Podcast Transcript

Over the last nine episodes we covered a number of different topics which together form the basis of valuing a business’ intrinsic value. I began the Investor Education Series in Episode 2 with a brief Overview of my Investment Process. My basic investing concept is to find the best businesses out there and increase my understanding of these businesses so I am ready to invest with conviction if or when the time comes that they trade at or below their respective intrinsic values. 

I outlined the process I undertake to find these wonderful businesses as follows: I begin by filtering out undesirable businesses through a basic stock screener and then compile these into a watchlist. From here I will begin the analysis process by reading through financial reports and news announcements of my selected company to gather relevant information to increase my understanding of the business. I will record all this data into my spreadsheet where I will work through my checklist which helps me analyse the business in a methodical manner. Now that I have a firm understanding of the business I will calculate its intrinsic value and then sit and wait until the business becomes available to buy at or below its intrinsic value. I also stated that I will only sell when there is a fundamental change within the business.

In Episode 3 titled Stock Filters I ran through how I use a stock filter to help me screen out undesirable businesses. I filter via three key measures, first is to filter out the industries which don’t meet my ethical criteria or any industries that I may want to avoid, second I look for low levels of debt and finally I also require solid levels of Return on Equity and Return on Invested Capital over a 5 or 10 year period. Guru Focus provides the best screener in my opinion, I have a link to my screener in the show notes. CLICK HERE

In Episode 4 titled Checklist, I ran through the importance of having a checklist and why I think every serious investor should use one. I compiled a list of a few checklist items that I use which are available on my website at growthwithvalue.com/value-investing, I also go into more detail about checklists in my eBook, ‘How to Value a Business’ (links in the show notes). Please also note that I am continually adding to this checklist as I learn more about different businesses and investing in general. You can download this free ebook as well as my other ebook, ‘An Introduction to the Stock Market’ and my ‘Value Investing Spreadsheet’ at growthwithvalue.com/tools. You will find the spreadsheet has the most up to date version of my checklist.

Episode 5 was all about Discount Rates. The discount rate is basically the rate at which we will discount all the projected cash flows produced by the business, the larger the discount rate the more conservative our intrinsic value. Within the Discount Rate we account for loss of capital by including a rate for inflation, we account for risk by including an equity risk premium and we account for opportunity costs by including the risk free rate. All these three rates added together gives us our discount rate. 

In Episode 6 I provided a brief overview of valuation and why it is important. In summary, we want to ensure that we are paying an appropriate price for our investments to ensure we receive adequate returns. A great business may not be a great investment if you pay too much for it. 

In this episode we also talked about how irrational the market can be at times. Although this volatility can be quite a deterrent, especially when it is to the downside, we must look through the short term noise of the market and take advantage of unfounded falls in price by investing while others are fearful.

Episode 7 was an overview of Cash Flow. I explain how we calculate free cash flow and what the difference is between free cash flow, as derived from the Cash Flow Statement, and earnings, as derived from the Income Statement. I also spoke briefly about the earnings figure Warren Buffett has been quoted to use which he has named Owner Earnings, I explain how to calculate this earnings figure from the financial statements.

In Episode 8 I spoke about growth and how to calculate it using the Compound Annual Growth Rate Formula. I raised the point that it is imperative to have a firm understanding of the business to give you confidence and increased accuracy when projecting the growth of a company, using its historical growth rate as a baseline to help make a decision.

Episode 9 was split into two episodes, both were on the topic of Intrinsic Value and how to calculate it. In Part A we looked the Discounted Cash Flow method, which takes a current cash flow figure and projects it forward at the calculated growth rate we expect the company will be able to achieve over the next few years, after which point we apply a long term rate of growth which is usually between 2% – 5%. From here we then discounted each of these future cash flows back to a present value using our predetermined Discount Rate, with the sum of all these discounted cash flow figures being the Intrinsic Value of the business.

In Part B we discussed how to calculate the liquidation value of the business and how this figure could be used as a good basis for determining potential investment risk or loss of capital.

In the final episode, Episode 10, we spoke about the Margin of Safety. We use the Margin of Safety to discount our Intrinsic Value which helps reduce the risk of any errors in our judgement of the business and also any unforeseen events that may negatively impact the business. It won’t protect us completely from such negative events but it may at least provide a buffer to help protect our capital and reduce any potential losses.

So in summary, we begin by filtering down the number of stocks to analyse by utilising a stock filter, from here we develop a watchlist of businesses. We will then begin to compile data on these businesses and run them through our checklist with the aim of increasing our understanding of the business. By having a firm understanding of the business, it will assist us when it comes to calculating the growth rate and cash flows the business is likely to achieve and will also provide us with the conviction to hold on to the company through any short term volatile market swings which are inevitably going to occur. We will also have the knowledge to assess if a fall in price is just pure volatility and irrational investors making poor decisions or if it is actually due to fundamental changes within the business.

We calculated the Discount Rate which we will use to discount future free cash flows to a present value. The growth of these future free cash flows is also important to fully understand as we do not want to over or understate the potential of a business. From here we have created the foundation which is required to complete a Discounted Cash Flow analysis and calculate the Intrinsic Value of a business. The last step we take before making an investment is to apply a Margin of Safety to our valuation. This is a very important step and one that should not be skipped.

Thanks very much for listening to my short Investor Education Series and I hope I have been able to help you to better understand a few key fundamental points behind valuing a business. From here you can continue to build your knowledge, which is a never ending process, and begin to make intelligent, fundamentally based,  investment decisions.