Guidelines from the Little Book that Builds Wealth
P/S (good for companies that are temporarily unprofitable, or temporarily having low margins. low P/E wont catch these, low P/S will)
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Do NOT compare P/S between companies in different fields
You might have a good stock IF -
- margins are low
- P/S in line with other companies
- you think they can cut costs and boost profitability
- margins were previously higher
P/B (don't worry too much about this one)
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Always think about what the B means
Primarily useful for financial services, not so much for everything else (page 175)
The branding of Harley isn't calculated in the B for instance
Neither is goodwill
P/E (important, but not the most important thing)
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Do NOT worry about current P/E
- Look at E when things were bad
- Look at E when things were good
- Determine if things are going to be better or worse than in the past
- Make your own E prediction for an average year
Some stocks deserve a lower P/E because they have poorer moats - these are NOT better buys (Palm / Blackberry)
P/Cash Flow from Operations (The BEST MULTIPLE)
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http://www.fool.com/school/cashflowbasedvaluations.htm
Defined as: Earnings BEFORE
-Depreciation (value of a building or equipment that goes down)
-Interest (paid for a bank loan I believe)
-taxes
-amoritization (repayment of debts or loans to things like bonds or mortgages)
Be a bit careful, since some companies may have to replace extremely expensive equipment someday. P/CF can burn you here
What is a good ratio?
Cash Return (Better than P/E)
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How much free cash flow a company is generating relative to the cost of buying the whole company, including its debt
cash return = (Free cash flow+net interest expense) / (market cap + long-term debt - balance sheet cash)
interest income - the cash horde a company keeps earns interest
interest expense - the interest that a company pays out when it borrows money to do things like build plants and so forth
net interest expense = interest expense - interest income
the example was covidien (page 182) generating a juicy 9.6% return, which is juicy because it should grow as well
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Valuing a company
A company is worth the present value of all the cash it will generate in the future. Thats it
Expenses + Reinvested money + free cash flow (owner earnings) = cash company generated
Free cash flow - the amount of money that can be extracted from a business every year by the firm's owners without harming the company's operation
Valuation factors
- likelihood that the future earnings will happen (RISK)
- how large the cash flows will be (GROWTH)
- how much investment will need to occur for the business to keep going (RETURN ON INVESTMENT)
- amount of time it can keep competitors at bay (MOAT)
Investment Return - driven by earnings growth and dividends
Speculative Return - driven by changes in the P/E ratio (emotional changes of the stock market)
Buy stocks with low valuations
Don't worry about management, worry about the economics of the business
How the Author does it
1. what are the returns on capital over the longest period available? (if bad, and future looks no different, there is probably no moat)
2. ID the competitive advantage. Why will high returns stay high? What is the moat? Are the customer switching costs high? Is the brand killer? Patents? Lower costs? Network advantages? What motherfucker what?
Return on Equity (Martha Stewarts 13% is "not terrible")
Deeres ~17 "solid"
Fastenel - ~22 "wow!"
Financial Leverage (lower is better) what is it? (Debt to Equity ratio?)