A Guest Post by Jim Moore
Many of us get lost in our own day-to-day business matters and forget to think about the long-run from time to time. Well, maybe you think of the long-run for your business, but what about your personal life? Building up retained earnings in your business is one thing, but you should also build up savings personally. The natural follow-on to this is: What do I do with my savings once I have it?
A deluge of information is constantly dumped on us from the financial media. The 10 Year U.S. Treasury Yield is well below 2%, the yield curve has inverted, and all the while stocks are again approaching all-time highs. How do you know what to focus on when it comes to analyzing stocks/investments? Do P/E ratios matter? What about bond yields vs dividend yields?
Sifting through it all can be daunting. As an analytical entrepreneur, you can ultimately break things down to first principles to really see what matters. Wise words from Charlie Munger can also be a good place to hang your hat. Let’s start with first principles.
First Principles of Investing
First, you should understand the basic premise of investing. Just like the manufacturer that buys raw material for X, then sells the finished product for X + Y, you are looking to achieve the X + Y with your X investment. In other words, you put out a sum of money today, in order to receive more than that sum in the future. Ideally, you’d like to cover your cost of capital (which should presumably include inflation).
For the purposes of this discussion, I will concentrate the “investment” focus on securities traded on the stock market since it’s simply akin to investing equity in businesses – a familiar concept for any entrepreneur.
Now, the next step is to figure out what drives stock prices (e.g., the value of a business). It won’t likely come as a surprise that Warren Buffett has (at many times) articulated two major inputs are responsible: 1) corporate earnings growth, and; 2) interest rates.
Corporate earnings growth is largely driven by a strong demand for a business’ product/service, improved productivity, acquisitions, and/or all of the above. Interest rates, on the other hand, are mostly market-driven, but sometimes governments can influence and/or help in setting market rates (at least for a period of time).
Evaluating the business in which you decide to invest is itself also quite important. Ask yourself if you’re investing in a commodity business with no inherent competitive advantage (e.g., a farmer selling apples) – in which case its survival may be harder to determine – or a robust business with a durable competitive advantage.
Certain businesses are able to exploit the benefits of living in a (mostly) market-based society more than others. For example, Costco has thrived in discount retail despite massive competition. Neither Walmart nor Amazon have been able to fully knock Costco off its pedestal. The company’s inherent business model allows for growth with increasingly more efficient systems that go on to benefit customers. The resulting sales and margin growth increases Costco’s cash flow over time. This excess cash (or at least the proportion attributable to the investor) is ultimately the return on the investors’ original investment.
To determine whether or not we should make an investment in such a company is the next question (Note: Costco was just used as an example and does not reflect a recommendation for purchase). Have other investors already discovered this gem of a company, and therefore it’s priced above its intrinsic value? Said another way, can we invest less money than we expect the company to generate over time (discounted back to the present)? To determine this some math is required. It’s not complicated math.
If you’re already too busy, the extra effort needed to analyze a stock may be time-consuming – and an index fund might be your best bet. But, if you are an entrepreneur that has ever bought a business (or plans to), you’ll want to know some practical math to help you value a business. To become a good investor, you might need to revisit your high school math textbooks.
Enter Charlie Munger: “It’s high school algebra, and people who don’t know how to use high school algebra should take up some other activity.”
Ultimately the formula we need is the discounted cash flow formula. It incorporates the important tidbits that Mr. Buffett has said will impact stock prices: Namely, interest rates and corporate profit growth. Incorporated in what is known as the “discount rate”, is the interest rate. The discount rate is essentially your opportunity cost. Here is an example of the whole formula:
Value of the Business Today = Cash Flow x (1 + g) / (k – g)
Where: g = earnings growth rate
k = discount rate
A single mathematical formula is rarely going to fully account for the myriad of variables worth considering when valuing a business at any point in time. That said, you can come up with a range of potential valuations by varying the inputs based on different scenarios, and get a good approximation of the potential range of values of a business. Either way, it’s one more tool in your tool kit, and with enough tools in your toolbox, you can build a solid future for yourself.
Good luck investing!
About the Author:
Jim Moore is an entrepreneur based in NYC. He runs a private investment partnership as well as a tutoring business. Jim worked on Wall Street for almost a decade and hung it up to regain the independence of time (and money) with the moral support (marrying an artist helped!) of his lovely wife. He describes the inadvertent degree earned through experience as an entrepreneur as more valuable than both undergraduate and graduate degrees he obtained in Economics. Feel free to reach out. He’s happy to share what he’s learned for those that want to listen.