Calculate the sustainable free cash flow yield, to get an intuitive valuation feel

Executive summary: Single stock valuation

Cash Flow / Stock price = yield

That’s actually the entire message of this post. Yes, true, you can move on to your next task of the day now.


Forget valuation multiples, DCF analysis, EVA etc. Just calculate the ‘yield’ of your holdings: “Profit”/market capitalization

5.4% yield? Good or bad? Worth the risk, the wait? You decide.

Is the yield high enough for you to hold on to the security forever, or do you require some price increase as well to be satisfied, to cover your costs, to reach your risk adjusted required rate of return?

Best guess is that if the yield is high you’ll get a price increase as well, because more investors will flock to the high yielder, whereas a low yield will come with a (at least an interim) price fall.

That’s it. That’s all you need. Well,… and love. Actually, love is all you need. The yield is just icing on the cake.

Gigi hugs from Flickr

Or frosting. Think about that.


Read this first

Before moving on, please note that this is purely a hard core finance article. There is no humor, no personal development ideas, no tips and tricks, no memes and no great mindsets to contemplate. It’s just numbers.

There is not even a tangible specific stock example… or a picture… or stock chart. But you can always go back to the Amazon example from a few weeks back for that.


“Is this stock worth buying?”

Let’s say you are more or less happy with the general investment environment (see last post about index outlook). Now, you just wonder if a particular stock is worth your time and money…

Here is one way of getting a feel for it.

What’s the latest annual profit? After taxes? After necessary investments in various operating resources? What’s this year’s free cash flow available for dividends , hoarding and re-investment?


That last question is key: Free cash flow, FCF


The cash flow is a much better measure of real economic profit than the operating profit or net income, since it’s for real. It’s really there in the bank account after everything is said and done, after all the accounting gimmicks, staff stock options etc.

Divide the FCF number with the company’s total market capitalization, FCF/MCap, and you get the cash flow yield. That’s your annual return on your original investment, if the price stays the same. Compare it to your bank account, a private loan to a friend, a government or corporate bond, e.g.

  1. FCF/MCAP = yield

How high a yield do you demand, require, on average, to buy the shares, given there is a risk associated with equity investments? 6%, 10%, 15%, 25%? That’s not for me to say, but the riskier the company, the more you probably want to demand in return.

The stock market in general has produced around 6% annual real performance, including dividends, over a century. That’s around 8% nominal return per year. If some kind of general Required Rate Of Return [RRR] was 6% / 8% during the same period, the stock market has on average been priced just right.

It makes sense as a starting point, that the market on average over a century was neither a bargain, nor a rip off. Hence the RRR was about the same as the annual return.

What’s your RRR for your stocks? What’s your “base” RRR and how much do you adjust for specific stocks. That’s entirely up to you and depends of thousands of subjective variables.

However, if you just want to fit in with everybody else, stay around 5-10% for most large caps (big, well-known firms), maybe as low as 2-4% for very stable business models, and up to 15-30% for newly IPO:d stocks with limited information or unproven or high-risk business models.

So, what are your RRRs?


Ask more of your shares

Statistically, a single stock is riskier than a group of stocks. Thus, you should typically require a higher rate of return from your single stocks than a broad index of companies, but I’m not judging anyone. 

Given your RRR and the actual yield, the upside/downside on the stock (for you) is thus pretty simple:

2. Stock potential = yield/RRR-1

3. Stock value = FCF/RRR

As an example, your company has a FCF of 50, a market cap of 400, and your RRR (return demand) is 7%. Then there is an (50/400)/7%-1 = 79% upside to the stock for you. The actual price of the stock could rise to FCF/RRR=50/0.07=714, before its yield was as low as your RRR.

Of course, the stock might never appreciate that way, since other investors have different RRRs and valuation models, but to you it is worth 79% more, so just keep buying as long as you have money to spare and the stock potential is positive.

NB: An asset returning 4% when you demand 8% is worth just half the price to you, since 4/0.5=8

Again: Let’s say you find a stock that costs 100 and has a cash flow of 4. If you can buy the stock at just 50 you would get a 4/50=8% yield.


Complicating things just a tad

There is just one problem; This year’s cash flow probably isn’t representative of the entire future of the company.

What to do? Easy! Make it representative. That’s easier said than done, but you can at least try. This is how:

The most important variables to normalize, make sustainable and believable, are profit margins, net working capital requirements, investment needs and tax rates. Simply adjust current year’s profits and cash flows according to long term sustainable margins, NWC, investments and taxes.

Unfortunately, even a professional investor or analyst that has spent 10 000 hours on that company alone still can’t do that with any precision. On the other hand, that leaves room for you to give it a stab too.

Think and guess. Is a 10% operating margin likely? Why? Why not? Competition? Tax rates in the future? Cash flow conversion (credit conditions, invoice routines, DSO…)?

If nothing else, you can piggyback on the analyst community, and assume that 3-5 years out, all variables have been normalized to the best of everybody’s ability. Be careful in the smaller caps though. Analysts and investors tend to be overoptimistic there.

