The key to understanding intrinsic value is grasping the fundamentals of the balance sheet. The balance sheet reflects the lifetime to date accrued net worth of that business entity. For the value investor, understanding how a balance sheet is laid out, works and how it reports net worth takes the investor to the next level of confidence with their buy/sell model for any potential investment. Simply stated, understanding the balance sheet places the value investor ahead of other types of investors. Knowledge about the balance sheet for your investment can provide all the necessary confidence you need to make good decisions when setting buy and sell points for that company’s securities. 

In essence, the balance sheet is a scale. Accounting ensures the scale always stays in balance. It is laid out with two sides; on one side of the scale are all the existing assets of the company. The other side informs the reader how those assets are funded. More mature or well managed companies fund assets with the lifetime earnings to date that are retained. Some companies borrow the money to pay for the assets. As an example, most people don’t realize this, but McDonalds funds the entire asset side of the scale with borrowed money and then some. Yet, McDonalds is one of the top 30 companies in the world. Thus, how can McDonalds have any intrinsic value when they actually owe more money to creditors than they have in assets?

This is why value investors must have a good fundamental understanding of how the balance sheet works. 

In addition, the balance sheet acts as a report. It informs the reader what kind of assets the company owns and it details how those assets were funded. Understanding this fundamental reporting format allows the value investor the ability to quickly get to the core reason the company has value. In many cases, understanding this reporting format allows the reader to easily determine a viable range of expected outcomes for intrinsic value. 

Understanding the balance sheet fundamentals allows investors to not only determine the core value of a company but its also assists the investor with determining which particular intrinsic value formula is the most reliable to use. You must understand these fundamental balance sheet relationships to assist with determining the best intrinsic value formula. In most cases, the balance sheet will provide the intrinsic value (subsequent articles) for the company. But without this knowledge, an investor can’t possible have a high level of confidence with intrinsic value formulas. It all starts with understanding the fundamentals of the balance sheet.

Fundamental understanding of the balance sheet starts out with keying in on the concept of balance. Once this core principle of balance is comprehended, an investor then must understand that THERE IS NO UNIVERSALLY ACCEPTED PRESENTATION FORMAT. There is a simple balance sheet presentation format that is ingrained into formal education of accountants; but, at the public securities level, industries have set how a balance sheet is presented. What is important here is that although the industry’s balance sheet format is different, it is still easy to comprehend this alternative presentation format and how it ties back to the basic presentation format.

Finally, after grasping how a balance sheet is laid out and works; a value investor begins to appreciate each industry’s presentation format. Now it is time to key in on the real reason all this is so important; matching the most important asset on the balance sheet to how this entity makes its money. What is the one or two most important assets and how they are presented aids the investor with determining value. How does a value investor discover this asset and how does one determines its value?

Each section below goes into this set of core fundamentals of a balance sheet. When done, the reader should be able to break any company’s balance sheet out into the core groupings and quickly ascertain the proper format for the company one wishes to invest. From there, a value investor will quickly key in the most important asset that makes this company go; what is the one single most important asset that provides all that wealth? With this understanding, a value investor can more easily derive intrinsic value and have extreme confidence with the intrinsic value outcome. 

Intrinsic Value – The Balance Sheet

The balance sheet is one of the five key financial reports. It is a required presentation with the company’s annual 10K report filed with the Security and Exchange Commission. Most publicly traded companies also include the report with their quarterly releases. The balance sheet identifies existing assets along with the sources of funds to finance the company. Sources of funds include liabilities, loans and money fronted by the shareholders and other equity stakeholders. Generally Accepted Accounting Principles (GAAP) and the accounting profession’s dual entry accounting system forces the balance sheet to exist in a state of equilibrium, thus the expression, ‘the balance sheet’.

As an investor, it is important to understand the primary purpose of the balance sheet; the balance sheet reflects the lifetime to date financial position of the company. The income statement only reflects the accounting year, whereas the balance sheet is just a snapshot of a single moment in time which is identified by the date of the report. The balance sheet states the book value of all assets and the book value of all debt (current and long-term) along with the resulting aggregated position of all stakeholders (Preferred Stock, Minority/Joint Owners, Treasury Stock and Shareholders). It starts out with a very simple equation:

ASSETS = SOURCES OF FUNDS (the core balance sheet)

This is then broaden out to reflect the two major sources of funds which have different risk levels:

ASSETS = LIABILITIES (preferred rights, less risk)
                        plus
.                   EQUITY (subordinate position to liabilities, greater risk)

In effect, the balance sheet is a three part formula. Part One reflects assets such as cash in the bank, receivables, fixed and other assets. Some of these assets are funded by short-term liabilities while others are funded with long-term loans (notes). Subsequently, liabilities are Part Two of the formula. The final part is of course equity. Equity in a simple state refers to what the shareholders have invested in the company. This investment is the initial purchase price paid to start the company plus the lifetime to date earnings referred to as ‘retained earnings’. Recall, each year as the company earns a profit, any profit not used to pay dividends or buy back stock (treasury stock) is then accumulated in an account called retained earnings. The end result is:

ASSETS = LIABILITIES + EQUITY

An easy observation is that this formula can be rearranged to state the value from the perspective of just the shareholders:

ASSETS minus LIABILITIES = EQUITY

This presentation format is not referred as the balance sheet, but as ‘Net Assets’. It is important for the reader to understand that there is a naming difference involved as often different wording is used to identify the various presentation formats of the balance sheet. The balance sheet refers to the core formula of assets equals liabilities plus equity. When referring to assets minus liabilities equals equity, accountants and finance folks refer to this as ‘Net Assets’. Notice how net assets equals assets minus liabilities. Thus:

NET ASSETS (assets minus liabilities) = EQUITY

This is key, value investors more often use the term ‘Net Assets’ when talking about value than the alternative term of ‘Balance Sheet’. Mathematically though, the two terms are referring to same financial equation; specifically, what is the value of the equity position of the company. An illustration will assist the reader in understanding this relationship:

This is the balance sheet for a real estate investment trust (REIT), American Homes 4 Rent, Inc. This company owns 56,400 homes throughout the United States. This is their balance sheet at 12/31/2021.

Notice the three highlighted summation amounts? The first is assets at $10.962 Billion. Liabilities equals $4.224 Billion and Equity equals $6.738 Billion.

Thus, the balance sheet formula (accountant’s perspective) is:

ASSETS = LIABILITIES plus EQUITY (sources of funds)
$10.962 B = $4.224 B + $6.738 B

Whereas, value investors will state that the net assets are $6.738 Billion.

ASSETS – LIABILITIES = EQUITY
$10.962 B – $4.224 B = $6.738 B

Notice also the very bottom financial value is referred to as ‘Total liabilities and Equity’. This value equals total assets. This goes back to the primary goal of the balance sheet, the two sides must be in balance, they must match.

ASSETS = SOURCES OF FUNDS
$10.962 Billion = $10.962 Billion

Again, this is extremely important, accountants use the term ‘Balance Sheet’ whereas investors, specifically value investors will use the term ‘Net Assets’. Please remember, they are saying the same thing, but just from a different perspective.

Intrinsic Value – Balance Sheet Presentation

When accountants go through their undergraduate studies, they are taught the balance sheet has a certain presentation format. Of course the primary form matches the core formula of assets equals liabilities plus equity, the two sides of the balance sheet. The core model used in studies is the traditional retail model. Here the model breaks out each side of the balance sheet into three subsections as follows:

ASSETS
.    Current Assets                              $ZZZ
.    Fixed Assets                                Z,ZZZ
.    Non-Current Assets                          ZZ
.    Total Assets                                               $ZZ,ZZZ
LIABILITIES
.     Current Liabilities                      $ZZZ
.     Long-Term Liabilities               Z,ZZZ
.     Total Liabilities                                               Z,ZZZ
EQUITY                                                               Z,ZZZ
.     Total Liabilities & Equity                        $ZZ,ZZZ

Notice how this model fits perfectly to the core concept of the balance sheet structure explained above, ASSETS = LIABILITIES + EQUITY.

In general, most companies try to mimic this presentation model as best they can; but each industry utilizes their own presentation format. Overall, the format each industry utilizes matches the core formula, it’s just that they may present it differently. Go back to the REIT above. American Homes 4 Rent uses a slightly modified model. In their case, they focus on fixed assets as the primary asset. Notice how total real estate dominates the value of total assets. This is their basic presentation format:

ASSETS
.    Total Real Estate                           $10.245 Billion
.     Current Assets                                     .597 Billion (cash, receivables, deposits, investments)
.     Non-Current Assets                            .120 Billion (goodwill)
.     Total Assets                                   $10.962 Billion

On the liabilities side, preference in hierarchy is given to secured notes over unsecured notes. In the traditional presentation format, unsecured liabilities are listed first and then secured loans are listed based on inverse seniority. 

Again, each industry presents their balance sheet in their own format. As a value investor, it is so important to understand this presentation format in order to better grasp value when it comes time to determine intrinsic value. 

There is another aspect of the presentation format that is important for value investors to understand and appreciate. Large companies, those in the top 2,000 in the United States tend to report the most important assets first along with their prioritized liabilities. Look at the REIT’s presentation above. Almost all REITs present in a similar format, they list their net real estate book value (cost basis less depreciation taken to date) as the first asset on the books. Whereas banks, list their cash available, then their portfolio of securities they own and loans they’ve made. Look at Bank of America’s format:

For Bank of America, the presentation format goes like this:

ASSETS
.    Cash                                                                                  $348.221 Billion
.     Federal Funds/Trading Accounts/Derivatives                   540.288 Billion
.     Debt Securities                                                                  982.627 Billion
.     Loans Made                                                                       966.737 Billion
.     Other Assets (fixed, goodwill, other)                                331.622 Billion
.     Total Assets                                                                  $3,169.495 Billion
                                                                                             ($3.169 Trillion)   

With banks, they generally list their assets based on liquidity from the most liquid to the group that will take extended to time liquefy in case of termination of operations. For banks, the government grades the quality of a bank based on its ability to liquidate its assets; thus, the balance sheet reflects this governmental compliance format. 

The liabilities section is similar, it is presented in the format of priority to repay. Existing customer deposits are first at $2.1 Trillion and then the remaining forms of liabilities based on their time windows.

All the banks follow this pattern with their balance sheet. Again, the presentation format is tied to the core concept of balance first; assets in the upper half and liabilities and equity in the bottom half. 

Each industry’s presentation format actually assists value investors with determining intrinsic value. When you understand what the industry presents as the most important asset over others and why, it helps to focus in on what matters the most to that particular industry. 

With REITs, it is real estate that is the most important asset and as such, it gets reported first. With banking, it is liquidity; because it is required by law. Thus, banks want the readers to see that they have adequate cash and other easily liquifiable assets (government bonds and debt securities) in their portfolio to cover any ‘run’ on the bank. 

For value investors it is so important to understand this relationship of what it is that the company does and how their key assets allow it to generate revenue. The company wants the balance sheet to reflect, by prioritizing, those key assets first.

Intrinsic Value – Matching the Balance Sheet Against the Company’s Purpose

A key fundamental of value investing is understanding how the balance sheet presents the priority of the particular company within a certain industry. Each industry is different and as such, there is an asset allocation or alignment that matches that industry’s purpose. Look at the difference in presentation format just between the two industries above:

           REIT’s                                                                                   Banks                                   
Net Real Estate      >92%                                   Cash                                                   10 to 15%
Cash                            3%                                  Federal Notes/Securities                       >50%
Other                           4%                                  Loans                                                      30%
                                                                           Other                                                     <10%

Look at what the company does, REIT’s collect rents; thus, real estate as an asset is the most important asset to own. It is difficult to collect rent on cash. Whereas a bank’s primary purpose is to generate net interest income. Interest comes off of debt securities (bonds) and loans. In their case, they want to maximize how much of their assets are lent out to debtors. The only reason they list cash first is because they have to meet a minimum cash position (liquidity) in relation to the total assets to be in compliance with the license they are granted by the Federal Reserve and other federal agencies.  But immediately after reporting this cash position, the primary asset is listed, securities and loans that make the bank money via interest payments as their revenue.

As a value investor, key in on this concept and it will help you to gain a better perspective of overall intrinsic value for a company. At this point an in-depth illustration will assist the reader with a better understanding of this fundamental principle of determining intrinsic value.

The financial sector of the economy is divided into several industries. One of those industries is insurance. Insurance is further segmented into different types. Some companies focus strictly on life products, others health insurance. But there is one that all of us understand and recognize, property and casualty. Customarily referred to as the P&C arm of insurance.

Unlike the other forms of insurance which have a steady pattern of benefit pay outs; P&C does experience some peak payouts at certain times throughout the year for natural events (tornados, hurricanes, flooding, wind and hail). Thus, this type of company must have reserves that can be easily cashed and cashed without undue additional costs. Look at their assets section of the balance sheet:

 Notice the very first grouping of assets are investments. Three-fourths of all assets are investments. Within this investment group, more than two-thirds are fixed income securities (bonds). The bonds are a key source of cash from the interest income (see articles within the Insurance Pool explaining this). Bonds are the key asset of a P&C company.

Look at the cash position, it is a measly $377 Million (.3%) out of the $126 Billion of assets. Insurance companies don’t need to hold cash, they just need access to cash. Bond and equity securities are an excellent easily convertible source of cash.

A property and casualty insurance company’s asset arrangement is strictly about the ability to convert assets into cash to meet forecasted catastrophic events. Think about this from the perspective of intrinsic value. Recall, intrinsic value is tied to the core value of a company. In this case, for a P&C operation, intrinsic value is strongly aligned with the quality of the liquifiable assets.

There is some additional value related to earnings; but, the balance sheet identifies the real intrinsic value of insurance operations. To validate this value, look at Allstate’s liabilities:

The first line is the standard P&C expected obligation of Allstate; they believe that in the upcoming year of 2021 and in the future tied to longer term P&C policies, Allstate will need to pay out about $27.6 Billion to settle damage claims. Since most P&C insurance companies are not pure P&C, most do also sell life insurance, the second line is the projected lifetime amount they will pay out for existing life insurance contracts. The third line ties to their annuity products.

The fourth line is the standard arrangement with their customers. When you purchase insurance, you agree to a certain ‘Annual’ premium and customers prepay for the upcoming year. In this case, almost $16 Billion has been paid and not amortized to the revenue section of the income statement at year-end. Most of these policies are for P&C policies for corporate size accounts and not necessarily at the individual levels. At the individual level, customers agree to pay the premium in the near future and this in turn is an asset on the balance sheet; thus, look at the line ‘Premium Installment Receivables, Net’ for $6.5 Billion in the asset section above.

Then there is a line for claims made but not disbursed yet, deferred taxes and other common forms of corporate liabilities (payables, notes, etc.). Altogether, Allstate estimates it owes about $95.8 Billion, of which most of this will be settled within a few years.

The key relationship is this, Allstate’s core investments plus existing cash plus receivables due from customers equals $101.1 Billion; its expected obligations are about $95.8 Billion; thus, there is a $5.3 Billion delta to the positive here.

In the aggregate, Allstate’s assets less liabilities are an estimated net assets position (remember from above, investors use the term ‘net assets’) of about $30.2 Billion.

There are 304 Million shares outstanding (trading) in the market on 12/31/2020 plus another 26 Million assigned to a benefit package for employees. This means each share on a fully diluted basis has a book value of $91.50.

However, book value DOES NOT equal intrinsic value. With P&C operations, intrinsic value is commonly within .9 to 1.4 times book value. Rarely, if ever, will intrinsic value exceed 1.5 times book value. The reason is straight forward, P&C operations use actuarial science and know within a few million dollars their full obligations related to the various policies they carry. Thus, given the risk of dramatic catastrophic losses (imagine seven or eight hurricanes, a large forest fire, several hailstorms in one year), it is quite possible to have to utilize net asset value to cover these unforeseen events; this in turn limits the upper range of intrinsic value for an insurance company.

Any unusual activity will quickly diminish intrinsic value of a P&C insurance company. Therefore, intrinsic value is merely the book value plus a few years of net earnings from the income statement. The extenuating risk factors associated with catastrophic events in excess of expected volume will dramatically impact intrinsic value. Therefore, intrinsic value will never exceed 1.5 times book value for P&C insurance companies.

For the reader, this site’s facilitator estimates intrinsic value for Allstate at $102 per share with a buy price of $81 per share.

The key is this, the balance sheet is customarily formatted to facilitate a better financial understanding of the company related to the industry in which they operate. Understanding these core fundamentals of how a balance sheet is laid out, formatted, reported and presented assists the investor with determining intrinsic value.

