should be rising over time as well.
e) Shares Outstanding = we like to see the number of shares outstanding stay the same or decrease (via buybacks). If the company issues more shares, then it's generating more equity (risk capital) and thus is diluting share price and earnings. Also, buybacks are a sign that the company is convinced about it's operating capacity. It's a bullish sign.
f) Return on Capital should be rising over time (otherwise the company would be making wrong investments and could be labeled a bad capital allocator).
If the Company passes these tests, then Great! But...what comes next?
The next step is being able to compare, at a glance, 2 companies and see which one is more robust. Morningstar allows us to do this easily, with 10 yr financials readily available.
For example, compare Coca Cola:
http://financials.morningstar.com/income-statement/is.html?t=KO®ion=USA&culture=en_US
to Pepsi:
http://financials.morningstar.com/income-statement/is.html?t=PEP®ion=USA&culture=en_US
This basic exercize will help avoid dashing into stock screeners without knowing what you're looking at. I would highly recommend reading the books used as references (at the bottom of this post) to get a more in-depth feeling for financials and company performance.
3. All stock screening roads lead to Graham
Graham was most likely the first "quantitative stock investor" in history. Old School Value has done up some impressive articles on him here: http://www.oldschoolvalue.com/blog/investing-strategy/graham-stock-checklist-screen/
but what we are going to do is show how solid, basic principles continue to work even today. Graham believed that a simple portfolio made of 30 stocks with
Price / Earnings < 10
Debt/Equity < 0.5
would outperform the market and generate around 15% p.a. How does this observation hold up over time? Portfolio 123 gives us a hand:
Backtest with:
Mkt Cap > 50 Mln
P/E TTM < 10
Debt/Equity TTM < 0.5
Rebalance annually
Backtest with:
Mkt Cap > 500 Mln (so removing any small cap bias)
P/E TTM < 10
Debt/ Equity < 0.5
Rebalance Annually
Notes: Graham's rules work best with an annual rebalance schedule. Quarterly or semi-annually limits the upside. Also, being more stringent on P/E levels (bargains) and/or Debt levels (quality) appears to limit the strategy's effectiveness as well.
What Graham did was just say: let's find a relative discount (via P/E, which we know is highly correlated to the stock price) on a stock that has low debt (so a certain measure of quality).
The results, from 1999 until 2015, speak for themselves. A passive buy & hold beats the market hands down. The question then becomes: can we do better?
References:
The Little Book that Beats the Market - J.Greenblatt
Quantitative Value - Grey, Carlisle
The little book of Value Investing - Browne
The little book that builds wealth - Pat Dorsey
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