Before Starting The Book
So I bought this book a few weeks ago, it was not recommended by the morning show guys over at The Motley Fool. I should restate that, they didn’t not recommend it and say it’s not a good book they just never brought it up.
I just know there are things I don’t quite have a grasp on when look at Yahoo finance at various companies financial statements.
So I went on Amazon.com and that’s how I came across this book. I bought a few others but I am starting with this one.
Hopefully I can learn a lot from it, I think I will
Things I hope to learn: Understanding how to read and interpret financial statements public companies make public. More importantly how to arrive at conclusions based on various calculations as that will be what is really important. Making the calculations will not be the hard part, I graduated with an electrical engineering degree and certainly any of the math done will not more advanced than honors algebra 2 I took in 10th grade.
Thoughts: I’m unsure if it will have too much info on private companies, which in the end is the goal. To learn about how to become a skilled analyst of private companies.
Also, when I am using quotes just understand it’s not going to be an exact quote but more of me paraphrasing.
Starting The Book
Page 5
So the book starts off talking about Benjamin Graham’s idea of “Mr. Market” and how he can behave on different days. “Mr. Market” is Graham’s way of personifying the movement of the very large set of stocks in the S & P 500, as they move based on their market cap weighted average.
I totally understand what he was trying to do and what he did when he would use this “Mr. Market” as a teaching term, but coming from my background of playing poker professionally I come to find that I am at odds with this idea.
Why? Because it is based on giving an emotion to something or “someone” that does not have any emotion at all.
The market is not one person that behaves a specific way, it is a huge conglomerate of thousands, even millions of peoples ideas all put together into a single output, that in this case Mr. Graham calls “Mr. Market”.
Emotional Decisions Are Bad, Bad, Bad
And it is my opinion that for the VAST majority these inputs, or people are making very poor, emotional decisions when they are deciding to trade their stocks.
Making a trade should be totally 100% void of any emotions. That’s what I think is best for just about any investor.
I think if someone buys into the idea of this “Mr. Market” and his emotions of being “happy” when the market is going up, or “sad” when the market is going down, is opening the door for them to have their own emotions creep into their very very very important investing decisions.
That’s bad, not good.
Guessing “Why” Up or Down?
We don’t know why (for the most part) the market goes up or down in a given day. What emotions or reasons individuals are having for wanting to sell or buy on that given day.
What I do know is the vast majority of those people will NOT beat the market over any decent sample size period (5+ years).
So why bother trying to interpret their emotions or what those fools are thinking or feeling? It’s a waste of time I think.
It’s a cute idea “Mr. Market” but it is definitely not for me.
I want to be a stoic when making investing decisions.
page 11
Emotions, Emotions, Emotions
“we can’t predict the future, but we can reasonably assume fear and greed will continue to play an active role in market movements in the future.”
Oh my god do I LOVEEEE this statement, it is pure gold!
Yes we can assume many people many of who will never come close to beating the market will continue to make emotional decisions (fear and greed) as time goes on, they will not get smarter or more emotionally intelligent. It’s just a fact, and I’m ok with that. It’s where the great returns come from for long term thoughtful investors, straight off the backs of the people losing money trading off emotions.
page 12
Goes more into the emotional aspects and talks about how great investors learn to separate any emotions from their decision making.
I couldn’t agree more.
Being completely void of emotion (yes it’s not easy) when for example the stock market is crashing on a given day is an essential skill to have as an investor.
Conversely being completely void of emotion when your portfolio is up %12 in a given day, it is just as important in this case (maybe even more so) to be completely void of any and all emotion.
I think this means you should not even be feeling any type of joy or satisfaction based off of the latter event occurring on a given day.
Not easy, I know.
Relating To Poker
So in poker this happens all the time. Going through huge up swings or down swings over the course of even a given 8 hour session. Going from being up 300bb ($1,500) to down -300bb(-$1,500) can happen, and more often than you might think or imagine.
So with swings like this is so important while playing live poker to not deviate from your game. Just because you are does not mean you should feel good and play more hands because you are hitting more cards.
That would be you letting your emotions creep in and in the long run that will hurt your ROI.
Getting unlucky? That does not mean you should play less hands or change your game in any way what so ever.
The cards do not have a memory.
That’s a fact.
around page 10 (sorry for jumping around)
The book talks about an idea I want to explore more. It talks about how game theory ideas relate to investing.
In game theory of a zero sum game if there are opposing sides and for this example only 2 sides, and one side advances or takes, then that means it came from the opposing side. It did not come out of no where, it didn’t come from thin air.
