Yesterday I posted about the equity investor knowing basic accounting. Add basic math and stats to it too. He needs to be able to compute ratios, see trends, see how the stated strategy is being reflected in the accounts…Today I am going to write about some more things a good equity investor should know.

Understand the value of the Present Value of the FCF: Not too many investors understand the importance of cash generation in a business. See the pe that successful companies like Colgate, Cummins, Gillette get. It is stunning to think that in such dull boring business they should get so much of respect. Aka pe.

After all steel and aluminium manufacturers do not get such pe. Reliance does not get such pe. Tata Motors does not get such pe.

Why do the Colgate of the world get such a good pe?

Certainty of cash flow. New production does not add to their fixed assets. If they want more tooth paste in Assam, they outsource it to a manufacturer in Guwahati who deals with the local law and delivers toothpaste to Colgate in Assam. Simple asset light model even though they are in the manufacturing business model. It is almost like software in their terms of numbers when they need to expand. Or like Telecom in its initial years. Market also respects that people will continue to brush their teeth, and shave immaterial of whether the market is rising or falling.

While investing people ask me “is this still valid”. One thing which has never, ever lost its significance is of course the Present value of future cash flows. Somebody who does not understand this, should not invest at all. All asset pricing is the PV of future FCF. This is true for bonds, real estate, and equity. Gold, of course is the greater fool theory! Valuing equity is tricky because all the parameters are a little hazy – how much cash, when, whether it will come,…unlike a bond where the timing and the amount of cash is a certainty.

Sensible fundamental investors focus on understanding the size, growth rate and sustainability of free cash flow.
Factors that an investor must consider include where the industry is in its life cycle, a company’s competitive position within its industry, barriers to entry, the strength of the brand, the pricing power, THE REAL EDGE, the economics of the business, and
management’s skill at allocating capital. It is easy to understand the pe of a Colgate or a Hdfc bank. Hdfc Ltd is a little tricky – the real cash flow lies in the mutual fund, life insurance, bank, and a few other IPO in the waiting. So it is a SOPV which will work for Hdfc and not just pe of the current earnings.

To evaluate Hdfc with just its ebidta is to forget the limitations of financial accounting. It is just the past that is being analyzed. You get rewarded in the world of investing for predicting the future cash flow. And get amazingly well rewarded for being able to guess right far before the world does. That gives you the rising eps x rising pe.

On the other hand look at the FCF of Tata Motors – it is a huge company with operations in many countries. Its cash flow is impossible to predict and i do not see FCF happening till 2021. Why risk keeping my money in a company with INVISIBLE fcf? So it has such a pathetic eps and such a low pe. Do not be surprised to see even lower prices soon!

That has what created wealth for promoters like Deepak parekh, Uday Kotak, Murugappa group, Supreme Industries….and mnc like the ones mentioned above.

PS: permanent disclaimer I may be owning put options, a current position or a call option in the abovementioned shares. I may have a vested interest in the price movement of these shares. Use your brains before you risk your money. If that looks tough, Index funds are not a bad option at all.