January 20, 2011

Is investing all about numbers?

A typical research report provides you with a few years of historical data and a year or two of forecast, especially of sales and netprofit. The better reports may also include some kind of valuation based on PE and discounted cash flow to arrive at an estimate of fair value.

Most of these research reports, atleast the ones for which you don’t pay much will stop at this point. To be fair to the producers of these reports, you get what you pay for – in this case next to nothing.

The point is that these free reports provide only the basic quantitative information needed for a decision. One cannot make a purchase only on the basis of numbers without understanding the context of these numbers

What is the meaning of context ?
A company usually operates as part of an industry and is impacted by the various competitive forces of the industry. For example – if you operate in the FMCG industry, advertising and distribution is a major part of the expense. In a similar fashion, fuel, raw material and power are big expenses for a cement company and advertising is nice add-on, though not a competitive differentiator.

So if you are analyzing a consumer goods company, you have to focus on the advertising expenses. In addition you will also have to understand the width and depth of distribution, brands recall, performance of new products and similar such non-quantitative details.

In case of a cement company, one has to compare the cost of production of the company with other competitors and understand if the company has a sustainable cost edge over other companies.

It is important to understand that the financial numbers of the company have to be evaluated not only on the basis of time (past numbers) but also with reference to other companies in the business (national and international). It is a rare report, that goes into this level of detail.

Beyond the context
The exercise of
calculating fair value of a stock is essentially trying to estimate the future of the company. It is silly to attempt mathematical precision in this task. One of the common criticisms of analysts is that their forecasts are generally wrong. I think it is stupid to expect any better from them. The world is far too complex for any person to be able to forecast anything in short term, forget the medium and long term.

I have a fairly elaborate template for analysing of a stock. An elaborate template does not make the analysis any better – it only ensures that I do not missing anything important. If you scan through the template, you will notice that I have a few sheets for DCF (discounted cash flow) analysis.

Now if I don’t consider DCF to be the end all of a stock analysis, why do I still do it? The main reason for doing a DCF analysis is to play around with various scenarios (in terms of sales and profit growths) and attempt to see how these scenarios have an impact on the fair value.

The standard approach for doing a DCF analysis is to look at the past numbers and to simply project them into the future, with minor variations in the numbers. The problem with this approach is that it is too simplistic.

A good starting point is to project the past numbers if you strongly feel that the past is a good indicator of the future. However it is important to look at possible scenarios in your valuation – try an optimistic scenario where everything works as planned and a pessimistic scenario when almost anything which can go wrong will do so. This approach will give you an upper and a lower bound to the fair value of the company.

How do you know what numbers to plug in for the two scenarios? This is where context of the current numbers and a qualitative understanding of the industry and the business comes into play. One has to have a sense of the business and the industry to put any meaningful numbers

The above approach takes away the need to make precise forecasts. You are now working with a range of values, which can re-worked as new data comes to light over time.

But this is all fuzzy !!
Absolutely right ! I personally feel that quantitative aspect of value investing is not more than 20% of the effort (and even that is an over estimation). The ‘numbers’ part of investing is the minimum. I will not invest in a company which has a high debt, is losing sales and has been making a loss for the last few years.

The first step I take is to look at the numbers to figure out if I need to dig deeper into the company or just move to the next idea. This step usually takes a few hours at the most and with practice and some automated options, it can be done even faster.

The real work starts after this first stage. There is no fixed formulae or approach for investing, but I will usually read through a couple of years of the annual report of the company, read about the competitors and understand the economics of the industry. Once I am done with a round of qualitative analysis, I fire up my DCF spreadsheet and plug in numbers to arrive at a range of the value. Over time I have realized that this step rarely throws any surprises.

If you do this exercise for a decent amount of time, you get a rough sense of the valuation as you are looking at the numbers. For ex: a company growing a 10-12% with an ROE of 15-20% would come to a PE of around 17-20 times current year’s free cash flow.

An example
Let me give an example from my past experience to illustrate my point. I analysed a company called MRO-TEK in late 2007. You can read the analysis
here. One of the key negatives for the company was that it was a small company in an industry which is dominated by the likes of CISCO and LUCENT who have R&D budgets which are a 100 times the annual revenue for this company.

I identified this negative fact, but there was no way to quantify this business risk. The last few years of data looked fine and stock appeared to be undervalued at the time. Fast forward to 2010 – The result for 2008 was a high water mark. The performance of the company has been sliding since then with the topline having dropped by 50% and the operating profit has turned negative. The company is simply operating in a fast changing hypercompetitive industry, where it is very difficult to make a profit.

I had a sense of this fact, but did not appreciate it fully (I am a slow learner :) ). If I had not been lucky in getting a quick exit, I would have lost money on this. This idea was a case of sloppy analysis, where numbers would not have helped.

