Course Outline

What does it mean to be a Business?

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Course Section 1 - Lesson 1

Business = Profits

What does it mean to be a "business"? Saying that my store is "open for business" conjures images of a cafe down the street opening its doors for the day. But that word: BUSINESS conveys a very special meaning.  

This is a course about business. It is specifically designed for people interested in buying and selling businesses on the stock market. And we are going to be talking a lot about stocks as we move forward through the material. But you must never forget that what we are talking about is business.

So what does the word business convey? Well, it makes it clear that this organization exists to make money. A business will never offer free products or services with no expectation of a profitable transaction in the future - as a charitable organization might. A business will also refuse to provide a service at cost or below cost like a governmental organization might.

Without profit or at least an intent to profit, there is no business.

Profits Move Business & the World Forward

Sometimes the idea of profit gets a bad rap. There seems to be a feeling of being taken advantage of when you know someone has profited off you. While I understand where this idea comes from, I couldn't disagree with it more. Businesses competing for profits is the engine that slowly but steadily increases everyone's standard of living over time.

Seeking profits is a good thing, and it is something that you as an investor should be searching for in the companies you invest in.  

Let's try to put our finger on exactly why striving for profits is such a good thing.  

The Power of Profit Seeking

In the year 1909, there were more than 24 million horses in the United States. That was about 1 horse for every 4 people. Around the same time, Henry Ford began mass-producing automobiles to make money. Initially, one of Ford's cars cost $825. That doesn't seem like much money for a car today. Still, at the time, that was nearly 3 times the annual salary of an average American. Additionally, it was significantly more expensive than the cost of a horse, the dominant form of personal transportation at the time, which was about $150. Because of this, cars were only affordable to the rich.  

However, Henry Ford wanted to sell as many cars as he could to maximize his profits. To sell more cars, he needed to get the price down. Over about 15 years, Ford managed to create a much more efficient process for creating each vehicle, which allowed him to drop the cost of his automobile from $825 to $260. The price decline meant that cars were now affordable to most of the population, and Ford saw sales boom. In 1909, Ford sold just over 10,000 vehicles. In 1924, he sold nearly 2 million. Even though Ford sold their cars for less, Ford's total amount of profit was much greater in 1924 relative to 15 years earlier.  

And we saw that increased profitability reflected in the value of Ford's stock. In 1909 the company was valued at ~8 million dollars. By 1924 the company was worth over $1 billion. A $1,000 investment in Ford in 1909 would be worth $125,000 by 1924. 

That is the power of profit-seeking behavior. Ford didn't cheat anyone out of the profits that he earned; in fact, he made the lives of 10's of millions of people better due to his automobile. The profits that his company earned and the increase in the value of the company's stock came from Ford creating an excellent product for customers who were willing to pay for that product.

Find the Profit

As we move forward through this course, I want you to remember that when we are looking for companies to invest in. The thing that will make you successful is identifying companies that create profits. Profits don't have to be immediate. Some of the best investments involve companies that are not currently profitable but will be in the future. But profits must come at some point. Otherwise, there will be no cash left to distribute to you, the owner of the business.

Spotting a Revolution is not Required

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Course Section 1 - Lesson 2

In the lesson, we looked at the rise of the Ford Motor Company and how Henry Ford's company became extremely valuable by producing a product that millions of people wanted and could afford.

You might be thinking to yourself: 

"Yea, that's great for investors that were around in 1910 and could buy shares of Ford, but it's not every day that a new mode of transportation is popularized."

And you'd be right. Revolutionary products like the rise of automobiles are rare. But it's important to remember that even when you're witnessing a revolutionary product, it's often far from clear that an investment in the company that makes the product will pay off.

When you are watching the rise of a product like the automobile in 1910, it's almost impossible to foresee its impact on the world. Even if you're confident that the product will change the world, it's not always clear that the current leader will be the one to win. 

Let's look at a more recent example that demonstrates both of these points.

The Rise of Social Media

In 1997 SixDegrees.com was launched to the world. What is SixDegrees.com, you ask? It was the very first social network. The site grew to over a million users in a matter of months. It appeared to be so promising that it was acquired for 125 million dollars just 3 years after launch. By the year 2000, it was dead.

Not long after SixDegrees.com closed, Friendster was launched. This site offered many of the same features popular on the most prominent social media networks today, including contact messaging, status updates, profile creation, and many others. On top of that, they had the users! The site received so much traffic in 2003 that its infrastructure crumbled under the load and forced most of its user base to search for a more stable platform.

