One of the biggest problems facing investors is trying to figure out a good starting point for assessing potential investments. Additionally, another problem we face is trying to make comparisons between potential investments to figure out which one is the better investment.
Some of the best answers to these challenges can be found in one of Joel Greenblatt’s lesser known books – The Big Secret For The Small Investor. Greenblatt provides a couple of tricks that he uses with his MBA students to 1) find a good starting point for assessing potential investments and 2) how to make comparisons between potential investments to figure out which one is the better investment. As is usual with all of Greenblatt’s teachings, sometimes the answers we’re looking for are best answered by making the challenge easier or not trying to answer the question if it’s too difficult.
Here’s an excerpt from the book:
We’ll begin by tackling the toughest problem of all. How in the world do we go about estimating the next thirty-plus years of earnings and, on top of that, try to figure out what those earnings are worth today? The answer is actually simple: we don’t. Instead, we just make the challenge easier.
We start with the assumption that there are other alternatives for our money. In my book, the main competition that any investment has to beat is how much we could earn “risk-free” by loaning money to the U.S. government. For our example (and for some reasons I’ll discuss later), we’ll assume that we could buy a ten-year U.S. Treasury bond that will pay us 6 percent a year for ten years. This is essentially lending the U.S. government money for those ten years with a guarantee that they will pay us 6 percent each year and then pay us all of our money back at the end of that time.
Now we finally have a simple standard that we can use to compare all of our other investment choices. If we don’t expect an investment will beat the 6 percent per year that is available risk-free from the U.S. government, then we won’t invest. That’s a great start! Let’s see what happens when we use our new tool to evaluate an investment in Candy’s Candies.
If you remember Candy’s Candies from Chapter 2, it’s really just our neighborhood candy shop. The business is for sale at a price of $100,000. Our best guess is that the business will earn $10,000 after taxes next year and that earnings will continue to grow a little bit each year as the town continues to expand. So here’s the question. If we invest $100,000 to buy the entire Candy’s Candies business and we earn $10,000 on our investment next year, is that better than taking that same $100,000 and investing in a U.S. government bond paying a guaranteed 6 percent per year for the next ten years? Let’s see.
The most obvious thing we can say right off the bat is that earning $10,000 in the first year on an investment of $100,000 is equal to a 10 percent return on our money (10,000 ÷ 100,000 = 10%). This is usually referred to as an earnings yield of 10 percent. That’s certainly higher than the 6 percent risk-free return we can get by lending money to the U.S. government. But, unfortunately, that’s not the end of the analysis. The 6 percent from the government is guaranteed, while the 10 percent from Candy’s Candies is just our best guess. Also, the 6 percent is guaranteed for ten years. The 10 percent return is our best guess for only next year’s earnings.
On the other hand, in future years we expect that 10 percent return to grow as earnings increase each year. In short, we are comparing a guaranteed 6 percent annual return that doesn’t grow or shrink to an expected but risky 10 percent return that we think will grow each year (but since it’s a guess, it could also shrink or disappear completely). How do we compare the two investments?
Here’s where it gets interesting. Are we very confident of our earnings estimate for Candy’s Candies? Are we very confident that earnings will grow over time? Of course, if we are, a 10 percent return that grows even larger as each year goes by could well be very attractive when compared to a flat 6 percent return. If we’re not very confident about our estimates, we might determine that the sure 6 percent from the government is a better deal. But that’s not all we can do with this analysis.
Now, we also have a way to compare an investment in Candy’s Candies with some of our other investment opportunities. Let’s say we also have a chance to buy our local Bad Bob’s Barbeque Restaurant. Bad Bob’s is also available for $100,000 (Bad Bob and batteries not included). We expect Bad Bob’s will earn $12,000 next year. That’s a 12 percent earnings yield for the first year. We also expect that earnings will grow even faster than Candy’s Candies over time. In addition, we are more confident in our estimates for earnings and future growth prospects for Bad Bob’s than we are for Candy’s Candies.
So while we still don’t know if either investment is more attractive than a government bond, we at least know that we think Bad Bob’s is a more attractive investment than Candy’s Candies. Why? This one’s easy. We expect to earn a 12 percent first-year return on our investment in Bad Bob’s versus 10 percent for Candy’s Candies, we expect that 12 percent return to grow faster than Candy’s Candies, and we have more confidence in our estimates for the local barbeque place than we do for the candy store.
So first we compare a potential investment against what we could earn riskfree with our money (for purposes of our discussion and for reasons that will be detailed later, we have set the minimum risk-free rate that we will have to beat at a 6 percent annual return). If we have high confidence in our estimates and our investment appears to offer a significantly higher annual return over the long term than the risk-free rate, we’ve passed the first hurdle.
