This week I discovered the most comprehensive guide Iāve ever seen on learning how to value invest (on reddit here).
Itās fairly long and thorough, so I took the time to summarize it here for you.
Key Learnings:
Do not invest based on market comparisons
Your job as a value investor is to underwrite each company on its own merits.
Do not compare the market price of one company to another company. You will fall into the trap that comes with a bull market run.
Letās look at a hypothetical example:
You wake up on a Tuesday morning to the sound of a leaf blower outside your window.
You roll over and check your Robinhood app.
You see that Salesforce stock is valued at 15x revenue and they are growing 20% per year.
Then you see a smaller software company valued at 12x revenue, growing at 20% per year.
Does this sound like a good investment opportunityā
Maybe, if you invest in this smaller company, then one day the market will realize this company is undervalued and your stock will go up until it gets closer to 15x revenue, just like Salesforce. Right?
š© Wrong.
I hate to admit, but invested like this for yearsā¦
This strategy is problematic for a variety of reasons, and it is how most individuals invest.
Here are some potential issues with this strategy:
How do we calculate a companyās true value?
I recommend you follow the Warren Buffet strategy of value investing.
Find a company that is undervalued by the market. Invest in it.
If you do that enough times, over time the market will recognize the mispriced value and your investments will do well.
But how do you price the value of a company? š Start with intrinsic value.
What is intrinsic value, and why is it important?
Finding the intrinsic value of a company requires you to value the business based on specific characteristics.
These characteristics include:
***Note, you can only apply this to cash flow-generating assets.
It does not apply to things like growth tech companies with no cash flow, and it also doesnāt apply to an asset like Gold, Silver or Bitcoin that doesnāt generate cash flow.
Using Discounted Cash Flow (DCF) is a good strategy for intrinsic value calculation.
Hereās how DCF is calculated:
Take a company like Caterpillar Inc. Here are the steps to calculate a DCF:
We can guess the future cash flows by looking at last years cash flows, and building in some reasonable growth rate based on your analysis of the company (this caries some risk).
The discount is a bit of a harder number to understand but it basically is an attempt to compare the value of receiving cash in hand today, VS what an investor would need to earn in a couple of years to make waiting worth it.
Itās most often based on another asset class in a similar category. So you can say āI think I would earn 8% per year investing in the S&P500ā. So 8% would be the discount rate you use.
(watch the video below for more on this)
When I buy a business, I donāt calculate the DCF but we are effectively making a similar calculation. If we want to buy a small business with $2 Million of cash flow, and it sells for $8M, then that business continues to produce $2M of cash flow. Thatās a 25% return per year.
Thatās considered a very high return in the investing world.
The Psychology of Investing
Even if one prices a stock correctly, and invests at the right time, itās still incredibly hard to become a world-class investor. Iām sorry but itās true.
You will need to avoid four of the most common mistakes.
Even when I call them out, youāll have trouble avoiding them (Iām not superhuman, I have trouble with this too!).
Iām a big believer inā¦
Illiquidity is a feature, not a bug
90% of people canāt handle investing in stocks or crypto. They may say itās great because āyou can take you money out anytimeā. Thatās nice. Itās also the biggest issue with these investments.
If I wake up in a panic, or my bank account feels tight for a day, I may just click āsellā.
I prefer to invest my money in:
I donāt want to manage my investments or check the stock market daily. I donāt plan to sell my index investments, and I simply canāt sell my illiquid investments when the market changes.
My main hope in this article is to help us all remember: when weāre investing, āļøwe do not just look at the price of a share, the market cap, revenues or price-to-earnings ratio.
Itās a big mistake. And most investors are making this mistake.
ā We review the financials (balance sheet, income statement, cash flow statement). Itās a full time job to be good at this stuff!
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Useful links
š Favorite Book on This Topic - The Little Book that Beats The Market
I love this book. I appreciate that it takes some of the key concepts I described above and gives you a simple formula you can follow to be successful in the market. There are a million traps you can step in investing in stocks. This may help you avoid some of those.
š„ Good Videos To Watch
š« Favorite Newsletter Article.
This week I particularly enjoyed Jack Reineās post on 6-types of wealth.
Health / Relationships / Knowledge / Time / Experiences / Money
I went to a fancy business school. At this fancy school, I was surrounded by some incredibly bright people..
There was a lot of talk of money, salaries, bonusesā¦etc
But it often felt like people were ignoring the other types of wealth in life.
With each life decision, youāre making a trade-off.
Make sure to use the right inputs in your decision to get the right output for your life.
For example, a lot of my brightest friends became consultants.
If you donāt know about it, consulting may require you to fly to a different city Monday morning to be on-site with a client, then fly home Friday. You repeat this process for months (or years).
In this case, youāre getting Money and some Knowledge.
But youāre losing Relationships and Time.
You donāt have control over your own time, and youāre never in your home city long enough to nurture community and personal relationships.
Alas, every pursuit comes with sacrifice.
My perspective of the 6 types of wealth.
Iāve organized these from most to least important in my life.
Health - You need this. You donāt really know how badly you need this until you donāt have it.
If you get hurt, or sick, your life becomes limited by your health.
Thereās no way around it. Itās a core building block. Take care of your health and a lot of other types of wealth will follow.
Relationships - This includes family, community, and partnership.
Iām a big believer that American cities and suburbs are harmful to our health. Imagine the classic European city. Itās built around a central square or a church where people gather. You can walk there from just about anywhere.
American city design has separated families and communities from each other. Individuality is celebrated. Sharing is shunned.
But we are community-driven creatures. Thatās why weāre obsessed with social media. We crave community.
Relationships are a meaningful measure of my personal wealth and I spend dozens of hours each week investing in this.
Knowledge - you compound this one like an investment.
You can gain it fast, or slow, but either way, nobody can take it away from you once you have it.
If you ever played Zelda the video game, the next reference will make sense to you.
As you go through the game and win, a Fairy will grant you a larger Magic Meter. You may die in the game, but when youāre reborn you still have the larger Magic Meter.
Thatās how I feel about knowledge. You go through life collecting ways to enhance your knowledge. And even if you fail in a startup or a job doesnāt work out for you, then you get to take that knowledge with you.
Time - Have you heard of time billionaires?
Warren Buffett is a financial billionaire. He has all the money in the world. But heās running out of time.
A 20-year-old has 2 Billion seconds left to live. Warren may have hundreds of millions of seconds if heās lucky.
Would Warren trade all of his wealth to buy another billion seconds of life? I think the answer is yes.
Use your time wisely.
And when you have time, use it in a way that 80 year old you would be proud š
Experiences - they make us happy.
Since the early 2000s Cornell Psychology researchers have proven again and again that experiential purchases are more satisfying than material purchases.
This happens for a couple of simple reasons:
Waiting in anticipation for an experience elicits more happiness and excitement than waiting in anticipation for material goods.
A good experience gone bad is better than a good material possession gone bad.
Think of people who went on a beach vacation, and it rains the whole time. You may hear them say āit rained, but we got some nice family time togetherā.
When someone buys a Porche, and the suspension breaks, we rarely hear the silver lining of that purchase
Money - This is the one thatās most easily measured. And perhaps thatās why itās unilaterally pursued in capitalism.
But there is a limit. Somewhere around $100k per year, there is a meaningful reduction of the return on happiness you get on every extra dollar you earn.
As the weekend approaches, I think Iāll be reinvesting my time in relationships, health and knowledgeā¦unless thereās fried chicken on the menu.
Have a fantastic week,
~ Sieva
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