Are these good steps to find a good business?

[Klogg]

Ah ok but coudln't you just look at total liabilities to look at the long term? Also I don't see the relation for the d/e ratio the stock holders equity part, what does the money that the stock investors put into the business matter for debt? Or is it an indicator how much debt is been stacking up compared to how much money poured in? If that's the case wouldn't we just use return on equity?

Unfortunately, even just picking out the on balance sheet liabilities you decide to take into account (although systematic's post is still definitely a good one).

You also have to consider things like operating leases or capital expenditure that the company has committed to. Sure, it may not be a liability on the books, but there will still be cash going out the door.
Whilst you may not include it in your debt to equity ratios, it doesn't make them any less important.

Its interesting to see the number of decisions that turned out well, not because of my research and analytical skills, but due to pure luck! Its also sobering to re-visit the decisions that had poor outcomes and be honest about the reasons! Like much in life its easy to fall into the trap my dear old Dad used to describe this way, "Son, there are only two outcomes in life, good management and bad luck."

I've had my fair share of this recently. Great thing to keep in mind.

 

[systematic]

Also I don't see the relation for the d/e ratio the stock holders equity part, what does the money that the stock investors put into the business matter for debt? Or is it an indicator how much debt is been stacking up compared to how much money poured in? If that's the case wouldn't we just use return on equity?

...My best quick answer (all I can do right now) to what you're asking there (i.e. why does the 'd' relate to the 'e' in the ratio)...it's about leverage. Think of it the same as how much debt to the equity you have in your home.
If you have $500k equity and a $500k mortgage, you are less levered than if you had, say, $100k equity and a $900k mortgage.

I'm not suggesting whether or not it is an important ratio, by the way, just trying to help you understand it. It's certainly a common ratio.

Cheers
Steve

 

[craft]

"Son, there are only two outcomes in life, good management and bad luck."

Absolute classic

 

[luutzu]

Ok thanks, I had a important question that's always on my mind I never saw the point of ratios like debt to equity ratio is total liabilities divided by stock holder equity. But I could of sworn that is was total assets - total liabilities anyways, couldn't I just look at total liabilities and stock holder equity seperatly? I don't see the difference.

Different people, and different vendors, may define these debt and leverage ratio differently. Here's how I understand it.

Debt I define as the interest-bearing loans and borrowings the company owe - to banks and lenders who will charge interest.

Liabilities, such as payables the company owe for goods received etc., that's technically also a debt, or a liability... but they're free money so depends on other factors, it's not much of a problem if the company can delay those payment... they get to use leverage for free.

So you got to separate what debt to equity ratio mean...


But in general, if debt is taken as both the loans and the non-interest component, divide by equity to get that ratio... it's a quick measure of the company's risk and ability to borrow.

Risk in terms of it owing too much to the banks and lenders, and any failed repayment mean bankruptcy. Borrowing capacity in that if the company have more equity than debt, they can generally go and refiance or finance/borrow to expand or when times are tough.

But if they have too much debt already, and the tough times come - either have to raise more equity, which dilutes existing shareholder value; or borrow at very high cost; or not able to borrow at all and go bankrupt.

The other risk is that to the lenders and the suppliers/employees etc.

If the company have high debt and liability, say too much payables... and there's very little equity in its balance sheet. The supplier and lenders will start to wonder why they are taking all the risk and not already own the business. So the company would either raise more equity to expand, safely still... or lenders will start to demand faster repayments or stop lending.

what's a safe and balanced ratio depends on the business and the industry; also depends on that liability or real interest bearing debt discussed.

you don't want a business with a lazy balance sheet; don't want one with too much debt that any uptick in rates will eat a lot into the profit that you share in, or send the company bankrupt...

So it depends. There are certain guidelines for different industry.



Accounting is just the beginning of understanding the business. You really got to really know the business to put the accounting numbers in context, else it can be quite misleading.

 

[RandomInvestor]

...My best quick answer (all I can do right now) to what you're asking there (i.e. why does the 'd' relate to the 'e' in the ratio)...it's about leverage. Think of it the same as how much debt to the equity you have in your home.
If you have $500k equity and a $500k mortgage, you are less levered than if you had, say, $100k equity and a $900k mortgage.

