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Posts Tagged ‘Free Cash Flow’

Why Free Cash Flow?

In this post, I will discuss the benefits of using Free Cash Flow (FCF) instead of Net Profits to evaluate the worthiness of our potential investments.  FCF is simply Net Cash Provided by Operating Activities – Capital Expenditures. Companies with healthy FCF are able to pay dividends, acquire other companies and pay off their debts. Cash is the lifeblood of all companies, and without it, you can be sure that weren’t be around for very long.

I have included figures from the now defunct behemoth, Enron to illustrate my points.

Enron Financial Results Summary (1996-2000)

By all means, Enron appeared to be a fantastic company. Revenue had jumped seven-fold and net income had jumped two fold in a short span of five years! Pundits loved the company and the stock priced soared.

The Rise & Fall of Enron - Taken from "BBC Enron: Timeline"

Free Cash Flow on the other hand, tells us a vastly different tale:

Enron Financial Results Summary (1996 – 2000)

In four out of five years, the company was facing a massive outflow of cash. A tell-tale sign that something is amiss. Enron had burned through all its cash and still required a substantial amount of money to keep running.  Eventually, it was revealed that fraud was being perpetuated. Enron eventually closed its doors as it crumbled beneath its own weight.

If it doubt, always remember the old axiom: Cash, not profit is king!

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As part of a series of introductory posts, I decided that making clear my investment philosophy would best serve my readers (or lack of).  Drawing inspiration of Benjamin Graham and David Dodd, I follow a value based approach to investing. I have summarized the key tenets of my philosophy as:

Safety of Capital

“Rule No.1: Never Lose Money

Rule No.2: Never Forget Rule No. 1”

– Warren Buffett

Preservation of capital is of paramount importance to me. I am extremely rise adverse, and choose to invest only after making a substantial time and effort to run through my investment thoroughly.

Margin of Safety

Suppose you were an engineer building a bridge. You estimated that 150 tons of vehicles passed through its roads at any given time. How much weight would you design the bridge to withstand? 150 tons? I doubt it. 200 tons? Now we are getting somewhere. How about 400 tons just to be safe.  That’s more like it.

The additional weight is the margin of safety (MOS) that engineers give themselves in case their calculations turn out to be wrong. Similarly, the same applies to investments. Suppose you calculated that the intrinsic value of a company was $0.30 a share. How much would you pay for it? The buffer that exists between the Intrinsic Value and the actual price paid is the Margin of Safety. I will provide a more in-depth discussion on this in subsequent posts.

Take Time To Mark Out Your Circle of Competence

Circle of Competence

Understanding what you know and what you don’t is essential in getting your investments right.  Never buy into anything that you can’t understand, no matter how appealing or attractive it looks.  Despite my extensive effort, I have yet to figure out how to analyze financial companies like UOB or DBS; hence I have never considered investing in them. We all have our specific areas of expertise. Getting our circle of competence right will play great dividends in future investments.

Mr. Market

Mr. Market suffers from wild mood swings; he might be on a manic high one day and depressed the next. The most important thing to realize is that you are free to ignore him if you chose to do so. Treat him as your friend if need be, but always realize that he’s serving you and not the other way round.

In short, exploit the tendencies of the market to swing from extreme high to record low. The market is just like a pendulum swing from one side to the other. Accepting it as part of the business cycle will give you conviction when others forecast only doom and gloom.

PE Ratio of the S & P 500. Don't be a slave to the market - Exploit it to your advantage.

Do note that this list is not exhaustive. I do hope that it’s a useful guide to get you started.

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Merry Christmas everybody!

Over the coming months, I will be posting up articles about Value Investing in Singapore. Among the topics covered are:

  • Core Concepts of Value Investing
  • Reviews of Value Investing Resources
  • Detailed Analysis of Companies in Singapore
  • And more to come!

I draw a great deal of inspiration from the Value Investing legends: Benjamin Graham, Graham Dodd, Warren Buffett, Pat Dorsey and more. Full credit goes to them for paving the way for us. As Issac Newton once said – “If I have seen further it is only by standing on the shoulders of giants.”  To those that are willing the effort, the rewards are great. I still remember reading my copy of “The Intelligent Investor” as if it was yesterday.  Even though the book was first published in 1949, I still recommend it to those who are unacquainted with the subject. The simple truths that it espouses remain stunningly relevant even today.

Warren Buffett - Value Investing Legend

To those who are doubtful or cynical (and I don’t blame you), I implore you to explore the subject with an open eye. I have enclosed a link below, an article from a benefactor of Value Investing – Warren Buffett; I hope it will lend some credence to the subject if I have failed to persuade you of its merits.

The Superinvestors of Graham and Doddsvilles

This journey ahead is both intellectually fulfilling and emotionally rewarding. I wish you the best of luck and hope that you will enjoy it as much as I have!

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