There are many strategies you can use 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.
I'm 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 and exploring his website.
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.
A moat means that a company has a competitive advantage that protects their 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 Switching Moat, where a product is 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 their competitors.
The numbers are:
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.
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 like the growth rates to be above 10%, but it is more important that the growth is consistent over the years. A company can have a down year, but if it does, it is important to investigate the reason why.
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. Levered free cash flow is the amount of money a company has remaining after paying all of its financial obligations. I use margins 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.
Once we have completed the aforementioned tasks, we must examine the company's management to ascertain its excellence. This exercise is somewhat different because we cannot look up numbers. However, what you want to make sure of 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. One great example of this is Steve Jobs. If you are more interested in learning how to determine good management, I would advise you to read Phil Town's books.
Once we have decided that we want to invest in a company, we want to ensure that we pay the correct price. There are three ways you can do this, and once the price reaches the highest price based on your calculations, you will open a position.
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.
In order to do so, we need 4 numbers:
1. Current EPS.
2. Estimated future EPS growth rate.
3. Estimated future PE
4. Minimum acceptable rate of return (should always be 15%).
If you want to know how to obtain those numbers, I would advise you to purchase Phil Town's books. I do not believe it is appropriate for me to share this information here.
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 PE. Then, divide the result by 4 (equivalent to a 15% growth rate over the next 10 years). Finally, divide the outcome by 2.
The second method of calculating a price is by determining the cap rate. A 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 represents the cash flow that is generated by the business each year without impacting its operations. This would need to be at least 10%. And the calculations are as follows:
Net Income - Maintenance Capital Expenditures + Income tax / Outstanding shares x 10 = xx
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.
All of this was just to give you an idea of the process I use to find and value companies and determine a price. I did not go into details, and if you want to read more about this, I would advise you to go to Phil Town's website. He also has calculators available, so you don't have to do all the calculations yourself if you don't want to.