A typical research report provides you with a few years of historical data and a year or two of forecast, especially of sales and netprofit. The better reports may also include some kind of valuation based on PE and discounted cash flow to arrive at an estimate of fair value.

Most of these research reports, atleast the ones for which you don’t pay much will stop at this point. To be fair to the producers of these reports, you get what you pay for – in this case next to nothing.

The point is that these free reports provide only the basic quantitative information needed for a decision. One cannot make a purchase only on the basis of numbers without understanding the context of these numbers

What is the meaning of context ?
A company usually operates as part of an industry and is impacted by the various competitive forces of the industry. For example – if you operate in the FMCG industry, advertising and distribution is a major part of the expense. In a similar fashion, fuel, raw material and power are big expenses for a cement company and advertising is nice add-on, though not a competitive differentiator.

So if you are analyzing a consumer goods company, you have to focus on the advertising expenses. In addition you will also have to understand the width and depth of distribution, brands recall, performance of new products and similar such non-quantitative details.

In case of a cement company, one has to compare the cost of production of the company with other competitors and understand if the company has a sustainable cost edge over other companies.

It is important to understand that the financial numbers of the company have to be evaluated not only on the basis of time (past numbers) but also with reference to other companies in the business (national and international). It is a rare report, that goes into this level of detail.

Beyond the context
The exercise of calculating fair value of a stock is essentially trying to estimate the future of the company. It is silly to attempt mathematical precision in this task. One of the common criticisms of analysts is that their forecasts are generally wrong. I think it is stupid to expect any better from them. The world is far too complex for any person to be able to forecast anything in short term, forget the medium and long term.

I have a fairly elaborate template for analysing of a stock. An elaborate template does not make the analysis any better – it only ensures that I do not missing anything important. If you scan through the template, you will notice that I have a few sheets for DCF (discounted cash flow) analysis.

Now if I don’t consider DCF to be the end all of a stock analysis, why do I still do it? The main reason for doing a DCF analysis is to play around with various scenarios (in terms of sales and profit growths) and attempt to see how these scenarios have an impact on the fair value.

The standard approach for doing a DCF analysis is to look at the past numbers and to simply project them into the future, with minor variations in the numbers. The problem with this approach is that it is too simplistic.

A good starting point is to project the past numbers if you strongly feel that the past is a good indicator of the future. However it is important to look at possible scenarios in your valuation – try an optimistic scenario where everything works as planned and a pessimistic scenario when almost anything which can go wrong will do so. This approach will give you an upper and a lower bound to the fair value of the company.

How do you know what numbers to plug in for the two scenarios? This is where context of the current numbers and a qualitative understanding of the industry and the business comes into play. One has to have a sense of the business and the industry to put any meaningful numbers

The above approach takes away the need to make precise forecasts. You are now working with a range of values, which can re-worked as new data comes to light over time.

But this is all fuzzy !!
Absolutely right ! I personally feel that quantitative aspect of value investing is not more than 20% of the effort (and even that is an over estimation). The ‘numbers’ part of investing is the minimum. I will not invest in a company which has a high debt, is losing sales and has been making a loss for the last few years.

The first step I take is to look at the numbers to figure out if I need to dig deeper into the company or just move to the next idea. This step usually takes a few hours at the most and with practice and some automated options, it can be done even faster.

The real work starts after this first stage. There is no fixed formulae or approach for investing, but I will usually read through a couple of years of the annual report of the company, read about the competitors and understand the economics of the industry. Once I am done with a round of qualitative analysis, I fire up my DCF spreadsheet and plug in numbers to arrive at a range of the value. Over time I have realized that this step rarely throws any surprises.

If you do this exercise for a decent amount of time, you get a rough sense of the valuation as you are looking at the numbers. For ex: a company growing a 10-12% with an ROE of 15-20% would come to a PE of around 17-20 times current year’s free cash flow.

An example
Let me give an example from my past experience to illustrate my point. I analysed a company called MRO-TEK in late 2007. You can read the analysis here. One of the key negatives for the company was that it was a small company in an industry which is dominated by the likes of CISCO and LUCENT who have R&D budgets which are a 100 times the annual revenue for this company.

I identified this negative fact, but there was no way to quantify this business risk. The last few years of data looked fine and stock appeared to be undervalued at the time. Fast forward to 2010 – The result for 2008 was a high water mark. The performance of the company has been sliding since then with the topline having dropped by 50% and the operating profit has turned negative. The company is simply operating in a fast changing hypercompetitive industry, where it is very difficult to make a profit.

I had a sense of this fact, but did not appreciate it fully (I am a slow learner J ). If I had not been lucky in getting a quick exit, I would have lost money on this. This idea was a case of sloppy analysis, where numbers would not have helped.

Is there a secret formulae?
There is no secret formulae for investing (if you are into quantitative investing, it’s a different story). At a certain level effective investing is very subjective in nature. It involves reading and digesting a lot of information and then combining it with your existing knowledge and experiences to come up with an estimate of fair value for the company

Unfortunately there is no shortcut in becoming a decent investor. One has to love the art of investing and be willing to learn and make small amounts of progress each day. Over time, the learning accumulates and you keep getting better at it.

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