Understanding the True Profit Margin

By Joe Ponzio on August 7, 2009  |  32 comments

On the heels of yesterday's article, I received an e-mail from a friend this afternoon asking me about my thoughts on inventory turns and profit margins. To paraphrase: The math doesn't work right, as the inventory turns don't affect the profit margins each year.

I didn't do a good job of explaining it properly; so, let's look at the "true" profit margin of a company.

Expanding Your Sphere of Confidence and Competence

By Joe Ponzio on January 16, 2009  |  27 comments

When it comes to buying stocks, there are a million different approaches, a million different ways to value companies, a million different charts to look at... You get the idea — it can be dizzying, especially if you are trying to learn how to invest and find some stable ground on which you can build your strategy and knowledge base.

That said, time and time again, the great value investors — Warren Buffett, Charlie Munger, Seth Klarman, and others — all teach investors one fundamental rule to intelligent investing: Stick with companies you understand really well...in industries you understand really well.

If you don't know a company or industry really well, you have to choices: learn it or skip it. You should skip it while you're learning. You should learn more so you have more choices and opportunities at your discretion.

Phil Fisher on Profit Margins

By Joe Ponzio on June 24, 2008  |  16 comments

Phil Fisher laid out fifteen points to look for in a common stock; three of them are directly related to profit margins. Calculated as net income divided by revenue, the profit margin is a quick way to determine which companies in an industry are most efficient (i) relative to the competition, and (ii) as a whole.

Does the company have a worthwhile profit margin?

To hammer the importance of this point home, you need not look further than traditional auto manufacturers.

But Can They Sell It?

By Joe Ponzio on June 24, 2008  |  4 comments

You've heard the clichés: He could sell ice to an Eskimo. She could sell a ketchup popsicle to a woman in white gloves. The sales force is the lifeblood of an organization. After all, the best product in the world is worthless if nobody knows about it. And so, we move on to Phil Fisher's fourth point:

Does the company have an above-average sales organization?

What's Happening with Research and Development?

By Joe Ponzio on June 22, 2008  |  12 comments

Today's research and development (R&D) is tomorrow's new product or process. The other day we (or more specifically, Phil Fisher) asked, "Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?"

The goal of R&D is to produce new products, services, or processes that will "still further increase total sales potentials" for the company. Not an easy question to answer, Fisher asks:

How effective are the company's research and development efforts in relation to its size?

Will They Seek Out More Profitable Lines?

By Joe Ponzio on June 18, 2008  |  9 comments

Businesses generally expand in three ways — increased sales of existing products, sales (and increased sales) of new products, and acquisitions to expand product lines. We looked at "increased sales of existing products" in Can They Increase Sales For Several Years? Fisher then went on to talk about "sales (and increased sales) of new products":

Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?

There are two schools of thought on this subject — the rational, business-like approach and the "other" approach.

Can They Increase Sales For Several Years?

By Joe Ponzio on June 11, 2008  |  3 comments

In Common Stocks and Uncommon Profits, Phil Fisher outlined fifteen points to look for when analyzing a company for purchase. When valuing a business, our job is to try and predict the future with a degree of accuracy and confidence. If it were as easy as plugging the financials into a spreadsheet, everyone would achieve consistent, double-digit returns.

Unfortunately, the future is more than a simple mathematical equation. Enter Phil Fisher.

Don't Ignore The Assets

By Joe Ponzio on January 14, 2008  |  16 comments

There is a school of thought that says that the value of a business is entirely in its future cash flows and that all assets are tools that provide that cash flow. In essence, many people believe that assets and equity should be ignored entirely. Let's look at it from a private owner perspective and follow it up later in the week with an examination of Buffett's early partnership letters:

From Free Cash Flow To Earnings And Back

By Joe Ponzio on November 19, 2007  |  22 comments

I'm just getting caught up on the slew of comments here and I wanted to jump in again on this string over on What The Heck Is CROIC? There seems to be some confusion as to how free cash flow and GAAP earnings are related and I figured that this would be a good topic rather than let it get buried in the comments.

Do GAAP earnings drive free cash flow? Or, does free cash flow drive earnings?

Robert Explains Financial Institution Valuation

By Joe Ponzio on November 7, 2007  |  21 comments

When asked how to value financial institutions, I've always taken the cop out plea: They're outside my sphere of competence. What makes that statement extremely interesting is that I own and operate one and I still can't value them!

Robert posted one of the finest, most eloquent, and thoroughly researched answers to the question of why it is so difficult to value financial services companies.

