Basics of risk, Investment Philosophy, and Financial Statements Flashcards
What are the basic tenants of Buffet’s investment approach? (5)
- Think of stocks as fractional interests in the whole company.
- Construct a focused, low-turnover portfolio
- Invest only in what you can understand and analyze.
- Demand a margin of safety between the purchase price and the long-term value of the asset.
- Protect yourself from emotional and speculative forces.
What attributes lend themselves to successful investment? (10)
- Reach an informed conclusion as quickly as possible - resist analysis paralysis.
- Invest in industries and situations that are within your circle of competence - don’t get FOMO
- Adopt a philosophy that supplies guidance, but remain adaptable - make a plan, stick with the plan, don’t fall in love with the plan.
- Immunize yourself against emotional influences.
- Be willing to take uncomfortably idiosyncratic positions - sometimes there is no difference between being early and being wrong.
- Invest at the bottom of the cycle - be countercyclical.
- Hold for the long-term and do not worry about volatility.
- Focus investments and bet big on your best ideas.
- Be inactive - if there are no good investments, do not invest.
- Place yourself in a position to always do what you think is best - dare to be great.
Name 3 recognizable patterns inside each company:
- The nature of the business
- The financial returns
- The management qualities
If the time horizon is long enough what 2 variables tend to line up?
The stock prices of a company tend to correlate well with the underlying economics of the business.
Chapter 1, The Greatest Investor Highlights what 3 concepts that are important to long-term investment success?
- The importance of collecting practical knowledge in relation to Business
- The importance of long-term rates of compounding.
- The importance of the conglomerate structure for diversified businesses.
What is the definition of investment philosophy?
Beliefs and insights about how financial markets work and what it takes to exploit those workings in service of an investment objective.
What are the 3 components of investment philosophy?
- Your view of the market
- Your methods
- Your temperament as an investor
What is meant by Buffet’s self-reliance mirrored as self-confidence in relation to roots of his investment philosophy?
Independent thought requires solitude and reflection and in addition to conflicting with the overall market sentiment are prerequisites to beating the market.
What is the Graham and Dodd definition of “investment”?
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
What is the goal of deep value as per Graham?
To limit downside - the first rule is don’t lose money.
What are 2 tangible guidelines highlighting the “margin of safety” approach when it comes to deep value.
- buy a company for less than 2/3rds of it’s asset value
- focus on low price to earnings ratios
What is the limitation of deep value according to Buffet?
Oftentimes deep value is associated with buying cheap businesses that have poor economics, and holding those businesses for the long run results in less than desirable outcomes.
How did Buffet sum up the disadvantage to deep value?
Time is the friend of a wonderful business and the enemy of the mediocre business.
What 2 chapters of the Intelligent Investor are often cited by Buffet?
- Chapter 8 - The Investor and Market Fluctuations
- Chapter 20 - Margin of Safety as the Central Concept of Investment
What are the 3 attributes of Mr. Market?
- is manic-depressive
- doesn’t mind being ignored
- is there to serve you as long as you don’t fall under its influence
Phil Fisher believed superior profits came from which 2 things?
- Above-average potential
- highly capable management
What company characteristic most impressed Phil Fischer and what did they derive from?
To grow profits over several years higher than the industry average.
– profits derive from sales and are a product of
1. a company’s R&D (corp. entrepreneurship) efforts and the market share available —- ability to generate future sales
2. merchandising capability (ability to generate sales now)
What is the advantage to being a low-cost producer? (2)
- able to withstand down cycles more easily
- low break-even point to drive out weaker competitors
What methods within a business can be used to track costs of doing business.
Install adequate accounting controls and perform cost analysis.
What is the advantage of acct. controls and cost analysis? `
Identify the products and services with the highest potential to shunt resources into their development.
Per Fisher, what is the relationship between growth, profits and financing?
Sustainable growth is easier to achieve if generated internally by profits than by equity or debt financing (which has the potential to erase gains from growth)
What are Fisher’s insights regarding management? (3)
Good managers tend to have 3 qualities:
- Intentions: How management responds during difficulties tells a lot about their intentions and integrity.
- Employee treatment: (blue - respect and decency /white - meritorious promotions)
- Depth of management for delegation
Phil Fisher’s 2 traits of good management:
- ability to maintain short-term profits simultaneously focusing on long-term gains.
- managers with honestly and integrity
Graham studied ______ and Fisher studied ______.
- balance sheets
- companies and people
How did Graham and Fisher differ in their approach to holdings?
Fisher held a few companies, and Graham held many companies over many industries.
What are the 3 buckets of Charlie Munger’s wisdom?
- Pursuit of worldly wisdom
- The study of failure
- The moral imperative to embrace rationality
Munger: relationship between physics and economics
Newtons 3rd law: for every action there is an equal an opposite reaction –> mechanical systems in equilibrium and supply and demand are similar.