Take the margins and other variables from, e.g., t+4 years and use them on the latest available 12 months sales numbers, or this year’s expected full year sales. Then use the resulting free cash flow as your basis for a yield and share potential calculation.

4. Sales at t=0 multiplied with margins etc. at t+4 => normalized cash flow at t=0, and normalized yield

Just as before, keep buying as long as the normalized yield is higher than your RRR. You’ll get at least your RRR on your investment, as long as you don’t have to sell the stock at lower prices, or your assumptions on future cash flow returns turn out to be wrong.


Calculate normalized cash flow yields and compare them to your required rate of return, and invest accordingly. Period.


The master class

Oh, I almost forgot. Then there is the question about growth after the normalization period.

If the company keeps some of its FCF, its equity will rise. If the company’s business is growing too, next year’s FCF will be higher as well. Depending on growth rates, the valuation of its equity, and your RRR, the relation between your RRR and the company’s yield will change.

E.g., if the growth in FCF is higher than your RRR, even by just the most minuscule amount, the value of the company should theoretically be infinite to you. Weird, and hardly practical.

Price = Cash Flow / (RRR-g)

It’s complicated. I’ll leave it at that. This was never meant to be a full course for stock valuation, just yet another Quick And Dirty piece of the valuation puzzle. By the way, as soon as you start complicating things or involve too much math and formulas, you risk losing your intuitive feel for the investment. Leave that to professional number crunchers. They are wrong often enough.

Does it seem hard? Difficult? You have no idea where to begin…?

Alrighty then, let’s do all the things that you wanna do! Here is a summary



  • Find the most recent annual profit, or a reliable estimate for the current year
  • Adjust it to get to free cash flow
  • Change margins etc. to long term sustainable levels
  • Divide the sustainable cash flow by the stock price
  • That’s your yield
  • Is that yield higher or lower than what you want out of an investment with that risk profile?
  • Is the yield higher or lower than what you estimate the market in general requires of that kind of stock?

Remember that the yield is “real”, i.e. if the company grows, the yield rises. That gives you an inherent margin of safety

On the other hand, the yield isn’t safe, neither is the stock price. You have to be prepared to hold the stock through thick and thin and never be a forced seller. The yield valuation method doesn’t say what other investors think, but what do you care if the stock moves up or down if you are going to hold it forever? You can always buy more on dips.


Did you hate this post? I feel you. I hated myself for writing it. Now, share it with somebody whose evening you want to ruin.

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How to trade a bear for dummies

If this is a newly born bear market this article shows how to deal with it


Istanbul has me now

Actually it doesn’t any longer, since I got back from Istanbul today (Sunday, October 4).

During my four nights there, I was asked in an e-mail whether I thought the downturn on the stock markets would be “smooth like in 2008” or exhibit a “small bounce by 10% now”.

True to form, I immediately replied I thought the current downturn probably will be interspersed by at least a dozen dead cat bounces of 10-15% each, just like during the last two bear markets.

You can take my word for it that’s how it usually plays out.

On the other hand, then you’d be taking this guy’s word, which might not be wholly recommendable…:

Table surfing in Istanbul


Bear market bounces, a.k.a. bull traps

Instead of trusting Mr Surfer above, check out these two charts, where I’ve highlighted bounces of approximately 10% or more.

If intraday data is counted, there are several more bounces. The following, however, is enough support for the thesis that you should expect much more than just a handful of large bounces during a short cyclical bear market:


Don’t worry about the US centric choice of charts. E.g., the Swedish OMX index exhibits the same pattern. The same goes for downturns in general. No matter differences in economic exposure, valuation levels etc.; where the S&P goes, the OMX goes too.


How to trade a cyclical bear

First, you have to decide whether you think a bear market is in the works or not.

I think the bear market has started, for several reasons: The bull market was getting long in the tooth, valuations are ridiculously high, market dispersion has increased, key moving averages were broken decisively during the drop in August, other markets have already signaled distress (oil, e.g.).

You may not agree. If not; as you were.

Second, should you care at all? If you strictly adhere to the “Buy and Hold” investment strategy, the answer is no. Just don’t change your mind any later than now. Actually, even a BAH investor can benefit from a road map for timing stock purchases, so keep reading.

Third, if you do care, if you want to trade the bear, do you want to make money shorting, or just try to time a large purchase close to the trough?

I’m not recommending anything here, I’m just asking you to analyze yourself, and make a game plan before things heat up. Bear markets are not child’s play and it’s easy to lose one’s religion during market routs.

Regarding buying at the bottom, you won’t know when it’s time, just as nobody rang a bell at the top. However, if you start buying once the expected annual return exceeds 10%, and then accelerate your purchases when market dispersion falls (trend uniformity increases) and junk bond yields fall significantly, you should come close enough.

There are too many ways the bottoming process could play out for me to detail them all here, but no matter what happens, just focus on buying ‘cheap enough’ and make sure you get the risk aversion trend with you before going all in.


