Skip to main content

Investments

Man is a slave to wealth, but wealth is the slave of no man. -Bhisma, Mahabharata

We build wealth by building a Fortress Balance Sheet. As part of this strategy we may not take as much risk but we will be able to weather any storm that comes our way. The Fortress Balance Sheet is an idea taken from Jamie Dimon at JPMorgan Chase built on the following principles:

  • Cash: Have enough cash to weather any storm for up to two years.
  • Smart Debt: Take on debt that can be paid off in full at any time.
  • Assets: Build assets that generate free cash flow.
  • Simple: Keep the balance sheet simple and easy to understand.

In terms of metrics we will be looking at the following:

  • Free Cash Flow = Net Income - Capital Expenditures
  • Debt to Free Cash Flow < 2x
  • Debt to Assets Ratio < 20%
  • NET-30+ Payment Terms

Financial Statements​

Income Statement

  • Income (is Revenue)
    • The amount coming from sales
    • Cost of Service / Cost of Goods
    • What it costs to deliver the Sale
  • Gross Profit
    • Income – Cost of Service
    • Should be positive otherwise business is not going to survive
    • This is the cost income coming from delivering the goods
  • Expenses
    • The overhead of running a company including salaries, etc. that are not tied to delivering the goods.
    • This is also where depreciation goes for stuff bought
    • Taxes as well are here.
  • Net Operating Income (Net Operating Profit)
    • Gross Profit – Expenses
    • This is what it costs to run the company
  • Net Other Income
    • This is money made from interest and other things unrelated to what the company produces
  • Net Income (Net Profit)
    • Total amount of profit / loss of running the company

Balance Sheet

The balance sheet is the cumulative growth of the company and so is an important document.

Assets = liabilities + owner’s equity

  • Assets
    • Cash
    • Inventory
    • Reduction in Inventory should increase Cash
    • Accounts Receivable
    • Think of this as a loan to the customer.
    • Long Term Assets
    • Buildings to have been bought a while ago and the value could have increased, but we can’t realize the change until we sell it.
  • Liabilities
    • Loans
    • Long Terms
    • Account Payable
    • To vendors, etc. Think of money you owe as a loan the vendors gave you.
  • Equity
    • Retained Earnings.
    • Money that isn’t withdrawn and reinvested into the company.

Question to ask:

  • Is your cash increasing or is it increasing because of an increase in liabilities?
  • Are your liabilities increasing to increase you cash?

Cash Flow Statement

The cash coming in and going out. Divided into three sections

  • Operating Activities
    • Cash from delivering our products and services.
    • We want to increase the amount of cash coming here to be higher.
    • The more money we get from operating activities the better.
    • Increase cash flow by getting money faster from the customer, and delaying paying the supplier
  • Investing Activities
    • We need to invest money in the future so this is where we would do it.
    • i.e Computers, machines, etc.
    • There should be some investment here otherwise you are not investing in the growth of your company
  • Financing Activities
    • Money from loans, etc.
    • How we get money from loans, our payments for loans, etc.
    • Are you paying a lot of this? If this is how you are increasing your cashflow that isn’t necessarily good.

Free Cash Flow = Operating Activities – Investing Activities

Financial Ratios

Profitability Ratios

Gross Profit Margin (Income Statement)

Shows the basic profitiability of your product or service before overhead or expenes are added in.

grossmargin = grossprofit / revenue

  • Is there a negative trend in gross_margin?

Operating Profit Margin (Income Statement)

operatingprofit[EBIT] = grossprofit – operating_expenses

operatingmargin = operatingprofit / revenue

  • Watch the operating_margin to see if costs are increasing faster than sales?

Net Profit Margin (Income Statement)

After all the other expenses have been paid for including taxes, interest, etc. netmargin = netprofit / revenue

Return on Assets (Income Statement, Balance Sheet)

  • How effective are we using out assets to generate a profit.
  • Don’t want it to be too high because that means the company isn’t investing in new facilities and equipment.

returnonassets = netprofit / totalassets

Return on Equity

  • What percent of profit you make for every dollar of equity invested in the company.
  • “From an outside investor’s perspective, ROE is a key ratio. Depending on interest rates, an investor can probably earn 3 percent or 4 percnt on a treasury bond, which is eessentially a risk-free investment. So if someone is going to put money into your company – or if you’re going to invest in sombody ele’s business – he or you willl want a substantially higer return on equity.”

return on equity = net profit / shareholder equity

Leverage Ratios

Debt-to-Equity

debt-to-equity ratio = total liabilities / shareholder equity

If > 1 then there is more debt used to finance the growth. If less then there is less debt. Bankers love this number because it shows how much debt the company has taken on versus the equity.