Munger: relationship between Darwin and markets
Markets are living, breathing systems that are open to perturbations that cause learning, adaptation, and unexpected change. Non-equilibrium traits: changes are inversely proportional to effects.
Munger: sociology and markets
The most robust system is one that is diverse -> as diversity decreases, agents conform in terms of mindset -> booms/busts.
Munger: psychology
Getting to the root of failure requires investigation of the psychological missteps along the way. In other words, remove standard thinking errors.
Munger: social proof tendency
Tendency to adopt the beliefs, actions, and opinions of the people around us. Adopting community -> conformity and decrease independence of thought.
Munger - what is rationalism and why is important?
Munger said Berkshire is a temple to rationality, and rationalism is the tendency to use the power of the mind to analyze and think via deductive reasoning. A priori thinking.
What is the counterpart to rationalism?
Empiricism - testing knowledge via the 5 senses. a posteriori
Name 6 myths regarding valuation:
- Valuations are objective
- valuations are timeless
- valuations are precise
- valuations are better when more quantitative
- to make money on valuation, you have to assume that markets are inefficient
- the product is important, not the process.
Types of investors:
1. underlying value of a firm is based on its financial characteristics
2. concentrate on buying a few businesses that are well understood
3. believe prices are driven by psychology (and underlying financial variables)
4. prices move with news
5. select stocks based on market movements
6. believe market price represents true value
- fundamentalists
- franchise buyers
- chartists
- information traders
- market timers
- efficient marketers
Name 3 types of valuation:
- DCF - discounted cash flows - value of an asset is the PV of its expected future cash flows
- relative valuation - find comparable companies
- contingent claim valuation - uses options pricing model on assets that share option characteristics
What is the PV equation?
PV = sum [ FV / (1+r)^t ] where r is the discount rate reflecting the riskiness of the asset and t is time
2 types of DCF models
- equity stake valuation - where the discount rate is the cost of raising equity financing
- firm valuation - the entire business - where the discount rate is the cost of raising debt and equity financing
Name a special case of equity valuation
dividend discount model
How is the value of equity (equity stake valuation) calculated?
Discount equity at the cost of equity –> residual cash flows minus expenses, reinvestment, tax, interest, principal at rate of return required by equity investors
How is the value of the firm (firm valuation) calculated?
Discount the firms expected cash flows minus expenses, taxes, reinvestment needs but prior to payments to either debt/equity at the WACC
What is WACC
weighted average cost of capital - average cost of different components of financing at the firm
Calculate the cost of debt
= pretax rate (1-tax rate)
Calculate the WACC
= cost of equity [equity/ (debt + equity)] + cost of debt [debt/(debt + equity)]
What 2 errors can be made when performing DCF valuations?
Error 1. Discount cash flows to equity at the cost of capital (too high of a value)
Error 2. Discount cash flow to the firm at the cost of equity (too low of a value)
calculate the cost of capital
cost of equity(proportion of equity funding business) + pretax cost of debt (1-tax rate) (proportion of debt funding business)
What 2 requirements are ideally needed to calculate DCF?
- stable positive cash flows into the future
- proxy for risk that correlates to discount rates
What 6 situations are not ideal and may require adaptation for DCF model?
- Firms in trouble
- cyclical firms
- firms w/ unutilized/underutilized assets
- firms w/ patents or product options
- firms in the process of restructuring or acquisition
- private firms
What 2 issues are a problem using the DCF in acquisitions?
- synergy? and how its valued
- change in management? and its effect
What type of valuation is derived from pricing comparisons and rooted in financial variables?
Relative valuation
What is the main difference between relative valuation and DCF?
relative valuation relies more on the market to support the underpinnings of the price - market is right on average but less right with individual stocks
What are 3 components that should lead to higher valuations, ceteris paribus?
- higher cash flows
- higher growth
- lower risk
What are the 2 paradigms of relative valuation and what are the differences?
- Fundamentals - use concrete variables but compared overtime and with each other - helps establish relationships as company characteristics change
- Comparables - compares how a firm is valued compared to another firm - finding comparable firms is often a challenge
What kind of comparison is happening when one ratio is compared to the same ratio of another company? Name a limitation.
Cross-sectional comparison - must make assumptions about fundamentals. E.g. does a lower than industry average P/E mean the company is cheaper or riskier?
What kind of comparison is happening when a ratio is compared to ratios in the past? Name a limitation.
Time Series comparison - companies change overtime due to changes in equity, debt, growth, size and it is difficult to control for those variables.
Name an alternative valuation method that takes a parts equal the whole approach? Explain how valuations are done.
Asset-based valuation - uses a combination of liquidation and replacement values of identified assets to generate an overarching valuation.
What is the difference between DCF and asset-based valuation?
DCF prices in growth whereas asset-based valuation cannot.
