Top 10 takeaways from Reading financial statements for value investors

“Money without financial intelligence is money soon gone.”

– Robert T. Kiyosaki

So how do you become financial intelligent, you ask?

In “Reading financial statements for value investing”, written by Stig Brodersen & Perston Pysh, accounting, which is de facto financial intelligence according to Kiyosaki, is described in a humoristic and simple manner. It is explained using Warren Buffet as a reference, who probably is the greatest investor of all time.

Today I will summarize the 10 most important points made in the book, so that you can avoid having your hard-earned money vanish in bad investments.

It is worth mentioning that this book has A LOT of great takeaways. I could gather around 35 of them before reducing it to the 10 following later. In this screening, I prioritized the ones related to key ratios, valuation, and accounting, since that is the theme of the book.

That being said, a lot of important takeaways to an investor won’t have room to be mentioned here. Such as “Always hope for a collapse”, “Invest in companies you understand” and “Buy companies with a moat”. Maybe these will be included later in other summaries, or they might appear in a future newsletter. Here are the takeaways, summarized:

  1. Determine the intrinsic value before buying.
  2. Keep a margin of safety to the intrinsic value.
  3. Determine a discount rate using a baseline.
  4. Price and value are two different things.
  5. Consider tax from capital gains when making the decision to sell a stock.
  6. Some ratios are exposed to the law of diminishing returns.
  7. Always question a large post in long-term investments.
  8. Study patents, trademarks and intangible thoroughly.
  9. For a company with high valuation, dividends are a no-no.
  10. Buy stocks with stable growth of equity.

Now, for those of you out there who are patient, (and patience is key for a value investor, as explained in Top 10 takeaways from The richest man in Babylon) here are the takeaways in an expanded form. My own comments will be in italic.

1. Determine the intrinsic value before buying.

“Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

From this quote, we get two important parts, the discount rate and the future free cash flow.

Free cash flow: Think about free cash flow as money that can be paid to the owners without affecting the future performance of the company in a negative way.

Free cash flow = Earnings + Depreciations + Amortizations –Change in working capital – Capital expenditures

Discount rate: A percentage used to value how much future cash is worth in today’s terms. The riskier the investment, the higher the discount rate.

The intrinsic value of a company can be calculated by discounting the future free cash flows to today’s value.

The first part, the future free cash flows, must always be estimated. A good starting point is to use the free cash flow from previous years, and the development it has had. Suggesting that the free cash flow will develop like it has done in previous years is probably not entirely wrong, but it’s not accurate either. The process is more complicated than that.

Now, onward to the discounting. Money today is worth more than money tomorrow. The question is just: How much more? One of the authors tried to explain this to his children.

In this example, the kids turned down a 100 % guaranteed yearly return. No sane investor would ever do that.

If you want 10 % return from your investment, the discount factor is 0.9 per year.

If you want 15 % return, it is 0.85.

Multiply the future cash flow with the discount factor the number of times that you are looking ahead, so:

Free cash flow year X (value today) = Free cash flow year X * (Discount factor)X

For the discount factor, use something that a similar investment would have. Sometimes the companies themselves lists this in their annual reports. The name is usually WACC (weighted average cost of capital).

Another way to go about it is to use what lenders are asking from the company, and then add a few percentage points. You can get the average cost of borrowed capital by looking at the amount of loans in a company’s balance sheet and compare it to financial costs in the income statement.

When you have the future free cash flow and the discount rate you just add all the cash flows up in today’s value. Then you have the intrinsic value of the company.

 2. Keep a margin of safety to the intrinsic value.

If you were to build a bridge for cars, and you know that the heaviest car passing by will weigh 1,500 kilos, you’d build a bridge that can support 2,500 kilos, or similar. You wouldn’t build something supporting only 1510 kilos, because that would be considered too dangerous, in case your calculation contains errors.

If you were to cook meatballs for 5 hungry Swedes, and the recipe says that 6 meatballs per person is enough, you’d cook 50 meatballs, or similar. You wouldn’t cook something like 31 because that would be considered too risky. What if your calculation contains errors? What if the Swedes had gone for a long cross-country skiing trip just before the meal, and were starving?

It’s the same when it comes to stocks. If you buy a stock at $50, you should probably think that it would be a good buy at $65 as well, anything else would be too risky.

3. Determine a discount rate using a baseline.

Buffet uses the 10-year Treasury note as a baseline for deciding the discount rate for his investment. This is expected to have 0, or as close as you can get to 0, risk. For any other investment, use this as a baseline and then add a certain amount of percentage points, depending on the investments risk.

Be careful here though. Let’s say that the risk-free return is 2 % one year. You want a margin of 4 percentage points from this baseline, so your investment must be able to give at least 6 % per year for you to invest. This means that you require a 200 % higher return (4 percentage points). If you keep that margin when rates rise to 4 % the next year, you’ll require 8 % for your investment. Noticing the difference? It is still 4 percentage points, but now you will only get 100 % more than the risk-free rate.