Summary Intrinsic Value – Balance Sheet Fundamentals

Novice and unsophisticated investors place greater reliance on net profits over the balance sheet to determine intrinsic value. However, most so-called experts forget what intrinsic value means; intrinsic value refers to the universally accepted core value of a company. In many cases, this can be easily derived from the balance sheet. If not derived from the balance sheet, the balance sheet can act as additional assurance that certain intrinsic value formulas are superior and best suited given the balance sheet information.

Understanding how a balance sheet is laid out, works and reports this information greatly assists value investors with determining intrinsic value. Gaining knowledge about balance sheet fundamentals takes a value investor to the next level of comprehension of value investing. Act on Knowledge.

This is the second part in a series about intrinsic value. It is the first in a four-part series about the balance sheet and different intrinsic value formulas that are tied to the balance sheet. The next lesson in this balance sheet series delves deep into analysis of asset matrixes and proper interpretation of that information. It also includes how to tie the asset matrix to the liability layout. Understanding this relationship allows the value investor to apply certain intrinsic value formulas which are explained and illustrated.

For those of you that have not, it is a good idea to read the first part of this series. In addition, there are some other articles to assist with a more comprehensive understanding of the balance sheet. 

• Intrinsic Value – Definition and Introduction
• How to Read a Balance Sheet – Simple Format
• How to Read a Balance Sheet – Equity Section Simple Format

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The post Intrinsic Value – Balance Sheet Fundamentals first appeared on ValueInvestingNow.com.

Intrinsic value’s definition has several different meanings when used in the business context. The word intrinsic refers to ‘innate’ or ‘inherent’. Whereas value refers to the exchange mindset between two or more parties. Thus, intrinsic value refers to the core understanding between parties of the worth of something. Bread is the perfect example. At its core concept, bread is a food we consume as a starch; we eat it due to its relatively inexpensive cost to fill our bellies. When you go to purchase bread at the grocer, there is already a preconceived price range for bread. Different flavors, packaging, size and type determines the final price within this predictable range. It is easy to spot prices that are too high or for some reason well below expectations.

Intrinsic value works the same way. When looking at the market price for a security, having knowledge of the intrinsic value prevents over paying for an investment. The key is determining this price range for the security. The primary rule for intrinsic value is straight forward; it is a RANGE and not an exact dollar value. Just as with the bakery section of the grocery store, bread is priced within a range. With value investing, the goal is to narrow this range to a set of values that are REASONABLE and OBJECTIVELY verified. Therefore, rule number two, intrinsic value must be reasonable and objectively determined. Finally, all users of intrinsic value must understand and appreciate that intrinsic value is not static. It changes every day and for highly stable companies, it should improve every day in a predictable manner with a high level of confidence.

The following sections cover these three rules tied to intrinsic value. The first section explains how intrinsic value is a RANGE of values and never a definitive amount. The second section discusses the importance of arriving at this price range in an OBJECTIVE manner and that the price range is REASONABLE given various ratios and performance indicators for the particular company. The third section below covers how intrinsic value is FLUID in business; it changes regularly and with highly respectable, stable operations, it is constantly improving. 

Intrinsic Value – A Range of Monetary Outcomes

Determining intrinsic value is not an exact science. Intrinsic value is a range of values determined from many different variables collected, collated and exercised in several formulas to derive results. In many cases, these results are extreme with their respective outcomes. For value investors, the idea is to acquire as many different results as possible over at least five and ideally eight or more different standard formulas. From these results, a range is extrapolated. As is typical with many derived results, highs and lows are tossed due to their extreme nature. Those that remain set the boundaries of the possible outcome. The goal is finding common ground from among the remaining outcomes. Narrowing this outcome to a common acceptable monetary range determines intrinsic value.

An illustration is appropriate. In this case, a simple well documented company is used to determine intrinsic value – Coca-Cola.

Typically, the first step involved with determining intrinsic value is to collect pertinent data. For the purpose of brevity, the following data was collected on Coca-Cola.

Data Point                       2021             2020             2019         2018          4 Year Weighted Average*
Revenue                          $38.6B         $33.0B         $37.3B      $31.9B                 $36.3B
Gross Profit                    $23.3B         $19.6B          $22.6B      $20.1B                 $21.9B
GP Margin                        60.3%           59.4%           60.6%       63.0%                   60.4%
Net Profit                         $9.8B            $7.8B            $8.9B        $6.4B                  $8.8B
# of Shares Trading           4.3B              4.3B              4.3B          4.3B                     4.3B
Earnings/Share                 $2.28             $1.81            $2.09         $1.51                   $2.06
Dividends/Share               $1.67             $1.64            $1.59         $1.56                   $1.64
Book Value/Share            $5.31             $4.48             $4.43         $3.98                   $4.84
Operating Cash Flow     $12.6B            $9.8B          $10.5B        $7.6B                 $11.1B
Free Cash Flow              $11.3B            $8.7B            $8.4B        $6.3B                   $9.7B
Growth Rate                                                                                                               3.7%
Discount Rate                                                                                                            7.75%
Average Market Price        $56              $55                 $52              $47
Dividend Yield                  2.98%         2.98%             3.05%          3.32%
Price to Earnings Ratio     24.5             30.4                 24.9             31.1

* Weighting is as follows: 2021 – 50%; 2020 – 25%; 2019 – 15%; 2018 – 10%.

Over time, Coke’s market price continues to increase reflecting the constantly increasing earnings per share. This is a DOW Jones Industrial member and as such, this company is highly stable and experiences a good growth rate for such a well established company (they been publicly traded for 103 years). Excellence is their standard. As such, the market price to earnings ratio will always be strong (>20:1 ratio). In effect, it is a great company to buy when the price suddenly dips more than 25% below the most recent peak price. However, recall, market price is NOT intrinsic value. Intrinsic value reflects a fair and reasonable dollar amount that mirrors a general agreement among parties as to the worth of a security. The difference between the two prices (market and intrinsic) is the speculative risk many investors take believing the market price will continue to increase.

For any stock based security, a fair and reasonable value is measured utilizing a discount rate. This is the rate an owner of this particular security desires for the risk they assume. For a high quality company like this, a discount rate of 5% is very fair. Coca-Cola has very little risk but risk still exists. It isn’t government grade risk (1 – 3%); nor is at the high quality bond risk rates of 3.5% to 5%. However, it is still a super high quality stock investment risk which typically starts at around 5%. Thus, as an investor with this type of high quality stock, a five percent return on your investment is considered fair and acceptable.

Therefore, the very first intrinsic value formula commonly used is the dividend yield tied to the stock based discount rate. In this case, the average dividend is $1.64 and with a discount rate of 5%; the stock is worth around $33 per share. Coke is highly stable, returns a dividend to the shareholder and, at greater than 60%, has one of the strongest gross profit margins for any company. It is a super quality company to own. It would appear on the face of values that $33 per share for intrinsic value is low. Thus, more intrinsic value formulas are required.

Intrinsic value formulas are commonly grouped by financial data. Historically, a very well respected formula advocated by Benjamin Graham and David Dodd (the Fathers of Value Investing) is a formula tied to earnings. Their popular formula is:

Value = Earnings times ((8.5 plus (2 times a reasonable growth rate))

With Coke, this would equal:

Earnings of $2.06/Share times ((8.5 + (2X3.7));
$2.06 X (8.5 + 7.4);
$2.06 X 15.9;
$32.75/Share

Take note how close this is to the dividend discounted result from above. However, a value investor should never rely on just two results. More are required.

A third and quite common approach is to use the discounted earnings formula. This formula is a income statement based formula and assumes earnings are normal and not inclusive of unusual or infrequent events. However, Coke, just like every other company, did experience an unusual event starting in March of 2020. COVID affected all companies across the board. With Coke, it definitely caused a decrease in sales in the amount of $4.3 Billion; thus, net profit was most likely reduced around $1.2B which in turn reduced earnings per share that year approximately 28 cents per share. In the overall scheme of things, this probably impacted the average earnings per share about 6 cents (due to the weighting effect of the 4 year average). The question here is this, should a value investor use the historical recorded average of $2.06 per share or adjust this for the COVID situation?

Surprisingly, the answer is to NOT adjust the average. The key is the average. Since 2019’s value is only weighted 25%, the net impact is slightly higher than 6 cents in the overall result. This aggregated 3% difference (6 cents divided by $2.06) isn’t going to dramatically affect the end result (with business, dramatic refers to a change of more than 5%) with the discounted earnings formula, or for that matter any long-term time derived result (discounted formulas customarily utilize 20 plus years to derive a result). Discounted future values are grounded in the near future over the extended future. The first seven years typically are worth more than 30% of the end result.

In this case, using a discounted earnings tool, Coke’s intrinsic value is estimated at $36.03 over the next 30 years assuming a discount rate of 7.75% and a growth rate of 3.7%. 

A Side Note
The discount rate used with the discounted earnings formula here is different than the discount rate used in the dividend yield formula. In the dividend yield formula, the discount rate reflects a much improved overall risk position because it is dividends and not earnings. Dividends are a direct payment to the shareholder; whereas earnings doesn’t guarantee all of it going in the shareholder’s pocket as dividends. Thus, the discount rate for earnings includes not only the portion tied to equity ownership (the 5% desired rate used with the dividend yield formula), but also the ‘no risk’ desired discount (usually around 2%), the size premium and the specific risk (is there a market for Coke’s securities). Thus, the discount rate for the discounted earnings and cash flow formulas is always higher than the discount rate for dividend yield.

Notice how this result is slightly higher than than the first two results? Often, value investors adjust the variables in the formula around the earnings. The two variables are the growth rate and the discount rate. Let’s assume a more conservative approach and increase the discount rate to 8.25% and reduce the growth rate to 2.9%; again, the idea is to be more conservative with the outcome. Using these factors, the intrinsic value shrinks to $30.96 per share. 

A more aggressive approach might be to reduce the discount rate to 7.25% and leave the growth rate as is, 3.7% (it is very difficult for companies that are fully mature, in this case Coke has been in business for over 130 years, to have strong growth rates greater than 4% per year). Using this more liberal approach, the discounted earnings approach values the shares at around $38.25. 

A user of this formula could extend the number of years with discounting future earnings and go to 40 years; this will add anywhere from $3 to $5 per share depending on whether the value investor incorporates conservative or liberal values for the two variables.

Notice already, the RANGE that is beginning to develop. To this point, the following results exist:

• Dividend Yield with a Desired Discount Rate of 5%                                                          $33/Share
• Graham & Dodd Formula                                                                                                    $33/Share
• Discounted Earnings (7.75%, 3.7% Growth, 30 Years)                                                       $36/Share
• Discounted Earnings (7.75%, 3.7% Growth, 40 Years)                                                       $41/Share
• Discounted Earnings Conservative Approach (8.25%, 2.9% Growth, 30 Years)                $31/Share
• Discounted Earnings Conservative Approach (8.25%, 2.9% Growth, 40 Years)                $34/Share
• Discounted Earnings Liberal Approach (7.25%, 3.7% Growth, 30 Years)                          $38/Share
• Discounted Earnings Liberal Approach (7.25%, 3.7% Growth, 40 Years)                          $45/Share

This pattern results in a RANGE of a low $31 per share (conservative approach, 30 years) to a high of $45 per share (liberal approach, 40 years). There are still more intrinsic value formulas an investor could use. Many investors like to resort to cash flow as a more reliable indicator than earnings. In general, there are two sets of cash flow values to use. The first is purely the operating cash flow. This is basically earnings adjusted for non-cash expenditures such as depreciation and amortization. Coke has a very strong amortization deduction each year related to the years of growth when they purchased many rights to own certain brands, formulas, distribution venues etc. over the last 40 years. 

From the schedule above, operating cash flows exceed earnings by approximately $2.3 Billion per year, or around 53 cents per year per share. In effect, the discounted formula uses $2.59 per share as the substitution value over $2.06 of earnings average per year. This additional 53 cents per year, increases the overall intrinsic value result about $9 per share. With the more conservative approach, the additional 53 cents per year increases the result around $8 per share. 

The key question here is, which is better? Should a value investor use discounted earnings or should an investor use discounted operating cash flows? The answer is is highly dependent on the investor’s belief system related to how cash flow is utilized. Most investors believe that it is important for the cash to be used to reward shareholders with dividends, reduce the overall risk of the company (paying down debt) and investing cash for future growth or to maintain the current growth rate. 

Think about this for a moment, if Coke doesn’t take their cash and invest some of this money as capital expenditures, the growth rate of Coke will drop over the next 10 years and it is possible, that without this reinvestment into new products, geographical expansion and developing expanded distribution systems, the company could begin to retrench as the competition will take advantage of this non-growth position. Since, most of the values derived above are heavily reliant on a moderate to strong growth rate, a good portion of the operating cash must be used to maintain the company’s market share and overall position in this industry. In effect, Coke must reinvest some of this $2.4 Billion per year to maintain their overall position. Reviewing the cash flows statement identifies that Coke reinvests around $1.5 Billion per year. 

The end result is that most of the 53 cents per share from cash flow is reinvested to maintain the company’s overall market position. Thus, a value investor can use operating cash flow as the basis in the discounted formula; but, the investor must adjust this for the required investment to maintain the company’s overall market position. This is known as ‘Free Cash Flow’ (Operating Cash Flow less Capital Reinvestment). 

With Coke, once you adjust the cash flow for maintenance requirements, it effectively ends up just slightly more than purely earnings, around $2.24 per share as the basis for discounted formula. This adds about $3 more per share with the end results and not $9 per share utilizing nothing but operating cash flow. Now the results are as follows:

• Dividend Yield with a Desired Discount Rate of 5%                                                          $33/Share
• Graham & Dodd Formula                                                                                                    $33/Share
• Discounted Earnings (7.75%, 3.7% Growth, 30 Years)                                                      $36/Share
• Discounted Earnings (7.75%, 3.7% Growth, 40 Years)                                                      $41/Share
• Discounted Earnings Conservative Approach (8.25%, 2.9% Growth, 30 Years)                $31/Share
• Discounted Earnings Conservative Approach (8.25%, 2.9% Growth, 40 Years)                $34/Share
• Discounted Earnings Liberal Approach (7.25%, 3.7% Growth, 30 Years)                         $38/Share
• Discounted Earnings Liberal Approach (7.25%, 3.7% Growth, 40 Years)                         $45/Share
• Discounted Free Cash Flow (7.75%, 3.7% Growth, 30 Years)                                     $39/Share
• Discounted Free Cash Flow Liberal Approach (7.25%, 3.7% Growth, 40 Years)      $48/Share

Again, the overall range of values expands slightly to a high of $48 per share. The range is now a low of $31 to a high of $48. Statistical analysis states to toss the extremes of $31 and $48 and now the range becomes a low of $33/share, Dividend Yield, to as much as $45/share, Discounted Earnings Liberal Approach. 

Most of the results are from $36/share to $41/share. A RANGE of values is now set. The next step is to narrow this RANGE to something REASONABLE and OBJECTIVE.

A Side Note
The more stable the company, the more reliable the discounted formula becomes. Mid-Cap companies require additional supplemental formulas to assess intrinsic value in addition to the discounted method. Use fair market valuations for fixed assets; incorporate business ratios; and utilize the company’s notes to the financials to identify critical key performance indicators. As the company moves through its life span and improves, the discount rate also improves (decreases). For Mid-Caps, discount rates of 11% and higher are necessary to account for the additional risks associated with these companies. For those that are improving within the Mid-Cap level of companies, the discount rate tends towards 11% from 12%; for those companies unable to improve or demonstrate sound financial results year after year, the discount rate must increase to compensate for this additional risk. Value Investors SHOULD NEVER consider Small-Caps, Penny stocks or even Over-The-Counter investments. For those types of companies, additional tools are required to determine intrinsic value and the associated risk of deriving a reliable result is magnified dramatically. This is why value investors should only consider the top 2,000 companies and within this pool of potential investments, only those that demonstrate continuous growth and performance during recessions or unusual events.

Intrinsic Value – A Reasonable and Objective Outcome

Is an intrinsic value of $36 to $41 reasonable and objective? How can you tell? Well, there are several tools available to value investors to confirm or independently verify that this is a good range of values. The most commonly used tool is the price to earnings ratio.

