Part 3 in a series of tutorials on value investing : Earnings, book value, debt, growth rates and market capitalization.

Part 1: My Investment Philosophy
Part 2: The General Store

Part 3: The Investor’s Toolkit:

The Investor’s Toolkit

There are a lot of tools that you can use to take the measure of a company. Things like return on equity, profit margin, enterprise value and so forth. But there are 5 key concepts which I want to explore in some more detail in this section before we dive into building out a more comprehensive valuation framework: market capitalization, earnings, book value, growth rates and debt.

Market Capitalization

Larger companies have their advantages. Their operations tend to be more stable. Earnings don’t jump around nearly as much as they do with the smaller companies. During recessions they’ll often continue to churn out profits, albeit typically at a reduced rate. They are widely followed by analysts so you can always find someone who will confirm that you are making a wise investment. (Although this is really not such a good thing.) For investors who may be a little less comfortable with the whole investing process, the relative safety and security of these large cap companies can be reassuring.

Personally, though, I usually prefer to hunt for opportunities on the smaller end of the spectrum. Smaller companies offer many advantages too and some wonderful opportunities to the independent investor. As you head down the size spectrum, the big, professional investors get squeezed out. There are simply not enough shares of these smaller companies trading hands to allow a big mutual fund to take a meaningful stake. That means that as an astute investor, you aren’t competing with the professionals anymore, you are matching wits with your fellow small-time investors. Analysts are less likely to report on these smaller companies and they don’t often make it into the news. They are largely ignored by the Wall Street machine and that means there is more of an opportunity for them to become mispriced.

Small cap companies have other inherent advantages. They are more nimble and able to pivot into new lines of business as opportunity presents itself. They are often run by enthusiastic founders with skin in the game. Being smaller, they can grow very quickly if the conditions are right. And not least, they are far easier to understand and analyze. Their annual report is unlikely to be some 100 page monstrosity, as you’ll occasionally see with the big conglomerates.

The lines between the large cap “blue chip” stocks and the small cap or mid cap arena are vague. Some small cap companies may exhibit very stable, large cap characteristics while some large cap companies can be even more volatile than their small cap cousins. Generally, though, the line in the sand seems to be around the $1 billion market cap mark in Canada and around the $5 billion mark in the US, where everything gets done on a bigger scale.

Earnings

If you look at a list of stocks in the newspaper or pull up a stock’s summary page on one of the big financial websites, you’ll always see the p:e ratio prominently displayed. Ignore it. The p:e ratio as quoted by these services is so frequently wrong so as to be pretty much useless to you in your investigation of the company. The quoted p:e ratio can be wrong for any number of reasons. The earnings figure that the p:e ratio is based on could simply be out of date. Or the company may have issued more shares since the last time the data was updated. More shares means lower earnings per share and therefore a higher p:e. The earnings could be technically accurate but include one-time items that distort the picture significantly. The earnings could be inflated by a big tax rebate or licensing payment. A more accurate approach to calculating earnings could be to back out these windfall items or else average them over a period of several years. The earnings on which the p:e is being quoted may not even be the right ones to use. If the economy is in recession and earnings have plunged, the p:e ratio could look extraordinarily high (because the ‘e’ has dropped so low). If you are banking on the idea that the company will recover, then it makes more sense to use the earnings figure from before the start of the recession as your guidepost.

What we are looking for is an earnings number that filters out all the noise and leaves us with a clearer picture of what the ongoing day to day operations of the business are. To this end, I’ll factor out things like currency exchange gains and losses, legal settlements, restructuring charges (unless they are a regular occurrence!), goodwill write downs, investment gains and losses, fair value adjustments, tax rates that fluctuate up and down like a yo-yo, etc. If the company is in a slump, I’ll use the earnings from before the downturn, adjusted for any subsequent share issuance or changes in the business.

In short, the earnings number I use for my p:e calculations is heavily edited and can be miles away from what is reported by the company or by the financial media. What I’m trying to construct is an earnings figure that represents what I expect the company to earn from its regular, day to day operations over the course of a typical, non-recessionary year.

