Theory of Investing
The highest credo in any investment proposition is always: the intrinsic value must be materially higher than the offer, where intrinsic component of any investment is the conjunction of one or more variables that form the argument to the final thesis, an estimate of the value of something.
While a proposition may be a stamp, land, a commodity or an Asset, here we focus solely on the investment valuation of equity – Stock picking.
The first order of an equity thesis is the business itself. The business is composed of an idea and execution of a product or service comprised of what we term the throughput variables–prices, costs – that contribute to the ultimate generation of earning power for the company. The conjunction of these variables forms the business model.
The second order is the understanding that a business model is an Entity amongst many in the capitalistic-ecosystem, that provide a landscape for companies in the same category (industry) to compete with similar or substitute business models. These lead us to focus on the two most important qualities in the Entity: The ability, sustainability and longevity of the company to profit from its business model, and the evolution of the business model to exogenous conditions.
Hence we may induce that a stock picking is nothing but business model picking.
This framework is beneficial for the user in two-ways. It helps the equity analyst to define his circle of competence and it helps in the screening of companies that one may feel confident in valuing and acting with a significant wager.
If we cannot understand the business model then we cannot understand how the profits are generated and how will they be in the future. If we cannot understand the business model we do not know if the Company will survive a crisis, or if competition will dissipate profits or if it falls prey to competitive destruction. Cash may stave off a temporary decline, but a business model may bail you permanently.
The third and final order of the thesis is the combination of the business model framework and the related financial condition of a company presented by the Financial Statements. The important step here is the understanding of the symbiotic relationship between the usage of the balance sheet with its assets and liabilities interacting with the flow of the business model in the Income Statement.
An investment valuation is nothing but a multiple regression where the weights of each decision making variable – the business model, the assets and liabilities - are given an individual weight that give us a value we should place on them. Thus the sum of all is the net worth of any Investment
In some analysis the valuation is straight-forward, whereas in others is more complex. There is no silver bullet for a methodology as each Investment depends on endogenous factors – the application of the business model - and exogenous factors – the market price and the opportunities it may offer. In some instances the business model framework takes second stage to a simple financial statement valuation, in others the evolution of the business model may be significant in order to determine intrinsic value.