A Dwarf Digging Deeper (Should I Buy That Stock? How Simple Valuation Metrics Help)
Some day, our dear friend, dwarf Hulrum, got annoyed by this boring dwindex. Sure, it is a great way to increase his assets and he now understands it very well after reading his human friend’s tales about cost averaging, fees, and such. But there must be a way to build his wealth faster, he thinks, and so he moves towards individual dwocks on the dwock market.
He really likes the brewery for its pixie stout (just as some humans might like shopping online, fashion, TV shows of certain media companies, car brands, and so on…) and, thus, decides to throw his dwarf money, ickles, at them. Sure, the dwock price seems a bit high, but what in the dwarves’ world can go wrong when buying a brewery dwock?
After visiting the dwock market cave and buying the shares, he congratulates himself to this great business decision — by instantly visiting the bar.
“From dwarf’s sweat and God’s love, beer came into the world.”(approximately according to St. Arnulf of Metz. Seems he was a joyful saint)
What a disappointment! The dwock price instantly dwindles, and our pour, erm, poor Hulrum loses quite some ickles.
So maybe, Hulrum figures, it is not a great idea to simply buy a stock because he likes it or its products.
Our clever dwarf thinks, well, then I will simply buy other dwocks, but these have to come from my dwarf kingdom. I don’t trust the others, and, after all, I am most familiar with my own.
Yet again, in the meantime, the other kingdom has risen to great diamond mining power and its dwocks soar, while Hulrum’s dwocks stagnate. Had he only read about the home bias…
In his despair, Hulrum once again tunneled to the human author, asking for help. And as the human author still has not given up hope that Hulrum, one day, will grant him his heartfelt wish, he is more than happy to help.
Disclaimer: the following content is for informational purposes only and does not constitute financial advice. Do not take any decisions based solely on my writing.
The tale is intended for beginner dwock picking dwarves. Of course, there is much more to it — but the author hopes that this article will at least help to avoid some harsh mistakes.
Lastly, dwinvestment dwarves usually commit to hold their dwocks for at least some years, so that the merits of this method can play out. Very short-term speculator dwarves may be served in a later article…
My dear Hulrum,
I am happy to hear from you again. I believe you will be a great dwock picker one day. However, I think you missed a very important thing in your recent endeavors:
Buying dwocks of some company means that you are buying parts of a business (see who says that in a real world, following a long history of wise predecessors). So it is important to take care that the business works well: Does it make money? How is its health, is it maybe apt to go broke? And is it cheap or expensive?
Grumbling in the tunnel. Something along the lines of how-should-I-know-all-that-Mr.-Wise-Guy…
Stay with me, dear Hulrum. Let me give you three main pillars of a solid dwock building:
- Profitability (Does and will it make money?)
- Health (Will it maybe go broke or is it stable when bad things happen?)
- Valuation (Is it cheap or expensive right now?)
And there’s good news, as there are numbers — called metrics — which allow you to check all this quite easily.
Think of it as a pre-screening, i. e., whether further dwock research is worth pursuing. I will lay them out for you quick and simple. I will, of course, use the example of a brewery. This brewery buys raw materials, brews beer, and finally sells and ships the enjoyable pixie stouts.
Go now, dear Hulrum, and get the brewery’s annual report — or look into the dwarves internet on finance pages. You will find all of the following measures directly calculated on such pages, no need for you to pick up the calculator. (Just make sure these are correct, when in doubt.) Then, we will take care of our three pillars.
Profitability: Gross/Net Profit Margin, Return on Assets (ROA), and Return on Equity (ROE)
Gross Profit. Good Profitability means that a company keeps a large part of the ickles that customer dwarves pay for their goods or services (revenue). If you give the brewery 2 ickles for a bottle of pixie stout and it costs the company 1.20 ickles to produce it (raw materials, packaging, labor and other direct costs of the beer), it will have 0.80 ickles in gross profit.
Gross profit tells you about whether the company can demand high prices from customers (or not) and whether the company is efficient in procurement and manufacturing (or not).
Net Profit/Net Income. But there are more costs to be covered, such as operating expenses (rent, equipment, marketing and the like), interest, and taxes to the dwarf king or queen, which are not so directly related to each bottle. Let’s say, these are 0,60 ickles per bottle. If you also subtract these costs per bottle of stout from the gross profit, you will get the net profit, thus 0.80 ickles — 0.60 ickles = 0.20 ickles per bottle.
Net profit tells you whether the company is profitable after subtracting all (!) costs.
If you want to calculate net or gross profit on all manufactured bottles (total revenue), just omit the “per-bottle” calculation. Then it is 2000 ickles for 1000 bottles, for example, and so on.
Now what is the net profit margin? You will get it by dividing the net profit (0.20 ickles) by the revenue (2 ickles), so 0.2/2 = 10 %. Likewise, gross profit margin is 0.8/2 = 40 %.
Humgrumblegrum… why do we calculate all that stuff?