Is there a secret formulae?
There is no secret formulae for investing (if you are into quantitative investing, it’s a different story). At a certain level effective investing is very subjective in nature. It involves reading and digesting a lot of information and then combining it with your existing knowledge and experiences to come up with an estimate of fair value for the company

Unfortunately there is no shortcut in becoming a decent investor. One has to love the art of investing and be willing to learn and make small amounts of progress each day. Over time, the learning accumulates and you keep getting better at it.


Lucky said...

There is no shortcut in becoming a decent investor. Cannot agree more.

One of the reasons one has to come back to this blog over and over again is that there is more than just stock analysis.

Keep educating. Thanks.

brian said...

I just discovered your blog and love how you're applying value investing techniques to stocks in India.

When screening stocks, I do exactly what you do and run a quick DCF calculation to see if it's worthwhile to investigate further. I've done this so much that I've created a DCF calculator that automatically pulls FCF numbers from Yahoo.

Keep up the awesome work!

Aneel said...

"One of the key negatives for the company was that it was a small company in an industry which is dominated by the likes of CISCO and LUCENT who have R&D budgets which are a 100 times the annual revenue for this company"

This is very interesting point on MRO-TEK which I feel ppl generally ignore when past numbers looks good. Based on your experience, we can derive that moat is definitely very important. Good point.


Gaurav said...


Your post makes a lot of sense. Though i am new into the world of investing personally, i am working in finance domain. I Learn a lot from you. Guidelines on scenario analysis are very good & highly appreciated. Keep up the good work.

- Gaurav

dhiraj said...

dear rohit as usual an illuminating post,however life and business are seldom linear events ,even a 3 year cycle is capable of throwing a sine wave curve, and to top that add positive and negative black swan events and that makes all lessons and analysis based on past numbers history! anyways we still need some framework to work on.

Ranajit said...

Nice post Rohit. Good insight and advice and I agree with you completely. It also helps to know one's blind spots which all of us have in different measures.

Btw, I do use DCF and other simple/complex valuation metrics to value a company ( and I agree that no valuation technique is perfect).

Have you had a chance to read Bruce Greenwald's book on value investing where he talks about another valuation metric - Earnings Power Value or EPV? Even though it is another quantitative valuation technique, it also requires a very close knowledge of the industry. I will be curious to know what you think of it?


Ramanand said...

Hi Rohit,
Thanks for the viewpoints. Can you clarify your below example?
"a company growing a 10-12% with an ROE of 15-20% would come to a PE of around 17-20 times current year’s free cash flow"
Here, by PE, do you mean the simple PE of Market Cap/Net Profit for the financial year? The words free cash flow at the end sound a bit confusing...do you mean cash flow rather than the stated net profit?
As an aside, do you think that high growth, high PE companies earn a better return for investors vs stable business, low PE, undervalued companies? Of course, assuming other things such as competitive advantages (moats), shareholder friendly management etc. being comparable in both cases.
Thanks & Regards

Smart Singh said...

Excellent post Rohit. I've had hard time, trying to convince people that buying individual stock needs a thorough and diligent analysis. But still have many friends who end up buying on 'tips'.

By the way, I had the pleasure of attending Prof Aswath Damodaran in person at this year's CFA conference. His presentation on 10 common mistakes in valuation was a hit. I'm posting the link here, if you don't mind.


I would encourage everyone to first attempt the problems in the handout. It would give you a great perspective into the presentation.

Rohit Chauhan said...

Hi lucky
if there was a shortcut ..we would all be rich :) ..just joking


Rohit Chauhan said...

hi brian
thanks for the comment

Hi aneel
a moat makes all the difference. think of a sugar company v/s a crisil or ITC. if you look at last 5 years, sugar companies which have almost no moat have not made money for investors. a crisil or ITC has made quite a bit of money for the owners


Rohit Chauhan said...

Hi gaurav
thanks for the comment. glad to know that you find scenario analysis useful ...as with the other things on the blog it is not entirely original. i have seen a lot of other good investors do it


Rohit Chauhan said...

hi dhiraj
the past numbers provide a starting point for the analysis. the investor has to think whether these numbers are representative of the future.


Rohit Chauhan said...

hi ranajit
i have greenwald's book. it is a good book. i have co-opted some models from his book into the template

my template is a bhelpuri of all my learnings :)


Rohit Chauhan said...

Hi ramanad

free cash is same as earnings in a lot of companies..however the strict formulae is

earnings+ depreciation - maintenance capex. i have covered this point in an earlier post.

think of a cement company ..it has to keep adding capital to its business to keep costs low. so its free cash flow is lower than earnings

on the high pe high growth issues ...i prefer low pe stocks. problem with high PE stocks is the risk is high. if the expected growth does not happen, you can lose a lot of money. in a lot of cases there is no margin of safety

arunsg said...

Own businesses you understand, said the Oracle.
Dont just look at the figures, look at the the soul, sez me. To investors and bachelors alike!