Price to Earnings

If you look at the history of Coke, the price to earnings ratio, i.e. the market price against the earnings hovers in the 20’s. The market price to earnings rarely dips below 20:1. This chart illustrates Coke’s PE ratio over the last five years. The sudden high PE ration in 2018 is a direct reflection of Coca-Cola taking advantage of the new tax law in December 2017 and paying a dramatic amount in taxes reducing their overall net earnings. Since the average market investor is aware of this, they are not going to suddenly reduce the market price for Coke. Thus, if the market price remains stable and the earnings drops dramatically, the ratio inversely changes. In effect, 2018 is an anomaly. By the way, this is one of the flaws of the PE ratio and is explained in detail in the lesson about price to earnings in the Business Ratios section of Value Investing on this website.

From above, the market is willing to spend at least 20 times earnings to own this stock. Current earnings plus some excess cash flow totals around $2.24 per share. At a PE of 20, that makes Coke’s market value approximately $45 per share. Value investors don’t want to buy stock at commonly accepted market prices, it just means that you will only earn dividends and although the yield will be good, value investors desire strong overall returns. To achieve this, the buy price, which is set below intrinsic value, must be dramatically (> 5%) less than intrinsic value. With Coke, given the unusual quality this company provides to its shareholders, a price differential including the additional 5% for margin of safety must exceed 25% in order to justify the risk associated with the holding period. An illustration is warranted here.

Assume that a fair market price is $45 per share based on a minimum 20:1 PE ratio. Given the risk of time to recover to a fair market price, a 25% discount is required to buy the stock. 25% of $45 is $11.25. Thus, to buy this stock, the value investor sets the buy point at $33.75 per share. This buy point is at least 5% less than intrinsic value. This makes intrinsic value approximately $35 to $36 per share. Take note how this is at the low end of the range established in the prior section. 

Thus, using PE ratios as a barometer of value, discounting the minimum average PE ratio 25% from the most recent look back period of five years can provide some insight to intrinsic value. If the minimum PE ratio increases to 25:1, the fair market price increases to $56 per share. A 25% discount puts the buy point at $42 per share. If this is at least 5% below intrinsic value, then intrinsic value is estimated at $44 per share. Notice how this estimate is well above the expected intrinsic value range of $36 to $41. However, it is within the overall range calculated in the prior section (Discounted Earnings Liberal Approach Price).

A Side Note
Please take notice of something interesting here, the discount explained above is different than the discount used with the Discounted Earnings/Cash Flow method in the prior section. Some readers will ask, why is it that this discount in this section is almost four times greater than the discount used in the prior section (discounted earnings/cash flow). There is an outright difference between the two uses of the term ‘discount’. In the prior section, discount is tied to multiple risk factors AND extrapolated over an extended perid of time. Whereas, in this section, the discount is instantaneous and is driven by a limited set of factors that can impact its value. In this case, the value investor’s risk is a very short period of time (six or less months) and the value investor needs to have dramatic change in a very short period of time. In the prior section, the different variables of growth and earnings are addressed over a very long time frame, 30 or more years. The end result is this, as time decreases, the discount rate must adjust accordingly, i.e. increase.

Using a 25% discount of a minimum expected market PE ratio is just one tool to provide additional confidence of the resultant values from the various intrinsic value formulas used when determining an intrinsic value range. Think of it as a quick objective outcome. 

Market Appraisal

Another objective tool is to ‘Appraise’ the company. Naturally, appraising Coca-Cola would take several years. Thus, to conduct a quick appraisal, one must use reasonable expectations related to determining fair market value of Coke’s assets. A quick look at Coke’s assets identifies the following on 12/31/21:

Current Assets       $22.5B
Investments           $18.4B
Fixed Assets            $9.9B
Intangibles             $41.3B

Most of the intangibles are Trademarks and Goodwill. Basically, Coke purchased these rights over the last 70 years to gain market share for non-alcohol beverages. Fixed assets reflect manufacturing, distribution and office facilities. Investments are mostly equity positions in other beverage companies, geographical territories and distribution venues. Since assets are recorded at cost under Generally Accepted Accounting Principles, their step-up in value to fair market value is not done and not reported on the balance sheet.

The step-up to fair market value is very effective with fixed asset intensive businesses like real estate, utilities, shipyards etc. Coca-Cola’s balance sheet relies intensively on intangibles. There is a very involved process to appraise intangibles. Thus, using this appraisal tool isn’t going to work with evaluating Coke’s overall asset position at fair market value less its liabilities to determine net aggregated value which is one way of measuring intrinsic value. A good illustration of how market appraisal effecitively calculates intrinsic value is with a REIT, please read Intrinsic Value of Essex Property Trust to learn more.

Another alternative is required.

Price to Book Ratio

A third objective tool is an old method called ‘Price to Book Ratio‘. This is a valuation ratio that emphasizes the importance of the book value for a company. It has many flaws and can be easily misinterpreted. But in general, it is more effective with highly stable operations, ones with an extremely extended history of exceptional performance. 

Book value reflects the net equity position of the company divided by the number of shares in the market. For Coke, it slowly improves from year to year. Coca-Cola generally prefers to distribute earnings and not reduce debt or improve the overall financial position of the company. It has such an outstanding history with sales and a top rated (if not one of the best among all companies) gross margin, which exceeds 60% of revenue. Thus, the company will perform very well year after year. Coke doesn’t take its earnings to improve its financial position, it pays out 80% of what it earns in the form of dividends. Thus, very little is used to improve the book value per share (retained earnings improvement).

This does however produce a highly reliable market measure with the price to book ratio. With this stable market measure, a value investor can preset a discount to buy. This is no different than how a house flipper will determine the maximum amount they are willing to pay for a piece of property given the market value of similar property. For a value investor, a net cumulative 40% discount is considered reasonable and necessary to make a good return on an investment. Thus, if the current price to book ratio is 12, a value investor is interested in buying when the price to boot ratio drops 40% or to around 7.2 price to book ratio. Again, think about a house flipper’s business dynamics. It costs extra money to purchase and sell the investment, secondly, the house flipper’s real risk is time. How long will it take to sell this home? In addition, he has to invest some money to improve the property. For most house flippers, they buy distress property at about 40 cents on the dollar and invest another 20 cents on the dollar to get the property ready for sale. Then it is just a matter of time to get it sold. Their total investment is around 60 cents on the dollar. So, just like a house flipper, a value investor considers buying the current investment with a 40% discount (paying 60 cents on the dollar).

During the first quarter of 2022, Coke’s price to book ratio is around 11.2; a 40% discount means that Coke’s intrinsic value is about a 6.72 of price to book ratio. The current book value is $5.78. Thus, intrinsic value will approximate $5.78 X 6.72 or $38.85.

Reasonable and Objective

Overall, two separate objective and reasonable approaches were used to validate the intrinsic value range established in the prior section. The first involved discounting the market price to earnings ratio at least 25%. Again, higher stable operations such as Coke, warrant a minimum market price discount of at least 20% in order for a value investor to take the risk and tie up capital for an unknown period of time while they wait for the market price to recover to the long-term price to earnings ratio. The more stable and less volatile the entity, the deeper the discount the value investor should consider when determining intrinsic value tied to price to earnings.

The second tool used is similar; but this tool is tied to the book value. Review the company’s price to book value, look at the history of the book value. For entities with very strong dividend payouts, the book value rises slowly over time. In contradiction to this are entities that limit their dividend payouts to under 30% like Disney. The retention of the difference forces the book value to step up significantly from one year to the next. In their case, their market price to book value hovers from 1:1 to as high as 4:1. Whereas Coke pays out almost all its earnings as dividends, their price to book value rarely goes below 7:1. Look at Coke’s price to book history over the last 10 years:
During the recession time period of 2008 through 2011, the price to book was low. Then it slowly rises to today’s 11 to 1 ratio. 

Notice how it hasn’t gone below a 7:1 ratio since back in 2016 to 2017 time frame. Thus, buying this stock at a 6 or 7 to 1 price to book ratio is considered an excellent buy assuming earnings have not decreased. 

Both independent tools indicate that intrinsic value in the upper 30’s to low 40’s is REASONABLE and OBJECTIVE. This matches the RANGE of intrinsic value covered in the prior section. The key is to get a warm fuzzy that the intrinsic value range determined withstands many separate tests and although the tests may indicate values just outside the range, the delta involved isn’t unusual or dramatic. Therefore, it is with a strong degree of certainty that Coca-Cola’s intrinsic value is indeed between $36 and $41 per share. Thus, buying at about 5% discount to intrinsic value to provide some margin of safety is acceptable and pretty much guarantees the investor a good return on their investment. A buy price between $34 and $39 per share is going to reward the investor well. The market will return to high price to earnings at some point for this stock and when it does, the value investor is going to be rewarded well.

The real value is the fact that Coca-Cola keeps earning money from one year to the next, even during a recession or some unusual event, like COVID. This continuous earnings means that the intrinsic value is constantly improving. This tells any investor that intrinsic value is FLUID.

Intrinsic Value – Fluid with Time

One of the top 30 companies in the world is McDonalds. McDonald’s average net profit percentage is in the low 20’s. Thus, it is a top notch producer of profit for its shareholders. Each quarter, McDonalds generates about $2.50 per share. Therefore, over a 92 day period, it is netting 2.7 cents per day for each share. Intrinsic value is tied to the 2.7 cents per day. The current intrinsic value assumes earnings of 2.7 cents per day. When McDonalds adds a new location, it earns a little bit more for that share each day. Over time, the earnings per day per share improve to 2.8 cents. Thus, each day, the intrinsic value is constantly changing. With high quality companies, it generally tends to improve over time. 

This fluid state requires the value investor to modify the intrinsic value on a regular basis. Customarily, it is done each year when the annual report is released. With some companies, this intrinsic value changes slowly. Coke is one of them. Since Coca-Cola pays out almost of its earnings as dividends, what is earned as profit has limited reinvestment utility; as such, future growth is slow and sometimes feels lethargic for a shareholder. A value investor must be aware of this and recognize that intrinsic value will improve, but very slowly over time. 

This ties to the market price too. The market price doesn’t fluctuate dramatically for Coke. Look at Coke’s market price over the last ten years:

Coke’s market price has improved from $25 a share to $60 a share over 10 years. This is a direct reflection of its ability to earn a profit. The key is volatility; it just simply does not exist with this company.

Yes, it is true Coke’s stock price dropped more than 25% in March of 2020. However, every publicly traded company saw their share price drop from mid February through March due to the COVID pandemic. Coke’s market price dropped more than 30%. But at no other point along this graphical time line has Coke’s market price changed more than 15% in a short time period, or for that matter even over long time frames. It has continuously improved (with the noted exception). Intrinsic value follows the same curve line over the same time frame. When Coke’s price dropped suddenly due to COVID, intrinsic value did not suddenly drop. Intrinsic value is tied to the long-term picture; market price is a today value.

This is just another example of why highly stable operations are coveted by all investors. Value investors have to recognize that opportunities to buy low with highly stable operations are few and far between these market price points. This brings into play core principle number four, patience.

With Coke, intrinsic value is constantly improving; slowly but surely over time. Intrinsic value is FLUID.

With some companies, intrinsic value can have severe changes in value from one year to the next. As an example, Union Pacific bought back some of its stock during 2021. It paid much more than intrinsic value to buy back this stock. In effect, the company used cash, $7.3 Billion, to buy back stock. Aggregated intrinsic value decreased $20 Billion from $120 Billion to $100 Billion. This outflow of assets shifts existing value off the balance sheet. This in turn reduces intrinsic value to existing shareholders, resulting in increased risk too. 

Value investors must be aware of the various activities that can increase and decrease intrinsic value. These actions affect intrinsic value from one quarter to the next, one year to the next. Thus, intrinsic value is FLUID.

Intrinsic Value – Summary

There are three rules with intrinsic value. First, intrinsic value is a range of values. Different elements of the various intrinsic value formulas can vary the outcome from relatively conservative estimates to high outcomes with more liberal element application. The key here is to narrow the range to a reasonable zone. This is where rule number two comes into play. That range of value should be reasonable and objectively verified. It is important to utilize other tests and tools to ensure that the range is reasonable and not extreme. Extreme results will result in either no opportunities to invest in the particular security, or when one does invest, it will not result in a good return. The more tests an investor can apply against the intrinsic value range, the more objective the outcome gets and the more confident the value investor is with the range.

Finally, a third rule exists. Intrinsic value is in a constant state of change; it is fluid in price. The mere fact the company operates each day changes the value incrementally each day. As profits improve, intrinsic value goes up. In some cases, the governing body of the company can make decisions that dramatically affect intrinsic value. Readers of financial statements must be on the look-out for these intrinsic value impact factors. 

Most importantly, intrinsic value exists within a RANGE of values; it should be REASONABLE and OBJECTIVELY verified; in addition, it exists in a FLUID state and can instantly change.

This is the first article in a series on intrinsic value. The series continues with the balance sheet approach to calculate intrinsic value. In addition, there is another article which covers income statement intrinsic value formulas. After that article is another explaining how to determine intrinsic value using cash flow. There are still others, they include utilizing business ratios and determining intrinsic value utilizing key performance indicators. The final article sums all this up. For the reader, the key is that there is NO SINGLE UNIVERSAL INTRINSIC VALUE FORMULA. Value investors must apply several formulas and test the results to gain a high confidence that the intrinsic value range is valid. ACT ON KNOWLEDGE.

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The post Intrinsic Value – Definition and Introduction first appeared on ValueInvestingNow.com.

Shifting from economic wide factors that impact market price to industry wide standards is essential with understanding and creating decision models for investment with a pool of similar companies. Industry standards are a part of the spectrum of business principles. This spectrum starts with tenets, universal rules that can not be broken by anyone in business. With value investing, the focus is on the primary business tenet of buying low and selling high. It is an undeniable requirement to increase one’s wealth. The spectrum moves towards core business principles that sometimes are not universally applicable. The final set are industry standards. Each industry has its own unique set of principles it must follow to be successful. Some are a function of law, others are driven by consumer expectations or the culture of the industry. For value investors, understanding this dynamic set of standards for each industry drives the holistic thinking of effective investing.

Value Investing – Industry Standards, A Pyramid of Principles

There is no universal finite set of business principles. In the aggregate, there are over several hundred of them. Many of them are not applicable to every industry; on the contrary, many are specific to a unique business or industry. The best approach to understanding business principles is to look at this in a holistic manner, i.e. overall doctrine down to a few rules specifically designed for that one business.

In effect, think of business principles as an inverted pyramid. The base of the pyramid consists of business tenets, common universal principles. Tenets support the next level, fundamentals. Fundamentals are the more common thoughts that most business managers use to govern their operation. However, some of these fundamentals are not applicable to all corporate operations. At this level, there begins separation of the tenets of business based on multiple variables including markets, business sectors and the underlying industries, customers, employees and vendors. In many cases, this level of the pyramid is impacted by law based on the various levels of our government system. The final tier supported by fundamentals is called standards. This level of principles involve customs, guidelines, rules and procedures.

Look at this depiction:

Notice that tenets are relatively few, again they are universal in nature and applicable across all industries. Fundamentals are the bulk of principles that exist. The reason for this is that many fundamentals are set by economic restrictions and law. The final upper tier is industry and business specific principles and are uniquely defined by the sector and industry.

This article is merely an introduction to the pyramid, other articles on this site go in-depth related to each of the tenets of business and of course fundamentals. Many of the standards are located in the pool of investments of this site and often include the respective accounting processes and operational issues the industry uses to implement the fundamentals.

To illustrate, a tenet of business is cited. The fundamentals of its importance are compared and contrasted using two different business operations. The comparison does not cover all the standards for each of the two business operations but just identifies one or two standards they each may use to comply with their respective fundamentals.

Tenets

Principles that are universal to all businesses are tenets of business. If any single business or industry can operate without this tenet or can break this principle, then this principle is really a fundamental and not a tenet. The principle must be applicable to all industries, all sectors, all aspects of operations and dealings with employees, customers and vendors.

As example, there is one tenet that all corporations must follow.

Efficiency and Effectiveness

Efficiency and effectiveness are the yin and yang of business. When one of these two elements is given more credence then the other element falters. The key is to balance them appropriately. This balancing act is different for every industry and is customarily driven by the respective purpose.

Efficiency refers to utilizing the least amount of resources to deliver the product or service. Intuitively, many companies focus on efficiency as this reduces the overall cost allowing for a profit on the bottom line. Effectiveness refers to delivering the correct product or service. Without it, the customer is highly unlikely to purchase again in the future. Every company must weigh these two elements in delivering the product or service. Use poor quality parts or resources to reduce costs (increasing efficiency) and the company increases the risk of being ineffective with delivering the product or service.

