Definitions
"Knowing what you don't know is more useful than being brilliant" Charlie Munger |
As a person with a quantitative analysis background, I am very comfortable working with numbers. This has proven to be a blessing in my investing journey as I don't' get hung up on the numbers but instead see them as part of a company's story.
Along this line, I use many indicators and metrics that are computed based on information extracted from the company's' financial statements. The list below also provides an overview of the formula behind the various indicators and metrics.
This list is not meant to be exhaustive. I don't want to repeat what is readily available online so I have tried to keep the list short. However, if you think that there are things that I should add or even delete, feel free to comment.
Item |
Description |
Acquirer’s Multiple |
This defined as TEV/EBITDA. Popularized by Tobias Carlisle, this
is a valuation framework that aims to assess the true cost a third party
would pay to acquire the company’s cash flow or operating profits. |
Altzman Z Score |
This is an indicator by Professor Edward I. Altzman, New York
University that is based on financial ratios calculated from data from the
company’s Annual Report. It is used to predict whether a company has a
high likelihood of bankruptcy |
Asset-based value (AV) |
This is the intrinsic value of a company based on the value of its
assets |
Beneish M Score |
This is a statistical model by Professor Messod D. Beneish, of Indiana
University that uses a number of financial ratios calculated from accounting
data to see whether it is likely that the reported earnings of a company have
been manipulated. |
Beta |
Beta is used in the Capital Asset Pricing model as a measure of the
volatility or systematic risk of equity in comparison to the market as a
whole |
Capital Asset Pricing model |
A model that describes the relationship between the expected return
and risk in the company. It shows that the expected return is equal to
the risk-free return plus a risk premium, which is based on the Beta of that company. |
Clean Surplus accounting |
An accounting concept where the changes in the shareholder equity which is not the consequence of transaction with shareholders such as share repurchase, dividends, etc are shown in the income statement. We thus have a relatively "quick and dirty" method
to calculate the market value of a firm - which should be
(approximately) the same as a valuation based on discounted cash flows. (Refer to
Free Cash Flow method and Residual Income method) |
Earnings-based value (EV) |
This is the intrinsic value of a company based on its discounted cash
flow/earnings. |
Earnings Power Value (EPV) |
This refers to the value of a company based on its discounted cash
flow/earnings assuming that there is no growth. It can be considered a
sub-set of the EV |
Free Cash Flow method of valuing companies |
This
approach is inspired by Professor Aswath Damodaran, Stern School of Business,
New York University. This is a method where the Intrinsic Value =
discounted sum of the Free Cash Flow generated by the business where Free
Cash Flow is defined as earnings less Capex and working capital requirement
but adding back depreciation/amortization. (Refer to Clean Surplus
Accounting and Residual Income method) |
Graham Net Net |
Defined
as the Total Current Assets Less Total Liabilities. Many would
consider this as a shorthand for the liquidation value |
Gross profitability |
This is a profitability indicator introduced by Professor Robert
Novy-Marx, University of Rochester. It is computed by dividing sales minus the cost of goods sold by total assets. |
Intensity of Core Earnings |
This is based on the Paper “Extracting Sustainable Earnings from
Profit Margins, Tel Aviv University. The measure is positively associated with earnings persistence and better earnings predictability. |
Kelly formula |
The formula was developed by
John L. Kelly Jr. while working at AT&T's Bell Laboratories. It is
currently used by gamblers and investors to determine what percentage of
their bankroll/capital should be used in each bet/trade to maximize long-term
growth. There are two key components to the formula: the winning probability
factor and the win/loss ratio. |
Magic Formula |
Developed by Joel Greenblatt, an investor and Adjunct Professor,
Columbia Business School, this is a ranking approach to select the best
companies to invest based on a combination of earnings yield and
return. Earnings yield = EBIT/TEV and Return = EBIT/TCE. I
often use it as a screen to week out those with a Magic Formula value of <
25 % |
Net Net |
Refer to Graham Net Net |
Position sizing |
This refers to the amount you allocate to each investment.
(Refer to Kelly formula) |
Piotroski F Score |
This is an indicator developed by Professor Joseph D. Piotroski of
Stanford University that has a number between 0 to 9 which is used to assess
the strength of a company’s financial position |
Reproduction Value |
This is
an asset-based value that is favoured by Professor Greenwald in deriving the
Asset Value of a company. It considers all the current costs to
create the company. Apart from the accounting for the physical
assets, this method also includes the cost to establish a business which
Professor Greenwald estimated as some multiple of the annual selling, general
and administration expenses |
Residual Earnings method of valuing companies |
This approach is inspired by Professor Stephen H Penman, Columbia Business School,
Columbia University, NY. Under this method, the Intrinsic Value = Total
Capital Employed plus discounted sum of the excess earnings where the excess
earning is defined as earnings after deducting a capital charge. (Refer
to Clean Surplus Accounting and Free Cash Flow method) |
Total Capital Employed (TCE) |
This represents the total funding for the company. It is defined
as Shareholders funds + Minority Interests + Total Loan. Looking at the
Return of TCE (EBIT/TCE) provides a perspective of the returns to all the
company’s capital provider |
Total Enterprise Value (TEV) |
TEV = Market capitalization + MI + Debt – Excess cash. This is a
valuation metric to compare companies with varying levels of debt. As I
am using the TEV in the context of the Acquirer’s Multiple where I have
excluded the contribution from associates and no- controlled joint ventures,
I have excluded the value of associates and non-controlled joint ventures from
the TEV computation. |
Value trap |
This is an investment that is trading at a low price relative to its valuation that appears to be cheaply priced, but is actually misleading. This low price is because the company is experiencing some insurmountable issue. |
WACC |
The discount rate to be used in the discounted cash flow analysis and
future described below |
- The risk-free rate is derived as per Damodaran Local Currency Govt Bond Rate for the year and adjusted by a rating-based default spread
- The equity risk premium is derived via a weighted average of the respective country risk premiums. I use the Revenue for each country where the company does business as the weights. I use the risk premium without the additional adjustment for equity market volatility
- The Cost of debt = risk free rate + company default spread+ country default spread with the country default spread based on the location of operations
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