It allows me to start any subject as a complete beginner, but over a short period of time end up as someone with a good or even great
fundamental knowledge of any subject by reading a few books.
A major part, practical experience, is
still missing, but just imagine what we would have to go through if
we did not have access to the knowledge at all.
Anything we would start would be from
absolutely nothing.
A good example would be the development of my investment process.
At the above link you will find a
time-line of my investment experience but here are the main points:
-
I started out with a basic
correspondence course on the stock market in 1986
-
I lost money I pooled with my
father using technical analysis
-
I listened to brokers and lost
more money chasing the hottest stocks while trading a lot
-
I discovered a book Winning on the
JSE by the mathematician Karl Posel that gave me a framework for
finding, evaluating, buying and selling undervalued investments.
-
From there I went on to read
Warren Buffett, Benjamin Graham, David Dreman and many more.
My investment process thus moved from a
process with no proven evidence of success to one that has
substantial proven success in the form of many successful investors.
All of this through reading and doing.
Over time my investment process has
moved from the use of a few basic financial ratios to
longer
check-lists.
Until recently my favourite valuation
metrics were:
-
Price to earnings ratio (“PE”)
the lower the better
-
Price to book ration (“PB”)
also the lower the better and
-
Debt to equity where I prefer
companies with less than 35%
The book suggests the use of two
ratios, one to identify good companies that earn high returns on
assets and a second ratio to identify cheap or undervalued companies.
Since reading the book these two ratios
have become the main valuation metrics I use.
To identify good companies
Ratio 1 = EBIT / (Working Capital + net
fixed assets + short term debt)
The higher this ratio the better.
Higher means the company earns a high return on its total assets,
fixed assets as well as working capital.
Where:
EBIT
= Earnings before interest and taxes
Working
capital = Current assets – current liabilities
Net
fixed assets = Total fixed assets – depreciation (Excludes goodwill
and other intangible assets)
To Identify undervalued companies
Ratio 2 = EBIT / Enterprise Value
As with the first ration a higher value
here is also better. Higher means you are paying less for the company
in relation to the profit it generates.
Enterprise value is calculated as
follows
= market capitalisation (number of
shares * current share price) + debt – cash
Enterprise value thus expresses the
value of the company to you as a private buyer of the whole company.
Firstly you pay for the market
capitalisation plus the debt, which you have to repay, minus any
available cash you can use to reduce the company's debt or pay out to
yourself to lower the purchase price.
The added advantage of using Enterprise
Value is that it already incorporates the debt and cash the company
has on its balance sheet. So you do not separately have to evaluate
the amount of debt the company carries.
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