I'm not suggesting whether or not it is an important ratio, by the way, just trying to help you understand it. It's certainly a common ratio.

Cheers
Steve

Ah ok thanks.

 

[RandomInvestor]

Different people, and different vendors, may define these debt and leverage ratio differently. Here's how I understand it.

Debt I define as the interest-bearing loans and borrowings the company owe - to banks and lenders who will charge interest.

Liabilities, such as payables the company owe for goods received etc., that's technically also a debt, or a liability... but they're free money so depends on other factors, it's not much of a problem if the company can delay those payment... they get to use leverage for free.

So you got to separate what debt to equity ratio mean...


But in general, if debt is taken as both the loans and the non-interest component, divide by equity to get that ratio... it's a quick measure of the company's risk and ability to borrow.

Risk in terms of it owing too much to the banks and lenders, and any failed repayment mean bankruptcy. Borrowing capacity in that if the company have more equity than debt, they can generally go and refiance or finance/borrow to expand or when times are tough.

But if they have too much debt already, and the tough times come - either have to raise more equity, which dilutes existing shareholder value; or borrow at very high cost; or not able to borrow at all and go bankrupt.

The other risk is that to the lenders and the suppliers/employees etc.

If the company have high debt and liability, say too much payables... and there's very little equity in its balance sheet. The supplier and lenders will start to wonder why they are taking all the risk and not already own the business. So the company would either raise more equity to expand, safely still... or lenders will start to demand faster repayments or stop lending.

what's a safe and balanced ratio depends on the business and the industry; also depends on that liability or real interest bearing debt discussed.

you don't want a business with a lazy balance sheet; don't want one with too much debt that any uptick in rates will eat a lot into the profit that you share in, or send the company bankrupt...

So it depends. There are certain guidelines for different industry.



Accounting is just the beginning of understanding the business. You really got to really know the business to put the accounting numbers in context, else it can be quite misleading.

lmao man I just realized the debt to equity ratio had the word "equity" in it omg I feel stupid haha. Like I knew it when I read but I didn't see the correlation I just might be on another planet lol.

 

[systematic]

lmao man I just realized the debt to equity ratio had the word "equity" in it omg I feel stupid haha. Like I knew it when I read but I didn't see the correlation I just might be on another planet lol.

...Nope, you're just learning!

 

[Value Collector]

2. Go on the company's website and find out as much as the possible so I know the company what it does its operations its products etc, well enough so when someone asks me for example "what does Mcdonalds do" I can give them a strong straight forward answer.

What does Mcdonalds do?

The simple answer doesn't always give you a good insight into how a company will operate as a sound investment.

The average person in the street would not be able to answer that question

 

[skc]

What does Mcdonalds do?

The simple answer doesn't always give you a good insight into how a company will operate as a sound investment.

The average person in the street would not be able to answer that question

They soon will.

 

[RandomInvestor]

Part of the answer is that different types of businesses need different approaches for analysis and different metrics become more or less relevant. Sometimes you may choose a metric to concentrate on for comparison of businesses in the same sector, but if you are comparing companies in different sectors you may choose a different metric.

IMO good analysis and research skills can't be developed just by understanding and choosing a set of metrics or formulas to enter data into. Its also something that doesnt have a defined endpoint - as in if you learn a, b & c you will be a successful and good investor. I believe its a constant learning, the more you read and discuss the more you learn, every company you research and analyse adds to your understanding of the process, and finally every investment you make can end up teaching you more about the process, learning how and why, what happened.

I also run a decision journal to record all my research, deliberations, and actions with predictions for the outcomes. Then I revise it regularly and reflect on my initial decision, the process that led to it and the outcomes and reasons for the outcomes.

Its interesting to see the number of decisions that turned out well, not because of my research and analytical skills, but due to pure luck! Its also sobering to re-visit the decisions that had poor outcomes and be honest about the reasons! Like much in life its easy to fall into the trap my dear old Dad used to describe this way, "Son, there are only two outcomes in life, good management and bad luck."

I LOVE that quote, it actually got me thinking, like I know that management is crucial to success of a business but got me thinking even more on the management side.