4. Price and value are two different things.

Sometimes the market is in a good mood. Then the prices of stocks are higher than the actual underlying value of the companies listed. On other occasions, it’s the other way around. Investors can benefit from this, by always seeing the difference between the two as an opportunity.

“Do you like to shop for deals? I sure do! Who doesn’t like to buy a quality product at a cheaper price? I buy more stuff when prices are low. Then, when the price increases, I buy less, or none. It’s funny; when people buy items at the store, this is likely how they shop – yet interestingly, when it comes to buying stocks, they do the exact opposite.”

5. Consider tax from capital gains when making the decision to sell a stock.

When selling a stock, you are usually taxed on the returns it has given. Obviously, this should be considered, but exactly how should you consider it?

  • Calculate the expected yield of stock A that you would like to sell, and of stock B, that you wish to replace A with in your portfolio.
  • Subtract the cost of capital gains from the investment you can make in B.
  • Compare the two, and see how much time it takes before B earns back that lost tax money.

Here is an example. Stock A has 8 % expected return and B has 10 %. Selling stock A today will decrease your capital by 30 % (Swedish taxes) of the return. Let’s say the return was 100 %. Then your investment capital with decrease by 15 %. When will you earn the money back?

As we can see, it takes a while. And the return on an old stock can be more than 100 % (even though the difference in expected future returns can be greater than 2 percentage points as well).

6. Some ratios are exposed to the law of diminishing returns.

For some ratios, a higher (or lower, depending on the ratio) number isn’t necessarily better. Well, it is better, but the marginal value is decreasing, so every increment is worth less. A good example is the interest coverage ratio:

Interest coverage ratio = (Earnings from operations (EBIT))/(Financial costs)

A coverage of 25 would be considered extremely safe. If another company has a coverage of 50, sure it would be a little bit safer, but not 100 % safer, which the ratio implies.

A few ratios with diminishing returns:

  • Interest Rate Coverage
  • Debt/Equity
  • Current Ratio

Some ratios that are not affected:

  • Every price ratio
  • ROA (Return on assets)
  • YoY (year-on-year) growth ratios

 7. Always question a large figure in long-term investments.

This is an account in the balance sheet under non-current assets. The value is related to long-term holdings, that are not a part of the company’s operating business. Basically, it means that the company is holding stocks in other companies, not related to the core business. If this figure is big compared to the total assets, you should be cautious. Some companies motivate such a figure by saying that they want to diversify. Yet, you could have done this on your own by investing in other companies if you wished for that. It is an excuse for not believing in the core business.

8. Study patents, trademarks and intangibles thoroughly.

These values are included in the account called intangible assets and are tough for competitors to copy. Therefore, they are a part of the moat that Buffet speaks so highly of. Moreover, intangibles are immune to inflation. This figure in the balance sheet is becoming increasingly important. In today’s economy companies have shifted from bricks and machines to intellectual capital, so a large figure is nothing to be afraid of, quite the opposite, if it can be motivated.

9. For a company with high valuation, dividends are a no-no.

Imagine that you buy a company with P/E 40 (considered a high valuation). Now, imagine that this company doesn’t invest anything back into the business every year. How do you then expect the earnings to grow so that the P/E of 40 becomes reasonable?

For a company with a high valuation, a substantial part of earnings must be reinvested in the business.

10. Buy stocks with stable growth of equity.

If the equity of a company grows, it means that the company has:

  1. Done a profitable year, with strong owner’s earnings (dividend, buyback of shares, payment on loans or reinvestment in the company).
  2. Issued new stocks.

If you can eliminate that number two was the cause for the increase, you have a compelling argument for stability. A company that year after year creates significant owner’s earnings is a solid reason to invest. If the company is using owner’s earnings to reinvest in the company, make sure that the ROE (return on equity) is adequate.

Some cases where you should be extra careful:

  • If the company isn’t stable. Historical results are not a guarantee of future ones, especially not without stability.
  • If the company has very high growth. If equity is growing by >20 % per year, it’s usually not possible for a longer period.
  • If the company has done a lot of share buy-backs or paid a lot of dividends. This will reduce the growth of equity as it is money that could have been reinvested in the company, but instead was given to shareholders.
  • If the company is using splits. This is only important if you are looking at a per-share basis.

Is there anything missing? What do you think are the top 10 takeaways from “Reading financial statements for value investing”? Do you want me to develop on any of the subjects? Let us know in a comment!

If you would like to read the full book, and, besides leaning how to study a balance sheet like Warren Buffet, give me some earnings to pay Swedish-level tax on, buy here it today.

For more investment tips delivered every Sunday, as long as IKEA doesn’t change their Wi-Fi password, stay tuned!

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