MY STRATEGY
There are many strategies that you can employ when investing in stocks. I am primarily a value investor, which means that I invest in great companies when they are available at a good price, based on their intrinsic value. I do not want to delve into the entire history of value investing. Instead, I would like to share with you my approach to valuing a company, which you can use as a guideline when reading my blog.
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I am very inspired by Phil Town and his Rule 1 investing. I utilize the tools provided in his books. If you wish to delve deeper into the subject matter, I highly recommend purchasing his books.
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Ok, let's go through this. Once you read my blog post on how I value companies, you will see that I refer to something called a "moat" and different metrics. I will go through them shortly.
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A moat signifies that a company possesses a competitive advantage that shields its business from other companies. A moat can serve various purposes for a business. It can be a brand moat, where consumers trust the brand. It can also be a secret moat, where the company holds a patent or trade secret. Another type is the toll moat, where a company has exclusive control of a market. There is also the concept of the switching moat, where a product becomes such an integral part of a consumer's life that it is not worth switching. Lastly, there is the price moat, where a company can offer a product at a lower price compared to its competitors.
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The numbers are:
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1. Return On Investment (ROIC): It refers to the rate of return that a business earns on the cash it invests in itself each year. The term refers to the amount of money that a business earns annually on its invested capital. A company should have a return on invested capital (ROIC) of more than 10% per year on average for the last 10 years.
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2. Book value + Dividends or Equity Growth Rate: Equity refers to the residual value of a company after selling all assets, paying off all debts, and retaining the remaining funds. The Equity Growth Rate refers to the annual increase in equity. Ideally, we would prefer growth rates to exceed 10%, but it is more crucial that the growth remains consistent over the years. A company can have a down year, but if it does, it is important to investigate the reason why.
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3. Free cash flow, levered free cash flow margin, and free cash flow yield. Free cash flow, in short, refers to the cash that a company generates after covering its operating expenses and capital expenditures. I provide the levered free cash flow margin to enhance clarity and improve understanding. Free cash flow yield refers to the amount of free cash flow per share that a company is projected to generate in relation to its market value per share.
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Once we have completed the aforementioned tasks, we must examine the company's management to ascertain its excellence. This exercise is somewhat unique because we cannot look up numbers. However, what you want to ensure is that the CEO works for the owners and not for themselves. You want a CEO who is driven to move the company forward and is not solely motivated by their salary. I also prefer management to have a long-term perspective and not be afraid to make "unpopular" short-term decisions to enhance long-term returns. If you are interested in learning more about effective management practices, I recommend reading "The Outsiders" by William Thorndike.
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Once we have decided to invest in a company, we aim to ensure that we pay the correct price. There are three ways you can do this. Once the price reaches the highest point based on your calculations, you will open a position.
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The first method for calculating a price when opening a position is to determine the fair value of a company (also known as the sticker price) and then apply a margin of safety. Ideally, the margin of safety should be 50%. Ideally, if we find a sticker price for a company to be $100, we would aim to buy it for $50. So, let's go through how we calculate a sticker price.
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In order to do so, we need four numbers:
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1. Current EPS.
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2. Estimated future EPS growth rate.
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3. Estimated Future Price-to-Earnings Ratio
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4. The minimum acceptable rate of return should always be 15%.
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Once you have the numbers, it is a fairly simple exercise. To calculate the future stock price with a 50% margin of safety, you need to multiply the estimated future EPS growth rate by the estimated future P/E ratio. Then, divide the result by 4 (equivalent to a 15% growth rate over the next 10 years). Finally, divide the outcome by 2.
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The second method of calculating a price is by determining the capitalization rate. A capitalization rate (cap rate) is essentially the annual rate of return that an owner of a company (or stock) receives on the purchase price of the company (or stock). Warren Buffett refers to this as "Owner earnings," which represent the cash flow generated by the business each year without impacting its operations. This would need to be at least 10%. And the calculations are as follows:
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Net Income - Maintenance Capital Expenditures + Income Tax / Outstanding Shares x 10 = xx
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The third method of calculating a price is known as payback time. The term "payback period" refers to the number of years it takes to recoup your investment. It shouldn't take more than 8 years to recover it through the compounded growth rate. In order to do so, you need the free cash flow from the company. Once you have obtained that, it is quite simple. To calculate the desired price, you need to multiply each year's free cash flow by 100% plus the growth rate. After performing this calculation for 8 years, divide the result by the outstanding shares.
If you prefer not to perform the calculations yourself, you can utilize the calculators available in the Tools section of this website.
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All of this was just to give you an idea of the process I use to find, value, and determine the price of companies.