This idea I know has to relate to how there are so many many people who not only can’t beat the market but that actually lose money over time while attempting to trade (especially day traders).
And these few people that do beat sometimes crush the market, that money is coming off the backs of so many people who are not beating the market.
Am I Too Negative?
I speak negatively or so it seems when I bring up this huge group of people who can’t handle their emotions and it’s not that I don’t think they are good people, it’s not it at all.
I just think they are attempting to play a game without being prepared for it.
No different than when I would play poker against people that had absolutely no chance at winning over any decent period of time. They were great people and fun to play with but the same, I look at them as being not prepared enough.
Chapter 2
Interest Rates
page 18
“as a stock investor is extremely important to keep an eye on the interest rate you should act differently in the stock market when the interest rate is low compared to when it is high”
I’m very new to understanding this type of idea, and I cannot wait to learn more. I know it does not mean that when interest rates are high you should sell or when they are low you should be buying, it’s not that at all.
Also it is definitely not about attempting to predict what the interest rates will do in the future. It is more about acknowledging where they are in the given environment that you are in, while contemplating various investments or divestments.
Inflation Information
page 21
Inflation happens because as time goes on people are consuming more and more. We can convince ourselves of this just by understanding that consumption is really talking about energy and we as people are consuming more energy than we did 10 years ago, 50 years ago, 100 years ago.
And not linearly.
Humans Consume, Alot!
So people are consuming more stuff, buying more stuff, selling more stuff and all of that generates more employment and wealth in a society. All of this will cause prices to increase over time.
Also couple this with what it cost to explore, invent, and invest in new technology which makes peoples lives more convenient. The investment needs a return and that return comes from being able to sell this new convenience for a higher price than the convenience that was in place prior.
And then we top all of this off with the government adding more money into the system over time to help support this increase in consumption.
A Thought Experiment
Do a thought experiment of the last idea, what if the government did not introduce new dollars into the system, what would happen?
Well a possibility would be that less and less people would be able to experience this newly invented convenience because there would not be enough dollars going around for that to occur.
It’s not finished idea I know but it’s on a journey and one day I will explore this more.
Dilution
page 30
Earnings Per Share, “This is an extremely important number because it represents the profit of the company for each share.”
So this is what I didn’t really understand when I first started investing and learning from the Motley Fool. The whole concept of dilution and how these shares are getting created out of thin air I didn’t understand where they came from or how they affected me.
Later I come to understand the equity share creation is the greatest cost to a business way worse than debt. I need to explore this more and I will when I get started with spreadsheets when learning more about the financial statements.
Equity Calculation
Page 32
Learning about the equity calculation I would see on balance sheets I never understood it. But it makes sense it’s what the company owns not including any liabilities on those assets.
It’s listed in the liability column because the company doesn’t have it as an asset it has an liability because it is liable to the shareholders that is with the shareholders own so it’s a liability to the company shows up as a liability on the balance sheet.
Makes sense now.
Heck is Book Value???
page 33
It’s talking about how the equity is the book value which I would hear so much and I never quite understood book value understood it’s what the company owns but I never quite fully understood that it was exactly the equity calculation on the balance sheet which makes total sense now.
UPDATE:
ok so the book value is just the equity divided by the total shares so you get a shareholder equity per share which is the book value.and that’s how you get a price to book which means stock price to share price. Or I guess you could just do market cap over shareholder equity to get the same number.
When they talk about some company trading at price to book ratios like Berkshire middle of 2022 when it was a good buy.
I will learn and more importantly understand way better when I starting putting numbers and examples on spreadsheets.
Of course I’ll share them when I start doing that, duhh!!!
Chapter 4
So right away chapter 4 starts off with a 1-4 list of Buffett’s principles and number three is stock stability I don’t understand this at all, yet
Does this have to do with like the volatility of the stock which would mean it’s really talking about other people’s expectations in the short term which I don’t believe is very helpful at all. Or maybe it’s not, I need to read on and figure it out.
Buffett’s Four Rules
Warrens four rules first rule load debt, understood second rule heigh current ratio which is just current assets minus current liabilities, rule three strong and consistent return on equity (ROE=net income/equity), which is like similar to return on invested capital but I have to exactly figure out the difference.