Interest Coverage

interest_coverage = operating profit / annual interest charges

How much interest is paid every year compared to how much profit is being made.

  • If it gets too close to 1 it is a bad sign.
  • If it is a high ratio then the company can take on additional debt.

Liquidity Ratios

Current Ratio

currentratio = currentassets / current_liabilities

  • Don’t want to be anywhere near 1 since that means you will barely be able to cover the liabilities that will come due with the cash yo’ll hae coming in.
  • Don’t want it to be < 1 since you will run out of cash in the future.
  • A number too high means that the company is sitting on its cash.

Quick Ratio

quickratio = (currentassets – inventory) / current_liabilities

The quick ratio shows how easy it would be for a company to pay off its short-term debt without waiting to sell off inventory or conver it into product.

Efficiency Ratios

Lets you know how well your balance sheet is doing.

Inventory Days and Inventory Turnover

  • How fast can you move investory and convert it to cash.

Inventory Days

daysininventory = average_inventory / COGS / day

  • Give the number of days inventory stayed in the system
  • day is usually 360

Inventory Turn

How many times inventory turns over every year. inventoryturns = 360 / daysin_inventory

  • How frequently you sell out your stock and had to replenish it.
  • The higher the number of turns the tigher your management of inventory and the better your cash position.
  • This is useful for retail

Days Sales Outstanding

Average Collection Period. How long it takes for customers to pay their bills.

days sales outstanding = ending accounts receivable / annual revenue * day

  • day is 360 ending accouts receivable = from balance sheet
  • great number for entrepreneurs
  • bring this down as it gives how long it takes for customers to pay their bills.
  • a high DSO is bad as it may mean the customers are in trouble.

Days Payable Outstanding

The inverse of Days Sales Outstanding. How long it takes for us to pay our bills. dayspayableoutstanding = ending Account payable / COGS / day

higher the DSO the less happy vendors are.

Total Asset Turnover

  • A company with lower turnover isn’t using as effectively as a higher one
  • How efficient you are at generating profit from the income.

totalassetturnover = reveneue / total assets

Return on Investment

Return of Inveatment is based on current value of money

  • The hurdle rate is what the opportunity cost of of getting a return else where at the present value.
  • What is the free cash flow generated by the equipment. This is the estimate per year.
  • What is the duration of the life of the equipment.

Net Present Value (NPV)

Over a period of time

  • Cash Flow Rate
  • How much it will cost and how to estimate

Example: A project starts Year 0: It costs -10,0000 Year 1: It brings in cash of 2500 Year 2: It brings in cash of 4000 Year 3: It brings in cash of 5000 Year 4: It brings in cash of 3000 Year 5: It brings in cash of 1000 Discount Rate = What you could have earned elsewhere. Ex 6% So you would do:

NPV = -10,000 + 2500/1.06 + 4000/1.06^2 + 5000/1.06^3 + 3000/1.06^4 + 1000/1.06&5 = -10,000 + 13,239 = $3,239

  • If NPV > 0 then accept
    • The 6% (discount rate is an opportunity cost)
    • The money is not free and could have been deployed elsewhere
    • If NPV is greater 0 than it is larger return than 6% we would have gotten elsewhere
    • If comparing different projects the project with the highest NPV has the highest return

Cash Conversion Cycle

How long it takes to replenish cash. day inventory outstanding + day sale outstanding – day payable outstanding

What data do you analyze?​

We analyze the SEC 10-K, 10-Q, and Insider Trading data. We download this data

whenever the SEC makes it available and do an analysis daily.

What else would you need to do on top of this data?​

This data only gives you the financials that Warren Buffett and Charlie Munger

look at. There are additional vectors such as analyzing management, moats and

other qualitative analysis that is up to you.

Can I get access to the 10-K and 10-Q data?​

Yes, it is available here.

What are the tenents?​

Tenets of the Warren Buffett Way

Business Tenets​

Is the business simple and understandable?

Does the business have a consistent operating history?

Does the business have favorable long-term prospects?

Management Tenets​

Is management rational?

Is management candid with its shareholders?

Does management resist the institutional imperative?

Financial Tenets​

Focus on return on equity, not earnings per share.

Calculate “owner earnings.”

Look for companies with high profit margins.

For every dollar retained, make sure the company has created at least one dollar of market value.

Market Tenets​

What is the value of the business?

Can the business be purchased at a significant discount to its value?