As users fled Friendster, droves moved over to the newest social media site MySpace. In a very short period, MySpace grew to over 25 million users. But just as MySpace was achieving orbital velocity, a new competitor entered the market. It's not clear exactly MySpace lost. They did have a buggy site with frustrating navigation. Still, they had users and for a social media platform being where the users are is the most important thing. The only thing we can say is that they got outcompeted.  

Now you probably know how this story ends, but assume for a second that you don't. Would you bet your hard-earned money that the next social media platform to enter the market and gain traction would survive the next 5, 10, or even 25 years? I don't know; it's tough to make that call in real-time.  

Of course, the next social media platform to rise was Facebook. And its rise was fast. It went from a million users in year 1, to 6 million in year 2, to 12 million in year 3. And then something big happened to the owners of Facebook. They received an offer of $1 billion from Yahoo.  

Sit back and think about that for a second, and imagine that you were an owner of Facebook stock at the time. You have just watched 3 major social networks rise and fall in less than a decade. In 3 years, your investment has gone from basically 0 to $1 billion. Would you have enough confidence in the staying power of your website to turn the offer down?

Or think about it from the other side, from the standpoint of someone considering investing in Facebook. Obviously, you wouldn't invest the entire $1 billion yourself, but if you had an opportunity to buy a small fraction of the company at Facebook at that price in 2006, would you have enough faith in its long-term prospects to pay? I'm not sure that I would.

Picking Revolutionary Companies is Hard

In hindsight, it always appears that identifying and investing in companies with revolutionary products is easier than it truly is. And the stories of these companies that turn people into millionaires with a small early investment are alluring. But is extremely hard to know where to place these investments in real-time.  

Luckily for us, we don't need to have clairvoyant-like powers to make profitable investments in companies. We simply need to understand the dynamics of competition and estimate the cash flow generating capabilities of a company to identify great opportunities.

How does a business come to exist?

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Course Section 1 - Lesson 3

In the first two lessons, we looked at a series of revolutionary companies: Ford: which made cars when no one owned a car, and social media sites like Facebook before people connected online.

Today these products seem inevitable. But in the last video, we discussed why it could be challenging to make money by investing in companies with revolutionary products.  

  1. It's hard to be sure that a product will gain widespread adoption, and 

  2. Once a product does go mainstream, it's often the case that the first company to market isn't the one that ends up as the market leader.  

While investing in these companies can be a profitable investment strategy (and one that we'll talk about later in the course), these types of companies can often serve as a source of a lot of investment risk in your portfolio.  

In this lesson, I want to take a big step back from looking at revolutionary companies and instead refocus our attention on relatively dull businesses.    

Businesses are Born to Meet a Need

Every successful business in existence operates to meet a demand that wasn't being met by society. Sometimes the demand is easy to spot, like the desire for a more efficient means of transportation - as we saw with Ford motor company. But just as often, the demand can be hard to see for outsiders. Companies that supply restaurants with food, remove waste from our cities, and transport natural gas are essential for nearly every city today.  

There are thousands of companies that most people rarely think about that enable modern society. Companies like utility operators that generate electricity and clean water for our homes or textile manufacturers that create the cloth for apparel companies are rarely on our minds. If we do think about them, it can seem as if these companies have always been there, quietly operating in the background. But that's not the case.

These companies have only arisen because there was a need that wasn't being met in society.  

Needs Change Over Time, and so do the Businesses that Meet Them

It's easy to think that your local power company, for example, has always been in existence, but of course, that's not true. Your local power company set up operations once there was enough demand to offset the cost of building the power plant and the infrastructure necessary to deliver the power to the homes & businesses in your town.  

Imagine for a second that a new generation of solar panels was developed that could power an entire home for a one-time cost of $100. In this alternative reality, it's easy to estimate where demand for traditional sources of electricity would go - it would go to zero. As demand for the local power company's product fell eventually, the power company would reach a point where it was no longer profitable for them to keep running their generators, and they would shut down the plant.

It's essential that when we are thinking about businesses and potentially investing in these businesses that we understand that they only exist because demand for their product or service exists.

