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The secret to improving your investment process

A single conversation with a wise man is better than ten years of study.
Chinese Proverb

I do not know about you, but as time goes by I appreciate the work of remarkable people, in any field, more and more.

It allows you to start any subject not as a complete beginner, but as someone with a good or even great fundamental knowledge by reading a few good books.

A major part, practical experience, is still missing, but just imagine what you would have to go through if you did not have access to the knowledge at all.

Anything you would start would be from absolutely nothing.

A good example of learning from others would be the development of my investment process.

Here is a short summary:

  • I started out with a basic correspondence course on the stock market in 1986
  • I lost money I pooled with my father using technical analysis
  • I listened to brokers and lost more money chasing the hottest stocks while trading a lot
  • I discovered a book Winning on the JSE by the mathematician Karl Posel that gave me a framework for finding, evaluating, buying and selling undervalued companies.
  • From there I went on to read Warren Buffett, Benjamin Graham, David Dreman and many more.

My way of approaching investing thus moved from a process with no proven evidence of success to one that has substantial proven success with the help of successful investors.

All through reading and doing.

Over time my investment process has moved from the use of a few basic financial ratios to extensive check-lists. For an example look at the article What does your check-list look like?

I have used this same process to improve the way I value companies.

Here is an example.

 

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My favourite valuation metrics used to be:

  • Price to earnings ratio (“PE”) the lower the better
  • Price to book ration (“PB”) also the lower the better and
  • Debt to equity where I prefer companies with less than 35%

That however changed in 2006 when I read a book by Joel Greenblatt called The Little Book that Still Beats the Market.

The book suggests the use of two ratios, one to identify good companies that earn high returns on assets and a second ratio to identify cheap or undervalued companies.

Since reading the book these two ratios have become the main valuation metrics I use.

To identify good companies

Ratio 1 = EBIT / (Working Capital + net fixed assets + short term debt)

The higher this ratio the better. Higher means the company earns a high return on its total assets, fixed assets as well as working capital.

Where:
EBIT = Earnings before interest and taxes
Working capital = Current assets – current liabilities
Net fixed assets = Total fixed assets – depreciation (Excludes goodwill and other intangible assets)

To identify undervalued companies

Ratio 2 = EBIT / Enterprise Value

As with the first ration a higher value here is better. Higher means you are paying less for the company in relation to the profit it generates.

Enterprise value is calculated as follows
= market capitalisation (number of shares * current share price) + debt – cash

Enterprise value thus expresses the value of the company to you as a private buyer of the whole company.

Firstly you pay for the market capitalisation plus the debt, which you have to repay, minus any available cash you can use to reduce the company’s debt or pay out to yourself as a dividend to lower the purchase price.

The added advantage of using Enterprise Value rather than market value is that it incorporates the debt and cash the company has on its balance sheet. So you do not separately have to evaluate the amount of debt the company carries.

What are your favourite valuation metrics? Let me know in a short mail and I will add it to the article.

My point with this article is to motivate you to never stop leaning.

Look for successful people in the field you want to leant about and ask them how and from whom they learnt.

If you find the same name coming up from different sources you know you are on to somebody worth studying.

For my best sources of learning about investing take a look at:

Value investing resources on the web

Nine investment books every investor should read

My best value investing articles

Profitable investing

Readers comments

Excellent addition from AV in Milan, Italy

My valuation metrics are:

  1. EV EBIT (Greenblatt tools)
  2. ROCE (Greenblatt tools)
  3. Then I like to check EVCash Flow (just in case EBIT is not representative for some industries) and Capex Cash Flow (show me the money)
  4. Average ROCE for the last 5 years (is the ROCE sustainable?)
  5. Average EVEBIT for the last 5 years (is it a value trap or a low margin sector?)
  6. DebtEquity
  7. 5 years compound average growth rate for sales, book value and EBIT (is the company growing and is it better than competitors?)
  8. EBIT margin and comparison vs competitors

EV – Enterprise value (market capitalisation + debt – cash)
EBIT – Earnings before interest and taxes
ROCA – Return on capital employed (EBIT / (total equity + long term debt))
Cash flow – Cash from operations – capital expenditure
Capex – Capital expenditure
EBIT margin – EBIT / Sales