Getting Started In Value Investing

Chapter 7: The Essential Valuation Variables that Really Count

• “In 44 years of Wall Street experience and study, I have never seen dependable calculations made
about common stock values...that went beyond simple arithmetic or the most elementary algebra.
Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the
operator was trying to substitute theory for experience, and usually also to give speculation the
deceptive guise of investment.” – Benjamin Graham
• You do not need to be an accountant or use complex math concepts to interpret financial
statements
• “If calculus were required, I’d have to go back to delivering papers. I’ve never seen any need for
algebra.” – Warren Buffett
• Financial statements are used to test the financial health of the company and gauge the potential
for future earnings
• The financial highlights at the front of the annual report are worth scanning, but the meat can be
found in the financial statements filed in the back of the report
• Companies are required to file reports on the their financial condition for the past three full
years of operations
• The three most important statements are as follows:
• Consolidated Statement of Income
• The income statement shows investors how much money the company is
making
• The first line item of importance on the income statement is net operating
revenue or net sales which is the total amount of sales less any returned goods
and cash discounts given to customers
• The second key line item on the income statement is net income which is all the
money left over after paying costs, expenses and taxes
• “All the sales growth in the world won’t produce the right type of investment
vehicle if, over the years, profits do not grow correspondingly.” – Phil Fisher
• It is important to note that income includes all revenue that has been sold not
actually collected
• Sales growth is important to note because companies that don’t grow sales will
have a very difficult time growing their bottom line profit
• The author likes to focus on companies that are growing their sales at
least 5% annually
• He also likes to see sales growth that is higher than the companies
industry competitors
• If the company is below industry peers the author wants to know why
• Earnings per share growth is also of great importance to the investor because a
company that increases sales, but offsets it with increased expenses is not
creating shareholder value
• The author likes to focus on companies that are increasing earnings per
share at 10% annually
• Net profit margin, as previously stated, is a great way to measure the
percentage of profit that drops to the bottom line for every dollar of sales
• Some companies and industries have lower profit margins making it
important for investors to avoid them
• Shrinking net profit margin over a several year period is a major red flag
because it signals one of the following three scenarios:
• Competitors are gaining ground forcing the company to lower prices in
order to compete
• Higher expenses are cutting into profit margins
• The cost of materials used to produce their products is rising placing
pressure on profit margins
• Consolidated Balance Sheet
• The balance sheet gives the investor a snapshot of the companies solvency and
liquidity
• There are three components of the balance sheet each of which is listed below:
• Assets – what the company owns
• Liabilities – what the company owes
• Shareholders Equity – what the company is worth
• Total Current Assets
• The balance sheet is crucial in displaying a companies liquid assets
• Assets are listed in order of their liquidity on the balance sheet
o Starting with cash all of the way down to less liquid assets like
prepaid expenses
• Current assets are those that can be converted to cash in the next 12
months
• Total Current Liabilities
• Current liabilities are debts or obligations that are due in the next 12
months
• Current Ratio
• Tracking current assets and current liabilities allows us to gauge the
companies liquidity
• An investor can find the current ratio by taking current assets and
dividing it by current liabilities
• We want to see at least $1 in current assets for each $1 in current
liabilities
• A company that does not maintain enough in current assets to meet
current liabilities could run into a liquidity problem quickly
• Solvency
• When a company takes on debt they have to pay back both the principal
and interest
• The balance sheet gives the investor the opportunity to analyze how a
company is managing its debt
• By computing the debt-to-equity ratio, long term debt divided by
shareholders equity, an investor has an accurate picture of the
companies solvency
• It is preferable to have companies that are funding their growth with lower
amounts of debt so that interest payments are not eating into profits
• However, debt can be a positive thing if the company is able to borrow long
term at low rates and invest back in the business at a higher rate of return
• The basic equation of the balance sheet is total liabilities plus stockholders
equity equals total assets
• Consolidated Statement of Cash Flows
• The statement of cash flows measures the flow of money coming in and out of
the company over a specified period of time that coincides with the income
statement
• There are three components to the statement of cash flows each of which is
listed below
• Operating Activities
o Cash that comes into the business from day-to-day operations
• Investing Activities
o Cash generated from the acquisition and sale of assets and
investment in property, plant and equipment
o Investment in property, plant and equipment is know as
capital expenditures
 o A large current capital expenditure should be offset by future
profits
o Capital expenditures are crucial to expanding the business
• Financing Activities
o The cash used to finance the company’s cash flow:
o Examples are lines of credit and issuance of debt
• Free Cash Flow
• This is determined by taking net cash flow from operating activities and
subtracting capital expenditures
• Key Points
• The footnotes attached to a company’s financial statements disclose some very
important facts but most people don’t bother with the fine print. This is a mistake.
• The important and key ratios are not merely exercises in accounting. They provide you
with the means for identifying quality companies and for eliminating the rest.
• Liquidity is, literally, the lifeblood of a company. Without adequate cash, nothing gets
done (not even the current bills can be paid). With enough cash, companies can, at the
very least, keep current on their bills, and are also able to expand without having to go
into debt.