Aggressive bear trading

I will trade the bear much more aggressively than most. I plan to do it in a way I couldn’t recommend anybody.

To start with, 75% of my active portfolio consists of XACT BEAR (which is a Swedish stock index ETF with a negative delta of 1.5). Hence, more than 100% of my portfolio’s net value is short. The rest, around 25% is invested in gold. I also have all but negligible amounts invested in a couple of single stocks and cash earmarked for oil.

I plan to reduce my short position whenever stocks drop by 20% (from a recent peak or with a sudden new, steeper, trajectory), like in Q1 2001, September 2001, summer and fall of 2002, October and November 2008, as well as March 2009.

Then I’ll increase my shorts again, after a bounce by more than 10%, and even more if the bounce grows to 20%, like in the second and third quarters of 2001.

Once the total drop amounts to around 50-60%, I’ll focus more on reducing my shorts after sudden plunges than putting them back on again after bounces and surges.

However, my main indicators for when to start going long in earnest, are market dispersion (industry, Advance/Decline, new highs/lows, etc.), dropping junk bond spreads, various sales multiples (P/S, Mcap/GDP etc.) and long moving averages.

Given that markets don’t just revert to the mean, but invert the overshooting to undershooting below the mean (unless the average has shifted upward permanently), the current downturn could be even more vicious than even I expect. Nevertheless, if I can buy stocks on multiples promising 10%+ annual returns, I will (fully knowing there could be another halving waiting before the ultimate trough). The above factors, as well as time, will guide me.

I have a feeling this cyclical bear, the third and last during the 18-20 year secular bear that started in March 2000, will be extraordinary. I’m just not sure how. It could be unusually large reductions in value from peak to trough, it could be the number of bounces, the intensity of plunges and bounces (due to e.g. higher lending, more derivatives and much more and larger HFT accounts), or a more prolonged process, e.g. Or all of the above.


Anatomy of this bear

What follows is my current game plan for the current cyclical bear.

Peak: summer 2015

Trough: between July 2017 and July 2018

Total drop in value: -60% for S&P 500 to 850

# Dead cat bounces >10%: 15

Just as during the previous two cyclical bears, I think we’ll see progressively bigger drops, followed by correspondingly bigger bounces, until both the plunges and bounces moderate (like between September 2002 and March 2003) after a capitulation event like the one in June, July 2002. That kind of bottoming out process is likely to take place between the summer of 2017 and the summer of 2018, i.e. 2-3 years after the peak.

I think the Fed will feel forced to try a rate hike sooner or later. Perhaps to signal all is okay. Then they’ll backtrack due to a market plunge (that I plan to buy on, i.e., temporarily reduce my short positions) and launch a new QE program (#4).

I think the USD will strengthen during the market plunge, the flight to safety effect helped by the interest rate hike. I also think China will devalue its currency aggressively, intensifying the currency wars. That in turn will propel real assets upward: gold, bitcoin and oil (though the latter needs to get low enough first).

I plan to buy oil again once it starts falling in tandem with weaker macro data.

I have enough gold… I think.


End game

High margin debt, and losses on derivatives  will pressure stocks in a vicious circle of liquidation, culminating in a final death spasm, sending markets down a final 25% in a single quarter with revenue based valuations reaching typical bear market levels.

Very few will have the guts or the cash to buy stocks by then. I hope to be one of them.

If you held on to your stocks throughout the bear, they probably lost 60-70% in value over 2-3 years, but you can of course still buy more for whatever cash flow you produce. Let’s just hope your job is secure, interest rates or rents haven’t risen too much, or you’ve lost your faith in stock markets by then.



The bear is here

Decide whether to sell, or just buy (I have already sold)

Whatever you take away from this article, just remember the recurring pretty large bounces.

I don’t intend to try to time them perfectly, that’s impossible. However, I’ll still buy on dips and sell on surges and hope to make a little extra even if I sometimes miss out completely.

Also note that the plunges become larger and larger as the bear progresses.

Bear markets almost seem constructed to cause the maximum amount of pain for long-onlies and newbies.

Most of all, prepare a list of things to buy when (if) they get cheap enough. Start building the list right away – either alone, or with a group of trusted friends (or on the line for that matter).

Remember that the return of any investment should be positive for you, not just your bank account. If certain investments or investment decisions keep you awake at night for long periods of time, it’s just not worth it. You are supposed to manage your resource allocations in a way that adds value to your life.

Sign up for my (weekly-ish) newsletter, and I’ll keep you posted on my personal investment choices. Don’t expect a high trading style turnover rate, but perhaps a few well timed decisions taken with a bird’s eye view of the markets. Tell a friend too.


Always be investing – this is how I interpreted my own advice when hungover in Istanbul (4 days in a row with the same 40 in 40

If you can’t control your finances or investments, at least you can control your body. That’s where your life begins, and that’s where it ends. The rest is just noise.