- It makes comparison between companies possible. If one itsy-bitsy company retains 60 ickles out of 1000 ickles per year in net profit, while a giant company retains 100 ickles out of 2000 ickles, which one is “better” — in this respect? Just calculate net profit margin: itsy 60/1000 = 6 %, giant 100/2000 = 5%, so (of course) the dwarf company is greater, or shall I say, more efficient. The giant company makes more ickles overall, though. It now depends on the dwock price, but more to that in the “valuation” pillar.
- After looking at some dwocks, you will get a feeling what is a good gross/net profit margin for a certain industry. Two very earthly breweries yield net profit margins of around 7.5 % and 15.2 % — easy to tell, which one to buy, isn’t it? — Well, not so fast, my dear friend!
Profit margins tell you about the pricing power and/or cost efficiency of a company. The higher, the better.
Return on Assets (ROA). The brewery needs certain stuff, like machines, inventory, but also ickles, to keep up the production. If it needs a lot of them, but generates little profit, would you like to own it?
No, as somebody has to pay for this stuff. And this is what ROA is about:
How efficiently are assets used to generate profits?
Thus, ROA is net income divided by total assets. Suppose our brewery needs assets of 30000 ickles to produce 20000 ickles of total revenue a year (from 10000 bottles). That leads to 2000 ickles in net income (see above, net profit margin = 10 % times 20000 ickles of revenue = 2000 ickles).
So ROA is calculated as net income divided by total assets = 2000/30000 ≈ 6.67 %. A very earthly brewery, again: around 4.4 %. Hail to the brewery dwarves! And again, for ROA, larger is better. Sorry, my tiny dwarf.
Return on Equity (ROE). Now to probably one of the most important metrics for a dwock dwarf.
Shareholders’ equity is the capital within the company which is linked to you, Hulrum, as a dwock owner. It is calculated by subtracting liabilities (money owed to the dwarf bank, for example) from assets (see ROA), so: assets minus liabilities. This is the capital brought in by you and me (or our pre-owners of dwocks) and we want to see good returns on our ickles!
Suppose, the brewery has a loan of 10000 ickles at the dwarf bank. Then shareholders equity is: 30000 (assets) — 10000 (liabilities) = 20000.
So, let’s divide net income by shareholders’ equity and obtain ROE: 2000 / 20000 = 10 %. A certain earthly brewery reaches 20.7 %. Lucky human shareholders.
Why is it so important? The ROE shows us how efficiently the company earns profits on our capital — after subtracting all expenses, including interest (on liabilities) and taxes (to the dwarf king or queen).
Profitability is great, and we now have four numbers to count on:
- gross profit margin (efficiency in manufacturing and selling products),
- net profit margin (overall efficiency),
- ROA (efficiency in all things the company needs to function) and
- ROE (do they earn us a nice profit on our capital).
But that is not enough, I’m sorry, my dear Hulrum.
Humhumrumroomphish sounds in the tunnel. Ok-if-it-serves-me…
Health: Current ratio and Debt to equity
What about a highly profitable company with huge ROE, which at the same time has a gigantic loan at the dwarf bank with overwhelming interest rates?
So, for example, the brewery might have 30000 in assets, but 29000 in liabilities, which makes stockholders’ equity 1000. This boosts up ROE to 2000 (net income) / 1000 = 200 %! Great, isn’t it?
Not unconditionally. What if the banks wants its money back by some gnomish contract? What if interest rates are 10 % of the 29000, which is 2900, and thus very large and impacting net income? What if the company can’t repay the loan, then, or cannot serve the interest? — Your beloved brewery might go broke.
So when looking at dwocks, we also need to check whether the company is healthy or not. Let me give you two quick measures to check. Remember, this is not complete in any way, but a very good method to avoid a beginner dwarf’s harsh mistakes.
Current ratio. This ratio serves to check whether the company is likely to be able to serve its short-term liabilities. If a loan becomes due (you have to pay back now!) or some bill comes in rather unexpectedly, can the brewery pay that? To roughly check, we divide current assets (things that are ickles, or similar to ickles, which means these can be used to cover short-term costs; but also receivables, that is ickles owed by customers — remember your evening at the bar?) by current liabilities (loans to be payed back soon, upcoming bills etc).
If current assets are larger than current liabilities, thus current ratio = current assets / current liabilities > 1, then it is more probable* that the company will not go broke in the near future.
*Sorry, Hulrum, there is never a sure thing in the dwock market. It’s always about probabilities.
Debt to equity (D/E). You already know debt (payable, for example, to banks with interest) and shareholders’ equity (see ROE). If you divide debt by equity (total debt / total shareholders’ equity), this gives you the leverage of the company — how much debt is used to “amplify” the money shareholders put in? The higher it is, the riskier a company usually should be considered by a prudent dwinvestor. Usually, only long-term debt among all of the debt is used to calculate the number.
If debt to equity is high, more debt is used to fund operations. If everything works well, that’s great (higher ROE) — if not, too much leverage is not good. See our friend Bheldan Grumblebelt‘s story.