Remember though, certain industries will place more value on one element over the other as the other element may not be as valuable to the customer. For example, think of a medical surgeon. Undoubtedly, a surgeon needs to be effective, many people will say no matter the cost. However, this isn’t true. You see, the surgeon is bound by the hospital’s need to exercise efficiency to keep costs down in order to comply with insurance company restrictions. Furthermore, many families simply cannot afford to pay an open-ended arrangement to be effective with the surgery no matter the cost. As the importance of one element increases the other can give but there are limits.

On the flip side are businesses that place a lot of emphasis on efficiency and less on effectiveness. However, they must still deliver the product or service the customer demands.

A good example is the electric utilities business. Efficiency, both scientific and administrative are necessary to keep costs under control. For them, every step of the process requires efficiency to reduce costs. For the consumer, they are only interested in having the source of energy at 120 volts, 60 Hertz. Thus, it is easy for an electric utility company to be effective, but difficult to maintain efficiency. Thus, the emphasis is with efficiency over effectiveness.

This efficiency/effectiveness tenet exists across all business sectors and industries. However, the fundamentals will be different tied to the respective sector and industry.

Fundamentals

Fundamental principles are not always universal. For some industries, certain principles are solely theirs. That same principle may not be applicable to another industry. For example, there is a principle with business known as the range of production. It’s basic definition states that a business should produce products at the maximum point of production (think of a manufacturing plant) to maximize profits. This principle assumes all products produced will be sold in the market.

The range of production is a key business principle used with many business sectors and industries. The mere fact that the principle has a restriction, ‘… assumes all products produced will be sold…’, makes it a fundamental principle and not a tenet.

This principle is utilized with the following industries:

• Consumer Products Manufacturing
• Food Production
• Service Sector

However, this principle is not applicable with some businesses.

As stated earlier, one of the common restrictions related to fundamentals is government regulation. A good example is the new marijuana industry. Although demand exists, state governments (specifically California, Colorado and Massachusetts) have set limits for production and restrictions to operate retail stores. Thus, this fundamental is not applicable to this particular industry. Since the range of production principle is not universal, it is considered a fundamental principle and not a tenet.

Going back to the two businesses used above for the efficiency and effectiveness principle, the fundamentals related to this tenet are going to be different. For the utility company, since efficiency carries greater regard, their business fundamental principles are focused on this tenet. For example, their efficiency issues will be science driven with production of electricity and distribution to the end-user.

As for the surgical business, their fundamental principles are focused on effectiveness. Some of their business principles may cover:

1. Proper Diagnosis (Hiring of Qualified Staff)
2. Acquisition of Lab Results in a Timely Manner
3. Patient Evaluation (Good Timing and Potential for Best Results)

Don’t misunderstand, the doctor’s office still has to practice some efficiencies in order to control costs and ultimately generate profits for the medical partners. But the overall business principles they use will defer to effectiveness over efficiency.

What is really fascinating is that each business will create their own standards, most often mimicking other similar businesses. These standards are not as encompassing as fundamentals, they are focused on one or two elements of the overall operation. Since most operations have hundreds, sometimes thousands of different elements to conduct business, standards can and are often voluminous with business operations. Think of all the manuals some companies follow in order to conduct business.

Standards

Many industry standards are tied directly to higher level fundamentals and a few are generated as a direct result of a business tenet.

Think of the surgery practice, their standards are oriented towards effectiveness in helping their patients get healthier. The clinical staff must have appropriate credentials, all operational practices are designed to maximize effectiveness from proper specimen draws to cleanliness. It’s about being effective.

Whereas with the utility supplier, standards are focused on efficiency. Something as simple as safety reduces downtime for the utility operation. Thus, standards are put in place to create uniformity and consistency across the entire organization to maximize uptime with production of electricity.

Even their financial standards are set against the industry standards for just about every aspect of production. Think about:

• Raw Resources Consumption and Energy Output
• Distribution Systems and Maintenance
• Business Ratios
• Proper Debt Financing

The financial standards used with utility operations are significantly different from those for the medical practice. One is a conglomerate whereas the surgical operation is most likely a partnership. Their legal structures, operating management team and insurance principles will be completely different.

Summary – Industry Principles and Standards

Every form of business operates under different standards. However, many businesses still utilize similar fundamentals but one industry or sector may exercise more fundamentals or different ones depending on the various forces that guide them. But there is one set of universal principles known as tenets. Here, all businesses have to follow these tenets as no one is exempt. With this understanding of the various levels of the pyramid of business principles the reader can begin to understand that there are hundreds of business principles out there. Use the above as guidance to help you understand your respective pool of investments. ACT ON KNOWLEDGE. 

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The post Value Investing – Industry Principles and Standards (Lesson 25) first appeared on ValueInvestingNow.com.

Value Investing – Market Forces

A simple illustration is warranted here. Using hotels as the model, Hilton Worldwide has $11.4 Billion in long-term debt and operating leases. See this snippet of Hilton’s liabilities section from its balance sheet 2020 annual report:

1. Choice – Every buyer and seller is given the choice to exchange their resources for a product or service. With value investing, choices are focused on the buy and sell points for investments. 
2. Opportunity Cost – When a transaction is completed, each party has lost at an opportunity to sell it higher or buy it lower. It also refers to an alternative buy or sell which may have better risk or reward. 
3. Supply and Demand – Defined as the willingness to buy or sell a product/service.
4. Market – Centers where suppliers and buyers meet to negotiate the equilibrium of value.
5. Equilibrium – The final net exchange price between a willing buyer and seller.
6. Price – The exchange rate between two parties.
7. Competition – Many sellers and buyers vying for resources.
8. Macro/Micro – See above.

All eight of these will come into play as a value investor. Throughout these lessons, anytime one of these affects the principle or particular situation, it will be noted and identified to the member. The key is that it is so important to be on the alert for these economic concepts and their respective impact on a business financial model.

In addition to the impact economics plays on a financial model, there is another equally impactful aspect of value investing. This is the business model.

Value Investing – Business Model

In business there are four distinct business models. Just about any business can be identified with one of the four. The following are the four types of business models:

1. Low-Volume, Hi-Margin
2. Hi-Volume, Hi-Margin
3. Low-Volume, Low-Margin
4. Hi-Volume, Low-Margin 

No single model is the best nor the worse. Each works within their respective industries. In general, the models exist by default and it is highly improbable that the model can move into another one of the types without changing the particular business sector/industry. An illustration is appropriate. 

Wal-Mart is by far the most significant retail player in the world-wide market. They control about more than 11% of all retail. They definitely follow the Hi-Volume, Low-Margin model mostly out of default. All of their competition uses the same model. It is impossible for Wal-Mart to shift their model to Hi-Volume, Hi-Margin format. Their customer retention would fall dramatically if they raised their prices. But, this model works well with the retail industry.

At the other corner sits Boeing. Here, it is low-volume with a hi-margin. Nobody is going to mass produce huge airplanes; it literally takes several years from start to finish constructing an airplane. Quality control is a cornerstone of their business and even a little error can cause huge repercussions. They could go to the low-volume low-margin section but the overhead costs would cause the company to lose money. If this happens, they would go out of business. Out of necessity, this type of industry exists using this model.

Some businesses lean more towards one of the four but may have elements of two of the business models within its structure. It isn’t as if every business has to fall distinctively within one of these four types. But some bleeding over exists between two of the types is rare not the rule.

The following sections below explain the four types of business models and provide examples of businesses that use this model. In addition, this article elaborates as why the model is successful in the respective industries and that no single model is absolutely the best. 

Low-Volume, High-Margin Business Activity 

An extreme example of this type of business is a shipyard. Imagine how long it takes to build an aircraft carrier. In reality, it takes a little over 8 years from start to finish. Prior to laying the keel, there are several years of engineering and material requisition requirements to build the carrier in an efficient manner. Then there is the construction period and the testing period before final delivery is made to the Navy. In effect, one product taking 8 years employing several thousand workers has to cover its share of the overhead and profit for the company. To do this, the final product may have hard costs of materials and labor that is half of the final price charged to the Navy. The bulk of the sales price has to cover all the equipment used, facility costs, general overhead, licensing (the government just doesn’t let anyone handle nuclear material), taxes, and a host of other costs to run a shipyard.

The following are more examples of low-volume, hi-margin businesses:

Large Companies

• Aircraft manufacturing – Boeing
• Heavy Equipment manufacturing – Caterpillar, Komatsu, Hitachi & Volvo
• Military Equipment manufacturing
• Large Industrial/Commercial Contractors – Bechtel, Fluor & Kiewit

Small Business

• Engineering Design/Build Companies
• Metal Fabrication
• Marine Fabrication/Construction
• Home Construction/Remodelers/Renovators 

There are certain business attributes that force the industry to exercise this model. They are:

• Significant initial capitalization (financial, perseverance, and knowledge);
• Almost all work is project based and requires extended time periods to complete;
• Highly complex interactions and resource management;
• Little competition 

Notice that in this model, although it is a low volume company, the term reflects the physical quantity, not the dollar value. Go back to the shipyard, an aircraft carrier is ONE item (low volume) but the sales price is nearly $8,000,000,000. That’s billions of dollars. 

In small business, it is really the same concept. For construction, it is ONE house, but it is an expensive item. It is the only way that a company can cover the indirect and overhead costs associated with running a construction company. 

Now on the flip side of this are industries that have high volume and high margins.  

High-Volume, High-Margin Business Activities 

Absolutely this is the preferred type of business model to have due to the contribution value both extremes bring to the company. But these types of companies are not as common and often have significant capital barriers to start operations. Mostly they are in the professional services industry such as law, accounting, engineering, and in some of the medical specialties. In general, the margins are in the 40 to 50% range. This is mostly attributable to variable costs as the primary cost driver. The following are some other examples of these types of businesses: 

• Coffee Retail/Coffee Supply
• Software Manufacturing
• Entertainment (Music Albums, Movies, Videos, Games)
• Hospitality Based Businesses (Hotels, Motels, Golf Courses etc.) 

An example of a large company with a high margin and a high volume is Apple. The I-Phones costs less than $450 to manufacture and get to market. Retail prices run in excess of $1,000 for the device. Apple sells nearly 100 million units per year. This is a rare business model that has driven the stock price off the charts. 

This type of business model is ideal. Typically in these types of business models, the overhead and capitalization costs are higher than other models. This is mostly attributable to the development of manufacturing facilities, distribution systems and reliance on technology. In addition, competition is keen as others seeking to enter this type of business model seek the same high margins this model provides. In effect, lucrative returns create competition. 

Another factor necessitating the high-margin requirements relates to higher than normal fixed costs. In many of these types of operations, fixed costs are recorded in the overhead section of the profit and loss report and therefore are not a function of cost of sales.

High-Volume, Low-Margin Business Activities 

This type of business model is traditionally seen in the retail and other consumer based product businesses. The following is a list of businesses that use this model:

• Convenience Stores
• Gas Stations
• Grocery Stores
• Fast Food Restaurants
• Retail Outlets
• Transportation (Bus Lines, Distribution, Taxis, etc.)
• Service Based Operations in More Discretionary Income Dependent Areas of Business
  • Nail Salons
  • Hair Salons
  • Massage Parlors 

An interesting business attribute is the low capitalization threshold to enter the market. 

One last interesting fact about these types of businesses; this is most common form of business in our consumer based society. This reflects several business attributes:

1. Easy entry for small business;
2. Low capitalization barriers;
3. Low knowledge thresholds;
4. Many support systems;
5. Limited government compliance requirements. 

In this type of model, the gross margin in absolute dollars is a direct reflection on volume. Competition is significantly keen. The best example of this are gas stations. In general, most gas retailers only have about an 18 cent contribution margin per gallon of gas sold. When the station down the street has his price 10 cents lower, he is really trying to garner market share that week. 

By the way, the number one company in the world using this business model. You guessed it: Wal-Mart. 

Based on this, you would think that it would really be tuff in your low-volume, low-margin business activity. Why would anyone get involved in that type of business model? Let’s find out. 

Low-Volume, Low-Margin Business Activities 

This one is the most interesting of all the business types. With low-volume low-margin operations the reader would wonder how on earth you would make a profit. Well, it turns out that there is another way to look at the equation. Less experienced business entrepreneurs always think in terms of margin as a percentage of sales. Experience and a little more sophistication teaches us that it is really about the absolute dollars. Which would you rather have? 

1. Sales of 200 units in one day at 18% margin or
2. One unit at 13%? 

Answer: It depends on the sales price. Assume that in A, the sales price is $7 per unit which means that we have sales of $1,400 and the dollar contribution margin is $252 (this is your high-volume, low-margin business model). OR in B, the sales price is $14,000 with a contribution margin of 13% which is $1,820. 

$1,820 is superior to $252. What industries fall into the type of model? Typically your household goods and high ticket items follow this model: 

• Auto Retail
• RV Dealerships
• Marine Dealerships
• Appliance Sales
• Jewelry and Luxury Goods Retail 

These industries typically have higher overhead costs and compliance related costs. Since buyers of the product are rare, advertising becomes a significant portion of overhead costs. Just watch TV for half an hour and about a 1/3 of your commercials relate to the local auto dealerships trying to convince you they are the best. 

The negative attribute of this model is the higher than normal risk associated with acquiring customers. Any reduction in market share can wreak havoc with the financial profitability of the business. 

Summary – Types of Business Models

Some businesses will fall in the marginal areas of one or more of the models above. A good example is a furniture retailer. In general, furniture has a high margin with low volume. But many furniture outlets try to shift their model towards higher volume with lower margins; thus the constant bombardment of advertising from them with their endless sales.  

Overall, each of the models described above works for particular industries. The shear nature of the industry forces their hand into the respective model. When you think about your pool of investments, which model is utilized? Combining economic wide forces with the respective business model allows the value investor and opportunity to appreciate the particular pool’s business characteristics and it sets the stage for calculating intrinsic value and the corresponding buy/sell points. In the next lesson, it is essential that value investors understand the number one force affecting investments – the Federal Reserve. Act on Knowledge. 

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The post Value Investing – Concepts of Economics and Business Models (Lesson 19) first appeared on ValueInvestingNow.com.

“Money makes money. And the money that money makes, makes money.”– Benjamin Franklin

Every student of investing is taught the core principle of discounted cash flows. This business principle is also used with intrinsic value. Application of discounted cash flows assists value investors with determining intrinsic value. Academia, major investment brokerages and the majority of investment websites place unquestionable belief in this single formula to equate value for a security. The problem is that all of them forget or ignore the underlying requirements to use and then, rely on the outcome of the formula’s solution. In effect, with intrinsic value and the application of discounted cash flows, there is a very narrow set of highly defined parameters whereby this tool is applicable and useful. Used outside of this framework, the result’s reliability quickly drops to nearly zero, similar to how the bell curve moves from the most likely outcome in the center to extremes on either side.

Look at this bell curve. Application of discounted cash flows can produce an excellent solution contingent on NO or limited deviation from the norm (the highest point in the curve). This article starts out by identifying the highly restrictive requirements to apply discounted cash flows. There are at most 20% of all marketable securities where this formula succeeds in determining intrinsic value. Secondly, the formula is explained to the investor and why it is so important to apply it properly. There are several terms and values the user must include in the formula; this section explains them in layman’s words.

The third section below goes into the corporate financial matrix to explain how to determine cash flows. Furthermore, cash flows are just not the past year or years; it is really about future cash flows. How do you equate value from an unknown variable well into the future?

The final section puts it together when determining intrinsic value. Unlike what others state, intrinsic value is not a definitive value; it is a range. The job of the value investor is to narrow that range to a set of values that are reasonable and effective with generating gains with the value investor’s mindset of ‘buy low, sell high’.

The overall goal of value investing is to buy a security at less than intrinsic value, commonly referred to as creating a margin of safety; then waiting for the market price to recover to a reasonable high and then selling that security. The depiction here illustrates this concept well.

The most popular method to determine intrinsic value is the discounted cash flows method. Experts espouse this tool because it is advocated in the book Security Analysis written by Benjamin Graham and David Dodd, the fathers of value investing. However, most so called experts didn’t read the entire book. Graham and Dodd only used this method under certain conditions. The same conditions as explained in the first section below. They strongly encouraged calculating intrinsic value from the assets valuation perspective (balance sheet basis) and not as a function of earnings plus cash adjustments (cash flow). What so called intelligent professionals fail to recognize and embrace is that the discounted cash flows method is only used under a limited set of parameters. The discounted cash flows method is taught in every business major and is most commonly used with the finance (banking) degree. The bleed over into investing propelled this formula to the forefront of investment lingo because it appears to resolve several complex needs. The reality is utterly different. The following section goes into detail about this particular finance algorithm and the restrictive set of conditions with which to apply the formula.