Amazon redux – this time twice as expensive

Warning, this is a long hard-core finance article. It’s mostly about the valuation of Amazon. The stock is so expensive, I can’t even… My blue sky scenario is -90%.


March 2000 was a good year for drunks…

I’ll show with a few simple assumptions and calculations why I think Amazon’s shares are 10-20 times as expensive as I would find attractive.

I’m not advocating going short the stock though. You have to realize when you don’t “get it”. At this point I’m not quite sure what would change my mind about this. It’s just so far off from what I consider reasonable that the situation simply is out of control. Hence, better not risk any money.

All I really do in this article is extrapolate growth and margin trends, and then state what kind of return I demand from an investment to consider it worthwhile.

You are free to have different preferences or assume others (i.e. the market) have.

Read on if you are interested in a step by step pedagogical approach to back of the envelope investing

Beer or IT stocks?

At the height of the stock market bubble in March 2000, you would have been as well off financially if you bought beer and recycled the cans (in certain states), than if you “invested” the money in many IT shares.

As it were, the entire Nasdaq index (not only tech stocks) declined by 80 percent, and many stocks declined by much more. Just cash would of course have been so much better than beer, not to mention bonds or gold.

The difference between an 80% drop and a a 90% drop is an additional fall by 50% in value.

And yet another 50% loss takes the total loss to 95%. A third sequential 50% loss, after the initial hypothetical 80% plunge, renders a total loss of 97.5%, which aptly describes the trajectory of many IT and new media stocks during the years 2000-2003.


Stars do fall; Nasdaq composite index 2002-2015

I should know, since I was chiefly (ir)responsible for buying shares in an internet consultancy called March 1st (named after its starting date March 1, 2000, at the very peak of the bubble). Luckily, we made back the initial losses on that position (and sold it before the bankruptcy in early 2001). We then went on to earn so much more shorting similar stocks in Europe, using the US stock market as a template.

Make informed investments, with whatever you have left after Mr Market taught you a lesson – always be investing

The IT crash was no surprise

To many thoughtful and experienced investors the crash of 2000-2003 didn’t come as a surprise. I have a list of 50 prominent investors and other pundits, that intelligently and timely forecast an epic bursting of the insane IT bubble. Many of those went on to correctly predict a housing crash and a financial crisis after 2006.

Neither of the last two crashes came as a surprise to anybody with the slightest knowledge of the art of valuation and the history of markets and bubbles. The timing, however, was often off by a year or two – or more. 

Crash number 3 is in the cards

I think it’s about time again for a correction of frothy share prices. And by correction I mean on the order of -50%.

There are dozens, if not hundreds, of fingers pointing to that conclusion, but this is one of my favorites:

Dr John P Hussman’s chart over “Price/GDP” vs. stock market returns

Observe, e.g, where the blue line bottomed in 2000, correctly forecasting ten years of negative annual returns 2000-2010. Or peaked in 2009, forecasting 12% annual returns 2009-2019 (with the market so far well on its way to fulfill that prophecy).

Chart from here at

  1. Notice the tight correlation
  2. Notice that when correlation falters for a while, it comes back with a vengeance. Actually this “error” in itself makes a better job predicting market returns than the revered “Fed model”
  3. Right now, market valuation points to negative annual total returns, including dividends, over the coming 10 years
  4. Usually the market corrects to levels where you can look forward to 10-20% annual returns over the coming 10 years. To get to that point the market needs to fall by 50-75% or stay level for 10-15 years. Which do you think is more likely?
  5. A vertical move upward by the blue line is tantamount to a stock market crash, thus changing the valuation from promising, e.g., 0% return to promising 10% annual returns the following decade.   


Amazon – buy the merchandise not the shares

I  have bought 2 Kindles from Amazon and hundreds of books. It’s a great company – for its clients.

However, let’s take a closer look at Amazon’s shares as opposed to their services. A quick visit to Market Watch tells you the stock price is 528 USD/share, with a total market cap of 251 bn USD.

There is no useful information on valuation, though, (since Amazon operates at a loss and doesn’t distribute dividends).

So, what do you do? Ask your friendly neighborhood hedgehog?

-No, you do the math yourself. If you consider yourself a real investor, that is. But first, let’s find out if you’re cut out for this. What kind of money person are you?


Amazon’s share price 2002-2015

N.B. Amazon’s stock price has already fallen by >50% twice, and by >30% several times


Astute Investor or Ignorant Speculator

  1. Active or Passive. A passive investor buys and holds single stocks or index instruments -and never sells. An active investor buys and sells at various intervals, depending on a multitude of factors (we’ll get to that later)
  2. Single stocks or index investing. If you chose index-only investing, forget about Amazon (duh!)
  3. Fundamental or Technical. Are you willing to make an effort to understand what you invest in, do the math so to speak, or are you more inclined to speculate on tips, momentum, stock charts etc?
  4. Hope or Safety. Will you trade on hype and hope, on blue sky scenarios, or do you have the discipline and patience to wait for opportunities that offer a margin of safety

If you are an active investor and single stocks focused you can proceed. If you are passive, just buy the stock or an index already and go back to sleep.