The Mindset of Demand

As a new investor, you must maintain a mindset of identifying where the demand for a company's products is coming from. Demand is the sort of thing that can exist for decades and then evaporate seemingly overnight. There are sources of demand that are more stable than others. Three that immediately come to my mind are food, water, and shelter. When you evaluate a company to invest in, you will need to make a judgment call about how stable the demand for that company's products will be in the future.  

As an investor, I like relatively boring companies because demand tends to be easier to estimate for these company's relative to their more exciting peers. When we get into lesson 3 and begin evaluating companies, you'll see that most of the work we will do is eliminating as much risk as possible from the investment decisions that we make. By choosing investments with stable demand, we can eliminate a giant source of risk early in the process.

All Companies Eventually Fail

In 2018, Jeff Bezos, the founder and CEO of Amazon.com generated a lot of press by stating that Amazon would fail. He wasn't saying that his business was currently facing trouble, only that eventually, something would come along that would force his now dominant company off of its pedestal. According to Bezos, companies tend to last for about 30 years. There are many exceptions to this statement, but the idea behind it is sound. Companies don't last forever, and you should not treat the companies you invest in as if they will. 

The Importance of Growth

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Course Section 1 - Lesson 4

Have you ever noticed that some types of businesses tend to be small while others seem always to be large? Interestingly, every town in America seems to have a shoe repair store, a dry cleaner, and a tax preparer that are owner-operated businesses. Why is it that some types of companies tend to be small while others like consumer goods companies or social media companies always seem to be large? And more importantly, why does understanding this matter for investors?

Let's start with why answering this question matters. Some characteristics make it difficult for certain kinds of companies to grow. While these businesses may be very profitable and may make their owners wealthy, they are not the kind of companies that should excite investors.

Components of Return

The total return of a stock investment is composed of two components: Dividends and Appreciation. Both of these are strongly affected by how much opportunity a company has to grow.  

If growth opportunities exist and a business can take advantage of those opportunities, sales and earnings growth will likely follow. As a company earns more, it can distribute more to shareholders, and as distributions to shareholders increase, the price of the stock will rise along with it. All of these are attractive characteristics.

Characteristics that Limit vs. Propel Growth

To take advantage of these characteristics as investors, we need to know what to look out for. I'm going to walk through four sets of characteristics that both detract from and encourage growth so that you can be on the lookout while you are looking for investment opportunities.

Service Businesses vs. Product Businesses

Businesses that require a given input of human labor for every unit of customer output are service-based businesses. Examples of service businesses include dentists, accountants, auto mechanics, hair salons, and many others. The defining feature of these businesses is that they require a provider with a skill that the customer is willing to pay for.  Service-based businesses are challenging to scale.

Efficiencies of Scale is a highly desirable characteristic in the companies that you will invest in. We always want to see a company become more profitable as it grows. Unfortunately, this usually isn't possible for service-based companies. There are several reasons why but the biggest is that human labor is expensive, and most service-based businesses are heavily dependant on a human in the loop.  

Product-based businesses, on the other hand, typically have considerable efficiencies of scale. A standardized product can be marketed, mass-produced, and sold with little additional per-unit cost.

When you're evaluating companies, you should tend to assign more growth potential to product-based companies as opposed to service-based companies.

Niche Focus vs. Broad Market Focus

In business, going after a niche can be a double-edged sword. On the one hand, it can be easier to gain a foothold in a market if your product or service is laser-focused on serving the needs of one particular set of customers. On the other hand, if your company never figures out how to expand outside of that initial niche, it may forever stunt the company's growth.

Focusing on a niche market is an entirely valid strategy for a young company. However, when you evaluate companies to invest in, you should be conscious of how companies position themselves and whether their positioning may put them at risk of limiting their future growth.

Linear Model vs. Platform Model

Linear business models provide value for their customers by providing them with a good or service. Whether it's a haircut or a hard drive, a linear business will provide something in exchange for cash. Most businesses are linear businesses, and there are many highly successful linear businesses operating out in the wild today.

The internet has enabled a new type of competition for linear business models, one that connects service providers directly with customers. Platform businesses don't sell a product or service; they serve as the middle man between the two.  

While most linear businesses will remain small, platform businesses, at least the ones that can attract both buyers and sellers, are almost guaranteed a significant market opportunity.

An example of a platform-based business is Uber. Uber doesn't have cars and drivers out in the world transporting passengers. All that Uber has is an app that connects drivers with passengers.  

Investors (especially those in linear companies) need to be on the lookout for areas where a platform-based business could disrupt the operations of their current holdings.