Equities

We invest in equities and dabble in commodities based on company moats through:

  • 7 Powers Framework
  • Financials focused on Free Cash Flow and ROIC
  • Understanding commodity and geopoliticial shifts

We optimize for two things Free Cash Flow and Return on Invested Capital. These two numbers affect every decision we make either internally with OpsZero or external investments we make. Focusing on Free Cash Flow has a couple benefits that other numbers don’t have. At the end of the day cash is king and that is where we need to value. We can increase and optimize Net Margin but that doesn’t result in cash increasing. So we focus on free cash flow. With cash flow generative investments we can take the output of the cash either through dividends or stock buybacks and increase the value of our holdings.

When analyzing a company our process is the following:

  1. What is the free cash flow change year over year.
  2. What is the return on invested capital?
  3. How is the company reinvesting it’s cash flow?
  4. Investing it
  5. Debt repayment
  6. Stock buyback
  7. Dividends

We focus on buying and holding companies for the long haul to reduce our tax payments. However, we are pragmatic and opportunistic in the short term to buy and sell stock. So we should focus both on short term and long term. The best way to do this is likely to buy when things are low and sell when things are high.

Financials​

The financial metrics of Return on Invested Capital, Free Cash Flow, Debt to Equity, and Effective Tax Rate drive nearly all decisions we make.

  • Do you have a lot of debt?
  • Can you pay off your debt immediately if you need to?
  • Is your debt working for you?
  • How are your Financial Ratios?
  • Free Cash Flow? (Cash from Operating Activities – Cash Invested in Capital Equipment)
  • Days Sales Outstanding – How long does it take your customers to pay their bills?
  • Quick Ratio – Ensure that we are not running out of cash and are growing at a steady rate. (Current Assets /
  • Gross Profit Margin – How can we reduce the cost of delivering our services?
  • Net Profit Margin – How can we increase the revenue while reducing the cost of getting additional revenue?
  • Debt to Equity – We want to use financing to grow our business but we shouldn’t be over leveraged?
  • Cash Conversion Cycle. How long do we have to convert outflow to inflow to have working capital?

Free Cash Flow​

Growth in earnings implies that we are expanding our capabilities and growing the organization organically. Look at Price to Free Cash Flow

Cash Conversion Cycle​

“The cash conversion cycle (CCC) is a metric that expresses the time (measured in days) it takes for a company to convert its investments in inventory and other resources into cash flows from sales. Also called the net operating cycle or simply cash cycle, CCC attempts to measure how long each net input dollar is tied up in the production and sales process before it gets converted into cash received.”

Free Cash Flow should be augmented with the Cash Conversion Cycle. It should be consistently decreasing over time. A Cash Conversion Cycle represents the amount of days it takes to convert inventory and sales into cash. If possible making this negative has the best benefit because it means you get the cash first before you pay for the goods.

  • Pay Down Debt
  • Pay Dividend
  • Stock Buybacks
  • Invest in Growth

What is the change in FCF? What is the FCF being used for?

def day_inventory_outstanding(average_inventory, cogs):
    '''
    average_inventory is the well inventory, but in a services business it can
    also be the uninvoiced time.
    '''
    return average_inventory / cogs / 360

def day_sale_outstanding(ending_accounts_receivable, annual_revenue):
    return ending_accounts_receivable / annual_revenue * 360

def day_payable_outstanding(ending_accounts_payable, cogs):
    return ending_accounts_payable / cogs / 360

def cash_conversion_cycle(average_inventory, cogs, ending_accounts_receivable, ending_accounts_payable, annual_revenue):
    return day_inventory_outstanding(average_inventory, cogs) + day_sale_outstanding(ending_accounts_receivable, annual_revenue) - day_payable_outstanding(ending_accounts_payable, cogs)

FREE_CASH_FLOW_MULTIPLE = 4
def is_acquire_price(share_price, free_cash_flow, total_number_of_shares):
    '''
    Buy at Less Than 4x Free Cash Flow
    '''
    return share_price < ((free_cash_flow * FREE_CASH_FLOW_MULTIPLE) / total_number_of_shares)

Return on Invested Capital​

Also referred to as Return on Capital. Return on Invested Capital is one of the best metrics to understand the health of a business. By focusing on ROIC we have a single number to understand if we are innovating and if those innovations are resulting in customers that are happy because they continue to purchase from us. Further, ROIC allows us to understand if we are allocating capital well. def return_on_invested_capital(net_income, debt, equity): return net_income / (debt

  • equity)

Debt to Equity​

Look at Earnings per Share and how it is changing over time. It should be > 0, if it is less than 0 then there is no equity and the company is overleveraged. Effective Tax Rate Reduce taxes so they can be reinvested into the business for further growth. def tax_rate(total_tax, taxable_income): return total_tax / taxable_income