See. Pretty picture

If you just can’t be bothered with math, spread sheets, forecasts and economics, do what so many others do: draw pretty pictures in stock charts and invest according to the patterns you think you can discern.

Or just follow whatever momentum or trend you want to see or you are told (tipped) about by a “friend” or broker. Just don’t blame me when you go broke.

lines in a chart are not real


Your broker is your adversary

Stock brokers don’t want you to make good investments. They don’t want to be your friend.

They want you to pay a commission.

When you buy, somebody else sells. One of you is often making a mistake. And the broker couldn’t care less.

Charlatans (stock brokers and company representatives) use extremely simple and misleading measures of valuation such as some future year’s Price/Earnings ratio (given made-up profit margins), perhaps complementing it with an arbitrary, historical growth number.

“Amazon has increased its number of employees by 38 per cent in the last 4 quarters and at ‘normalized’ operating margins of 10% it’s trading at an EV/EBIT ratio of just 21.5 x (12 months forward op. earnings), i.e., only half its (employee) Growth rate! PEG=0.57 which is below 1, hence BUY!”

Assumptions: TTM sales of 95.8bn in June 2015 will grow at the same 17% rate the coming four quarters to 112.1bn. The operating profit at a 10% margin will be 11.2bn. The current EV is 251bn-10bn cash pile=241bn. The EV/EBIT thus comes to 241/11.2=21.5. The growth rate used in the PEG calculation is the last known employee growth rate.


Stock pitch break down

The above may sound convincing. But if you look more closely you’ll see the cracks in the facade:

  • Okay, so the number of employees grew by 38%. Even if it could be representative of future growth in some cases, it’s also a cost now. Sales, however, only grew by 17% the last four quarters (despite a 36% growth inemployees in the preceding period), and slowing. Thus, a better forecast of sales growth going forward would be 15%, given current trends.
  • In addition, the relevant growth rate, for applying a valuation multiple, is the growth rate going forward after the year of the multiple (which probably is even less, given the deceleration the last few years). Actually, unless profitability accelerates soon, Amazon needs to taper its hiring pace, which should hurt sales growth even more. Nevertheless, let’s give them the benefit of the doubt for now and assume 15% sales growth. We can refine the model later.
  • “Normalized” profit margins at 10%? Whats “normal” with 10%, when actual margins have been between 0-1%? Are there any plausible reasons to forecast higher margins than what Amazon has produced the last 5 years?
  • Actually, there might be. If Amazon reaches ‘scale’, when growth diminishes, margins could increase. This is the trickiest forecast of them all, since Amazon hasn’t reached “steady state” with sustainable growth and margins, so what to do?
  • Look to similar companies for guidance on potential margins. Also make a sanity check on what ROE those margins imply for Amazon (Return On Equity). Few companies stray outside 5-20% ROE for long. A higher ROE draws in competitors, and a lower ROE is a waste of capital. Assuming Amazon can increase its net margin to 1.5% (operating mgn approx 2%), Amazon will make a decent 14% ROE (1.5%*112bn/11.768=14.3%). Hoping for more is just that; hoping and believing the hype.
  • EV/EBIT-ratio of 21.5. Why is that supposed to be cheap in an absolute way? How can you tell? To start with it should be compared to profit or cash flow growth, which (at steady margins) can be approximated by sales growth – in our example at most 15% (probably less after 2016). Suddenly the PEG is 21.5/15=>1.43 instead of 0.56. That still doesn’t say anything about whether it’s a good buy or not, even if it can be compared to other listed companies’ PEG ratios. Anyhow, it’s apparently a lot more expensive than what the broker first said.
  • And, I almost forgot, that was based on a 10% op. profit margin. Assuming 1.5% instead, renders an EV/EBIT of 143 and a PEG of 10. That is 19x expensive-er than the broker was saying.
    • In addition, whatever happens in 2016 is less worth than if it were today, so profits should be discounted by your required rate of return. An EV/EBIT of 143 a year from now is some 5-10% more expensive than the same multiple today, or >150. That however still doesn’t answer the question whether Amazon’s stock is expensive. Do, however, compare the 150x on trailing EBIT to the more typical 10-20x multiple seen in the S&P 500 index. Enticed?
  • Continuing to use the extreme simplifications above, you can calculate an earnings yield to see what your actual return would be in a single year. If you dare extrapolate that year indefinitely, you can even rely on it as the stock yield. In Amazon’s case, given 1.5% operating profit margin and a 30% tax rate the net profit is 112*0.015*0.7=1.18 bn and its earnings yield is (profit/market cap) 1.18/251 = 0.47%.
  • If you are lucky all this profit generation is converted to cash and distributed to you in some way. Also, if you are lucky, the coming four quarters are representative of the coming eternity for Amazon’s business (in practice only about 50 years count).