A fascinating article in the course materials section describes why platform-based businesses are so transformative; I highly recommend giving it a read.

Regional Focus vs. National/Global Focus

While a company getting itself into a position where it geographically limits its growth is rare, it is crucial to be aware of situations where a company may be incapable of serving customers outside its current geographic footprint. Companies whose operations are geographically locked to a particular region are at a high risk of bumping up against a growth ceiling without making significant changes to how they run their business.

We Don't Really Care About the Size of a Business. 

What matters from an investor's perspective is how much opportunity exists for a given business. There are high-level characteristics of a business that have outsized effects on its future growth opportunities. Understanding what those characteristics are will help you weed out growth-stunted investments before they can drag down your investment returns.

Competition: The Battleground of Growth

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Course Section 1 - Lesson 5

Business owners always want their companies to grow. Growth, as we learned in the last lesson, is valuable. But if every business is looking to grow, then surely these organizations will eventually collide with one another, right?

Right.

This collision between the interests of two or three or hundreds of businesses is where competition comes in. As investors, it's essential to understand the competitive landscape for the businesses we consider investing in. Seeking this understanding will allow us to better gauge the true potential for growth that our investments hold.

Classifying Competition

The first thing we should try to understand is how much control a company has over the price of its products. Your first thought may be: "A company has absolute control over the price of their products - they can charge whatever they want." But that's not true, at least not if a company wants to make sales. A long time ago, economists came up with a classification structure that simplifies answering that question. Firms are classified based on the number of competitors are in their market and how differentiated their products are from one another.

The four classifications are Pure Competition, Monopolistic Competition, Oligopoly, and Monopoly. You can see each category plotted on the chart below.

Companies classified in the pure competition bucket have no control over the price they sell their products. Farmers fall into this bucket, one farmer's wheat is the same as another farmer's, and thousands of farmers are competing to sell their wheat. They have no choice but to accept whatever the current market price of grain is.

On the other side of the chart are monopolies. An example of a Monopoly is the diamond company De Beers in the 1900s. They owned the only diamond mine in the world. If someone wanted a diamond, they had no choice but to pay whatever De Beers was asking. 

In between the two extremes are Monopolistic Competition and Oligopolies. Monopolisticly competitive companies sell differentiated products into a market with many different but competing products - think Apple's iPhone and the cell phone market. On the other hand, oligopolies are composed of a few companies selling very similar products, much like how just a handful of major corporations control nearly all of the US mass media market.

As investors, we prefer our investments to have as much control as possible over the prices they charge their customers. While monopolies are often viewed with disdain in the media, they can make desirable investments when they exist. By the same token, companies that operate inside of a purely competitive market are subject to market conditions that may threaten to put them out of business.  

Competition Over Time

In addition to understanding how the structure of markets affects competition, it's also important to understand how competition at the industry level evolves through time. The image below depicts an idea commonly referred to as the "Industry Life Cycle."

This image plots the total sales of an industry through time and attempts to label at which stage of its life the industry currently exists. When you're interested in investing in a company, it's helpful to try to identify which stage of the industry life cycle the company is operating in. Doing so will help you to set expectations around how quickly the industry as a whole will grow, how stiff competition will be, and how the company you're evaluating will be engaging with competitors.

Early in the industry life cycle, direct competition tends to be low. Instead of directly confronting one another, it is usually far more profitable for companies to move into new markets as quickly as possible and capture new customers who are not being served.  

As the industry matures and new customers become harder to find, companies will begin to compete more directly. As competition intensifies, individual companies will try to set themselves apart through either the quality of their product (which will increase production costs) or price (which will reduce the income per unit sold). Both of these levers reduce total profit, and we begin to see industry-wide profit margins contract.  

Incorporating Competitive Analysis into your Process

Understanding competition at a high level is a fundamental tool for assessing an industry in the early stages of your analysis. By simply answering two questions:

  • How would my target company's market be classified? (i.e., Pure Competition, Monopolistic Competition, Oligopoly, or Monopoly)

  • In what stage of the industry life is my target company's industry in?

You can gain a reasonably solid grasp of how difficult growth will be to generate and how profitable companies will be inside a given market.

Section Summary - One

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Course Section 1 - Lesson 6

We've covered a lot of ground in the first section. We've examined what it means to be a business and how businesses create value for their customers and owners. We've talked about how companies come to exist. We've discussed why flashy companies attempting to build revolutionary products don't always end up being the best investments. Finally, we've laid the groundwork for understanding two of the most important concepts we'll encounter once we begin researching stocks: growth and competition. We covered these topics quickly.

