When I analyze a company (or any other investment for that matter), I try to boil it down to the simplest model possible. By keeping the model simple I can then look at the critical profit drivers without being distracted by superfluous factors.
The simplest investment model that I can think of is the "structured settlement" Structured settlements involve paying a sum of cash up front to the payee of an annuity (like a lottery winner) in return for a claim to the cash flows of that annuity. This is a big, fragmented industry (type in "structured settlement" into Google and look at all of the companies "paying BIG MONEY for your settlement.") The main reason for the competition is that settlements have predictable, safe (for the most part) cash flows. Most of the work of the company goes into marketing the service, then going to court to file the appropriate paperwork. The rest is math.
Let's say that Joe Somebody just won "$1 million" at the Virginia Lottery. The $1 million is in quotes because Joe doesn't get a check for $1 million - he gets twenty $50,000 checks every year. Ordinarily, Joe would be very happy to get these yearly checks, but he has a problem - his wife, Jane, needs a $200,000 medical procedure, and the somebody family doesn't have health insurance. This is where the structured settlement companies come running (yes, they will be running!)
The smiling salesman for SS Inc tells Joe that there is nothing to worry about, he will take care of this problem. In exchange for a portion of his future cash flows, SS inc will cut Joe and Jane a check for $200,000, and everybody will live happily ever after.
The problem for SS inc is, how much cash flow do they need to claim in order to make a profit? The analyst goes back to his trusty spreadsheet and does a simple calculation - what would it take to get a 10% pre-tax rate of return on the $200,000? The structured settlement industry is very competitive, so 10% is the best they could hope for. The answer is $23,492 per year for 20 years. In return for $200,000, the Somebody's will give up almost half of their cash flow.
But wait! There's more! Since the cash flows are almost 100% guaranteed (Lotteries have profit margins that would get casino managers thrown in jail!) SS inc can finance this investment with a lot of debt. They go to their bank and get a 6%, 20 year loan for 80% of the $200,000, or $160,000. Now, they only need to pay $40,000 out of their pocket - the bank pays the rest.
The cash flows now look like this (in thousands):
Year 0 1 2...
Capital (200) 23.5 23.5
Debt 160 (13.9) (13.9)
Equity (40) 9.6 9.6
Instead of getting an IRR of 10%, the leveraged investment now generates an IRR of 23.5%, which isn't too shabby!
This example is not advice on how to get rich starting a structured settlement business - the industry is very competitive, and you need a lot of legal training to handle all of the paperwork. This example shows a simplified way of looking at two important measures of company performance - Return on Capital (ROIC) and Return on Equity (ROE). While ROE is a vitally important measure, any analysis must start with ROIC, since ROE can be inflated with excess leverage.
What would you pay for the entire lottery prize? Let's say you want a 20% pretax ROE, and are willing to finance 80% of the investment at 6%. You would pay $451,191 for the stream of payments, which would come out to a 9.2% ROIC.
What would you pay for SS Inc? If you thought that they would only do this one investment, you would only pay for the present value of the stream of cash flows, minus overhead expenses. What if the company had the capacity to do more deals in the future? You would have to estimate how many deals they could get, as well as how much they would need to spend for them. Maybe they have a "preferred partner" deal with the Lottery, which gives them first shot at any settlement (for a fee, or course!) What if the competition is fierce? The discount rates would be driven down, and therefore ROEs. The company that has the lowest funding and admin costs would have the advantage, as well as companies with special partnerships, or maybe expertise in complex or difficult settlements.
Another model that is helpful is the real estate model. I'm sure you have all seen the "nothing down" books and courses, promising endless riches using "other people's money." Most of them are overpriced scams. There are, however a lot of people who make a great deal of money buying and selling real estate. One of the more successful real estate investors is a man by the name of John Reed. He sells some moderately priced books that tell you really how its done. His website is top-notch, and includes a hilarious "views of real estate investment gurus", which skewers all of the infomercial hypesters.
What really caught me were his strategies, which sound as if they came right off the pages of Security Analysis! Here is the summary, quoted from the site (emphasis mine):
"There are three broad categories of investment strategy that I advocate:*bargain purchase*increase value
*double-digit cap rate.
Bargain purchase is the purchase of real estate for at least 20% below current market value.In the increase-value strategy, you buy a property for its current market value, but you select only properties with some unrealized potential. Then, immediately after purchase, you make whatever changes are necessary to increase the value of the property. In general, you must increase the value by at least 20% within six months in order for the strategy to be worthwhile.
Double-digit cap rate means that you buy the building on terms that it has a capitalization rate of 10% or more. The capitalization rate is the net operating income (rent minus operating expenses but before debt service) divided by the purchase price. In other words, it is the cash-on-cash rate of return you would get if you owned the property free and clear. In the absence of a bargain purchase, double-digit cap rates are very hard to find. They generally only occur temporarily in depressed markets or in small market niches.
The most common real estate investment strategy, however, is one which I condemn: buying properties which the investor believes will soon increase in value due to market-wide appreciation. This is, in fact, pure speculation. No one knows which areas will appreciate. Many billions have been made by investors pursuing this strategy, but they were simply lucky."
Benjamin Graham couldn't have said it better:
*Buy properties below market value
*Buy and fix (which is what LBO firms do)
*10% Cap rate (which is precisely the rule of thumb that Tweedy, Browne uses when evaluating an investment - only it is expressed as EBIT/EV.)
John Reed only buys what he sees and knows - not what he hopes for.
Here is a partial list of some strategies that he describes in his courses:
Bargain-purchase techniques Articles in back issues of Real Estate Investor's Monthly
Title Date of issue Subject
Adverse possession 5/93, 6/93 Acquiring property by adverse possession
Alcoholic and drug addict sellers 6/88 Acquiring property from addicted sellers
Bankruptcy property 12/90 Acquiring property out of bankruptcies
Bargain lots at lenders' auctions 3/94 Acquiring lots from lenders who seized them from failed builders
Builder leftover lots 12/96 Acquiring unsold lots from developers who want to move onto their next project
A corporation and its real estate are soon parted 4/88 Acquiring "surplus" corporate real estate
Assessment district sales 10/93, 11/93 Acquiring property auctioned off for nonpayment of special assessments
Delinquent subdivision mortgages 4/95 Acquiring property indirectly by buying delinquent mortgages on subdivided land
Delinquent tax sales 6/91 Acquiring property that is being auctioned off for nonpayment of property taxes
Discount lien releases 10/90, 11/90 Acquiring property which apparently has no equity but where lenders will release liens at a discount
Distressed builder auctions 9/91 Acquiring property from lenders who have foreclosed on failed housing developments
Distressed owner bargains 3/95 Acquiring property from persons who are in various personal difficulties
Drug property seizures 4/91 Acquiring property from U.S. Marshals who seized it from drug dealers
You won't find an "EBay" or a "Starbucks" in here! This doesn't mean that you don't look in good neighborhoods, or charge high rent - it does mean that the real estate (and stock) market is reasonably efficient, and you have to do a little digging to make excess profits.
Obviously, analyzing a company is much more complex and uncertain than these simple examples. However, if you can find a solid, easy to understand concept to use as a starting point, you can stay focused on the key principles and have a higher chance of success.
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