Happy New Year Value investors! I have a question related to reading a financial statement. There are quite a bit of different metrics keep an eye out for, and I am particularly worried about being tricked by nicely ornamented accounting practices. I understand that every appraisal is different, but are there some general things that you guys are looking for? I suppose profits is a good example of a metric that comes in many shapes and sizes, however which measure of profits do you use for discounting cash flows? (I realize this might be a stupid question, but many companies seem to report EBITDA as their primary measure of performance, whereas I’d say it makes more sense to use Net Income)
Rob Urban: Forget EBITDA, it is not real cash flow. Subscribe to a good financial website (gurufocus or Morningstar) or get a data feed (zacks) to pull up historical statements side by side. Your question cannot be answered in FB as it is too complex to answer here. Op cash flow – avg Capex is a good starting point but not the final answer. Look for growing revenues, consistent LOW debt, growing retained earnings, consistent or shrinking shares outstanding, predictable earnings and stable or growing ROE above 15%. Start there for high quality businesses and you should be safe
Guille Ggh: For your run of the mill company: Cash Flows from Operations – Capital Expenditures – Intangibles Acquisitions.If your company is a serial acquirer (IBM, Cisco, HPE, Etc) you would like to subtract the cost of Net Acquisitions, so Free Cash Flows become: CFO – CapEx – IntangiblesAcquisitions – NetM&A. For serial acquirers, M&A works pretty much as capitalized R&D, and so you better subtract that cost as well.
Rob Urban: https://en.m.wikipedia.org/wiki/Owner_earnings
Owner earnings – Wikipedia
Stephan Heuler: You already made a great step questioning EBITDA!
Rob Urban: Here’s the CORRECT method to value businesses, do not use net income in DCF models or you’ll get consistent overvaluation. https://seekingalpha.com/article/4071626
Owner Earnings: Warren Buffett’s Favorite Formula
Praveen Datta: My method for evaluating dividend stocks… http://smartersquirrel.com/…/dividend%20investing…
Dividend Investing 101 – Brookfield Infrastructure Partners
Guille Ggh: This is actually it:https://financetrain.com/how-to-calculate-fcff-and-fcfe/
How to Calculate FCFF and FCFE – Finance Train
Rob Urban: We need a FB group dedicated to valuation. Warren Buffett – “If I ran a business school there would be only 2 courses. How to value a business and how to think about markets. No modern portfolio theory, no beta, etc. You don’t have to be right on 4,000 or 400 businesses – not even 40. Circle of competence. Start with a small circle and slowly expand. Don’t spend time on companies that don’t lend themselves to valuation. Accounting is useful, but sometimes it is not meaningful. Durability of competitive advantage is the key. And market fluctuations. The market is there to serve you – not instruct you.”
Guille Ggh: Well, we do have plenty of private equity and CFA groups dedicated to the very topic of valuation best practices (I recommend analystforum.com). I am always disappointed that most value investing online communities are full of amateurs who worship Buff…See more
AnalystForum | CFA Exam, CAIA Exam, FRM Exam Forums
Rob Urban: I agree with you that there is excellent instructional material in the CFA course, a gold mine, but valuation is not one of them. Introducing statistical volatility (Beta) into WACC produces garbage. So does relative valuation. So does DCF terminal value and ignoring asset values. Not applicable in real life finance and also why the vast majority of CFA trained portfolio managers underperform the market.
Guille Ggh: Totally agreed, I have not met anyone in the buyside who actually uses anything close to beta. WACC is fine as long as the cost of equity reflects your real cost of opportunity (again, not beta). CFA does incorporate excess non operating assets as part…See more
Nicklas King Hargett: Thank you for all of the replies, I will look into each reference once I have a bit more time on my hands. During my finance course we were always given expected cash flows rather than financial statement material.. We also relied on arbitrarily established betas and WACC, so it was a very mechanic application of the theory, hence I never got to learn how to extract the data from a financial statement, haha. I’m glad you guys are very helpful.
Marquardt Frickert: Buffett and munger said by then self ebitda is shit
Dan Ferris: It’s a mistake in my opinion to believe one metric is better than another, partly because all the numbers on the financials come from the same source. So if EPS is bad, maybe free cash flow isn’t much better. Investors need to undersand why the data is presented as it is. So, if you see EBITDA reported, ask yourself why it’s being reported. Is it to cover up a poor business performance? Or does it help you understand that particular business better than you otherwise might? Munger says replace the term “bullshit earnings” for EBITDA wherever you see it. That’s because he knows why many people use it: to represent earnings as healthier than they really are. But you can’t take Buffett/Munger’s word for it and ignore EBITDA. You must UNDERSTAND why EBITDA is being presented when you’re looking at statements. (I just saw there’s like 11 replies before me, so forgive me if this one is redundant!)
Nicklas King Hargett: I think this is really valuable advice, to understand the underlying mechanisms of business economics. I suppose EBITDA is just the earnings after overheads and operational costs have been deducted, so it doesn’t represent the financing of capital and capital expenditures.. My problem is that I’m just not knowledgeable about when one is appropriate and another one is not :0) Thank you for your contribution
Dan Ferris: Yw! And don’t worry about how knowledgeable you are now. Just start with one company and figure out what the numbers mean for it. That’ll help you with the next one and the next and before you know it, you have a much more complete context of what any individual metric could mean. I think moving slowly, understanding one company at a time, helps you make faster progress overall.