A few weeks ago, I fell down an internet rabbit how and I ended up reading an article about efficiency. That article broke down the drawing of a car and showed that once the artist was about 20% of the way through the illustration, the viewer could clearly identify the picture's subject. This drawing demonstrates the Pareto principle in action.  

I believe that's what we're working with in this course. You are most certainly not going to be an expert on any of the topics we've discussed so far. But the mere fact that you have been exposed to the ideas will convey a significant portion of their benefits to you.

With each lesson, I have linked to articles, videos, and exercises that will help you cement the ideas in your mind, and I encourage you to read, watch, and complete those. 

I devote a lot of energy to telling stories throughout these lessons hoping that these stories will stick in your mind and better illustrate the sometimes boring - albeit important - topics necessary to understand on your path to becoming a competent investor.  

While I hope the material is enjoyable to consume, I also hope you will not simply sit back and absorb it passively. Use the course materials I've provided, chew on the ideas in your mind, and actively try to think about examples and counter-examples to the ideas I've put forward.  

If you commit to doing that, I am confident that as we continue through the course, the ideas will become engrained in your mind, and you will begin to apply them naturally to your own investment ideas.

A Stock is not a Piece of Paper

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Course Section 2 - Lesson 1

There once was a money tree. Every day dollar bills would fall from the canopy to the ground where the tree owner, Mr. Jingles, would collect them. Some days just a few bills would fall; other days, hundreds would. While income was inconsistent, it did provide a good life for Mr. Jingles and his family.

One morning, while drinking his coffee, Mr. Jingles was struck with an idea. What if, instead of collecting the money from a single tree, he planted more money trees? He was sure the idea was a good one. The only problem was that more trees would require more land, which Mr. Jingles didn't have. He would have to buy land, but his current money tree provided just enough money for him and his family to live comfortably, and he didn't have enough savings to make the purchase himself.

To raise the money for the land, Mr. Jingles decided to sell an interest in the cash dropped by all of the money trees for the rest of time. This interest is what we refer to as stock.

Stock = a Proportionate Interest in a Company

I've said it before in this course, but stock in a company is simply an interest in a business. Every shareholder owns some amount of the "Equity" of the company. The number of shares of stock that an individual owns is their interest in the business. If a company has issued 100 shares of stock and you own 5 of those shares, you own 5% of the company.

Why Do Companies Issue Stock?

Usually, companies will issue shares of stock for the same reason as Mr. Jingles. They have projects that they believe will be profitable and don't have enough cash to pursue those projects. Selling shares in the company today provides a company with the money they need to initiate a project immediately.

A second justification for issuing stock is the company's current owners' desire to "take the company public" so that they can convert their existing equity holdings into cash. This process is referred to as an IPO or initial public offering.  

IPO's give early investors, usually private equity and venture capital companies, an opportunity to sell shares that they've acquired before the company was a publicly traded stock.  

What are the Benefits of Being a Shareholder?

Shares holders don't just get to see their holdings on their monthly brokerage statements. Stock ownership provides shareholders with certain rights as a result of their investment. Let's take a look at the six rights of shareholders.

Voting power 

Shareholders have the right to vote on major issues that affect the company. Standard issues that are put to a shareholder vote include the election of a board of directors, potential mergers or acquisitions of companies, and approving dividends paid to shareholders.  

Right to Dividends

Investors have a right to any amounts that the company pays to shareholders in the form of dividends. Dividends are paid on a per-share basis. Every shareholder will receive a payment equivalent to their ownership interest times the total amount of dividends payable to all shareholders.

Ownership in the Company

Every shareholder has a claim on the assets of the company. If the company were to liquidate its assets, shareholders are entitled to whatever is left after all debt holders have been paid.

Right to Sell Shares

Every shareholder has the right to be able to sell their shares as they see fit. When an investor purchases shares, they are not committed to holding shares for any amount of time. The investor can sell them as soon as a better opportunity comes along, or they no longer find the shares attractive.

Right to Inspect the Books

Every shareholder has a legal right to inspect the company's books. All company financial statements and filings must be accessible to shareholders, regardless of the number of shares an investor owns.