Rule four is appropriate management incentives which I love in the monthly fool has always instilled in me you want to find companies especially smaller companies that have management skin in the game and then incentives are aligned with the shareholders
This last one number four can we come at odds with all of the stock-based compensation that the high growth companies have been doing
Debt To Equity
Page 44, debt to equity calculations pretty simple which is add up all of the debts and make sure you know the assets and calculate the equity from that. Just divide the debt divided by the equity to get the ratio, Warren likes a .5 ratio as a rule of thumb which means these are just safer companies that can maneuver better when things change because they don’t have as much debt obligations.
So page 45 is talking about the current ratio which is the current assets divided by the current liabilities and the word current pertaining to within the past 12 months
Buffet lights his companies that have a ratio above 1.5 which means he just likes them to have more assets than liabilities by 50% more, again very safe for a change of environment, unforeseen events.
Page 46, okay so here is how we learn how to calculate ROE it is the net income divided by the shareholders equity which we just learned was the assets minus the liabilities of the business.
Page 48 ROE calculations making a lot of things and how buying the second machine which was double the cost of the first machine but still only produced the same profit as the first machine totally reduced the ROe
This really demonstrates management’s decisions severely affect the company’s performance with how they allocate capital and therefore increasing or decreasing the ROE
Return on Equity
Okay so page 49 is confusing me it’s telling me that a higher ROE something over 8% like Warren buffet likes is a good thing. And are we that has been steadily increasing over the last 8 to 10 years.
So the key to a study or increasing ROE is the fact that you want your net income to be greater than or equal to the shareholder equity or if not greater then just right at there staying consistent enough.
If the net income starts to dip below the shareholders equity then that will cause the ROE to decrease, which can be ok if it is minimal and only short lived.
You want companies with consistent ROE
The net income must follow the investment level to maintain the ROE or be more than it to increase the roe
Management Aligned with Shareholders
Page 52 very important talking about owner operators having their own incentives and watch out for CEOs that want to expand their empire become more notable more famous at the expense of obviously shareholders who will be supporting their agenda.
Page 53 specifically talks about management having incentives based on the share price because this can be manipulated and I know this from watching the morning show at the motley fool. They can manipulate earnings in the short term which will obviously hinder long-term performance which is not not what you want as a long-term investor shareholder.
Management Speaking Incorrectly
Management can start to give inappropriate reactions saying things about the psychology of the market driving their stock price down or other nonsense like that.
I definitely want to avoid companies that have incentives based on the stock price in the short term, I need to look into Unity because I think this might have happened recently?
I want companies that clearly disclose how much it will be compensated on base salary plus the variable incentives, and not try to hide this in small footnotes around their reporting.
Summarizing
Page 55 summarizing
1. Debt to equity ratio of below .5 is preferred. Too much debt can disrupt even the best business in the worst times
2. To maintain flexibility maneuverability you want a current ratio of at least 1.5 this means short-term assets over short-term liabilities by more than 50%
3. Aim for a ROE above 8% consistently over 10 years, and also consistent with the ROE not changing too much.
4. Management or your agents they’re one task is to give you the most value for your invested capital over the long term Make sure they’re incentives are aligned with yours
Speculation vs Value Investing
Page 57 this is very important from Ben Graham you would constantly stress to his students that speculation was reliant on change in future results whereas investing was not. Hmmm
The book makes this point that Coke is not reliant on changing their future product however a company like Apple would be as people might not be using smartphones in the next 20 years the same way they are now.
It’s saying that a true value investor is interested in persistent products that do not change due to technology.
Apple as a Value Investment?
The book talks about Apple and how it might be more of a speculation but I mean 10 years ago if you bought apple I see that as a value investment especially if you bought it in 2018 when it was trading at 10x free cash flow. For that to be bad y ou would have to foresee the iphone being obsolete within the next 5 years. Ok no.
A lot of talk in the motley fool morning show (Bill Man, Jim Guillies, John Rotanti) about the difference between the value investor and a growth investor and all that and it seems that this book is dividing them in some terminology that I can wrap my head around finally.
Page 60 talking about the day trading but how much taxes they pay I don’t really have any thoughts on this besides that I’m not an idiot I would never day trade and pay those insane taxes while thinking I can guess which way I’m short-term stocks are going to move All it is is guessing humans psychology, yeah I’ll pass.
Owner Earnings From Buffett
Page 65 the first time they bring up owner earnings which I have heard Warren talk about before. It is like earnings per share it is earnings after everything All taxes all everything have been paid. What the owners have a claim to after everything.
Moats
Page 70 talking about moats they always talk about this in the morning show and it makes total sense you want companies that have distinguishable notes that you can understand and identify. A company without a moat as a company that will have a very hard time keeping competitors at bay
Page 80 we are finally at discount rates and something beyond linear math, oh what fun!