Comment on errors in relative valuation vs DCF.
Because relative valuation inherently includes more information from market pricing, those errors can accumulate through the valuation process. DCF is influenced less by potential market errors because variables are firm specific cash flows and growth rates.
What type of valuation is based on a potential event in the future, and what style of valuation is applied to it consequently?
Contingent claim valuation includes information that might potentially and significantly change an outcome for a company and is accepted to be similar to pricing options. E.g. patents or undeveloped reserves.
What is premise behind using options pricing models vs DCF for applicable assets?
DCF tends to underestimate the payoff when the contingent events are triggered.
What 2 types of assets can be priced with options pricing models. Provide examples of those assets and differences.
- Financial asset - stocks and callable fixed income securities (bonds)
- Real assets - commodities, real estate or even investment projects
Real assets are typically traded much less than financial assets, and therefore much harder to value.
What 4 questions do financial statements help answer in terms of valuation?
- How valuable are the assets of the firm?
- How were funds raised to finance these assets?
- How profitable are these assets?
- How much uncertainty or risk is embedded in these assets?
What is the difference between how accountants view a firm versus someone doing a valuation?
Accountants measure current standing and past performance of a firm and valuations are concerned with the future of the firm.
States value of assets and mix of financing at a point in time.
Balance sheet
States revenues and expenses over a period.
Income statement.
What 3 uses of cash on the statement of cash flows are shown?
Uses of cash for:
1. operating
2. investing
3. financing
Revenues - operating expenses =
operating income
Acct. equation –>
Assets - liabilities = owner’s equity
operating income - financial expenses - taxes =
net income before extraordinary items
net income before extraordinary items - extraordinary losses (profits) - income associated with accounting changes - preferred dividends =
net income to common stockholders
what are extraordinary losses (profits)
those not associated with operations
cash flows from operations:
net cash flow from operations - taxes and interest expenses
cash flows from investing:
net cash flow from divestiture and acquisition of real assets (cap ex) and disposal and purchase of financial assets ( including other firms )
cash flows from financing:
net cash flow from the issue and repurchase of equity/debt after dividend payments
Definition of asset:
Any resource that has the ability to decrease cash outflow or increase cash inflow.
3 principles for the way accountants value assets
- Book value (historical value possible adjusted up or down) is the most trusted
- Distrust of market or estimated value
- Preference for underestimating value
Comment on the difference in use of depreciation in reporting and tax statements.
U.S. firms often use straight-line deprec. in financial reporting and accelerated deprec. for tax purposes –> can lead to relative lower expenses and an overstatement of reported income.
LIFO or FIFO for inflation?
F.I.FO –> lowest estimate of CoGS and highest net income.
*LIFO - high CoGS and low net income during inflation because the last goods are the most expensive. high CoGS reduces taxable income the most
What is the problem w/ LIFO and FIFO when it comes to valuation?
Harder to compare firms that use different methods but usually reported in footnotes as LIFO reserver
securities or assets owned another firm that represent less than 20 percent, 20-50 percent, > 50 percent
- minority passive investments
- minority active investments
- majority active investments
what is marking to market?
Investments held to maturity are often marked at historical cost (book value), but when beings sold they are sold at market value.
For an investment held to maturity, what financial statement are the interest and dividends shown on?
Income statement
For an investment available for sale, what financial statement shows the unrealized losses or gains?
The balance sheet, not the income statement
For a trading investment where are the unrealized gains/losses shown? What is the valuation?
Income statement; at market value.
Name 3 types of minority passive investments:
- Investment held to maturity
- Investment available for sale
- Trading investment
What is the equity approach to valuing investments and which investment type is it used for?
Investments have an initial acquisition value, and a proportional share of the net income/losses made by the firm in which the investment was made plus the dividends received from the investment reduce the acquisition cost. – minority active investment
What happens with financial statements for a majority active investment?
There is a consolidation of the 2 firms’ balance sheets, and the share of equity in the subsidiary owned by other investors is shown as a minority interest on the liability side.
Comment on the costs of patents and trademarks depending on internal vs external generation.
Internal - costs expensed in that period (not on the balance sheet)
External - if an intangible asset is acquired from an external party, it is treated as an asset.
What is the difference between the value of assets acquired and the market price (after being reappraised to fair value)?
Goodwill
2 types of long-term debt
- loan from a bank or other financial institution
- bond issued to financial markets
What are the two types of leases?
- operating lease
- capital lease
Explain what an operating lease is and how it is accounted for.
Operating lease exchanges the right to use property for a lease expense –> income statement not balance sheet
Explain what a capital lease is and how it is accounted for.
Capital lease exchanges the actual property, so lease expense and depreciation expense
Describe over/under funding in an accounting plan.
Overfunded - excess assets in the fund
Underfunded -
What is the difference between deferred tax asset and deferred tax?