 

[RandomInvestor]

What does Mcdonalds do?

The simple answer doesn't always give you a good insight into how a company will operate as a sound investment.

The average person in the street would not be able to answer that question

The reason I said that because Peter lynch once said if you can't describe what a business does in a minute or less you should not own that business. I believe other famous investors said this to.

 

[luutzu]

They soon will.

The book it's based on - Behind the Arches - is also a great read.

 

[luutzu]

lmao man I just realized the debt to equity ratio had the word "equity" in it omg I feel stupid haha. Like I knew it when I read but I didn't see the correlation I just might be on another planet lol.

Accounting equation is Assets = Debt + Equity.

So whether you use debt/equity or debt/assets, it's basically the same thing. They just give you a different perspective. ie. debt as a percent/ratio of equity; or debt as a percent of total assets.

 

[Value Collector]

The reason I said that because Peter lynch once said if you can't describe what a business does in a minute or less you should not own that business. I believe other famous investors said this to.

I am not saying you shouldn't understand the business, and be able to describe what it does, you definitely need to be able to do that.

What I am trying to get to is that the simple answer that most people go to eg "Mcdonalds sells hamburgers" doesn't really describe their business model well.

You have to be able to understand exactly how a business generates its revenues, where and how those revenues come about, their profit margins, their competitors, and when they make a profit what do they do with it, are they paying it out, buying back stock or growing the capital base etc etc.

Over time you will stare to get a good understanding of the different types of businesses out there.

 

[Value Collector]

The book it's based on - Behind the Arches - is also a great read.

Yes it is, I loved it. I recommend it.

I just watched the trailer to the movie, and Ray seems like a much bigger a hole in the movie, lol. I thought the book made him loveable.

 

[Boggo]

An easier way to that approach would be to first screen the entire ASX for stocks which meet your financial criteria.

For example, you might want (picking random things here just for example and not a recommendation) to find only those stocks which:

Pay dividends at a rate exceeding x% return per annum

Have a P/E under whatever amount

Have a trend of increasing earnings over the past x years
...

Where to start, that's the issue for most.
First thing is are you an investor who is willing to sit on a stock and hand it down to your kids after you collect the dividends along the way, or are you willing to buy into a company and hold it for a period of time and exit when either the fundamentals or the price changes. Both of those go hand in hand and probably 99% of people on here adopt the latter method but hate to be referred to as traders.

If you want to see an example of a Mum and Dad investment type stock then look at TLS, an ASX top 20 stock whose profit this year is the same as it was at this time ten years ago and the stock price is the same now as it was in March 1998 (factor in CPI and inflation since then !!)
Possibly a great stock to hand down to your kids after you have tied up your savings to collect the dividends.

That's one way to go.

Another way that I prefer while going back to smurf's post above (highlighted bit) is to screen the market but for stock price behaviour as that will in turn usually reveal changes, or potential changes to stock fundamentals.
You can buy fundamentals but only at the price that is going at any point in time and this where price behaviour is a barometer of both sentiment and fundamentals.

There is always a reason behind why the price of a stock will change. When I find stocks by scanning and then looking at chart price behaviour I may have a dozen candidates but only need two or three, how to decide is the issue.

I will run through an example of one that worked, not all of them do but if you can back up a price behaviour with some basic support information it will most likely make that stock stand out from the rest and lean the odds in your favour.

The stock I will use as an example is WHC, weekly chart below. I prefer weekly charts for three reasons, one is that it smooths out daily gyrations, two, if the new trend stays intact for a week then it may be significant and thirdly if it is just daily trade activity that has caused an overreaction during the week may also be evident in that weekly bar behaviour or in the opening day of the week that follows which is also where you would be considering an entry.

In the case of WHC, it pops up in a scan, looks like a new trend but it has done this twice on the way down and failed both times. Why should this time be different.

Scared to say it but lets have a very simple look at fundamental basics, what does WHC do and is there anything that could have an effect.

WHC produces coal, great, I can oppose the loonies and greenies in one hit. (loonies = baristas with taxpayer funded degrees in arts, humanities and women's studies who are now experts on climate change and immigration)

Next, what is happening with coal, China cutting production by reducing production days from 360 to around 260 and coal price, on the way up, coming off a low with a valid reason.