Choosing A Growth Rate: CROIC vs. FCF

By Joe Ponzio on October 16, 2007  |  13 comments

The value of a company lies entirely in the future, and it is our job to predict that future with a degree of accuracy and confidence. To choose a growth rate, we must delve into the inner workings of a company and see how quickly it will grow internally.

Enter CROIC.

Heads I Win Big; Tails, I Don't Lose Much

By Joe Ponzio on October 12, 2007  |  21 comments

One of Mohnish Pabrai's favorite quotes goes something like this: Heads I win; tails, I break even or don't lose much. When it comes to investing in the stock market, that seems like an ideal to strive for.

Let's examine some worst case scenarios in owning pieces of businesses.

Do The Math In Your Head

By Joe Ponzio on August 30, 2007  |  19 comments

Perhaps you've noticed that I switch between discount rates. Maybe you've seen me throw the past out the window and use future owner earnings assumptions that differ from past median growth rates. Or, you may have noticed that I'll use 8-year timeframes on some companies and 15 year timeframes on others.

I think it is human nature to seek out the perfect spreadsheet or formula to predict the future of the markets. It doesn't exist, so it is best to understand various methods and assumptions so you can draw your own rational conclusions based on reasoning and data.

Does Discounted Cash Flow Always Work?

By Joe Ponzio on August 24, 2007  |  7 comments

Interestingly enough, quick asked a question that was going to be the topic for today. When does the discounted cash flow model work? When does it not? Is this a method that can be used for all businesses at all times?

The short answer is: The discounted cash flow method always works for valuing a business. But, I'm not known for short answers, so let's explore the weaknesses in this model. Considering that my spreadsheets have been taken, used, and modified around the web, I think I should qualify a few of the assumptions in there.

The Value Of A Moat

By Joe Ponzio on August 7, 2007  |  9 comments

If your business doesn't have a moat, it is unpredictable at best. Can money be made in no-moat businesses? Absolutely—but it is a gamble at best. Ben Graham, Warren Buffett's mentor and friend, stated:

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

Though a small- or no-moat business may offer a "satisfactory" return, it does not promise safety of principal. So, we invest in wide, deep, shark-infested moat businesses. But, how do we put a value on that moat and factor it into our price?

When growth slows down

By Joe Ponzio on August 2, 2007  |  5 comments

Yesterday, a visitor brought up a couple of points regarding the analysis of Johnson & Johnson. It looks as though growth might be slowing based on the 2001-2006 owner earnings growth rate and he brought up a good point—is it a cause for concern?

Calculating The Value Of A Business - Part IV

By Joe Ponzio on July 24, 2007  |  56 comments

By now, you have determined what your desired rate of return is. Personally, I like to use 15%. At that rate, my money will double approximately every 5 years. Why 15%? Considering that I have to find the companies, analyze them, say "no" to most of them, and patiently wait on the sidelines until an opportunity comes along, 15% is the minimum annual return I want to justify the work that I have put in.

Calculating The Value Of A Business - Part III

By Joe Ponzio on July 23, 2007  |  1 comment

In Part I, we looked at Shareholder Equity as the first step in calculating the intrinsic value of a company. Then, we looked at Buffett's owner earnings and further explored intrinsic value in Part II. When you buy stock, you are buying a piece of a business—usually, a small piece. You are essentially becoming a silent partner in that business.

Calculating The Value Of A Business - Part II

By Joe Ponzio on July 20, 2007  |  28 comments

In Part I, we looked at Shareholder Equity as the first step in calculating the value of a company. Shareholder Equity essentially tells us how much our company is worth if it shut down operations, sold off its assets, paid its debts, and distributed the cash to the shareholders. Though Shareholder Equity tells us the "wind up" value of the company, we do not expect our company to, well, wind up its operations.

Thus, we need to know its intrinsic value—our company's value as an ongoing business. Once again, as always, we turn to Warren Buffett for advice.

Calculating The Value Of A Business - Part I

By Joe Ponzio on July 19, 2007  |  16 comments

The Greater Fool Theory is a belief that you can buy a stock at any price and sell it to some other, bigger fool for a profit. In times of ever-increasing markets, this theory often shows itself to be true. Still, reality must come crashing down at some point. It always does. And that is precisely when great fools lose tons of money, and great investors come to life.

What The Heck Is CROIC?

By Joe Ponzio on July 17, 2007  |  59 comments

Perhaps one of the most important, and least used, numbers on Wall Street is CROIC—Cash Return On Invested Capital. A Google search for "earnings in investing" brings up some 7 million results. "CROIC in investing" brings up 47, of which 5 belong to F Wall Street (probably six after this post).

As I promised Oliver on July 13th, let's explore CROIC for a minute.