Next, we compare our potential investment with our other investment alternatives. In our example, Bad Bob’s offers a higher expected annual return and a higher growth rate, and we are even more confident in our estimates than we are for Candy’s Candies. So we obviously prefer Bad Bob’s over Candy’s Candies. Of course, if we have high confidence that both investment alternatives offer a better deal than the risk-free government bond, we can always decide to buy both. But, in general, this is the basic process that I go through when evaluating and comparing businesses to invest in for my own portfolio.
When I teach this concept to my MBA students, at this point in the discussion I always ask them the following questions: What happens if we are trying to value a company and we’re having a hard time estimating future earnings and growth rates? What if the industry is very competitive and we’re just not sure if current earnings are sustainable? Maybe we have a question about whether some of their new products will be successful. Sometimes we’re not sure how new technologies will affect a company’s main service or product. What are we supposed to do then?
My answer is always simple: skip that company and find one that’s easier to evaluate. If you don’t have a good idea about what’s going to happen in the industry, with the company’s new products or services, or the effects of new technology on the company, then you can’t really make good estimates for future earnings or growth rates. If you can’t do that, you have no business investing in that company in the first place!
But I know what you’re thinking: Thanks for the advice, but this stuff still sounds really hard to do.
In reality, I don’t expect even my best MBA students to be very good at making estimates of future earnings and growth rates for most companies. In fact, I tell them not to bother. In the stock market, no one forces you to invest. You have thousands of companies to choose from. I tell them the best course of action is to find the few companies where you have a good understanding of the business, the industry, and the future prospects for earnings. Then make your best estimates and comparisons for the handful of companies you can evaluate. For these companies, an evaluation can also include relative value analysis, acquisition value analysis, or some of the other methods that we’ve already discussed.
But that’s what I tell them. What I’ll tell you is that you’re absolutely right: this stuff is hard. But that was my point all along. All that I want is for you to begin to understand some of the challenges faced by professional investment managers. I want you to appreciate how tough it must be to make confident estimates for dozens and sometimes hundreds of companies. I want you to understand the questions that need to be asked, the comparisons that need to be made, and the complicated assessments that have to be reached about the future.
In fact, these issues are so tough, it’s kind of like we’re all stuck taking that Shakespeare final together! But don’t worry yet. If Hamlet can make it, so can we. (Wait, did Hamlet make it?) Anyway, there’s plenty more ahead including a discussion about all the things I tell my students to do, an examination of what most professional investment managers actually do, and finally, advice for what most of you should do (hint: it doesn’t involve making a single estimate!).
But first, let’s go to the summary and review what we’ve learned so far.
1. It’s hard to make earnings estimates for the next thirty-plus years. It’s hard to figure out what those earnings are worth today. So we don’t.
2. Instead, when we evaluate the purchase price of a company, we make sure that our investment will return more than the 6 percent per year we could earn risk-free from the U.S. government (see the box [below summary] on this page for further explanation).
3. If our investment appears to offer a significantly higher annual return over the long term than the risk-free rate and we have high confidence in our estimates, we’ve passed the first hurdle.
4. Next, we compare the expected annual returns of our potential investment and our level of confidence in those returns to our other investment alternatives.
5. If we can’t make a good estimate of the future earnings for a particular company, we skip that one and find a company we can evaluate.
6. It’s really hard for investment professionals to make estimates and comparisons for dozens and sometimes hundreds of companies.
7. We’re about to learn what I tell my students to do so that they can meet some of these challenges.
8. If Hamlet can make it, so can we! (Unfortunately, I just checked and it turns out Hamlet is a tragedy.)
Why is 6 percent the minimum annual return that any investment should beat? Why do we look at the ten-year U.S. Treasury bond? What if the tenyear Treasury bond is paying less than 6 percent? What if the ten-year bond is paying more than 6 percent?
Obviously, if we can earn 6 percent per year on our investments without taking any risk, we should invest in something else only if we have confidence that that investment will pay us a much higher rate over the long term. The ten-year U.S. government bond, though not perfect, is the closest we can come to a guarantee of a risk free fixed interest rate and the return of all of our initial investment.
Although the risk-free U.S. government bond rate is sometimes less than 6 percent, we use 6 percent as our minimum to be conservative. We look at the ten-year bond because ten years is a relatively long time (using a thirtyyear bond rate would also be acceptable).
If the ten-year bond rate is above 6 percent, we would use that higher number. Obviously, if we could earn 8 percent risk-free, that would be the rate our other investments should have to beat.
What if we find a company for $100,000 that we expect to earn only $5,000 next year? Could we ever buy that company, since that would only give us a 5 percent annual return? The answer is actually yes. If we had high confidence that in a few years that company’s earnings would grow so much that it would be earning $10,000 or $12,000 per year, we might consider it.
In other words, the company would soon be returning 10 percent or 12 percent per year even though next year it would only be returning 5 percent. Under these circumstances, it could be better than our risk-free return.
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