Definitions

Fundamentals 00: Definition of key terms used in the blog.  Revision date: 23 Mac 2021


Definitions
"Knowing what you don't know is more useful than being brilliant" Charlie Munger 

While you don't need to be an accountant to understand my blog, there are some terms that I use throughout my analysis that are "technical jargon".  Many terms come from different disciplines and may not be familiar even among accountants. That is why I have described them here.

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.

This blog is reader-supported. When you buy through links in the post, the blog will earn a small commission. The payment comes from the retailer and not from you. Learn more.




Reading guide
If you are a first-time visitor to this blog, you may not be familiar with some of the concepts that I have used in my analysis and valuation. I suggest that you check up the 3 Fundamentals series - Fundamentals 01, Fundamentals 02, and Fundamentals 03

It would enlighten you further on the points I made in the various case studies.

As part of the sharing of experience, at the end of most of the case studies, I have also pointed out some lessons that can be learned from the case presented. 


Revision date: 2 June 2020


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.

This is the only relative valuation metric that I rely upon. My usual approach to triangulate the intrinsic value is to use this in conjunction with Asset Value, Earning Power Value, and Magic Formula.

Altman Z Score

This is an indicator by Professor Edward I. Altman, 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.

I use this in conjunction with the Beneish M Score and Poitroski F Score to gauge the "quality" of a company.

Asset-based value (AV)

This is the intrinsic value of a company based on the value of its assets.  There are several components of the AV ie non operating assets, Graham Net-Net, NTA, and Reproduction Value.

I normally breakdown the AV into the respective components to get a sense of the "quality" of the AV.

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.

I use this in conjunction with the Altzman Z Score and Poitroski F Score to gauge the "quality" of a company.  

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.

My approach is to use the "build-up" approach as per Professor Damodaran to derive the Beta for a company.  Damodaran has a dataset of the Beta based on industries that I rely upon.

Capital Asset Pricing Model (CAPM)

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. 

While I don't believe in volatility as a measure of risk, I agree with Professor Damodaran that the CAPM is presently the best model for determining the cost of equity. So I use the CAPM until a better model comes along.

Clean Surplus accounting

An accounting concept where the changes in the shareholder equity which is not the consequence of transactions 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).

In practice, the comprehensive income in the P&L nowadays accounts for all the income sources.  

Earnings-based value (EV)

This is the intrinsic value of a company based on its discounted cash flow/earnings.  

My normal approach is to break down the EV into several components ie non-operating assets, EPV, and Earning with growth.  This provides a better understanding of the "quality" of the EV

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.

I get most excited if I find that the market price is less than the EPV as I consider this the most reliable Earning-based value.

Free Cash Flow method of valuing companies

The approach is inspired by Professor Aswath Damodaran, Stern School of Business, New York University.  This is a method where the Intrinsic Value = the 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)

I use two methods to determine the EV - the Free Cash Flow method and the Residual Income method.  This is my way to handle the various accounting assumptions used in Financial statements.

Graham Net Net

Defined as the Total Current Assets Less Total Liabilities.  Many would consider this as a shorthand for the liquidation value

This is the gold standard for "cigar-butt" type on value investments. I have found that in certain sectors eg retailing, the Graham Net Net may not be a good proxy for liquidation values.

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.

This is one of the key performance indicators I use to gauge the performance of a company.

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.

I use this in conjunction with "accruals" to judge the quality of earnings.

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.

I don't use the actual formula in my investment process. However, I use the idea ie that you invest the most in those stocks with the highest conviction.

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 %

I use this together with the Acquirer's Multiple, AV, and EV to gauge whether there is a sufficient margin of safety.

Net Net

Refer to Graham Net Net

Position sizing

This refers to the amount you allocate to each investment.  (Refer to Kelly formula)

There is a relationship between the position size, the number of stocks in the portfolio, and the total dollar amount allocated to the portfolio.  Refer to my articles on asset allocation, portfolio construction, and management for more details.

Piotroski F Score

This is an indicator developed by Professor Joseph D. Piotroski of Stanford University has a number between 0 to 9 which is used to assess the strength of a company’s financial position.

I use this in conjunction with the Altzman Z Score and Beneish M Score to gauge the "quality" of a company.  

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 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.

In practice, I have generally found the Reproduction Value to be much greater than the Book Value. So I place greater emphasis on EV than the Reproduction Value.

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)

My EV is derived based on the average of the values using the Residual Earnings method and the Free Cash Flow method. In practice, I place greater emphasis on the Residual Earnings method compared to the 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 providers.

Since I looked at earnings from a company's perspective (rather than just the shareholders' perspective) most of my return metrics are based on TCE.

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. 

Be careful when you rely on other sources for the TEV as some do not subtract out the cash.

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 issues.

If you are a value investor, this is the most important concept. I see a value trap and a bargain as the opposite sides of the value investment coin.  You cannot talk about buying opportunities without thinking about value traps. 

WACC

The discount rate to be used in the discounted cash flow analysis and future described below.

Since I use value companies based on the perspective of a firm, this is the most relevant cost of capital to consider.




WACC
The discount rate refers to the rate you use in discounted cash flow analysis to determine the present value of all future cash flow. In the early days, I used a simple 10% discount rate for all the companies as this was my target returns.

However, I later found out that according to finance theory the discount rate should account for both the time value of money as well as risk. The discount rate should thus be different for different companies.

This led me to adopt Professor Aswath Damodaran's model where the risk is built into the discount rate. Damodaran derives the cost of equity using a Beta that accounts for the various company's business sectors and an Equity risk premium that accounts for where the revenue comes from.

Mathematically, the formula for the WACC is




Ke = the cost of equity.

Kd = the cost of debt.

T = marginal corporate tax rate.

Ve = value of equity.

Vd =market value of debt


The key parameters and assumptions of this model are:
  • 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 ree rate + company default spread+ country default spread with the country default spread based on the location of operations.
  • The company’s beta is built up based on the weighted average un-levered beta of various sectors the Group is in. This is then levered based on the D/E ratio of the Group

I am of course coming from the perspective that you have the skills to analyze and value companies. If you do not have such skills but still want to invest as a value investor, one way is to rely on other experts to assess and value companies for you.  

Those who do this well include people like The Motley Fool. Click the link for some free stock advice. I suggest that you subscribe to them.


END




Investment books that I have read.

Books


Comments




I actually learned valuation from the book "Investment Valuation" by Damodaran. It took me about a year to go through chapter by chapter as I also did the exercises. The "Little Book" serves as a refresher.

 

 

 

This is a good "formula-type" book for a newbie. I still use the Magic Formula as part of my valuation metrics together with Asset Value, Earnings Value, and the Acquirer's Multiple.


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I am not an investment adviser, security analyst, or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them. 

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such. 

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