An earthly brewery company has a D/E-ratio of around 0.9, another 1.3. But there are industries in which lower, and others in which higher leverage (and thus D/E-ratio) is common. This might make sense — but not necessarily so. Check this very carefully, my dwarf friend, and make your own comparisons and estimates.
Valuation: Per-Share Concept and Price to Earnings-Ratio
Now we have a feeling if a company makes enough ickles for us and is efficient in that (profitability). We can furthermore assess whether the company is in sound short-term health condition (current ratio) and how risky it might be (D/E-ratio). Now let me get back to your initial dwock choice.
You bought the dwarf brewery stock, in my eyes a very wise decision in terms of attractiveness in the dwarf realm indeed. But wouldn’t you look for the price in anything else you buy? There has to be good value for money. And valuation is all about that.
Think about a dwock. It represents a share of a certain company. Say, the company has 1000 stocks total (“outstanding”, real-world: measured as “diluted”) and you own 10 of them, then you own 10/1000 = 1 % of the company.
As a dwockholder, you should always be concerned about “per share” measures: How much earnings of the company belong to one share? For example, if the net income is 2000 ickles as above and there are 1000 stocks total, the earnings (net income) per share, called EPS, are 2000 ickles / 1000 = 2 ickles.
What would you pay for a dwock which has 2 ickles of earnings per share? You won’t get all of these in cash each year, maybe some 0.5 ickles or so in dividends (cash payout), but in the end, you own these 2 ickles, either within the company (if not paid out, maybe even more when reinvested) or in cash (if paid out). So, answer my question assuming you actually get these 2 ickles.
Would you pay 2 ickles? 10 ickles? 100 ickles? I guess you’d agree that 100 ickles once for 2 ickles a year in earnings (at least this year, nobody knows the future) seems a bit high. However, 2 ickles seems a bit low.
Price-to-Earnings-Ratio (P/E). There is a measure for that, which is called Price-to-Earnings-(P/E-)ratio. You simply divide the current dwock price, say, 22 ickles by the EPS, say, 2 ickles, and get a P/E-ratio of 22/2 = 11.
Now you could compare, say, the other dwarf kingdom’s brewery with a P/E-ratio of 8. Thisother brewery seems cheaper: you pay a smaller price per ickle of net income.
Now what?
P/E-ratio allows you to compare companies within a certain industry against each other. Lower is cheaper, higher is more expensive.
The P/E-ratio can also be read as: If net income stays as it is, how many years will it take to repay the dwock purchase price by earnings?
But take care, my dear Hulrum: As in real life, cheap stuff might have a reason to be cheap — and expensive stuff might not be worth the price. So use the P/E-ratio wisely and always in context of other factors.
The P/E-ratio goes up when price goes up or earnings go down, as shown in the image below.
For example, price might go up (period 18–19) — “more expensive?” — but earnings earnings do even more so (also period 18–19), and thus P/E drops.
A very common P/E-ratio is 15–20 for some reason in our human world. You might use this number as some kind of reference (lower: cheap, higher: expensive), but it really depends on the industry. More on that maybe in a later dwarf-human-exchange.
Actually, there is much, much more to it than these numbers. But, my dear dwarf, these will give you a good feeling for a company before you start diving into the enormously important soft factors (remember “cheap for a reason”!): What about the management, the industry itself, future perspectives? What about competitors?
Let us have a final look at two sets of these numbers — and you decide, if and which of these blacksmiths (surprisingly resembling these of our human world) you would want to consider.
My dear human friend,
That was quite a lot of knowledge. I nearly felt a bit naive, but I am a proud digging dwarf, so that subsided fast.
I understand that both A and B are quite similar in terms of net profit margin, even though A seems more efficient in manufacturing (larger gross profit margin). ROA is better in A, so this is in accordance; however B has a huge ROE. I was very excited about that before I saw the D/E-ratio: B uses lots of leverage like I did last time with Bheldan Grumblebelt. Current ratio is above 1 for both of them, so I don’t worry too much. B seems much cheaper in its P/E-ratio; however, the huge leverage makes it risky. So I tend to investigate A further…
Just kidding, I asked an experienced dwinvestor dwarf and he answered for me. But don’t worry, I’ll get more inclined in the near future.
After all that, I will now go and buy beer, not the brewery.
Yours gleamingly,
Hulrum
For curious dwarves who want to dig deeper:
- The example balance sheet, cash flow and income statement numbers were roughly based on earthly breweries and also blacksmith-like companies, but scaled to ickle currency in the text examples.
- The earthly author of this article already had some satisfying value investing successes, but of course also (due to proper risk management only some minor) disappointments. He supports Hulrum as good as possible and intends to provide him only with proven and carefully considered information.
DISCLAIMER: This article presents my own learnings based on studies generated on synthesized (random, i.e., artificial) data which is statistically similar to real-world time series, and personal experience. The content is, thus, purely educational. Past performance is not reliable indicator of future results. The article should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.