There you have it. Given a set of simplifications, you can expect around 0.5% yield on an investment in Amazon. It doesn’t really say anything about what price you’ll be able to sell the stock for in the future, but if you just hold on to it forever, you’ll get an 0.5% annual return on your investment, unless Amazon’s business changes radically.


The quick and the dirty

Happy? I’m not. And that’s not because of the low return, or that the stock might (should) fall dramatically in the meantime (to a price where you could expect at least a 7% annual return). It’s because of all the simplifications.

Just because you put a lot of numbers down on paper doesn’t mean they are correct or you are any wiser


Also note that, if in the future, when you want or need to sell the stock to get your capital back, another valuation paradigm dominates, perhaps demanding the historical 6% or 10%, 15% or even 20% return on equity investments, the Amazon stock price will be proportionally lower.

At a 9% required return, Amazon’s stock price would be just a twentieth (27.50 USD/share) of what it is at 0.45% required return.

That was the quick and dirty way of analyzing and valuing single stocks. You should at least do as much for any stock you contemplate buying.

  1. Estimate (extrapolate) sales growth and margin trajectory in an informed manner
  2. Calculate future profits and cash flow that take into account total available market, innovation and competition
  3. What yield in relation to the company’s market cap does that cash flow produce?
    1. If you’re happy with that yield and don’t care if the stock falls in price, you’re good to go
    2. If the yield is below your required return (9% for example) or the historical market return (7%) and you do care about price fluctuations, tread carefully. 
  4. Is that enough? Are there better alternatives? Is it enough for others (i.e., the market)?


Get out of here!

If you felt that was already too much, you are not an active or fundamental investor. A sell side analyst does a lot more. It’s not necessarily better or more effective but it’s impressive work.


The long winding road of doing sell side level research and stock analysis

Make company forecasts like a ‘pro’

  • Make reasonably detailed Profit & Loss, Balance Sheet and Cash Flow forecasts. These are hundreds or thousands of Excel rows long, several hundred columns wide and dozens of sheets thick 
  • To do that you need to forecast sales, costs, wages, investments, loans, interests, taxes, dividends, buybacks etc
    • Any one of those components can be forecast using a dozen other inputs
  • To do that you need a view on demand, competition, currency (FX) trends/fluctuations, technological development etc.
  • You also need the company’s history to have an inkling of how its products have been received by the market and how management has been able to juggle all variables historically.
In addition to this fundamental single stock valuation, you should add a handful of supportive layers:
  • Total market valuation (if the stock market in general is “cheap” you stand a better chance the entire market will rise and help your shares appreciate. The latter, however, only really matters to a hedge fund and not for a long only index fund)
  • Momentum in the stock or the market (positive market trends can lift all boats)
  • Risk tolerance, i.e., your willingness to gamble (and willingness to lose)

Stock prices move in cycles. Sometimes a certain industry or company is in vogue and sometimes it’s not. You can try to speculate blindly with this momentum or you can choose to invest whenever the price (valuation) is below a certain maximum threshold and sell when it is too high for a comfortable plausible return. Dare to make your own judgement of value and buy when others don’t.

It’s better to look the fool before, than after an event


Analysts make meteorologists look good

There is no secret to forecasting. No one can do it anyway and stock market pundits and economist are among the worst forecasters of all.

I think my complete immersion in finance for a quarter century is why I have always marveled at the accuracy of weather forecasting (no irony, I am amazed of what they can do).

The following can serve as a rough guide to informed forecasting of financial data. But remember that your forecasts don’t become the truth just because you put them down on paper.

Collecting historical data

  • Get at least five to ten years of history for a simple set of parameters for the P&L: sales, cost of goods, cost of personnel, cost of loans, taxes
  • Make a rudimentary balance sheet: real Long-Term assets, goodwill and intangibles, Short-Term assets, cash,  net working capital, equity
  • Cash flows: operating profit after tax, investments, changes in Net Working Capital
  • Double check for funnies: too low wages vs history or vs. competitors, high personnel option compensation, share count development; profit, cash flow and equity not adding up over the years etc. Make charts of every series and subseries you can think of an look for kinks, trends, holes, bumps and so on. Then investigate those by reading old Q-reports, ex ante guidance commentary and ex post explanations.
  • Check the latest quarterly trends more carefully: DSOs, e.g., (Days Sales Outstanding=accounts receivable/sales) = how easy is it to get paid, is the company overselling or even sending unsolicited invoices?
Making forecasts like a baws
  • Find leading data series in daily, weekly, monthly or quarterly data: from competitors’ sales, costs etc, weather data, monthly national data, PMI surveys, national industrial output statistics, retail sales, FX, etc
  • Start forecasting: Basically extrapolate trends in historical company numbers and leading data series. Allow for cyclicalities and reversions to the mean. E.g., profit margins and Return On Capital Employed numbers tend to gravitate to a mean for the industry or the economy. Do not expect super profitability or super growth for eternity. Check how long the very best companies of all time sustained their growth, margins or returns. Check what the average company did, including those that failed and are no longer here. Easiest is to check nation wide numbers for margin and growth trends.
  • Analyze really long cycles (over several decades or longer) and trends to make sure you don’t get myopic, narrow sighted, seeing only one half of a cycle and thinking that is a long term trend to be extrapolated without risk

Knowing what you don’t know

All of this is particularly difficult for new companies and even more difficult if they operate in new industries. There is no history, no precedent. That doesn’t mean you get off more easily. Quite the opposite. The risk is higher and your work is harder.