Done, there is one candidate for Monday based on sufficient fundamental (no need to argue over how to calculate P/E ratios )

Buy in on Monday, do a bit of a Google on coal prices during the week (whaaaat- $100 per ton by Xmas - Yay ).
http://www.indexmundi.com/commodities/?commodity=coal-australian&currency=aud

That is one way of doing it, not for everyone but after many years I always end up back with the KISS principle.

That's my
This is not intended as a TA vs FA argument starter, just a way of showing that it can be kept simple.
My history indicates that it only works about 48% of the time but still gives a win/loss of about 2.8/1.0.
The profit is in the exit plan when I get it wrong.

Another way of achieving an outcome is to calculate all of these items that are in a fundamental analysis spreadsheet I was sent, I tried using it twice only !!...

P/E: Price/Earnings
ROA: Return on Assets
ROE: Return on Equity
EPS: Earnings per Share
YIELD: Dividend Yield
CATAI: Current Assets to Total Tangible Assets
CBTA: Cash Balance to Total Assets
CBTL: Cash Balance to Total Liabilities
CLTL: Current Liabilities to Total Liabilities
CTCCL: Change in Total Cash Flow to Current Liabilities
OCFTAI: Operating Cash Flow to Total Tangible Assets
OCFCL: Operating Cash Flow to Current Liabilities
PDACL: Profit before Depreciation and Amortisation to Current Liabilities
QACA: Quick Assets to Current Assets
QLCL: Quick Liabilities to Current Liabilities
RPTAI: Retained Profits to Total Tangible Assets
TLTAI: Total Liabilities to Total Tangible Assets

(My WHC screener scan response chart - click to expand)

 

[RandomInvestor]

Accounting equation is Assets = Debt + Equity.

So whether you use debt/equity or debt/assets, it's basically the same thing. They just give you a different perspective. ie. debt as a percent/ratio of equity; or debt as a percent of total assets.

Ah ok. But I don't see how the amount of assets is equal to the Debt + Equity. I don't see the correlation?

 

[RandomInvestor]

I am not saying you shouldn't understand the business, and be able to describe what it does, you definitely need to be able to do that.

What I am trying to get to is that the simple answer that most people go to eg "Mcdonalds sells hamburgers" doesn't really describe their business model well.

You have to be able to understand exactly how a business generates its revenues, where and how those revenues come about, their profit margins, their competitors, and when they make a profit what do they do with it, are they paying it out, buying back stock or growing the capital base etc etc.

Over time you will stare to get a good understanding of the different types of businesses out there.

Ah ok thanks mate.

 

[RandomInvestor]

It's probably worth mentioning I seem to have a problem either grasping concepts or I over think it, I believe its a combination of both, because I feel like I only truly understand something when I go "Ohh I see" or "Ohh I get it" that's pretty much my response everytime I understand something that was a difficult. But I think I saw what the d/e ratio is useful for I think. so if the d/e ratio of company is 5 that means that the company has 5 dollars of debt of every 1 dollar of equity.

 

[luutzu]

Ah ok. But I don't see how the amount of assets is equal to the Debt + Equity. I don't see the correlation?

A company's assets are resources that it control. Resources comprised of what the owner/s put in (equity), and what lenders and suppliers etc., loaned or yet to receive. Hence, A = L + E.

So when you do these debt/equity ratio etc., you have to interpret it in the context of the business and its financial performance. So you'd want a company that can somehow use other people's money for cheap, or for free; but don't want to be in it if business condition deteriorate those debt aren't cheap and aren't free and you go bankrupt.

Remember you're investing in a business, not investing in some historical numbers or forecasts that will hit the dots as predicted.

It's safer to go for companies with strong barriers and established pposition - all because these kind of corp. tend to be able to keep doing what it has been doing without much trouble as far as you can see. It shouldn't mean you buy big blue thinking the world it operates in will be like it had so it's safe.

Reverse that and if you understand a business enough, feel confident about its future enough... its current financials can pretty much be ignored. Risky, but so are buying big and hold thinking there's no risk.