Enterprise value of company
The average investor has the wrong idea about how the stock market works, Mayer says. “He thinks about the price of his stock in terms of its quoted stock price. But even then… he often misunderstands what that price represents.”
Think of when you buy a house. You don’t ask, ” What’s the value of equity in the house?” Nobody cares about that. The price of the house has 2 components : the value of the equity and value of the debt. You pay off the debt first. Equity is the residual. It’s the same with companies. You have 2 components : equity and debt. The combination of debt and equity gives you the total worth of the company – its enterprise value, as stock experts like to call it.
Difference between earnings and cash flow
Most investors focus on a company’s P/E ratio – the relationship between the stock’s market price and its earnings per share. But a better way to make investment decisions is to invest like a professional trader.
A dealmaker will always want to compare earnings to enterprise value, because this gives him the bigger picture – the kind of picture you’d have if you were investing personally in a company.
Earnings don’t repay loans – cash flow does. It is a reminder to always look beyond earnings and figure out the cash flow – the cycle of collections and disbursements. At times those cycles can vary very widely; in fact a company that otherwise appears profitable can suddenly find itself in a cash crunch.
Worse, you could end up like Lucent Technologies. Lucent made lots of sales and gave generous terms so it could keep booking those profits for Wall Street’s benefits. It kept meeting earnings targets and showing nice growth, but meanwhile its accounts receivable were ballooning. Lucent wasn’t collecting the cash nearly so well as it was booking sales!
So what happens? At some point you have to write off the uncollectible receivables. Lucent’s customers started to get trouble themselves and stopped paying their bills. Some went out of business entirely. All those pretty earnings had to be reversed out. That means the company reported losses. Suddenly, those earnnigs per share target went out of the window. THe market took down the stock. It went from from under $80 to under $5.
That is why you must pay attention to cash flow. But paying attention to cash flow is more than just a protective measure – it is a way of finding gems.
You care less about dividends
The key question is this : How well is management allocating its resources? A company that borrows money to meet its dividend payment is probably not making a wise decision. Dividends are best paid with surplus cash flow that the business cannot put to good economic use.
Is management reinvesting in good projects or in good business that is likely to create more cash for shareholders and for the business in the future? In other words, are they making good use of precious resources?
Two Simple Clues to Stock Market Success
According to Mayer, Joel Greenblatt is one of his favourite investors. In Greenblatt’s book titled “The little book that beats the market”. In it, Greenblatt divulges his magic formula – a strategy that returned 30.8% vs 12.4% for S&P500 over that time. The basic goal of Greenblatt’s screen is to find good companies at bargain prices. To do that, he relies on two simple clues.
The 2 clues are :
1) Return on invested capital (ROIC) = Net income – Dividends / Total Capital
2) Earnings Yield (EY) = take the inverse of PE ratio and turn it into a percentage.
So for example a stock with P/E ratio of 5 which has a earning yields of 1/5 =0.2 or 20%
ROIC is a measure of quality. When comparing businesses, all other things being equal, the higher the return on invested capital, the better. So that’s the first measure. Greenblatt puts his screen to thousands of stocks on the maret today and rank them, highest to lowest.
Second, we need something else to measure cheapness. Just beacuse a business is great doesn’t mean its stock price will rise. That is where earnings yield come in. The basic idea is to compare what a business earns to what its price is in the market. Therefore, the higher the earnings yield the better. It means more earnings for your dollar.
Graham still has a Net-Net idea. Most of the net-nets were troubled companies. Investors hated these companies, which is why they were trading where they were. A lot of the companies you’ll find on the list are not popular names, and indeed many of them have short-term clouds hanging over their heads. This makes sense, since it explains why they are so cheap. Still these are tough buy for the average investor.
And it requires patience to stick with Greenblatt’s idea, something else the average investor doesn’t have a lot of – and that’s being charitable. The magic formula doesn’t work every year. There are times when it will lag the market. But this is a good thing, in a way, because such underperformance will tax most investors’ patience and they will abandon it before the idea really has a chance to work its magic.