Sell side analysts take advantage of the lack of data, and of the general optimism, to forecast blue sky scenarios, luring in buyers. Rising share prices then act as (false) evidence the forecasts are correct.

Typically, new companies are valued using new (i.e. unproven) key indicators; like clicks or eye balls or users, no matter if the latter are paying customers or not. Some even use costs as a key indicator, when there are no sales. The more costs, the more losses, the higher the value… Biotech analysts have been trail blazers within ‘cost valuation’. The more biotechs spend and lose, the more they’re worth -until they’re not.
Let’s not forget about the smoke and mirrors of three-letter abbreviations.
There are only so many three-letter combos to go around. Consequently the same three letter combos mean diferent things in different industries and at different times.
That’s not a flaw, it’s by construction. It’s supposed to create confusion and make the client or outsiders feel inferior, afraid to look stupid. The companies first make some analysts feel stupid who then turn around and fool their clients. Oh, it’s a WAP company! Buy. They have a BTC mechanism and make a ton on OEM…
Don’t fall for the simple three letter abbreviation trick
Ask and ask again until everything’s clear. Then make reasonable forecasts not based on 100% market share forever, constantly rising margins, and world domination of this industry and ten more nearby.
Take a minute to remember all those formerly glorious companies that perished and disappeared in the 2001-2003 downturn, despite all the thre-letter combos in the world in their Power Point presentations.

Don’t forget geographical trends, product trends… to see if, e.g., the first markets, the home markets are losing steam, or perhaps if new markets are small but growing quickly – which might not be visible in overall numbers otherwise. Slice and dice numbers in all directions and look for S-curves, tapering, bumps and exceptions.

Typically it takes at least a few years to get reasonably good at doing fundamental research, and at least a week to build a basic valuation model for a single company. It’s hard work and it’s complicated but it’s worth it if you have a nest egg worth a handful of years’ income to invest.

Professional analysts have spent years on their models, but that’s going overboard in my opinion and only meant to impress clients.
Equity research is at its foundation very simple; don’t let anybody tell you it’s best left to professionals. Just make sure you know what you know, and be honest to yourself about what you don’t know and what risk that entails
Less is often more
Most important of all, don’t make your model larger than what you’ll actually keep updated.
Don’t fill it with more data than you’ll actually use.
Erase whatever is unnecessary. Ask yourself, does this particular data series affect the final valuation in any way. If not, get rid of it.
And, again, it’s not true just because you wrote it down, or based it on an extrapolation of series of numbers. The future is inherently unknowable. It can’t be foretold. Less things happen than could have happened and we never know fully beforehand which one’s it’ll be. We don’t even know ex post what caused a certain future to come into being.
Don’t supersize that model, please
Stopped clock markets – or analysts

Stock prices and stock markets very seldom reflect the true long term value. Just as a stopped clock shows the right time twice a day (in Europe, actually only once), the stock market is valued more or less correctly about every six years or so.

That’s a good thing. It’s something you can profit from; if you have the guts to take a contrarian view when everybody else is screaming sell or buy. Or the guts to run with the lemmings for a while longer, even after the fat lady has finished her aria.

Markets are not weighing machines, they are beauty contests (in the short to medium run). They don’t find the correct value of a stock and stay there. On the contrary, markets forces of fear and greed create trends where the (perceived) prettiest stock is bought and the ugliest sold, until something, anything, changes and the trend reverses.

This makes stock prices and markets oscillate (in cycles of decades) around the true value. In the short term prices oscillate around some perceived popularity value.
The long term cyclicality creates twin opportunities for you as an investor: 1) follow the momentum, and 2) buy low, sell high. I think you should try to do it all:
  • Buy whenever a stock or an index is reasonably valued, or cheap, even if the trend is negative. Keep buying small increments.
  • Ride the momentum until it seems to stop (market dispersion crosses a threshold) or valuations venture too far out in the 5% tails
  • Sell if it is extremely expensive, no matter the trend, but don’t go short until market dispersion tells you risk aversion is high enough.
A precise depiction of professional investors in action

Hype and Hope is not a strategy

Don’t rely on blue sky scenarios. Very few companies hit it big. Why would yours? Perhaps just because you are looking at it (quantum mechanical interpretation).