Discounted Cash Flows – Highly Defined Set of Parameters

In the perfect world, there is no inflation, there is no cost of money and a particular investment would return the exact same amount of interest year after year without risk; without failure to continue; with constant demand by the market for the product and no deviations from performance. It is simply flawless. Here, one can easily determine the return on one’s investment; it is simply the cumulative sum of all future earnings in the form of cash less one’s investment.

As an example, a farmer is selling you a goose, yep, the one that lays a golden egg every day and the goose never dies. The farmer is just tired of watching the goose. You agree to buy it for $10,000. The market never changes, the egg weighs exactly one ounce and the goose produces one egg a day forever. Gold prices never change, gold is $10 an ounce. Thus, after one year, you earn exactly $3,650. Each year after, you earn another $3,650 and this goes on forever. As stated above, the conditions are perfect:

• The goose requires no maintenance;
• The goose will live forever (doesn’t get run over, doesn’t runaway, nor gets eaten by a predator);
• The goose is never stolen;
• The goose requires no food, no water; just sits there and lays an egg a day;
• Gold prices stay exactly the same, $10 for an ounce;
• There is no inflation;
• Every egg is exactly one ounce of pure gold;
• There is constant demand for gold;
• Life is good.

Well, this investment seems easy to calculate. After 3 years, you have earned $10,950 and you’ve gotten your original investment back plus some. Now, the investment will just continue to provide you with $10 a day for the rest of your life, your children and grandchildren’s lives. This is just too good to be true.

Notice how unrealistic this really is. First off there is inflation! Because inflation is the number one issue with lending money, an investor has to take this into consideration. Buying a security is very similar to lending money. Financial resources leave your pocket and in return you get a piece of paper with a promise to pay or some type of rights to control the outcome. This desired payment whether as interest on a bond or as a dividend for stock is the return on the investment you crave. This so called return will not happen immediately. You will receive these incremental payments over time. Thus, inflation decreases the value of each incremental payment. Assuming each incremental payment is equal and inflation is nominal, the payment received 30 years from now will be almost half in comparison to the first payment you will receive. A simple annual inflationary rate of 2% means that the payment received 30 years from now is only worth 55 cents on the dollar. If the inflationary rate is 4%, the value of that future payment drops to 31 cents on the dollar.

This is what the discounted cash flows is referring to when talking about making an investment. Again, all other parameters are perfect; its just inflation you need to consider.

This too is unrealistic. Other factors come into play. Now the formula starts to get more difficult to calculate. The most obvious is that the core formula assumes the cash payments are equal. The market doesn’t work that way. With bond payments, yes; with dividends, the answer is no. Dividends are constantly changing. Value investors only consider high quality, top 2,000 companies to invest with; these companies have continuously improving dividend payments. With most, dividend payments almost double every ten years. Now, there is a new dynamic brought into the formula. Not only do we have to discount the cash flows for inflation, but the cash flows are not even throughout the life of the investment.

For the discounted cash flows method of determining value to work well, it assumes a highly defined set of restrictions including:

• The discount rate is stable throughout the life of the investment;
• Cash inflows (periodic payments) are positive and predictable;
• There is a high degree of certainty for future cash inflows;
• The investment is pure, i.e. little to no chance of default (bankruptcy, insolvency etc.).

There are only so many publicly traded securities that meet this criteria. Immediately, any reasonable investor would automatically eliminate penny and small-cap investments. These types of investments are tied to young growing companies. It is highly unlikely that the discount rate will remain stable even in the short-term forecast (next three years). Any new product or service this company provides is unpredictable related to market acceptance and more importantly, competition. It is nearly impossible to state with a high degree of confidence that there will be future net positive cash inflows for this company. The simple truth of the investment is that companies that fall within this market capitalization spectrum have a much higher degree of default both in the form of bankruptcy and almost certainly at times, insolvency.

Middle capitalization companies are in a much better position than penny and small caps. However, they lack the one key element with exercising the discounted cash flows formula – stability of earnings. Only high quality, top 2,000 companies can demonstrate a long history of continuous positive earnings. It is from earnings that an investor begins the necessary adjustments to determine cash flows. This is explained further in the third section below. The key for the investor is that the discounted cash flows method to determine value is only effective with top notch corporations. The required attributes include:

1. Large market capitalization based companies, in general, the top 2,000 companies; this supports the attribute of longevity of existence into the future (the goose will live forever).
2. Highly stable history of positive earnings demonstrates the ability to produce cash; think of the goose laying the golden egg each day.
3. The company produces goods/services that will remain in demand by consumers for the foreseeable future; this matches the attribute of demand for gold.

Even out the top 2,000 companies, a recognizable portion are unable to demonstrate these three required attributes to apply the discounted cash flows tool. A perfect example is Tesla. Tesla lacks history of earnings and secondly; Tesla has competition and therefore it is difficult to have a high level of confidence that there will be demand by consumers for its vehicles six to seven years from now. To further validate this, General Motors recently announced its intention to develop and sell electric autos starting in the mid part of this decade. This will eat into Tesla’s market share of the electric car market. The novelty of owning a Tesla has worn off.

The above attributes can be summed up as follows:

• Security – low risk companies
• Positive earnings
• Stable and desired product mix

For those of you that are savvy investors, the attributes mirror those attributes used with the dividend yield theory. The difference is that value investors are not buying solely for dividends, they are buying low to ultimately sell high in the near future, generally within two years. The dividend is just an additional benefit. The real value is the growth in the market price for the respective security.

If the attributes exist to apply this formula, then the investor needs to understand the formula’s two most important elements.

Discounted Cash Flows – Formula Analysis

The discounted cash flows formula is straightforward. How much is a certain set amount paid in a given period in the future worth today? If the payments are made as a stream over several periods of time, the net result is the cumulative sum of each individual period.

All the periodic payment periods are spaced equally apart, like a month, a quarter or a year. Each successive period has the discounted rate raised by the power of that period. Therefore, the formula is:

Discounted Cash Flow Value =   Cash Flow Period 1          PLUS       Cash Flow Period 2        PLUS     Cash Flow Period 3    PLUS     …
.                                                    (1 + Discount Rate)¹ Power of One           (1 + Discount Rate)² Power of Two         (1 + Discount Rate)³ Power of Three      

The impact of time reduces the value of a future payment significantly. Look at the following table for a payment of $100 per year over 15 years given four different discount rates.

Period     2%         3%          5%          8%                         
1           $98.04    $97.09     $95.24     $92.59
2             96.12      94.26       90.70       85.73
3             94.23      91.51       86.38       79.38
4             92.38      88.85       82.27       73.50
5             90.57      86.26       78.35       68.06
6             88.80      83.75       74.62       63.02
7             87.06      81.31       71.07       58.35
8             85.35      78.94       67.68       54.03
9             83.68      76.64       64.46       50.02
10           82.03      74.41       61.39       46.32
11           80.43      72.24       58.47       42.89
12           78.85      70.14       55.68       39.71
13           77.30      68.10       53.03       36.77
14           75.79      66.11       50.51       34.05
15           74.30      64.19       48.10       31.52
Totals   $1,285   $1,194      $1,040       $856

If you study the table and look at the graph, there are several important aspects of the discount rate that an investor must understand in order to give the discount rate its proper respect. First off, as the discount rate increases, the end results decreases. Furthermore, the longer the time frame involved, the lower the value each extending period out produces for the investment. In effect, what this table and graph illustrates is that a $100 per year cash inflow for 15 years will return $1,500. However, depending on the discount rate involved, the value of that $1,500 is going to be only effectively worth so much today. 

To illustrate, assume a company proposes to sell its bond to you for exactly $1,000 of value. In exchange, you will receive exactly $100 per year for 15 years. There is no terminal payment; just a flat $1,500 in equal installments. Remember, this bond must meet all three ot the criteria to qualify to use the discounted cash flows method when evaluating an investment. First, it must be a secure investment (assume its a Walmart Bond). Secondly, the company must have a history of positive earnings; Walmart qualifies for this particular required attribute. And finally, the company provides a highly desired product mix; Walmart fits this attribute too. Thus, this investment offer meets all the required criteria as a solid investment.

Now the question is – What is my discount rate? Looking at the table above, if you use 5% as the discount rate, it means you get $1,040 of value over the course of 15 years. Since you are paying $1,000 for the investment, you are technically increasing your wealth by $40 over this 15 year time period.

As an alternative, the bank is offering to pay you 4% interest per year on a $1,000 Certificate of Deposit. This means that over 15 years, you will receive $1,400 ($1,000 of principal and $400 of interest). Whereas with the bond, Walmart is willing to give you $1,500 over the same time period. Thus, the discount rate with the Walmart bond is slightly more than 5.5%. 

The key for the investor is that the discount rate is your personal desire for a rate of return on an investment. If your personal rate is 6% return, then the bond isn’t worth $1,000 up front; you are forced to offer a lower value for the rights to receive $100 per year for the next 15 years. It turns out, at 6%, you are willing to pay $971.22 for the rights to the $100 annual payments. This doesn’t mean the seller, in this case Walmart, will accept that; what it means is that the two parties are close. Walmart is willing to pay 5.5% interest and the buyer wants 6% interest. If another investor is willing to accept a 5.5% return on their investment, then Walmart will sell to the other party. This is supply and demand. 

This is the exact same relationship with any security in the market. How much are you, the buyer, willing to pay to own a certain set of rights? The most coveted right is a financial reward for your investment. With bonds, investors want interest and of course the original principal back. With stocks, investors want both dividends and an increase in value of the market price for that stock. The right to vote your shares have little to no value for the common stock trader.

In order for the market price to increase, other buyers in the market must be willing to pay more than you paid for the same stock certificate. There is only one way this is going to happen. The company must be growing which in turn creates desire with other investors. The industry is stable and the economy is not in a recession. Growth is defined as continuously increasing earnings. 

Don’t forget, time with the discounted cash flows formula works against value. The further out the cash inflows are received, the lower the overall worth of that respective inflow. Go back to the table, look at the 8% column and go out 15 years. With a discount rate of 8%, the $100 payment is only worth about 32 cents on the dollar. Time is of the essence with the discounted cash flows formula.

For value investors, what they seek to do is to set a low buy price for a particular security. They also want some assurance the particular security’s market price will increase in a reasonable period of time in order to sell this security at a higher price and earn gains. The discounted cash flows formula is used with certain types of companies because it can effectively provide a comfortable buy price if the discount rate is tolerable by investors. The key is that the value investor’s discount rate must be higher than the market’s tolerated discount rate. This allows the value investor to buy the security at a lower price and then sell this security in a market that believes a lower discount rate is reasonable and acceptable. This part is explained in more detail in the final section below. For now, the investor wants to know how do you determine cash inflows? What exactly are cash inflows?

Discounted Cash Flows – Corporate Cash Flows

In the last section, emphasis was placed on both the discount rate and the period of the investment. But the formula has another essential element necessary to equate a final value – cash inflows. If you asked 20 professionals to define cash flows for the discounted cash flows formula, you will get 24 to 30 different responses. There is no single correct answer; there are good answers and poor responses.

At one end of the spectrum of responses, an investor will tell you that the only cash inflow that counts with the formula is the actual cash the investor receives, i.e. dividends and the proceeds from the final sale of the security. Is this the appropriate outcome for cash flows in the formula?

At the other end of the spectrum, a professional investor will state that cash inflows equals earnings net of taxes, plus depreciation/amortization and any other non-cash adjustments. This is commonly referred to as cash flow from operations. The thinking here is that this cash flow covers both reward to the shareholders and any remaining cash is used to maintain or expand the company’s operations which ultimately benefit shareholders as growth results in greater dividends in the future.

If you look at how profits are typically used, they are used for four different purposes:

1. Pay dividends to shareholders (this is the preferred outcome for most stockholders);
2. Expand operations by investing in new property, plant and equipment and/or research and development;
3. Reduce debt; AND
4. Set some money aside for adverse economic conditions that may arise in the future.

Other investors will take a more conservative approach than the extreme position of cash flow from operations and state that cash inflows equals cash flow from operations less the amount necessary to keep the company in the same economic position as it started at the beginning of the year. In effect, it equals cash flow from operations less investment in property, plant and equipment. This particular point along the cash inflows spectrum is referred to as ‘Free Cash Flow’.

The best answer the author has researched and agrees with is that cash flows equals actual value a shareholder will receive whether immediately in the form of dividends AND/OR via growth of the company in the future. The key is that growth is different for each industry. Some industries are expanding at phenomenal rates (think of geriatric care, home health and mining) and others are contracting, i.e. in decline (coal, paper information such as periodicals, newspapers etc.). Thus, any retention of profits to fund expansion has a different return on that investment depending on the industry’s position in the economy. Invariably, any dollar retained is not going to grow at a rate a dollar in the hands of the investor can earn via reinvestment. In effect, the discount rate for retained dollars must be higher than the discount rate an investor would use with actual cash received in the form of dividends or interest. The end result is a highly complex formula to derive a current value for cash inflows.

Fortunately, the very restrictive nature of the formula’s requirements eliminate industries in decline; remember, one of the required attributes to apply the discounted cash flows formula is a strong and desirable services/product mix for the investment under scrutiny. For the investor, growth from the respective retained earnings will never match the return on reinvestment from immediate cash returned to the investor (dividends and interest); thus, utilize a slightly higher discount rate to compensate for this dampening impact growth has with retained dollars.

Thus, a good answer to determine cash inflows is as follows.

Cash inflows equals net earnings adjusted for:

1. 1. Unusual or extraordinary events (most often losses) net of the respective tax effect from the event;
   2. Adding back depreciation/amortization;
   3. Less a reasonable reinvestment into existing property/plant/equipment to maintain the company’s respective position in its industry; AND
   4. Less a reasonable investment to expand the company’s position within its industry.

This formula almost mimics free cash flow as commonly defined by academia. It is different in that there is an additional deduction to fund growth. This additional dampening value reduces cash inflows with the formula and ultimately the net present value of those inflows. In most cases, this dampening value approximates 20% of average depreciation from the most recent three years.

The key to making this work is to use the average earnings adjusted for the respective four items above from the last seven years. If the company is growing, there will be an average growth determinant from this history. This growth rate is used for determining future inflows over the next five years. In addition, to keep the formula straight forward, the sixth iteration is the projected cash inflow for the sixth year times a factor of 20 discounted back to today’s dollars. This way, the investor doesn’t have to project out for another 20 years. The core intrinsic value outcome using the discounted cash flows method has marginal contribution beyond 25 years, go back to the table above, the results are dropping by more than 3% per year after 15 years. Thus, there is not much contribution from a value in the 26th year utilizing the discounted cash flows formula.

To illustrate this, look at the historical earnings and the adjusted earnings for Norfolk Southern Railroad.

Norfolk Southern Railroad
Values are in Millions of Dollars
Year     Reported Earnings    Unusual Items     Depreciation/Amortization     PPE Maint     Growth Invest   Adjusted Earnings
2014           $2,000                           $281                          $956                                   (1,219)              (191)                      $1,827
2015           $1,550                           $290                       $1,059                                   (1,276)              (212)                      $1,412
2016           $1,663                           $181                       $1,030                                   (1,309)              (206)                      $1,359
2017           $5,400                      ($3,001)*                     $1,059                                  (1,335)              (212)                       $1,911
2018           $2,660                              $2                         $1,104                                  (1,368)              (221)                       $2,177
2019           $2,717                           $288                        $1,139                                  (1,391)              (228)                       $2,525
2020           $2,013                           $484                        $1,154                                  (1,379)              (231)                       $2,041
Total                                                                                                                                                                                     $13,252
Average Earnings Per Year                                                                                                                                                    $1,893
Growth Rate (Approximate Value using Compounded Growth Rate)                                                                                    5.6%
*This reflects adjustment for the tax rate change under the new law passed in December 2017.