Who doesn’t love a good utilized exponent?
Obviously the equation is very simple to me and solving for a different variables with my background but let’s do some examples anyway.
Interest Calculations
This might sound like I’m bragging and it’s not meant to be that way. I just need to remind myself to not be intimidated by what I’m learning and that it will just take time.
Any and all math I come across will be nothing more than man I knew like the back of my hand in 10th grade. I will not be needing to use any of my 400 level college engineering calculus 5 material.
PV – Present Value
FV – Future Value
R – Interest Rate
n – Time compounded
These I did in google sheets I am going to try and do a copy/paste and bring them over.
| FV = PV * (1+R)^n | PV = FV/(1+R)^n | R = (FV/PV)^(1/n) – 1 |
| = 100 * (1+.05)^10 | = 163 / (1.05)^10 | = (163/100)^(1/10) – 1 |
| $163 | $100 | 5.01% |
ok that worked well, and now I know for the future I can do this with copy/paste from google sheets, awesome!
Intrinsic Value
Page 86 Warren Buffett says intrinsic value can be defined simply it is the discounted value of the cash that could be taken out of a business during its remaining lifetime.
Two main components in this statement it is the discount rate and the estimation of the future cash flows
Jim Guillies from the motley fool frequently talks about discounted cash flows and the importance to understand that your calculations are based on the assumptions that you enter in.
My point of view coming from my poker mind is to use this similar to how I construct RANGES when dealing with a villain in a given hand. I don’t attempt to put the villain on specifically 2 given cards.
I attempt to assign a range of possible hands the villain might be holding and then act accordingly given that range I decided on.
2 types of calculations
so the book is telling me there are 2 types of intrinsic value calculations which by the way I was not aware of.
- discounted cash flow calculation. Ok I know of this one.
- variant method, similar to how you value fixed income bonds… ok I have no clue here.
DCF Model
- estimate the free cash flow
- estimate the discount factor (which I’m still a bit confused on, would you use the risk free rate or a rate that is aligned with how risky you see the investment?)
- calculate the discounted cash flow for 10 years
- calculate the discounted cash flow in perpetuity beyond 10 years (morning show guys would call this terminal cash flow, it’s like once the growth stops they grow more inline with inflation/GDP I think?)
- Calculate the intrinsic value
- calculate the intrinsic value per share
Example:
FCF $1,000
Growth Rate 10 years 6%
Discount Rate 10%
long term growth rate 3%
Shares outstanding 1,000
Learning the Calculation
First, the most important cash flow is the one that is “free”. It is free from things that have already happened to the cash left over.
Namely these things (John Rotonti) would pound these into my head over and over from the motely fool. I remember him saying 5 things, so lets see what I remember before moving on in the book. A company can do all of these before it gets to free cash flow to owners:
- buyback stock
- pay a dividend
- pay down debt
- invest in growth (i’m not sure about this one , lets see what book says)
Update: I got them, sort of. I put invest in growth and the book had buy new assets so similar.
The money left over after all of those things is the money the owners can claim without having any negative impact on the company because all uses of cash for the company have already taken place, and whats left over is what the owners can claim.
Calculations
| end year | |||||||
| 1 | 2 | 4 | 6 | 8 | 9 | 10 | |
| FCF(n) | $1,060 | $1,124 | $1,262 | $1,419 | $1,594 | $1,689 | $1,791 |
| = FCF(1) * (1+GR)^n |
so this is calculating what the free cash flow will be as time goes on based on the constant 6% yield, which of course will never be the case it will never be exactly 6% but these assumptions and you need to be able to estimate and start somewhere.
And this is where the idea of ranges in poker can play in, while doing different calculations with different assumptions.
Like a worst case assumption and best case assumption. So similar to poker analysis of a hand it’s astounding.
all of this is based on the assumptions of FCF yield, but something that can help is to use the ROE return on equity which I learned about a few pages back.
