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Valuation (Avoid Value Traps (STAGES (STAGE 1 - Gross margin and operating…

- - - - Doing everything to gain market share can be fatal to financial institutions like banks and insurance. The adverse effect usually doesn't show up until severalyears later, which is why they need a strict underwriting process to qualify customers and price the potential loss properly. It wasn't long ago that banks relaxed their underwriting standards and gave loans to subprime borrowers who
        would otherwise not qualify. They got into price wars with loans that offered “zero down, zero percent, and zero payment.” The financial crisis caused by subprime loans eventually drove the world's financial system to the brink of collapse. The banks that had the most exposure were punished most heavily, too. Many of them are gone and forgotten
    - - Insurance companies can get into deep trouble if they take on too many customers without pricing the risk properly. In the early 1970s, GEICO almost destroyed itself because it wanted to gain more market share. It charged too little for its car-insurance policies. The company was on the verge of bankruptcy before increasing prices and getting out of the states where it was unprofitable. By doing that, it lost market share but became profitable again. When I bought my first house in 2000, I insured it through an insurer called Texas Select. The insurance premium was considerably lower than other insurers for the same coverage. But in 2006, the company went bankrupt, and I had to switch to another insurer at a higher premium. Texas Select's low rate may have worked on a very small group of well-qualified customers, but being too aggressive with pricing drove the insurance company out of business.
- - - - Where Market Value is Share Price x Outstanding Shares
      - Where Book Value is Net Asset of the Company. Meaning if company liquidated all of its assets and paid off all of its debts, the remaining value would be company's book value
      - If P/B is less 1, then potentially undervalued. But also be noted as having problems such as recent acquisitions, write offs or share buy backs.
- - - - Financial Strength
        
        Altman Z Score, Rank 1 to 10
        
        look out for Bankruptcy scenario
        
        Debt to Revenue Ratio
        
        Check if Company issuing new debts
        
        Interest Coverage, should be > 10
      - Profitability Rank
        
        PART 2
        
        Issuance of debt & Shares
        
        If the company keeps issuing new debt, it likely means that it cannot generate enough cash to fund its operations. This is certainly a warning sign. With more debt, the company may earn more, but its debt burden gets higher and its balance sheet gets weaker
        
        Similarly, if a company keeps issuing new shares, it probably means that it cannot generate enough cash to fund its operations and it cannot borrow. This is also a warning sign. With more shares, the shareholders are diluted.
        If a company's stock price is at a very high valuation, issuing new shares benefits existing shareholders. In this warning sign, we don't distinguish the prices at which the company issues new shares
        
        Piotroski F-Score, <4 is warning
        
        Beneish M-Score
        
        Beneish M-Score checks the quality of reported earnings and is an indicator that measures if the company manipulates its earnings. It was developed by Indiana University professor Messod Beneish in 1999,10 and it considers the relationship between accounts receivable, revenue, gross profit, current assets, depreciation, current liabilities, and others to determine the quality of earnings. A higher score indicates that the company might be manipulating its earnings.
        
        Sloan Ratio
        
        Sloan ratio emerged from the 1996 study by Richard Sloan, a former University of Michigan researcher.11 He found that if a company's earnings include a significant amount of noncash earnings, its stock underperforms. Sloan ratio is calculated as the ratio of noncash earnings to assets. Therefore, Sloan ratio can be used to measure the quality of earnings. If Sloan ratio is high, a warning sign is triggered
        
        Interest Coverage
        
        It is defined as the ratio of a company's operating income to the interest payment on its debt. The higher the ratio is, the lower the debt burden is. Therefore, it is also a measure of the financial health of the company. If the interest coverage is low, a warning sign is triggered.
        
        short % of Float
        
        This warning sign triggers when the company's shares are heavily shorted
        
        I used the example of short attacks on Fairfax Financial, where the stock was manipulated by the short attackers. But many times, short sellers are right. Companies do lie, and short attackers can police their acts. A study by former University of Chicago researcher Owen Lamont in 2003 found that in the three years after the attacks by short sellers between 1977 and 2002, the companies' stocks underperformed by 42 percent on average, even though these companies professed innocence by suggesting they were the subjects of a bear raid or conspiracies, or they alleged that the short sellers were lying.12 The shorts were mostly right—often it was the companies that were lying and conspiring to defraud investors, not the reverse! The short sellers may know something that others don't.
        