Deferred taxes will be paid in later years and deferred tax asset is an overpayment of taxes.
where is preferred stock accounted for?
balance sheet at original issue price
What 3 types of categories do expenses fall into?
- operating
- financing
- capital
What expenses provide benefits only for the current period? Which arise from raising capital, and which are used to purchase long-term assets that generate benefits over multiple periods?
- operating
- financing
- capital
What 4 sections is the income statement divided into?
- income from continued operations
- income from discontinued operations
- extraordinary gains/losses
- adjustments for changes in accounting principles
What 2 expense categories are considered operating expenses but can be considered over multiple years?
- depreciation and amortization
- research and development
What 4 types of nonrecurring expenses are there?
- unusual/ infrequent items - gains/losses from divestiture/acquisition of asset or devision
- extraordinary items - gains/losses from marketable securities
- losses associated with discontinued operations -
- gains/losses with accounting changes.
Name 2 measures of profitability:
- return on assets
- return on capital
What does EBIT stand for?
Earnings before interest and taxes
What are 2 forms of return on assets?
= EBIT (1-tax rate)/total assets
= (net income + net expenses (1-tax rate) / total assets
What is another way of looking at EBIT?
operating income from the income statement
In terms of return on assets, how is total assets measured?
book value for most assets
What is pretax ROA?
EBIT/total assets
What is return on invested capital?
[EBIT(1-t)]/ (BV of debt + BV of equity - cash)
What is ROC written as a function of after-tax operating margin x capital turnover ratio
EBIT(1-t) / Sales * Sales / BV of capital
What 2 ways can ROC be increased?
Increasing the profit margin and utilizing its capital more efficiently to increase sales.
What is a profitability measure related to the investor?
return on equity
What is return on equity?
ROE = Net income / book value of common equity
What two accounting themes underlie risk management?
- risk being measured is risk of default (as opposed to risk of variance around actual returns)
- acct. risk measures are generally static - over 1 period of time
What are two accounting measures of risk?
- disclosures about potential obligations or defaults in footnotes of balance sheet
- ratios designed to measure both liquidity and default risk
What is a liability triggered by an event?
Contingent liability - lawsuit e.g.
What is the risk arising from the need to finance current operations?
short-term liquidity risk
current ratio?
current ratio = current assets / current liabilities
net working capital?
net working capital = current assets - current liabilities
quick ratio?
quick ratio = cash + marketable securities / current liabilities
current ratio up vs current ratio down
up - rising inventories?
down - to many short term obligations
accounts receivable turnover
sales / average accounts receivable
inventory turnover
cost of goods sold / average inventory
What 2 problems do current ratios have?
- ratio can be easily manipulated around financial reporting dates
- current assets/liabilities can change by an equal amount
days accounts receivable outstanding
= 365 / AR turnover
days inventory held
= 365 / inventory turnover
accounts payable turnover
= purchases / average accounts payable
days accounts payable outstanding
accounts payable turnover
Measure of short-term liquidity risk:
required financing period = days accounts receivable outstanding + days inventory held - days accounts payable outstanding
How does financing period showcase short-term liquidity risk?
Greater the financing period, greater the short-term liquidity risk.
What are measures to meet interest and principal payments in the long run?
measures of long-term solvency
interest coverage ratio?
= EBIT / interest expenses where higher easier to cover interest
fixed charges coverage ratio? ( in terms of earnings)
= EBIT (before fixed charges) / fixed charges
cash fixed charges coverage ratio? ( in terms of cash flows )
= EBITDA (before fixed charges) / fixed charges
operating cash flow to capital expenditures
= cash flows from operations / capital expenditures
cash flow from operations
EBIT (1- tax rate) + depreciation - change working capital
What measures examine the capacity to pay back principal on outstanding debt?
debt ratios
debt to capital ratio vs debt to equity
= debt / (debt + equity) vs debt / equity
market value of debt to capital ratio
MV of debt / (MV of debt + MV of equity)
market value of debt to equity ratio
MV of debt / MV of equity
Define risk per Damodaran?
Risk that our investment returns a value we didn’t expect.
From a risks standpoint, who’s perspective sets stock prices?
the marginal investor
What are the 3 steps to risk analysis?
- defining risk as the distribution of actual returns around expected returns
- differentiating between risk of a few investments versus a wider cross-section of investments
- alternative models for measuring market risk and the expected returns that go with it
How is the spread of actual returns around expected returns measured?
Measured by standard deviation or variance
What is the bias toward positive or negative returns represented by?
skewness
What are the 2 groups of reasons are why actual returns may differ from expected returns?
- firm specific risk
- marketwide risk
What does kurtosis represent?
lower kurtosis (smaller tails) -> fewer extreme positive and negative values.
What do the shape of the tails
what does a right-skewed distribution represent?
right skewed -> long right tail -> large positive returns