ROE = Net Income / Share Holder Equity
Share holder equity = current assets – current liabilities
Looking back to the future
Look back at the past will help greatly for estimating the growth rate you enter, but also look at what the company as planned for the future
Discount factor and discount rate are different. Discount rate is constant and what you use while thinking about the risk factor of the investment
discount factor is based on what year you are talking about like this (1+DR)^n
Discounted Cash Flow
| year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| FCF | $1,060 | $1,124 | $1,191 | $1,262 | $1,338 | $1,419 | $1,504 | $1,594 | $1,689 | $1,791 |
| DF | 1.10 | 1.21 | 1.33 | 1.46 | 1.61 | 1.77 | 1.95 | 2.14 | 2.36 | 2.59 |
| DFCF | $964 | $929 | $895 | $862 | $831 | $801 | $772 | $744 | $717 | $690 |
| sum | $8,203 |
So the math is pretty straight forward and it really comes down to understanding and conceptualizing what the numbers mean.
As the cash flow is increasing as the years go on up to year 10 by 6% annually, that cash flow discounted back to todays value at the rate of 10% is becoming less and less.
so in year 10 we can see the company will earn $1,791 of free cash flow for the owners but at the same time in todays dollars the REAL VALUE today is $690. $690 today is $1,791 10 years from now (at 10% rate).
Perpetuity Cash Flow
So a few thoughts of mine first. This number is completely arbitrary and the book kind of just picks the number 10 because how can a business keep growing and growing it has to slow down at some point.
Starbucks disagrees, and Monster energy says, hold my coffee and watch this.
Ok but moving forward, 10 years is ok to assume, but just understand it is an assumption.
oh also the book is talking about that the perpetuity or long term growth rate and how it is an assumption of what that number is. Yes I agree clearly but we must make this assumption and again I’ll probably do this with ranges when I get more comfortable with it.
Perpetuity Cash Flow Equation
FCF – $1,000
DR – 10%
GR – 6%
LGR – 3%
DPCF = FCF * (1+GR)^11 * (1+LGR) / (DR-LGR) / (1+DR)^11
book just kind of says this is what it is, enter the info into the google sheet and calculate it, but ehhh I just can’t do just that. I need to figure out what each part of the equation is doing.
Lets start with the first part FCF * (1+GR)^11, putting our numbers in we see that $1,000 * (1+.06)^11 = $1,898. So this number is the amount of money in year 11 you will have in FCF for that year(but not really because year 11 is only 3% growth the terminal rate).
Ok makes sense, but we know that after year 10 we didn’t grow at 6% anymore, we grew at 3% so we need some adjustments. What I’m thinking instinctually would be to take the FCF of year 10 and then multiply that by 1.03 the LGR but I bet it will be the same in the end it gets simplified down to the equation above.
Out of curiosity that number is 1,000*(1.06)^11*1.03 = 1,955, which would be the free cash flow of year 11 we’ll see if this amounts to anything in helping me understand.
Ok I’m an idiot, the actual equation has this in it. the * 1.03
ok moving on
so the numerator we have figured out and it is the 11th year free cash flow so we still need to make adjustments.
next we divide by the interest rate difference of the DR and the LGR which is 7%. Dividing by a rate leads us towards the present value, while multiplying by the rate leads us towards the future value, something for me to remember.
so we take out $1,955 and divide it by .07 to get $27,929 so this number is the terminal cash flow but we need to bring it back to today still
then we take this number and divide it by (1+DR)^11, which brings our number back to the current day that is related to our starting FCF of $1,000
and we get, $9,790 so this is the terminal cash flow back to today, but I am honestly confused like how many years is this for? I know the farther we go out in the future it will have a smaller and smaller effect on the present value but how many years is this calculation for.
Calculate the Intrinsic Value
Intrinsic Value = Sum of first 10 years of FCF discounted back + perpetuity cash flow discounted back = $8,203 + $9,790 = $17,993
value per share is $17,993/1,000 = $17.99
so this means that if you bought 1 share of the stock at the $17.99 price you should expect a 10% return on your investment moving forward.
Remember you assumed a discount rate of 10% but lets say you bumped that up to like 15% because it is a riskier earlier business then you would need to calculate again and you will find that the share price will be lower for intrinsic value because of the higher risk of 15%
I learned how to play with the numbers of growth rate and also the discount rate which shoots out outputs of different share prices. Changing those variables really shows how they affect the share price.
Changing the Variables
Making the growth rate higher means the share price would be pushed up. This means the company can grow faster than I thought and the intrinsic value is higher.
Also changing the discount rate which I like to think of as the risk rate for the company, affects the intrinsic share price output. Making the risk percentage higher means it is a riskier company and would shoot out a share price worth lower today because of that risk.
The book does calculations a second way, and on their website but it needs Buffett’s criteria to hold true for that to happen and to be useful, namel Debt to equity of below .5, current ratio of less than 1.5, and finally ROE consistently above 8% and not changing much.
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