Debt

For every company I look at, I add up all their debt and then subtract out any cash they might have squirreled away. If the total debt is more than three times their annual earnings, that’s a deal breaker for me. Many of the low p:e stocks you may come across have a low p:e precisely because investors are nervous about the amount of debt the company is carrying. Debt limits a company’s options and can be a real millstone around its neck when things turn south (as they inevitably do from time to time). A financially strong company (low debt, cash on hand) is much better equipped to handle the occasional setback and has the flexibility to pursue new business opportunities when they present themselves.

Book Value

Most of my attention gets focused on the underlying earnings of a company and my fair value assessments usually revolve around these earnings numbers. But there are times when book values also enter into the equation. The book value of a company is the sum total of all of its assets minus all of its liabilities. In a bankruptcy sale, this is supposedly what you might be left with after all the assets have been sold off and the creditors made whole. Thus, it provides a sort of safety net under the stock price. As well, the book value gives you an important insight into how much substance there is behind those sparkling profit numbers.

As with debt levels, this number tends to come more into focus when things go badly. If profits unexpectedly dry up, there may be no ‘e’ to base a p:e ratio on and investors instead will start to look at the value of a company’s assets to determine what they are still willing to pay for the company.

Because I’m usually looking at book value in the context of a worst case scenario, I typically calculate the tangible book value, which is the book value minus any intangible assets like “goodwill” that can’t be readily converted into cash in a fire sale. When I speak of book value, I’m usually referring to this tangible book value number, not the more inclusive figure.

Growth Rates

Growth rates are an essential piece of the puzzle when evaluating new stock market investments. A company that is doubling in size every 3 years is worth a lot more than one that is slowly withering away. But like value, growth can be a slippery concept. Are we looking at growth in sales, growth in earnings or maybe growth in book value? What if earnings have doubled but sales have stayed flat? Has the company been inflating its earnings by cutting costs and if so, is this sustainable? Is the company growing because of something they are doing particularly well or are they just riding an updraft in their industry? Is growth set to accelerate in the future or level off? And so on.

When I consider growth, I am generally looking for long-term growth in all three of the main company yardsticks: earnings, sales and book value. Over a 5 or 10 year period, one may have grown faster than the others but I like to see them all in the same rough ballpark. If not, if book value has flatlined, for instance, while sales and earnings have doubled I need to know why. What I’m trying to do is form an opinion of what the future outlook for growth is. If the company had a large pile of cash that was generating close to nothing in interest income and it used this money to build a big, new factory, this would be expected to boost sales and earnings, but the book value might not change. They’ve simply swapped their cash asset for the new, more productive factory asset. However, once they’ve used up their cash they can’t pull off this trick again so in this case, past growth would not necessarily translate into future growth.

Softer, more subjective factors often find their way into your growth estimations. Does the company have a hot, new product coming out? Do they have patents that are set to expire? Are new competitors moving in on their turf?

In assessing historical growth rates (which hopefully give you some insight into what future growth rates might be) it is important to compare the current situation to an equivalent point in time during the last business cycle. The economy goes through cycles of growth and contraction and companies, especially smaller ones, tend to follow along. Earnings may be robust during the expansion phase of the business cycle, fall to next to nothing during the periodic recessions and then jump back up when the recession ends. If you only look at the growth in earnings over a short time period, you may get a very misleading sense of how the company has actually grown, if earnings have accelerated from near nothing at the cycle low back to their more normal level following a recession. If you’ve just come out of a recession, it might look as if earnings have tripled over the last 3 years but if you looked back a little further you might see that the company is actually no further ahead than it was 5 years previously, before the recession began.

Assessing the potential growth rate of a company is a real art and I never try to put too fine a point on my own analysis. As I’ll explore in the next section, all I do is lump a given stock into one of three very broadly defined growth categories. Trying to get more precise than that is just setting yourself up for disappointment.

In the next section (Part 4: Building a Valuation Framework), we’ll use our investor toolkit to slot companies into one of 6 broad categories that we can use as the basis for a more accurate and complete estimate of fair value.

Part 1: My Investment Philosophy
Part 2: The General Store