This means the cash flows for the next six years including the sixth year as a multiplier of 20 equals:

2021             $2,002 Million
2022             $2,114 Million
2023             $2,233 Million
2024             $2,358 Million
2025             $2,490 Million
2026            $52,579 Million (Factor of 20 for sixth year result)

Reasonable discount rates are between 3.5% and 8% depending on the industry. The greater the stability of earnings, the lower the discount rate. The railways industry has six publicly traded companies, not a single one has lost money in any year in the last 20 years. Stability of earnings for this industy is highly reliable; railroads are a very secure investment. Thus, the discount rate for this industry is 4%. The discounted cash flows result at a 4% discount rate for the above inflows equals:

$51,481 Million

The number of shares outstanding today is 252.1 Million. Thus, each share’s intrinsic value using the discounted cash flows method at 4% equals $204. If the investor used a 3.5% discount rate which is not an unreasonable value, the value per share increases about $5 per share. Today’s market price (03/15/21) for Norfolk Southern is $261 per share and the entire industry’s market prices are at their all-time highs. This site’s value investment fund currently has its buy trigger set at $180 per share for Norfolk Southern; i.e. there is a 12% margin of safety against the intrinsic value. The 2022 intrinsic value reset is conducted at year end. All the above elements in the formula are updated and the algorithm is rerun to derive the updated intrinsic value based on discounted cash flows.

From this section with application of discounted cash flows, the reader learned that determining cash flows from the prior seven years is a derivative of adjusting earnings for unusual items, depreciation, investment back into property plant and equipment and finally a reasonable cash investment to fund growth. The outcomes are averaged and a growth rate is calculated. The final adjusted earnings average is then extrapolated out for the next five years and a terminal value is merely a factor of 20 for the sixth year of growth. All six final values are discounted based on a reasonable discount rate as determined by the industry’s performance. Some helpful guidelines are:

• Growth rates for top 2,000 companies RARELY exceed 8% per year, a more common growth rate is between three and six percent per year; 
• Discount rates are from 3.5% to 8% depending on the nature of the industry and the economy as a whole;
• In most cases, the adjusted average earnings will always be less than the most recent reported traditional financial earnings due to reinvestment requirements;
• Do not apply a growth rate to any value beyond six years;
• Stability of earnings is the number one factor when determining the discount rate, the better the stability the lower the discount rate;
• Only use the discounted cash flows formula contingent on the respective entity meeting the restrictive attributes for application:
  1. Low risk companies (long and positive history of performance)
  2. Always positive earnings
  3. Service/Product mix desired by consumers

Discounted Cash Flows – Intrinsic Value Range

There is no such thing as a definitive dollar value for intrinsic value. Intrinsic value is constantly changing, just like the market price for stock. Each quarter, earnings are reported and the end result is a change to intrinsic value. When intrinsic value is less than $50 per share, it is important to get the result within plus or minus 5% (approximately $2.50 per share). As the intrinsic value increases towards $200 per share, the investor should be able to get the intrinsic value to within plus or minus 3% (up to $6 per share). 

Thus, certain factors in the above formula drive accuracy with determining intrinsic value using the discounted cash flows method. Since the formula is only effective with highly stable and profitable companies, the formula user must accept that the outcome is going to be an estimate. Look at all the variables involved with determining an outcome:

• Determining Adjusted Earnings
• Calculating a Growth Rate
• Establish a Discount Rate

Which of the above variables has the greatest impact on the outcome for intrinsic value? Let’s explore.

Discount Rate
The discount rate has recognizable impact on the outcome. A mere 1% change in the discount rate changes the final intrinsic value output by $7 per share. This is just a little over 3%. Thus, it is important to have a proper discount rate. Remember, the higher the discount rate, the more conservative the intrinsic value result. For example, if the discount rate for the above Norfolk Southern Railroad were 5.5% and not 4%, the intrinsic value drops to $189 per share from $204.

Factors that impact the discount rate include:

1. 1. Current Inflation Rate
   2. Industry’s Position Within the Gross Domestic Product Algorithm – Is it improving? If no, an investor ups the discount rate about .5%; positive gain in the overall GDP does not impact the discount rate.
   3. Investor’s Cost of Capital – If an investor has to utilize borrowed funds to make the investment, the end results needs to be more conservative thus the discount rate must increase. Add 1.5% to the discount rate for every 1% interest an investor must pay beyond the current 15 year mortgage interest rate.
   4. Personal desire for risk, a higher discount rate reduces risk.
   5. The stability of earnings for the respective potential investment, the better and longer the history of stable earnings, the lower the rate.

These factors are covered in more detail during Phase Three of the membership program on this site.

Growth Rate
A company’s growth rate is driven by many variables. The most important is of course the management’s team decisions about the future of the company. How are they pursuing additional revenue streams, reducing costs, improving efficiencies? Most mature companies do not have high growth rates. If they are performing well and have introduced plans to make improvements or broaden the sources of revenue, growth for mature companies can hit as high as 8%. Realize that mature companies have already completed their respective fast growth periods in their life cycle. The respective industry can only garner a certain percentage of the economic sector they exist within. Thus, growth often comes at the expense of other members within their industry. 

The growth rate includes the expanding economy. Thus, most companies have at least 1.5 to 2% annual growth as this is the growth rate for the entire economy. The industry may experience its own growth due to new products or shifting of consumer needs. Thus, for most large mature companies, growth rates of more than 4% require objective justification; in effect, the investor must provide substantial evidence of this growth. 

For Norfolk Southern above, their growth was driven by several factors over this six year period. First, the company grew the volume of trainloads by more than 3%. In addition, it was able to reduce its operation ratio by almost 10% during this time period. This alone added more than 3% of the 5.6% growth rate used in the formula above. Therefore, these two factors along with economic wide growth is how this company ended up above 4% growth rate.

Growth comes from multiple sources. Broadening revenue streams is the most common growth impact factor. But some industries are already at their maximum revenue capture; thus, revenue growth can only occur by expanding market share or introducing new venues (with railroads, think of new lines or customer cooperation agreements). Other sources of growth include reducing costs of sales, reducing overhead costs or changing the product mix for a better margin. 

With Norfolk Southern above, the 5.6% compounded rate reflects the continuously improving bottom line as a percentage of revenue. The result was derived using the compounded growth rate formula which is more conservative than the average growth rate formula. 

The growth rate impacts the volume of earnings expected in the following year and then the compounding over the next five cycles for six full cycles. Since profits for highly stable top 2,000 companies are in the hundreds of millions of dollars, a single percentage change with growth can extrapolate out into about a couple of hundred million dollars with the cumulative absolute cash inflows determinate. The discount rate dampens the final value the growth rate generates. Thus, the growth rate can impact the final intrinsic value about one to two percent. It is important to pay attention to it; but in the overall equation, it has the least impact.

Adjusted Earnings
Adjusted earnings has the greatest impact on the intrinsic value formula. A mere $10 Million on average from the prior seven years will affect the intrinsic value by at least $1 per share. Thus, being off $100 million per year with a railroad formula can result with an outcome that is more than 3% off. 

With the formula above, the averaging effect dampens any incorrect result from a single year. The key is to get the data straight from the annual financial reports. The investor must utilize all three of the primary reports – balance sheet, income statement and cash flows statement. Each of the respective elements are covered in great detail in Phase Three of this site’s membership program. For now, the above is just an introduction to the formula. Don’t forget, as stated above, often the formula is modified or adapted to every industry. The formula above doesn’t work as well with highly leveraged industries such as banking and insurance. It can work with real estate and the hospitality industry; but does require some slight modification. The adjusted earnings formula is customized for every industry. 

The key is that intrinsic value is never a single dollar value. It is a range. The goal is to keep the range narrow by selecting the most appropriate values (discount, growth and earnings) that will shift this range higher or lower. Ideally, intrinsic value will have a range of plus or minus 3%. With an estimated $200 per share intrinsic value, the value investor’s range will be $194 to $206 with $200 as the most likely intrinsic value. With lower market price shares, getting to within plus or minus 5% is the target. The risk factor does increase with lower price shares, but an investor offsets this with a higher margin of safety such as 25% safety margins from the mid-point of the intrinsic range. Getting that range as narrow as possible is mostly impacted by determining adjusted earnings (cash inflows for the prior seven years). The discount and growth do have a bearing on the final result, but nowhere near the impact adjusted earnings has on the result.

Summary – Application of the Discounted Cash Flows to Determine Intrinsic Value

Discounted cash flows is a popular but highly misused investment formula. As it pertains to calculating intrinsic value, it is almost always improperly applied. The discounted cash flows formula is highly reliable within certain parameters. The respective security under scrutiny must be backed by a highly stable historically top 2,000 company in the market. There are three required conditions:

1. Security – low risk companies
2. Positive earnings
3. Stable and desired product mix

If the conditions are met, the formula is viable. The formula is:

Discounted Cash Flow Value =   Cash Flow Period 1          PLUS       Cash Flow Period 2        PLUS     Cash Flow Period 3    PLUS     …
.                                            (1 + Discount Rate)¹ Power of One        (1 + Discount Rate)² Power of Two     (1 + Discount Rate)³ Power of Three      

This formula is merely stating the current value of future cash inflows. Cash inflows are a function of several factors that greatly affect the end result. In general, cash inflow equals net earnings adjusted for:

1. Unusual or extraordinary events (most often losses) net of the respective tax effect from the event;
2. Adding back depreciation/amortization;
3. Less a reasonable reinvestment into existing property/plant/equipment to maintain the company’s respective position in its industry; AND
4. Less a reasonable investment to expand the company’s position within its industry.

This adjusted earnings outcome is slightly modified for every industry. It is not purely applicable across the board. Investors must take into consideration several other factors depending on the industry considered for investment. This outcome, called adjusted earnings, has the greatest impact on the final intrinsic value result. Two other elements of the discounted cash flows formula also impact the outcome, but not to the degree as adjusted earnings. The discount rate can change the outcome a little more than 3% for every 1% change in the discount rate. The growth rate is the final element and has the least impact on the outcome. However, it is still important to ascertain the growth rate as it does assist in getting a more accurate intrinsic value result.

Finally, intrinsic value is never a single dollar value; it is a range. The goal is to get the final result to plus or minus three percent of a reasonable value. The greater the confidence with the formulas underlying values, the lower the margin of safety necessary when purchasing a security. Always increase your margin of safety percentage with lower market price stocks, i.e. less than $50 per share. ACT ON KNOWLEDGE.

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On February 21, 2020 the Dow Jones Industrial Average was 29,000, on March 23rd, 2020 it reached the 18,600 mark and hovers in the 24,000 range during the month of April, 2020. The underlying driver for this decrease is COVID-19 and the required shelter in place mandate by most state governors. The economic impact is yet to be determined. This is the uncertainty aspect of economics. The term ‘economic uncertainty’ has a historical definition which has been modified due to the pandemic response. This article will cover the historical meaning and then its updated definition. The term is redefined due to the Paycheck Protection Program loan applications. One of the requirements is for the owner of the company to certify that their business meets the definition of economic uncertainty. The historical definition and the current legal definition are different. Thus, it is important for the reader to differentiate between the two meanings.

Economic Uncertainty – Historical Definition

If you think of the economy as a train pulling a load on the track, you would base its near future position on its current and historical trend. It is unlikely its current speed will change; thus, we can predict its future position with some degree of confidence. The short-term position is easier to determine with greater conviction and accuracy than 3 to 6 time periods out. Why does our confidence decrease the further out in time the train travels? Inherently, we know that there are variables that can impact the outcome. What if the train slows down? What if there is engine trouble? Worse yet, what if the track is blocked and the train must stop to wait for repairs?

In economics, these unknown variables are referred to as uncertainty. Uncertainty is typically measured and reported at the macro level. This is due to vast resources available to predict the economic results in the near future with a high level of certainty. Again, the further out in time the prediction is made, the more uncertain the forecast becomes.

Economic uncertainty is rarely reported at the micro level. In effect, each of the industry groups, or even at the corporate level, has to take into consideration all the factors that impact their respective situation. The U.S. Federal Reserve prepares economic uncertainty reports and provides data for a slew of variables such as:

• Foreign Trade Policy
• Interest Rates
• Consumer Debt
• Unemployment
• Manufacturing Production
• …

At the micro level, this isn’t prevalent; thus making it difficult to evaluate economic uncertainty, especially for a small business.

The end result is that economic uncertainty is a macro level term defining the ability of the economy to continue on its current path in the near and long-term.

Economic Uncertainty – Modified Definition

The term ‘economic uncertainty’ is used with the application for a loan under the Paycheck Protection Program administered under the Small Business Act. On page 2 of the application, the 2nd certification uses the term ‘economic uncertainty’. In effect, the applicant states that the current economic uncertainty makes the loan request necessary. It is here that the historical definition comes into play. The macro level of uncertainty, i.e. the current COVID-19 pandemic affects the ability of the applicant to continue operations. Therefore, the applicant must take into consideration the macro factors and customize them to their respective operation, i.e. convert economic uncertainty to the micro level.

Interestingly, the text of the Congressional Act (Public Law 116-136) provides guidance for the applicant. Under Section 1103(a)(4) there are either three criteria experienced or a separate fourth condition to qualify. They are:

(D) is easy to understand. Those businesses mandated by state government to close, commonly referred to as ‘non-essential’ meet the requirement and easily qualify to affirm economic uncertainty. Those in the marginal areas will run into problems validating economic uncertainty. A good example would be a company servicing restaurants such as the linen service provider or meat vendor. These businesses will experience a decrease in sales but not a total stop to operations. Will they qualify?

The Act specifically states that all three A, B, & C must be experienced. Thus, those operations that slow down in overall production and sales will most likely not qualify for the Paycheck Protection Program. The applicant must document and provide substantial evidence of all three minimum criteria. This will be difficult as all criteria have its own set of nuances. For example, under (A)(iii), how does the applicant substantially prove technological difficulties? Will the fact that certain customers are closed and therefore they do not respond to phone calls and e-mail qualify?

The real question is how much change must be experienced to qualify for certification related to economic uncertainty. It is the author’s opinion that the change in the aggregate must equate to more than 25%.  At the individual variable level, the change must be a minimum of 5% but that in the aggregate, all three variables must add up to a minimum change (overall production) of no less than 25%. Any change less than 25% can be the result of factors not related to COVID-19 and the associated macro response. The key is to be able to convince a court of law that the applicant experiences economic uncertainty directly related to the current economic situation. The greater the impact, the more likely the courts will agree that at the micro level the applicant is experiencing economic uncertainty. ACT ON KNOWLEDGE. 

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  Value investing utilizes a buy low, sell high tenet of systematic processing of stock and other security investments. Value investing reaps substantially greater returns than all other major market measurement indices (DOW, S&P 500, Russell 2000, NASDAQ, etc.). The average annual pre-tax return is >20%. When you subscribe, you receive access to all existing articles, books, lessons, webinars and reports explaining how value investing works. In addition, each month, the subscriber receives additional articles, reports and buy/sell points for high quality stock purchases. Follow along as the fund updates regularly and discover how to invest like a pro and earn excellent returns on your investment. Subscription is for one year of access to the value investing pool of information.

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Insolvency refers to the inability to pay bills in a timely manner. It does not mean bankruptcy but long-term insolvency is an underlying factor of bankruptcy. Many owners and/or managers of small business have no idea of how to determine if the company is insolvent or headed towards the inability to meet their day-to-day obligations. This article is designed to assist the reader in understanding how to detect actual insolvency or identify potential insolvency.

Prior to reading this article, please be sure to read the introductory article: Insolvency and Bankruptcy – Know the Difference as it is a great lead in to the more sophisticated information provided here. There are several links throughout this article to assist the reader in understanding other elements of insolvency. If you are having trouble understanding some of the formulas, please refer to the material linked to help you.

This article will first teach you about the basic tools used to detect insolvency. Other articles on this site will explain this in more detail using trend lines to evaluate a company’s ability to pay its current liabilities. Finally, I will explain some tricks and nuances related to insolvency so that you have a well informed position of knowledge related to insolvency.

Insolvency – Basic Tools of Detection

There is one tenet of insolvency the reader must remember and keep in their mind at all times. Insolvency is an extended time period and not a single moment in time. In effect, it takes several months to become insolvent and rarely does it exist for a short duration, such as one or two days. Again, insolvency extends over a long period of time, at least two months and often over many months (more than six). Given this, the tools to test for insolvency must be exercised over time, and not for a single day or a few days.

An illustration is an excellent way to make this point.

Remember, insolvency means that the company has an inability or trouble meeting all of their obligations. Obligations consist of current liabilities and payroll. Obviously, it takes cash to pay the liabilities. Look at this simple balance sheet.