Inoculate yourself against rosy forecasts by checking old stock market tables and company histories. Where just a handful succeeded, hundreds fell into oblivion or exhibited mediocre numbers.
Remember that you are only looking at the winners when looking at the current stock market
In fact, even the very best, the hundred top cash flow growers f all time, the Warren Buffets of listed companies, didn’t grow faster than 20% per annum for more than 20 years. OK, that fact needs to be checked, and many do manage to grow 100%+ per year for a few years, making compound numbers very impressive.
However, once growth falls to 20-40% per year there are rarely many years of >20% growth left. But, don’t take my word for it, look for yourself in the industry your current pet stock is operating in.
Status: It’s complicated
In the end it all is unbelievably complicated, despite there being just two possibilities at any given time: Up or Down?
There are thousands of professional investors, if not millions, trying to make money on the market, using different strategies. There are scores of companies competing for the same client wallet share. Remember that company management often get their forecasts completely wrong at turning points, so how could you beat them at their own game?
Don’t just flip a coin and hope for the best. Do the only thing very few investors do.
Pay attention to long term fundamentals, be patient and only buy when you have a decent safety margin, in terms of returns and think you can hold on forever and be pleased with that.
Don’t run with the crowd, unless you know what you are doing.
  • Don’t hope to sell the stock to a bigger fool
  • Don’t hope for efficient markets having priced all shares correctly so you can just wander in and buy blindly
  • Don’t hope that just any old stock will work as a hedge against inflation and money printing.
Equity research, explicit summary
  • Equity research is really easy and impossibly complicated at the same time. Just as life in general. Decide what type of effort you are willing to put in and what level of risk you accept. Just be explicit about it
  • Decide what kind of an investor you are. Active? Fundamental? Single stocks or index? Technical overlay? Gambler? Act accordingly
  • Do the math properly if you are going to do it at all. There is no big secret to forecasting; just do it, and be clear about your premises at all times. Make plausible and reasonable forecasts that are internally consistent. Double check your variables repeatedly. Believe the hype if you want; make a leap of faith in a product if you want, but make sure you understand that is what you are doing. Be explicit in your extreme assumptions.
  • Cheap or not? Compared to what? To your required return? To your marginal borrowing costs (your most expensive loan if you have any), to what you think the market’s marginal required return is or will be in the future? Compared to other stocks? Here is an overview, a check list, for doing equity research.
  • Decide on timing: It may be cheap, but markets are trending sharply downward. Then don’t buy until things calm down, or be prepared to ride a long downturn. Pace your purchases, buy a tenth at a time unless you have a specific game plan.
  • Wait. Be patient. Don’t expect good opportunities just because you are looking right now. It may take years for real opportunities to arise, whether it is about stocks, finding a life partner or a dream job. It can take 20 years for fundamentals to manifest themselves (though 8 years usually is enough). If you bought on the right side of cheap, time will work for you. In the meanwhile you accumulate dividends and perhaps buy more shares.
Addendum: The blue sky scenario is Amazon trading down by 90%

My best guess is that Amazon’s sales growth will fall slightly each year from 17% to 15%, from 15% to 10%, and sooner or later from 10% to 8 to 5% (assuming around 5% nominal growth rate for the economy in general).

Just spending a few hours with Amazon’s numbers, I think it is 10-20x as expensive as it should be. The current growth rate is only 17% per year, despite expanding its staff by 38%, and the company is hardly making any profits.

A year ago, when I last looked, sales growth was 20% and employee growth 36%. Fundamentals are not getting any better.

Assuming a decent 15% ROE in the future implies 1.5-2% operating margins and not even a 0.5% earnings yield (net profit/market value).

I would require at least 10-20x that return, i.e. 5-10% annual return on my investment, to bet on Amazon succeeding in its endeavor to sell everything to everybody. Consequently, the stock price needs to fall by 90-95% to satisfy my return requirements.

In addition, I can’t see any reason to assume growth or margins expand meaningfully in the future. Rather, I am worried growth will taper faster than most expect and that margins might fall to zero or below. I know the market believes and assumes Amazon can raise its margins to 5-10% as soon as it wants to, as soon as it concludes its hypergrowth phase (17%, remember?). It’s just that you seldom see those margins in retail. Ask Wal-mart.

In my opinion the blue sky scenario is Amazon trading down by 90%. The base-line and worst case scenarios are that Amazon falls even more and becomes completely irrelevant and taken off the market.

So, what should you do? Well, not buy Amazon, that’s for sure.

There are tens of thousands of other listed companies worldwide, many of which look more interesting than Amazon.
And if they are all too expensive, just wait. I’m sure you will get a good opportunity within the coming ten years, and in my opinion, most likely within two.
If that seems too long to you, you just aren’t fundamental enough. Go play with the chartists instead.
Final words; do this
1. Make the simplest possible models for your current investments. Spend about an hour (or less) on each company to begin with. What sales, margins, and valuations are required to make you happy? When? Is that plausible? If not, contemplate selling – not least given the extremely high general market valuation environment. But read my disclaimer first.
2. Sign up for my newsletter and free e-Book to stay up to date and learn more
3. Share this article with a friend that’s gone deep into story stocks