Monday, August 11, 2008

The Investment Zoo Chapter 11: Looking Beyond the Skeleton

In this chapter, Jarislowsky gives some suggestions on what to look out for when valuing a company. He starts with bank debt and opines that it should not exceed accounts receivable to prevent liquidation problems. He also likes to see current ratio's of around 2 times as a rule of thumb, since with enough current assets a company can more readily take advantage of purchase discounts and shouldn't have problems paying debts as they come due. He points out that debt denominated in a stronger foreign currency could end up more expensive for a company.

He likes to see net income without high interest charges as the company has more ability to pay or raise dividends for shareholders. One of the best indicators for Jarislowsky to invest in a company is if a company increases dividends when net income and cash income are growing.

With income tax rates, ensure that the values used in your valuations are sustainable for a company into the future. If the rates look too low , re-adjust to a higher rate. You want to avoid including a one time income tax break as a reoccurring one in your valuations.

Jarislowsky places no value on goodwill when calculating debt to equity or other ratios. He feels that goodwill is essentially unproven to be worth something and would rather err on the side of caution.

He likes to look at gross margin, sales expense, advertising, administration expense etc. to understand if management is implementing good cost control measures. One of his key negative indicators on cost management is if sales are rising but margins are not improving. This is a warning sign for him that management might be doing a poor job and validates the reasons why.

He doesn't put much stock in book value and return on equity. The reason is he feels that a company could buy back their own shares, be left with very little book value but still be worth a lot of money. Goodwill can also inflate book value. He points out that in dying industries (he mentions steel and textiles) that book value can be enormous, but no one is building or buying the plants. He doesn't feel that book value represents fair economic value very often.

For investments, Jarislowky wants to see predictable growth in solid companies. He feels this is one of the best ways to earn a lot of money with investing. One of the most important aspects of operating figures of a company's past is that they provide an opportunity to get a read on the quality of management. If the balance sheet has too much debt, then perhaps management is gambling. If a company has lots of excess cash and is sitting on it, it might mean management doesn't have ambition or imagination on what to do. Excessive inventories might mean poor systems and a lack of control.

He concludes that assessing management is a key aspect to sound security analysis.

No comments:

Follow by Email