                                        XYZ Company
                                         Balance Sheet
                                              12/31/17

Current Assets:
    Cash in the Bank                  $141,205
    Inventory                                210,200
    Total Current Assets                                    $351,405
Fixed Assets                                                      300,000
Total Assets                                                     $651,405
Current Liabilities:
   Accounts Payable                $175,110
   Payroll Due on Friday             65,291
   Total Current Liabilities                              $240,401
Long-Term Debt                                               185,000
Equity                                                               226,004
Total Liabilities & Equity                               $651,405

It is apparent that XYZ cannot pay their current liabilities including payroll. There simply isn’t enough cash in the bank to meet the obligation. This is a single moment in time, it looks bad doesn’t it?  Well, let’s modify this a little. Assume that accounts payable are not due immediately but are due at the end of January. Only the payroll is due immediately. Can XYZ meet their obligation in the upcoming week? Yes, they can. $141,205 is more than enough to pay the staff on Friday. Is XYZ insolvent? It’s hard to tell at this point, so having an understanding of the other factors can greatly impact your thinking. Questions to would ask include:

• Did the company recently make dividend payments to the owner(s)?
• Will the inventory turn over during the month of January?
• Since there is no accounts receivable, is it safe to assume the inventory is paid in cash at the point of sale?
• Is there a line of credit available to utilize in case cash is needed?
• Do the payables have longer terms, such as due in several months?
• Is this company a seasonal operation?

The last question is interesting, because if this is a summertime operation, i.e. the company sells mulch; then I might be concerned about solvency. But let’s say its a government contractor in Minnesota that provides road salt for various parties that must pay immediately upon purchase.

A preliminary test to identify insolvency is the current ratio. It is simply all current assets divided by all current liabilities. With the above example the current ratio is:

XYZ’s Current Ratio = $351,405     = 1.46:1
                                      $240,401

As long as the current ratio is not less than 1:1, it means the company is solvent based on this ratio. However, notice that it is an instant ratio, just for this one moment in time. To better evaluate the company, the ratio should be reviewed for each month ending for the prior six or more months to get a line graph of the ability to pay its current liabilities. Naturally, the higher the result, the better off the company is to meet its obligations. Ideally, ratios of 3:1 or more are best.

There is a drawback to using the current ratio and its the inclusion of inventory in the numerator. Often inventory is a significant sum and it can leverage the ratio higher. Therefore, another ratio is considered superior. The quick ratio which excludes inventory really identifies the ability to pay current obligations immediately. For XYZ Company the quick ratio is $141,205 divided by liabilities of $240,401 or .588 to 1. This is a big red flag for just about any company out there.  Ideally, quick ratios of 1.5 or higher are good; over 3:1 is coveted.

As with the current ratio, this ratio should be plotted over several months to identify a trend line.

To augment the above two ratios, other ratios will help to identify cash flow skills including the inventory turnover ratio, the accounts receivable turnover ratio and finally the cash ratio. The cash ratio is even more restrictive than the quick ratio as it only includes cash in the numerator and excludes all other current assets. With really small businesses, this ratio is best but again, it is easily manipulated as it only tells the story on that day.

Finally, the owner/manager will want to review the cash flows statement, specifically the cash flows from operations section to confirm the operations ability to earn cash and how the cash is utilized throughout the statement’s time period.

If there is one thing learned from this section, you need to remember this: 

When using any ratio, all data points should come from multiple time periods to identify a trend line and not just a moment in the life of the operation. 

The next section will help you to understand this trend line concept more clearly.

Insolvency – See the Whole Picture

Although the various ratios are helpful in identifying the trend line of cash status, the best tool to evaluate insolvency is looking at the whole picture.

A novice entrepreneur will misunderstand what cash is all about. In your more successful operations, the owners purposely keep the cash position low. As he company earns the cash via profits, the cash is distributed to the owners via dividends, draws or distributions depending on the nature of the company. Review the equity section, specifically the debits related to payments made to the ownership. If this number is high and occurs regularly, it is a key sign the company is a cash cow and is working well. Here insolvency is not an issue as the owners can easily put cash back into the company at a given moment’s notice.

Other important points of interest include:

• Cash Outlays for Fixed Assets
• Principal Payments on Long-Term Debt
• Status of Tax Obligations
• Industry Standards

All of these impact the picture of insolvency. For example, those involved in real estate especially housing, it is not uncommon to have low ratios and sometimes very extreme ratios due to debt issues. When an apartment complex is restructuring its debt, the ratios can get wonky to say the least. Those businesses in the service industry will also have odd ratios because there is very little inventory involved. For them, the accounts receivable turnover ratio becomes the primary ratio to evaluate the ability to have cash flow and of course meet the current obligations. Thus it is important to understand the industry while detecting insolvency.

One last helpful hint, look at the accounts payable aging report. Is this value increasing over time? Is it shifting towards a higher average age? This is a key sign of inability to pay current obligations and a good source of understanding management’s overall ability to generate cash from sales.

Summary – Insolvency Detection

Notice in the above sections, the focus is on the balance sheet and not the income statement. Insolvency is a balance sheet issue. The income statement only comes into play to confirm profitability. Losses over several periods will eat into the cash position thus affecting the ratios above. But in general, stay focused on the balance sheet, utilize the liquidity ratios and evaluate insolvency over time. ACT ON KNOWLEDGE. 

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Of the basic business principles, economies of scale has the greatest impact on profitability over any other business principle. As an enterprise’s investment is spread over higher volume the cost per unit of production decreases. The differential between sales price and cost changes add to the overall profitability for the company.

Economies of scale exists in two distinct forms. One isn’t reported in the financial statements and is referred to as the ‘learning curve’. The second form is identified in the financial reports and is called ‘leverage’. When both forms exist in a business and tweaked to perfection, efficiency is maximized and therefore profits reach optimum peaks. Once achieved, the business must exercise the same forms of scale as they grow from a start-up to a publicly traded company.

Learning Curve

Children are the perfect examples of how learning works. After failing in their first attempt they’ll try a different tack until they achieve success. With each attempt the time decreases significantly at first, then marginally after achieving success; basically they get faster. It is human nature.

This same behavioral process exists in business. It exists in all aspects of operations, management and ownership. If management utilizes the feedback loop, the decision process continuously improves and the positive results are economies of scale. To illustrate this the reader needs to understand how the learning curve is applied in operations, management and in overall ownership.

Operations

With operations the learning curve is demonstrated in small incremental steps. Simple human movements (ergonomics) increase speed and effectiveness. Better employees are always looking for ways to make their jobs faster and easier. Even the custodian finds ways to be more effective such as timing of cleaning, frequency or using stronger detergents. The curve is constantly in action.

The goal is to maximize human energy for peak performance thus reducing the cost per unit of production. An illustration is prudent:

In a pizza shop one of the employees notices that when an employee took a phone call for an order, the employee would take the order, wash his/her hands, make the pizza and spend time rotating the pizzas in the oven. There are five employees working, each responsible for the order they took on the phone. After observing this pattern for several days he suggests dividing up the work process. This allowed one person to be focused on producing pizzas reducing his hand washing frequency. One person took the calls, one made the pizza, another cooked/rotated and boxed the pizzas. A fourth checked the customer out at the register. Instead of five, now the same workload is performed by four employees. Here is the math:

Prior Method
Pizza Production per Hour                    18
Hourly Wage Per Worker                  $12.00
Five Workers Wages/Hour                $60.00
Cost Per Pizza                                     $3.33

New Method
Pizza Production per Hour                     18
Hourly Wage                                      $12.00
Four Workers Wages/Hour                $48.00
Cost per Pizza                                      $2.67

The new method reduces the labor cost per pizza by 66 cents. Over a course of a single night serving 70 pizzas the pizza shop saves $51 in labor. Extrapolate this value over a couple hundred nights in a year and the profit increases $10,200.

For those of you not familiar, the process change illustrated above is referred to as division of labor. Basically, the business scaled the labor and generated a positive economic return.

Management

Management learns from their decisions too. If willing to try new approaches to problems and test different methods management can continuously improve operations which scales the business up for more profits.

Continuing with the same pizza shop, suppose the demand for pizzas increases to 36 pies per hour for three hours on Friday and Saturday nights. The shop’s problem is the inability of the existing oven to handle that volume. The oven can only handle 20 pizzas per hour. One option available to management is to replace the existing oven with a conveyor drive oven that can process 42 pizzas an hour at a cost of $4,800.

Can the pizza shop gain economy of scale converting to a new oven system if the contribution margin is $5.00 per pizza?

The answer is a simple math problem. The marginal increase is 16 pizzas per hour (36 pies per hour less the volume from the traditional oven of 20 pizzas per hour) for three hours, two nights a week at $5.00 per pizza. Therefore:  16 pizzas * 3 hours * 2 nights * $5 each = $480 per week. In ten weeks the new oven is paid off. Now the pizza shop is scaling up production by expanding capacity.

Management needs to be careful because all production exists within relevant ranges. Using the same situation above suppose the demand for pizzas is actually 21 an hour for three hours per night, two nights a week. Is there an economy of scale now?

Answer: One additional pizza generates a marginal gain of $5 per hour times 3 hours a night times 2 nights per week which equals $30.00 per weekend. It will take 160 weekends (3 years) to pay for the new oven. Under these circumstances, purchasing the new oven would be a mistake. There is a range of production in business that has a bearing on economy of scale. In the case illustrated the new oven would operate at the low end of capacity whereas the existing oven operates at its high end of capacity. Economy of scale is more efficient at the higher end of capacity. But often the real value of the learning curve comes for the top of the company; the owners.

Ownership

Owners of small businesses reap huge profits when the owners learn from their mistakes. If they are willing to change and adapt to what is wanted or even what works well, the profits can soar. Often owners fail here, more out of pride than anything else. They often refuse to believe that their original idea is a low performer or even a failure and just like the captain of the ship they go down in the sinking.

But if willing to learn and change, they can garner the value of changing to what generates real value. The following is a true story the facilitator experienced,  only the name of the company was changed to protect the owners.

Advanced Restoration performed water, fire and storm damage repair services for insurance companies. I was hired as the controller. Once I learned about the industry and the respective nuances I converted the accounting system to class accounting. Basically, I recorded jobs based on the three major divisions of work. After one year of information I determined that water based work (flood damage, water leaks, etc.) generated significantly greater profits. The two owners, Ray and Fred, were at an impasse as to how to proceed.

Ray was interested in the volume of revenue. The business had grown to $3 Million  in sales per year in less than three years. During that three year period total losses exceeded $250,000. Fire damage jobs had much greater revenue per job due to structural damage. Ray desired more fire damage work because the average sales volume per job was two to three times more than water based work.

Fred was more conservative and had deeper pockets. He had much more at risk. Explaining to him the math involved and his knowledge of construction influenced Fred to shift towards more water work. It was to no avail. Ray’s adamant position that higher revenue meant profits in the long run won out. He firmly believed that economy of scale was revenue driven.

After two years of working there I estimated, knowing Fred’s personal wealth position, the company had maybe a year left at best. The revenues were much higher but now the losses were getting larger and the cash flow tighter. Ray refused to accept the obvious and Fred’s loyalty to Ray predetermined a certain fate. The business lasted a little longer than one more year.

In this real life example, Ray thought the economy of scale exists in the form of higher revenue. Economy of scale is a function of any one or more business attributes that drive profits higher. It is not limited to revenue.

GREATER REVENUE IS NOT THE SOLE PERFORMANCE FACTOR IN GENERATING ECONOMIES OF SCALE. ECONOMIES OF SCALE IS A FUNCTION OF MAXIMIZING PROFITS WITH THE LEAST AMOUNT OF RESOURCES.

The learning curve is most often exercised via people, processes and product as illustrated in the examples above. But most business entrepreneurs equate economies of scale to the financial aspect of business.

Financial

The most common interpretation of ‘Economy of Scale’ is financial based. Simply stated, invest more capital, ramp up operations and generate more profit per unit of production.

Financial investment into more equipment or having additional working capital can speed up production. Greater production generates more margin which then covers overhead costs quicker adding to the bottom line sooner. All of this is predicated on demand from customers for the product or service. This is why novice business owners are adamant about volume and not efficiency. In the majority of cases volume does generate economies of scale, but to truly peak profits businesses must do both, generate efficiency and expand volume. As an example:

Corey owns a carpet cleaning operation with two vans and steam cleaning mounts (actual pump and suction system mounted inside the van). Each van/mount system costs $40,000. Corey has seen growth in business over the past few years. Each unit (van/mount system) generates $170,000 in sales per year on average with a contribution margin of $90,00 per unit.

His accountant has advised him that to cover the costs of adding another unit to the business would necessitate an additional $75,000 in sales. This is a 23% increase in volume for the carpet cleaning company. Is it realistic for a small carpet cleaning operation to increase volume 23% in a single year? It is highly unlikely, maybe in two years but one year is unrealistic. Corey should expect severe losses during the first year of operations.

If Corey could generate an additional $170,000 in sales for this new unit, his contribution margin would increase $90,000. Overhead costs would remain relatively stable and his bottom line would increase $90,000 adding significantly to his personal income. For Corey, there are other forms of non-capital investment that can generate additional profits; in effect, greater efficiency.

Other Forms of Economies of Scale

The single most unproductive aspect of carpet cleaning is the actual up time for cleaning. In a typical day about 15% of the van’s utilization is a function of driving between jobs. What if their were less jobs but more production at each job? This is where other forms of economies of scale can benefit the bottom line.

• Knowledge – Having the right people on staff trained in other areas of expertise can generate economies of scale.

Corey decides to add additional accessories to his mounts and now cleans upholstery, curtains, throw rugs and blinds. The technicians receive training for these additional services. Over time each unit increases its on-site time and revenue per job, thus increasing the efficiency per unit.

• Certification – Exclusive recognition by higher authorities for acceptance as a member or associate can also create an economy of scale.

After several years of classes and testing Corey is granted certification to remove blood and human tissue/fluids.  He then submits his business certification to the local governments, morticians and insurance companies. Now he uses his equipment to clean up crime scenes, suicides, accidental and natural deaths.

Corey passes the test for water damage cleanups and insurance carriers include them on their list for homeowner water damage emergency extraction and drying.

• Experience – Experience (like a child learning from their mistakes) allows owners to master the learning curve. In Corey’s case, he has learned that educating the customer about cleaning and household hygiene generates more frequent requests for carpet cleaning and more extended thorough services while the technician is on-site.
• Heart – Loyalty and trust bind customers to businesses. In Corey’s case, over time some regular customers simple left their key for the technician to enter the house. One of his technicians even went so far as to walk the customer’s dog. In return the customer generated several referrals.

After reading the above, the reader will surmise that these four other methods are a form of the learning curve principle.

Summary – Economies of Scale

 Economies of scale is not solely a function of revenue. It refers to maximizing production with the least amount of resources. There are two forms of scaling. One form involves scaling up operations via the learning curve. This includes efficiency with human ergonomics or equipment utilization. It also refers to management learning new approaches to processes. Owners can make a difference with what they learn about business, whether to change the service or product or financially leverage the business. All of these generate economies of scale.

The second form of scaling refers to the traditional definition which is an investment of capital to expand operations and grow sales to cover the additional costs of capital. Any marginal contribution after covering these costs add additional dollars to the bottom line. Act on Knowledge. 

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Break-even analysis is a managerial (cost) accounting tool used to examine the relationship of price to cost of a product. It also considers various sales volumes and the effect on profit given the different relationships of price to cost. The break-even analysis is an essential tool in maximizing profit with the least amount of resources. It goes much further by defining the minimum production necessary to cover (pay) fixed costs at various sale prices. Naturally the higher the sales price the sooner fixed costs are covered with production.                               

This article explains the sales price to cost relationship. The impact of sales volume and how it affects total profit is expounded upon in Break-Even Analysis – Sales Volume and Profit on this website. To grasp the fundamentals of break-even analysis the reader must first understand some basic terms used in cost accounting including:

1) Fixed Costs
2) Variable Costs
3) Sunk Costs
4) Markup
5) Contribution Margin

Secondly, a break-even point is explained and evaluated at different sale prices (price points) and the corresponding contribution margin is determined. Finally a comprehensive example along with an outcome table is derived with insights in assessing the results. Once the fundamentals are understood the reader can now evaluate simple and basic single item break-even analysis.

Break-Even Terminology

There are hundreds of terms used in cost accounting but a few terms are synonymous with cost accounting and they include fixed and variable costs along with contribution margin. These three terms plus two others are often used with break-even analysis and are explained below.

