Cash Flows From Financing Activities Expenses Cash Flow From Investing How to Do a Buffett-Graham Inspired Stock Analysis

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How to Do a Buffett-Graham Inspired Stock Analysis

First, I’d like to refer to a quote from Ben Graham’s ‘The Intelligent Investor’ that sums up what your job should be when analyzing any security, in our case common stocks.

“A security analyst deals with the past, present and future of any security issue. He describes the business; summarizes its business results and financial position; lists its strengths and weaknesses, its opportunities and risks; estimates its future earning power under various assumptions or as ” best guess.” Makes detailed comparisons of different companies or the same company over different time periods. Finally, he expresses an opinion on its attractiveness as a buy if it is a common stock.”

In general, these are activities that investors should diligently perform when analyzing a stock for a potential purchase. To expand upon these simple ideas, we will elaborate on how to conduct the activities of a security analyst, keeping in mind the timeless framework of the Ben Graham/Warren Buffett type of analysis.

Are you a defensive or entrepreneurial investor?

A Buffet/Graham-inspired investor must be aware of his personal style and tolerance for volatility, and must choose between being a defensive or an entrepreneurial investor. As a defensive investor, Graham recommends sticking with larger companies that have a long track record (20+ years) of dividend increases. A long-term track record of dividend increases, he explains, is a reliable measure of the quality of an issue. On the other hand, an enterprising investor can look for smaller, undervalued stocks that trade at prices below “net working capital (or working capital)” and/or issues that have a favorable “return on invested capital (ROIC)” we’ll go into later more details.

Common stock criteria

Graham’s strict philosophy of style should adhere to these specific criteria. More recently, Buffett has ventured outside the guidelines and become more willing to pay a higher price for a company with ‘intrinsic value’. Nevertheless, the Buffet/Graham inspired investor should strictly follow the financial condition and earnings stability guidelines outlined below. These are common characteristics that all great investments tend to have.

1. Earnings Multiple – Earnings multiple or p/e ratio below 10.
2. Financial situation – a) Short-term assets at least 1.5 times greater than short-term liabilities and b) debt no more than 110% of net short-term assets. (The criterion I like to use for debt is that long-term debt/equity must equal less than 0.5)
3. Stability of earnings – has not lost money in the last 5 years.
4. Earnings growth – Last year’s earnings were higher than the year before.
5. Price – Less than 120% of net tangible assets.

A closer look at net working capital, net working capital and ROIC (return on invested capital)

Very simply, net working capital and net working capital can be used interchangeably (they are the same thing). To arrive at net working capital, you take the value of current assets per share minus the value of total liabilities per share, divided by the number of shares outstanding. If that figure is higher than the share price, the issue is trading at a discount to net working capital, or net working capital, which in Grahams’ mind would symbolize great value. Graham has long been a proponent of buying stocks that trade below their net working capital. Stocks trading below net short assets are almost impossible to find in a bull market. During a recession, keep an eye out for these super cheap deals, which tend to bounce back when the market recovers.

ROIC is closely related to earnings per share, but is a more pure way of measuring a company’s earnings power. A key advantage of ROIC over EPS is that it ignores accounting and one-time costs that can skew EPS estimates.

ROIC = Owner’s Earnings / Invested Capital

Where the owner’s earnings are equal to the operating profit…
– plus depreciation
– less income tax, stock option costs, capital expenditure and any income generated by unsustainable pension fund returns.

And where invested capital is equal to total assets…
– minus cash, short-term investments and non-interest-bearing short-term liabilities
– plus past accounting costs that reduced invested capital

At least 10% ROIC is attractive; even a 6-7% ROIC issue can be somewhat attractive if the company has great brands and competent management.

Reaching your margin of safety

Stocks that meet most of the above criteria can significantly increase your margin of safety, reducing your potential for losses (a big part of Graham’s philosophy). The approach of Mr. Buffett combined Graham’s margin of safety with an emphasis on future growth and detachment from market behavior and benchmarks. Buffett relies less on quantitative analysis and prefers to think more simplistically when making investment decisions. Buffett’s philosophy focuses on easy-to-understand companies in excellent financial health that have a fantastic track record of continuously increasing ROIC. Both philosophies emphasize high-integrity management that thinks like an owner rather than a manager and doesn’t pay itself lavish salaries.

Using Buffett/Graham inspired analysis, an investor can learn to understand how to value a stock and thus compare the issues against each other to arrive at a more favorable investment decision. When investing, it is necessary to emphasize the willingness to say “no” and reject investment opportunities that do not follow certain criteria. Buffett and his partner Charlie Munger have spoken about this publicly several times. Basically, they say that you can encounter up to 20 life-changing investment opportunities in your lifetime. An investor’s goal should be to firstly identify these opportunities and secondly to take advantage of them by acting boldly and investing heavily in them.

Please write all questions to me personally. I’m John, my passion in life is teaching about saving, investing and stocks. Happy to answer questions or chat. john@riseofamillionaire.com

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