Notes on investing

May 16, 2020

This is a collection of notes and observations about investing, and in particular value investing.

Important: don't listen to me, or anyone else giving investment advice online, and definitely not buy and sell recommendations.

Instead, read about the process:


Price is not equal to value

This is an important reality that is easy to forget, just because something is bought or sold at a certain price doesn't mean it's fair valued.

Warren Buffett once said: "Price is what you pay. Value is what you get." (At least according to Google!)

It doesn't really matter who said it (probably Warren Buffet), but what this means is that you can pay a low price for something with high value, but also pay too much for something with low value.

However, value is to be determined by you. I might value something a lot higher than someone else, especially when it would provide me with something it wouldn't neccessary provide someone else (productivity and time-saving services are good examples).

In investing, it's somewhat safe to assume that at least most people want to increase their overall wealth (not always in monetary terms).

How to determine value?

According to the efficient-market hypothesis, the market is always fairly valued (value is equal to true value). You can't beat the market, and the only way to gain wealth is random movements (i.e. speculation) or cheating. This approach to determining value is unrealistic (as discussed above) and not very reasonable, and we want to be reasonable, so we should probably ignore this and assume markets are inefficient (i.e. there exist some information asymmetries).

So, if the market is inefficient, how do we determine value? This is the fundamental problem for value investors, and it's more like a process than fixed answer (we'll also assume most investors have their own unique approach).

In general, when buying or starting a business, we own 100% of the shares. In this case, its value could be whatever we paid for it, or all assets, but more realistically, it would be a combination of its assets and future earnings. It's possible to forecast earnings a few years into the future, then assume a set growth rate forever (this is its terminal value).

Basically, to determine value, we'll first need to estimate future earnings.

Estimating future earnings

The most straight forward method to estimate future earnings is to represent earnings as a function of revenue and expenses, where revenue should increase (preferably, but not always!), and expenses should decrease, i.e. margins should get better with time.

All public companies report revenue and expenses on their quarterly reports, here's a 10-Q filing for Dropbox. These filings also report assets and other relevant numbers (such as cash flow and metrics).

It's especially important to keep an eye on a few operations fields:

  • Revenue
  • Gross Profit
  • Operating Expenses (or all operating expenses individually)
  • Operating Income
  • Interest Income (sometimes reported as "Other Income")
  • Taxes
  • Net Income
  • Shares Outstanding

From the operations fields above, we can determine various business health and sanity ratios (to make sure we don't make an unrealistic estimation), such as Gross Margin, Operating Margin, and Tax Rate, as well as determining year-on-year change in revenue and expenses (ratios shouldn't fluctate much!).

In the reports, we can also find a few important balance sheet fields:

  • Cash (including non-current cash and marketable securities, it's up to you to decide what to count as "Cash")
  • Debt (or anything that need to be repaid or converted into shares)
  • Intangibles
  • Total Assets
  • Total Liabilities

From the balance sheet fields above, we can determine some additional ratios; "Tangible Working Capital" (what we actually need to keep our business running), Return on Equity, Return on Tangible Equity, and "Return on Tangible Working Capital" (what we get from capital needed to run our business).

We can also go one step further; goodwill as a percentage of share price (basically intangibles per share, too much and you don't actually own anything), Return on Research Capital (important for research-heavy companies), Price to Research and Development (to compare between business investments in research and development).

How to build a model?

Based on the above fields and ratios, we can build a model to forecast earnings based on what we think future revenue and operating expenses will be (keeping margins and sanity ratios in line with historical values or within industry specific ranges). This process becomes easier with specific knowledge in whatever industry our business is operating in, we should be able to estimate or reason about likelihood of various events, sales targets, new product impact, and so on.

A good model should estimate revenue and expenses for at least a couple of years into the future (to our best knowledge), then assume negative growth until earnings are close to zero.

There are a lot of resources on analysing company earnings available online, but the most important parts to understand are; Income Statement, Balance Sheet, and Cash Flow Statement.

How to determine net present value?

To determine what we should pay today, we need to obtain the net present value, basically sum the discounted cash flow (or future earnings) and add net cash.

For discounting cash flows, a good discount rate would be the risk-free rate plus a market risk premium, e.g. likelihood that estimated future earnings does not happen, minimum expected return, or relative risk compared with peers. This should give a good estimate of value, and not too different from current market value.

A good discount rate would also take into account your specific knowledge in the industry, something you know less about would naturally result in a higher discount rate, i.e. higher risk.

Buying and selling

A common and potentially harmful approach is to "buy low and sell high" based on market movements, this is called market timing (basically speculation, not recommended by anyone respectable as far as I know).

A similar but better approach is to buy when price is lower than net present value (including some margin of safety), this means buy and hold until price on market is higher than your estimated net present value per share (or until relative return is approaching some upper limit). This also means short selling when price is higher than net present value.

Is leverage, or buying on margin a good idea?

This is disputed. There's nothing fundamentally wrong about buying with leverage, assuming you did your research and have a good margin of safety (so even if wrong, you might get positive returns). However, it's worth to note that using leverage can result in more debt than value.

Summary

  • Don't speculate, do determine value based on estimated future earnings.
  • Buy when price is lower than net present value, sell when price is higher (or at set return).
  • Ignore market movements, most news, and analyst recommendations.
  • Be careful when applying leverage.

Disclaimer

This is not investment advice. I am not suggesting that anyone should do anything mentioned in this post (nor invest in any stock or other financial instrument). Do your own research, and don't risk what you can't afford to lose.