Fixed Costs  – Those cash out costs per accounting period that must be paid no matter what level of production exists. Examples include rent, property taxes, insurance, legal compliance and so forth. Other fixed costs can include:

* Management salaries especially those contractually negotiated
* Labor Force – Minimum staff in place without serving the first customer; think of a hotel crew, restaurant staff and hospital personnel.
* Operational Costs – Utilities, sanitation and maintenance are required no matter how many customers use the facilities. Great examples include swimming pools, resorts, theme parks and government complexes.
* Capital costs of debt service
* Communications – Landlines, internet and cell phones

Variable Costs – Those costs that have a 1:1 correlation or very high dependency on sales are referred to as variable costs. Traditionally, variable costs include materials and labor for products and services rendered. Other variable costs include utilities and manufacturing equipment costs. Variable costs are referred to as prime costs in the food service sector of the economy.  

Sunk Costs  – Some costs are expended and can not be recouped no matter what the company does. A profit can be earned to pay back the investor’s fronted capital used to pay for initial costs; but they can not be directly recovered. As an example, organizational costs to get the company set up cannot be retrieved whereas cash outlays for raw materials for production can be sold as raw materials thus recovering that cash outlay. Typical sunk costs include building construction (some aspects),  specialized equipment purchases and engineering. The difference between sunk and fixed costs is the cash outlay involved. Sunk is where cash has already been expended, fixed are required and ongoing. Usually fixed costs are contractually created like a lease agreement.       

Mark-Up – The percentage increase over costs charged on costs to generate profit. It is often confused with margin which is the percentage of the sales price that is gross profit. For example, a 25% mark-up on costs of $1.00 is 25 cents. The sales price is $1.25. The margin created is 20%; 25 cents is 1/5 (one-fifth* of  $1.25; which equals 20%).

Contribution Margin – This is the value each unit of production generates over variable costs. It is always stated in dollars and rarely stated as a percentage. An item sold for $1.00 having variable costs of 67 cents has a 33 cents per unit contribution margin.  For technical purposes it has a 49% mark-up (33 cents as a percentage of 67 cents equals 49%).

In break-even analysis, sunk costs are not considered in the formula. Only fixed and variable costs are used. Variable costs are at the unit of production level and fixed costs are considered in their totality. The goal of the formula is to calculate the number of units that must be sold to cover all fixed costs after subtracting variable costs. In effect break-even analysis determines the contribution margin per unit needed to offset fixed costs over a production run (multiple units).

Basic Formula For Break-Even Analysis

The concept behind the formula is straightforward. Break-even is the number of units that must be sold to cover all cash costs of fixed and variable. Imagine owning a hot dog cart. It costs $700 per month in fixed costs to operate the cart. As a vendor you have to pay the lease payment for the cart, the monthly food license and insurance. You sell your hot dogs for $5.00 each, they’re the foot long all beef kind with any fixings the customer desires. The variable costs of food, condiments and supplies are $2.25 each. How many hot dogs must you sell to cover fixed costs, i.e. break-even?

The formula is:

# of Units for Break-Even = Fixed Costs
                                              Sales Price minus Variable Costs
# of Units                            = FC
                                               SP – VC
X = $700
        $5.00 – $2.25
X = $700
       $2.75
X = 255 Units

From the terminology section above, contribution margin is defined as the value each unit of production contributes towards other costs. In effect it is the sales price minus variable costs. Notice in the formula the denominator is stated exactly the same way. Since sales price less variable costs is identical to contribution margin, the formula can now be simplified as:

Break-even Point (# of Units of Production) = Fixed Costs
                                                                          Contribution Margin
                                            OR
                                                                  BE = FC
                                                                           CM

For the hot dog cart it is:

          BE = $700   = 255 Units (Hot Dogs)
                   $2.75

It is essential to understand that the break-even point does not include any profit which is used to pay for or recapture sunk costs (historical costs). At this point the hot dog cart vendor has calculated the number of hot dogs he must sell to break-even for cash out purposes. Any units sold in excess of 255 contribute $2.75 each towards profit. Again profit is what is necessary to recoup sunk costs. Take this example further, suppose the vendor wants to earn $2,000 for himself plus $500 to offset his risk (financial outlay at start-up). What is the formula?

The new break-even or production point is the fixed costs of $700 plus $2,500 more or $3,200. This new production point in units is:

Break-even = $3,200   = 1,164 units
                       $2.75

Now let’s zero in on the contribution margin for a moment and explain the impact it has on the formula. Remember markup is the percentage on COST used to determine sales price. If the cost is $2.25 and the contribution margin is $2.75 then the markup as a percentage is:

Markup = $2.75      Contribution Margin
                 $2.25      Costs of Production

Markup = 122.22%

This makes perfect sense as $2.75 is much greater than the actual cost. If the cost were $2.50,  the markup would be $2.50 (sales price is still $5.00); therefore the markup matches cost and would equal 100%. Anytime the contribution margin is greater than costs, markup is at least 100%.

What would happen if the markup was even higher than 122%? To do this,  the sales price would have to go higher (we are assuming that we have no control over variable costs of $2.25 and therefore we cannot reduce variable costs).

If the hot dog vendor goes to a 150% markup, what is the break-even point to cover fixed costs? The markup value is the contribution margin. 150% of variable costs of  $2.25 equals ($2.25 X 1.5) which equals $3.38. The new sales price is variable costs plus contribution margin which equals $5.63 per unit. The new break-even point for fixed costs is now:

Break-even = $700  = 207 Units
                       $3.38

Notice that as the markup increases there is greater contribution margin so unit sales can go down and still cover fixed costs. This goes back to the fundamental business principle of sell high. If you really want to cover fixed costs as fast as possible, sell one hot dog (unit) for $702.25. One unit will cover the variable costs of $2.25 plus fixed costs of $700. By the way, what is the markup?

Markup equals contribution margin of $700 divided by variable costs of $2.25.

Markup = $700
                 $2.25

Markup = 31,111%

THE KEY TO BREAK-EVEN ANALYSIS IS THAT AS THE PRICE FOR THE SALE OF A UNIT INCREASES, CONTRIBUTION MARGIN INCREASES THEREFORE THE NUMBER OF UNIT SALES NEEDED DECREASE TO COVER FIXED COSTS. THE LOWER THE SALES PRICE THE MORE UNIT SALES ARE NEEDED TO COVER FIXED COSTS.

To illustrate how the break-even point is analyzed, let’s look at a comprehensive example.

Break-Even Analysis – Comprehensive Example

Dennis wants to open an auto repair shop and decides to specialize in brakes only.

His idea is to replace existing pads and turn the rotors. After discussing with his CPA, he calculates the monthly fixed costs to operate including his salary will run $13,700 per month. The variable costs for a two brake system, single axle is as follows:

Brake Pads     –           $21.77  (combined for both wheels)
Supplies          –              2.49
Labor                           38.52   (includes taxes and insurance)
Tools                                .41
Total Variable Costs   $63.19

Dennis wants to know how many jobs (customers agreeing to purchase a single axle brake replacement) will it take to cover fixed costs. He has heard his competition mention at least a 50% markup is required. Dennis wants a schedule in 10% increments of markup starting at 50% and ending at 120% to determine how many brake jobs per month must be performed to cover fixed costs of $13,700.

Step 1 – Determine markup values and final sales price for all eight increments

Incremental                  Markup Value           Sales Price
Markup         Cost       Cost * Markup      Cost Plus Markup   
50%            $63.19          $31.60                     $94.79
60%              63.19            37.91                     101.10
70%              63.19            44.23                     107.42
80%              63.19            50.55                     113.74
90%              63.19            56.87                     120.06
100%            63.19            63.19                     126.38
110%            63.19            69.51                     132.70
120%            63.19            75.83                     139.02

Step 2 – Calculate break-even points for various markups

Fixed Costs    Markup %   Contribution Margin  Break-even Units
$13,700            50%                $31.60                           434
13,700              60%                  37.91                           361
13,700              70%                  44.23                           310
13,700              80%                  50.55                           271
13,700              90%                  56.87                           241
13,700            100%                  63.19                           217
13,700            110%                  69.51                           197
13,700            120%                  75.83                           181

Notice the number of units for 50% in comparison to 100% is a multiple of two? At 50% Dennis must do 434 brake jobs; at 100% markup the number of brake jobs is half.

The above tables follow the fundamentals of break-even as outlined in prior sections:

1) As the sales price increases, the break-even point decreases.
2) As markup increases contribution margin also increases.
3) Therefore, as markup increases the break-even point decreases.

To help the reader understand more about the break-even analysis some insights are appropriate.

Insights

A very important business fundamental has to be considered here. Break-even analysis functions perfectly in isolation. That is,  it works well when only one product or service is rendered.

Think about Dennis and his brake shop. What is the likelihood that brakes are going to be his ONLY product? Realistically most customers will not know if their brakes are bad, so how will he get customers? Sure he can offer free inspections, but now he has two services (inspections and brake replacements), each with variable costs.

All businesses encounter this complexity complicating the formula. It is nearly impossible to think of any business out there with a single product where the formula will work in isolation. Therefore, the formula must be modified to account for more business variables. The next article in break-even takes into consideration the sales (units sold) curve when discussing the sales price which is a function of markup. This is just the first of many additional variables the entrepreneur must consider in understanding break-even analysis.

Summary – Break-Even Analysis

All businesses need to evaluate the level of production necessary to cover cash out costs (both fixed and variable). This process is called break-even analysis. The formula is simple in isolation, i.e. a single product or service. It is: 

Break-even Point = Fixed Costs
                                Sales Price Less Variable Costs

The denominator is also referred to as a unit contribution margin which is a function of markup. As markup increases, the sales price increases creating greater contribution margin. As this increases, less units are required to be sold to cover fixed costs.

This relationship of sales price to variable costs and the volume of fixed costs is an important business association that has a significant bearing on profitability. An entrepreneur must understand the core break-even analysis fundamentals in order to succeed in business. ACT ON KNOWLEDGE.

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The post Break-Even Analysis – Fundamentals first appeared on ValueInvestingNow.com.

Those small publicly traded businesses with share prices of less than $5 and capitalization of less than $50 million are referred to as penny stocks. Penny stocks may trade on any of the major stock exchanges. For investors the risk is generally greater and the chance of instant success is remote at best. To counter this relatively volatile environment an investor can participate for a relatively low investment dollar amount.

To understand this investment environment the reader must first understand the corporate legal structure, the growth cycle of business; the different exchanges and their corresponding rules, and the overall risk scenario. The following sections explain these basic penny stock fundamentals. Read them prior to risking any hard earned money.

Corporate Legal Structure

There are several different legal structures for a business. The most comprehensive legal status is the ability to exist as a corporation. The state of residence grants this privilege to an investment group (can be as little as one individual). The investors own a position (a part) in the business by purchasing shares.

Each year the company must renew its entity status with the state by filing notices of renewal and of course paying a fee. each state is different in their requirements but the essential documentation is as follows:

1) A granted legal name and address
2) Notice of filing agent (person to contact in regard to issues)
3) Board of Directors
4) List of Corporate Officers
5) A journal or resolutions

To financially start and fund growth the company is allowed to sell shares of stock. Initially, shares are sold to family and friends giving the identity of a ‘Closely Held’ business.

In the early stages of development the price paid per share is primarily determined by the majority owner. This price rarely has any fundamental relationship to the financial status of the business. Since growth of any sort in business requires expansion of equity more shares are sold.

Business Life Cycle

Just like a baby grows up to be an adult, a business grows too. A child outgrows its toys, clothing and needs. A business outgrows its equipment, office space and management team. At some point a huge investment is needed to set the long-term course for the business. In life we call this college. In business this significant investment in growth can no longer be funded by the closely held owners. The business must seek funding from other sources.

Most businesses utilize the angel investor network or venture capitalists to fund this important step in maturation. Naturally the investment capitalists are merely a temporary step as they desire their money back with a reward. This is accomplished by transitioning the ownership from privately held status to a publicly owned business. The company is ready to transition to the stock market.

Stock Markets

The stock markets are governed by the Securities and Exchange Commission (SEC). In addition each market has its own set of rules and minimum requirements to join. The following is a list of the respective markets and some of their minimum standards to participate. Penny stocks exist in all of them but it doesn’t necessarily make that business a sound investment.

New York Stock Exchange

Without a doubt this exchange has the greatest amount of equity investment in the world. It is one of the oldest exchanges and the most prestigious too. Their requirements for membership are demanding and difficult for penny stock companies to comply. One of the requirements is a minimum share price of $1.00. Membership fees are expensive and compliance is costly. It is rare to find penny stock companies trading on this exchange, most that are trading were robust at one point and are having difficulties maintaining their status on this exchange.

American Stock Exchange

This exchange is where investors find better quality penny stocks. This exchange has high standards of conduct requiring minimum share trading volume, a threshold of unique investors, minimum capitalization and reporting standards. For penny stock companies this is the big league for play.

To assist the reader in understanding penny stocks, the following are the definitions of the various capitalization levels.

Market Capitalization 

Market capitalization is simply the numbers of share outstanding (held by investors) times the market price. Thus, a share trading at $70 each with 70,000,000 shares means the capitalization value is $490 million. Companies are grouped by their capitalization value and assigned a category.

Category                  Value                                           Examples
Large Caps           > $5 Billion                                    Wal-Mart, Exxon-Mobile, GE
Mid Caps             > $500 Million < $5 Billion            Large Shipyards, Kraft Foods, Airlines
Small Caps           > $50 Million < $500 Million        Technology, Manufacturing
Penny Stocks       < $50 Million

NASDAQ

NASDAQ refers to the National Association of Securities Dealers Automated Quotations. This market exchange has a wide variety of all the various levels of capitalization identified above. The requirements are still strict but the costs of membership are significantly less than the two upper exchanges. The bulk of good penny stocks are found on this exchange.

This exchange actually uses tiers or levels of trading and there are minimum share prices for trading to maintain status on that tier. For those penny stocks unable to maintain these minimums, NASDAQ requires the company to participate in its over the counter exchange.

Over the Counter (Bulletin Board)

This is the most common exchange used by penny stocks. It still has minimum requirements to participate and most companies can easily meet the tests.

As stated above it is owned by NASDAQ and all participants must still comply with the federal regulations. The problem here is that often people confuse this exchange with the simple over the counter trading.

Over the Counter Trading

These types of shares are traditionally publicly offered by significant ongoing businesses but restrict their activity to within state boundaries so as not to violate federal law or regulations. Usually only those with money receive a prospectus relating to a stock offering for over the counter shares.

This is a common tool when small local banks start-up or desire to expand in neighboring districts.

Risk

The most important issue of penny stocks for an investor to understand and appreciate is the greater risk associated with this type of investment. Unlike well established operations, risk with penny stocks exist in every aspect of business.

Immature Existence

Almost all penny stocks trading on the market trade for young inexperienced companies. Unlike the large caps at the other end of the market capitalization spectrum, penny stock companies have younger and immature management, lack of history and a product or service that may not hold favor with the consumer. The best comparison is David and Goliath. Unlike the biblical result, Goliath almost always wins in business.

Lower Reporting Standards

Mid caps and large caps have extensive legal and accounting professionals to ensure the highest level of compliance reporting as required by the two bigger exchanges and the federal government. Penny stock companies lack this professional depth due to cost and inexperience. Therefore the quality of information streaming out to investors from penny stock companies leaves a lot to be desired by potential and existing investors. This lack of information creates a heightened sense of distrust and greater extreme reactions to any set of news. These lower reporting fundamentals add to greater volatility in share price.

Low Trading Volume

One of the many drawbacks of penny stocks is the low volume of trading and number of unique shareholders. This lower volume makes the stock susceptible to price manipulation. This includes pump-and-dump schemes. The core problem is that low quality companies trade in lower standard exchanges. These exchanges don’t require extensive reporting compliance plus federal regulators are more likely to ignore illegal activity or problems because the SEC is overwhelmed with issues in the larger markets.

Stock Price Volatility

Because there is low volume and limited number of investors any news about the company creates unreasonable reactions from the investors. The price per share swings can reach 20% frequently causing heartache for investors.

Lawsuit Mania

One the most troublesome aspects of any new business is protecting your rights especially legal ownership such as patents and copyrights. Lawsuits abound at this level most often preventing the company from gaining a foothold with market share. Several lawsuits can cost millions of dollars wiping out young companies.

Investment Requires Sophistication and Patience

If you are looking for a quick buck, penny stocks is not the best course of action. To be honest I have yet to see a legitimate get rich quick scheme that works.

If you desire to invest in penny stocks, read, read and read some more. Get sophisticated in a particular industry, learn how to read financial statements and have patience. It took Warren Buffet more than 30 years to become a billionaire and that was with regular stocks. This site provides the basic business principles used by business; so read, read and read some more. ACT ON KNOWLEDGE. 

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The post Penny Stocks- Introduction first appeared on ValueInvestingNow.com.