Bootstrap Stock Analysis
I'm relatively new to this whole blog writing thing. I've asked for feedback from some of the initial readers of this blog - well intentioned friends and family mostly. A couple of pieces of feedback were somewhat recurring:
1) Some of the posts are, well, a little... long. And dense.
2) The Bootstrap method of stock analysis is not clear.
With that in mind, I thought I'd try to revise the blog entries going forward, chunking them up into smaller bite sized pieces.
By way of practice, I thought I'd spend today's post describing my general method of stock analysis. Then in upcoming posts, walk through each aspect of the analysis with a specific company. So, with no further delay, an outline of the Bootstrap Stock Analysis Process:
Overview: I'll always start with an overview of the company. The purpose here is to understand the basic structure of the company and how it makes money. I'll often go through years of annual reports, sometimes to reports 10 years old, to try to find out haw the company has done over time and if it has delivered as planned.
Common Sense Test: Can I understand the business? I like to think of this a bit like a story line - think more Dr. Seuss less Robert Ludlum. It should be simple enough for you to understand, although if you are a Phd in molecular biology, simple might be much more complicated that what I might consider simple. The point is, you should be able to understand the business and explain how it makes money.
Bear Case: I find it useful to construct a story of why NOT to buy a stock first. Many things in the Bootstrap world may seem backward, but I have a reason. First, I generally get excited when I first start investigating an idea. There is some reason that this company has caught my eye and sub-consciously or consciously, I am trying to find reasons to like the investment. When developing an argument for an investment (or anything else for that matter), I have a tendency to grab data that supports my argument and ignore or resist data that negates my argument. Going through the exercise of thinking about what could go wrong with investment - first - can help you seriously asses what risks this investment might have, plus it reminds me of debate class from high school.
Bull Case: This is the thesis for why this is a good investment. I like to imagine that I am involved in the "Strategic Planning" department of the company. Wearing a power suit, living on repeated injections of coffee. Asking questions like: How many more stores can we really build? What are the new markets that we can enter? Are we best in class operationally or can we cut costs and increase efficiencies? And, what's for dinner? OK, maybe you don't need to be in Strategic Planning for that one. Here you are trying to determine how the competitive landscape looks and how the company is going to drive improvement going forward. If you do this several times one thing you begin to notice is how many times you are wrong in your Strategic Plan. The point isn't whether you are right or wrong, but how large the potential opportunity is. Management is sneaky, and they have more information than you, so it shouldn't be too surprising that if you think up 10 great ways that they can grow the business, they can think up a couple more that might even be better.
Valuation: This is the process of determining how much a share of stock is worth. Our goal is to purchase at a discount, hopefully at a big fat discount, to what a share of stock is worth - but remember we are buying a business, so we are really analyzing how much the business is worth, then we just apply it on a per share basis. Lots of people get really caught up in this area - generating spreadsheets, performing detailed analysis ad nauseum. Since I want to get a whopping discount to what I think the company is worth (this helps protect us if we are wrong in our assumptions), I'm not too worried about hitting that tenth decimal point. There are tons of books and strategies on valuation, but I'm just going to touch on two that I find fairly useful:
Discounted Cash Flow Analysis (DCF): In this type of analysis, we think of the company of as a cash generating mechanism similar to a bond. Whatever the company does, it throws off cash every year. What DCF does is to add up all the cash that the company throws off over time and tells you what it should be worth now. The easy way to think about this as if it were reverse interest. Using a bond as an example, you would evaluate a bond based on it's term and interest rate (coupon), if you could buy a bond for $1,000 that paid you $80 or 8% per year, then returned your $1,000 in 10 years, you might think that was a pretty good deal. But how about 5% a year? How about 3%? At some point this becomes a not so attractive investment. DCF is a similar concept, but instead of the initial investment, you are told what the cash outflow over time is. In the bond example, if I told you you could get $80 per year for 10 years, then $1,000 at the end, how much would you pay for it? If you decided you would pay $800, then your return would be 10% per year ($80/$800). The 10% is called the discount rate, or the interest you would require on your investment to make it worthwhile and the value of the cash stream is $800. DCF is a similar concept for evaluating a company, if we can model or assume the cash the company will make over time, and assign a minimum accepted return, the DCF calculation (a bunch of excel columns and math) will tell us how much we should pay for that investment.
Revenue or Operating Model: Once you've done a Bear and Bull case, it should be pretty easy to build an operating model based on those assumptions. This is a process of building a forecast - here at Bootstrap HQ we call that an educated guess. For example, for a retailer, you might estimate the number of new stores they could open. Based on currently store performance, you could build an estimate of revenues and profits from the increased store base and use this to determine reasonable earnings for the company. On a earnings per share basis, this could be used to calculate a reasonable price per share of the company based on current or historical price multiples for this company or like competitors.
Generally, with any valuation method, I'll perform a range of outcomes, kind of Good, Bad and Ugly scenarios of what might transpire over time. This means that we get a range of potential stock prices. Don't worry, a range can be very helpful. I try to think in terms of probabilities, not absolutes. For example, if you come up with a range for a stock value of $20 - $40 and the stock is trading for $15, then the probability is high that there will be a successful outcome. If the stock trading around $25, then the probabilities are lower that there will be a successful outcome. No magic - you are just trying to put the odds in your favor. Do it often enough, for long enough and we will do quite well, I'm sure.
Conclusion: Buy or not buy, that's what it comes down to. Unless you are a current owner and are trying to decide to keep holding or sell. It's not rocket science. It's also not exact. That's why investing is frequently referred to as an art and a science.
This process applied consistently over time should allow us to determine companies that are more likely to outperform.
Next post, we will use this analysis technique to walk through a current investment opportunity!
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7/28/2008 11:02 PM
The Dividend Guy Blog wrote:
Welcome to the July 29, 2008 edition of investing carnival. I am pleased to be hosting the carnival this week and appreciate everyone’s input and work they have put into the individual posts. Editor’s Picks Dividend Growth...
The bootstrap method is very good.I especially liked the idea of making a bear case first -that is good advise.
As for discounted cash flow analysis being a little tough,valuation is not easy.But what one has to remember is that if value investing was easy,then everyone would have been doing it.
I am here to learn value investing.You are doing an excellent job-keep up the good work.
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Thanks for the feedback. I also lean towards the value investing camp, so hopefully Bootstrap Investing will hope us both learn more!
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