        PART 1
        
        Operating Losses, if company has experienced operating loss over the past 10 years (if yes, warning triggered)
        
        Gross Margin Growth, Operating Margin Growth
        
        If Gross Margin and/or the operating margin of the company are declining.
        
        Asset Growth faster than Revenue Growth
        
        Day Sales Outstanding
        
        Days sales outstanding measures how quickly the company can get paid after delivering its products. It is a financial ratio that illustrates how well a company's accounts receivable are being managed. Here we compare the average of days sales outstanding over the past 12 months with the average of the past five years. If it is getting longer, a warning sign is triggered. A longer days sales outstanding means that it takes more time for the company to get paid after a sale has been made, or it is selling its products on credit.
        
        Day sales of Inventory
        
        Days sales of inventory measures how quickly the company turns its inventory into sales. If this indicator is getting longer, it means that the company is having difficulty selling. We compare the average days sales of inventory of the past 12 months with the average of the past five years. If it is getting longer, a warning sign is triggered.
        It is typical for a retailer to increase its inventory before the holiday season because it usually does more sales during this time than any other time. Therefore, this parameter needs to be compared with the same period from the previous year.
        
        Owner earnings diverged from reported earnings
        
        Owner earnings is a concept Warren Buffett introduced in his 1986 shareholder letter. It measures the true earnings of the company from its existing operations to its owners. It is an estimated number from the financial statements of the company. If there is a long-term deviation between the owner earnings and reported earnings, a warning sign is triggered
        
        Divergence between net income and free cash flow
        
        Similar to owner earnings, free cash flow measures the net cash generated by the business. If there is a long-term deviation between the two, a warning sign is triggered.When a company is in fast expansion, its earnings are usually reinvested into the business, which lowers its free cash flow. It doesn't necessarily mean there is something wrong with the company
        
        Cost of capital higher than the return on invested capital
        
        A company creates real returns only if its return on invested capital is higher than its cost of capital. For the purpose of the warning signs' checklist, however, if the cost of capital is higher than the return on capital, a warning sign is triggered.
        
        Revenue, Earnings Growth rate of 10-year, 5 year, 3 year and 1 year periods (if decline, Warning)
        
        PART 3
        
        Dividend Pay out Ratio
        
        Dividend payout ratio is the ratio of annual dividend per share to its annual earnings per share. Dividend is the cash distribution of earnings to shareholders. It comes from earnings and must be supported by earnings. If a company's dividend is consistently a large percentage (e.g., 80%) of earnings, it may not be sustainable.
        
        Dividend yield relative to historical range
        
        Here we check the current dividend yield relative to its historical range for the periods of ten years, five years, three years, and one year. If the current dividend yield is close to the historical lows, a warning sign is triggered. Usually a lower dividend yield is associated with a higher price
        
        Stock price relative to historical range
        
        This item checks the current price relative to the historical price range for the periods of ten years, five years, three years, and one year. If the stock price is close to historical highs, a warning sign is triggered.
        
        Part 4
        
        Valuation ratios P/E, P/B, P/S relative to historical range
        
        This item checks where the valuation ratios price-to-earnings (P/E), price-tobook (P/B), and price-to-sales (P/S) currently stand relative to their historical ranges for the periods of ten years, five years, three years, and one year. Normally, you don't want to buy a stock when it is most expensive relative to where it was traded historically. If any of the valuation ratios are close to historical highs, the warning sign is triggered.
        
        Higher Forward PE
        
        Forward P/E is calculated as the current stock price divided by the next year's earnings as estimated by analysts. If a company's forward P/E is higher than the current P/E, it means that Wall Street analysts expect its earnings to decline. This is a warning sign. There can be big misses from analysts' estimates.
        
        Buyback track record
        
        If a company is buying back its own stock, it is usually considered a positive sign. With this item, we check the track record of the company with its buybacks over the past. If it doesn't have a good track record, the warning sign is triggered. This means that the company is not good at timing its buybacks.
        
        All insiders selling and no insiders buying
        
        If a company's executives and directors are selling its shares heavily, and no insider buys, a warning sign is triggered.
        
        Tax rate
        
        In principle, if a company pays a lower tax rate, it is good for shareholders. But if a company claims good earnings but pays a lower tax rate, investors need to know why. Is this due to a tax haven, poor quality of earnings, or other reasons? This warning sign triggers if the tax rate the company pays is too low.
    - - PART 1
        
        Profit Margin Growth
        
        For any business, even if it is at the same level of operation, its operating cost gradually increases because of inflation-induced higher costs of salary, rent, and maintenance. It has to grow its sales at least faster than inflation to be sustainable over the long term.
        
        Two things can lead to profit-margin growth. I want to use the example of a retail chain to explain. For a chain store that grows by opening more stores, its cost on inventory management, marketing, and administration does not grow as fast as the number of its stores. As the company opens more stores, its profit margin increases. This is growth-driven profit-margin growth. If the chain store no longer opens new stores, it can still make more money by selling more at each store. This is productivity-driven profit-margin growth.
        
        The two parts of profit growth can exist at the same time. A company must control cost as it grows. The productivity-driven profit-margin growth is an indication of the competitiveness and pricing power of the business
        
        Minimum 10 years Period. 1 Market Cycle
        
        Share Buyback
        
        Instead of issuing new shares that dilute shareholder value, the company is buying back shares. Usually the buyback is considered as returning value to shareholders. It may drive up the stock prices as the profits are now distributed on a smaller number of shares.
        
        Not all share buybacks are created equal, as pointed out by Buffett. Share buyback is valuable only if the company buys back its shares at below the intrinsic value of the stocks. If a company buys back at above the stock'sintrinsic value, it destroys value for the remaining shareholders over the long term
      - PART 2
        
        Rising Dividends
        
        If a company is raising dividends, it means that the company is confident in its profitability. It is positive sign. But as with share buybacks, paying dividends weakens the balance sheet of the company. Investors need to think about its effect over the long term.
        
        Paying down debt
        
        Paying down debt is always good for a company to do, although it may reduce return on equity as the company is now less leveraged.
        
        Insider Buying
        
        The only reason insiders are buying their own company's shares is because they think they will go up, as Lynch pointed out. Academic studies also found that insiders are mostly long-term value investors. They buy their own company stocks when they think their companies are favorable as long-term investments
- - - - PEG
        
        It is common practice for investors to use the price-to-earnings ratio (P/E ratio) to determine if a company is over or undervalued. However, the PEG ratio is much more relevant to aggressive growth investors. This ratio takes long-term earnings growth rates into consideration, which is vital to the growth investor. For example, a stock trading at 20x earnings with a 10% growth rate is much less desirable than a similarly valued stock with a 30% growth rate.
      - Lowest PEG Not Always Desirable
        
        Common wisdom says that 1.0 is the ideal PEG ratio, but reality doesn’t quite measure up to that. The S&P 500 sports a PEG of about 1.5. Anything above 1.8 is probably overvalued, while abnormally low ratios carry their own set of risks. As mentioned above, beware of overly rosy analyst predictions of indefinite hyper-growth. Unrealistic expectations are usually priced into those stocks and they can fall hard when these companies inevitably fail to meet these expectations.
  - - - Growth Metrics
        
        Both strong earnings growth history and impressive earnings prospects are the main concepts that GARP investors borrow from the growth investing strategy. However, instead of super-normal growth rates, pursuing stocks with a more stable and reasonable growth rate is also a tactic of GARP investors. Hence, growth rates between 10% and 20% are considered ideal under the GARP strategy.
        Another growth metric that is considered by both growth and GARP investors is return on equity (ROE). GARP investors look for strong and higher ROE compared to the industry average to identify superior stocks. Moreover, stocks with positive cash flow find precedence under the GARP plan.
      - Value Metrics
        
        GARP investing gives priority to one of the popular value metrics – price-to-earnings (P/E) ratio. Though this investing style picks stocks with higher P/E ratios compared to value investors, it avoids companies with extremely high P/E ratios. Moreover, the price-to-book value (P/B) ratio is also considered.
        Using the GARP principle, we have run a screen to identify stocks that should offer solid returns in the near term.
      - Screening Parameters
        
        Along with the criteria discussed in the above section, we have considered a favorable Zacks Rank #1 (Strong Buy) or 2 (Buy).
        
        Last 5-year EPS & projected 3–5 year EPS growth rates between 10% and 20% (Strong EPS growth history and prospects ensure improving business.)
        
        ROE (over the past 12 months) greater than the industry average (Higher ROE compared to the industry average indicates superior stocks.)
        
        P/E and P/B ratios less than M-industry average (P/E and P/B ratios less than that of the industry indicate that the stocks are undervalued.)