The Right to Sue for Wrongful Acts

Suppose investors discover that the board of directors has acted in its self-interest at the expense of shareholders. In that case, investors have the right to sue the company for damages.

All of these rights are an important part of being a shareholder. While we typically elevate that status of investor's right to dividends, in reality, if investors were to lose any of their other rights, their ability to earn an acceptable level of return from their investment would be compromised.

Limited Liability of Stockholders

One of the most important features of a stock investment is the fact that investors' liability is limited to their investment in the company's stock. If an investor purchases $1,000 worth of Apple stock, then the worst outcome for the investor is that the price of Apple stock may fall to zero. If the management of Apple commits fraud, while investors would not be happy, they would not have to worry that they may lose their home over the lawsuits that Apple as a company will face.  

By the same token, investors can benefit from unlimited upside potential. As long as Apple keeps growing and the value of Apple's shares keeps increasing, the value that is generated accrues to shareholders. There is no limit to how much of an increase in value shareholders may earn.

So that is a Stock

A share of stock is much more than a piece of paper or a line item on a brokerage statement. A share of stock truly represents an interest in a company with all of the rights that an investor in a company should expect.

Investment Vehicles

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Course Section 2 - Lesson 2

We don't often think too hard about the mode of transportation that we choose to take us where we need to go. Traveling down the street to get a bite to eat: we take a bike. Traveling to see family 20 miles away: we take a car. Going on a vacation across the country: we take a plane. Because we travel so frequently, assessing the pros and cons of each mode of transportation is second nature, and we can instantly identify the correct type of vehicle to get us where we need to go.

Investing isn't naturally ingrained in us the way that travel is. Often we know where we want to go: Save for retirement, save for a new home, save for a rainy day. But because these decisions are made infrequently, we are not as conditioned to know what investment vehicle we should choose for a given destination.

In this lesson, I want to review the types of investment vehicles available to us as investors. Of course, as this is a course on investing in stocks, this will be one of the few times that we mention most of these. However, I am sure that knowledge of what options are available will serve as valuable context as you orient yourself around the many investment options you see available in your brokerage account.

Securities that Companies Issue

We are, of course, aware that public companies issue shares of stock, but that's not the only option companies have to raise capital. In fact, issuing stock is generally considered expensive capital. 

To reduce the implied cost that a company pays to fund itself, a company will issue a mix of 3 types of securities: Equity, Debt, Preferred Shares. If a company healthy, it will usually issue debt as it is the least expensive funding method.

Corporate Debt: Corporate bonds are fixed-income instruments that companies issue as a way to raise capital. When issued, a bond will have a defined term and an interest rate that it will pay over the life of the bond. An example might be a 3% interest rate paid over 20 years. If an investor were to purchase $100 of this bond, they would expect to receive $3 each year for 20 years. In the final year, they would receive their principal, $100, back as well.

In the event that a company goes bankrupt, its bondholders are paid before its preferred stockholders and common stockholders, making it the safest of the three types of investments.

Preferred Stock: Preferred stock is a hybrid security that sits between debt and equity. The payments that preferred shareholders receive are fixed. However, the company can abstain from making payments to preferred shareholders during periods of distress without penalty. The catch is that preferred shareholders must be paid before common shareholders can receive dividends.

In the event that a company goes bankrupt, bondholders still get paid first, but preferred stockholders get paid next.

Common Stock: Stockholders are the true owners of the company. They take the most risk but also have the highest upside if the company succeeds. This course focuses on these securities.

Fund Products - Mutual Funds and ETFs

I will refer to mutual funds and ETFs in aggregate as pooled investment vehicles. The two types of investments are very similar but different in important ways. Both investments aggregate funds from many investors into a single investment pool which then buys the securities on the investors' behalf. For this service, they both charge a fee.

Mutual Funds: Mutual funds are typically actively managed investment strategies, although many passive options exist. These funds will invest in a range of securities, including stocks, bonds, and preferred stock as well as more arcane investment options like mortgages, options, futures, and commodities, which we won't be discussing in this course.  

When you invest in a mutual fund, the first decision that you have to make is the type of investment exposure you want. There are ~8,000 mutual funds currently operating. Nearly all of them will focus on a specific investment style, for instance, large-cap growth stocks, international stocks, investment-grade corporate bonds, and many others.

Once you decide on a strategy, you then attempt to select a fund company that you believe will deliver that strategy most effectively. Once a fund is selected and your investment made, you don't have to take any additional action. The fund company will monitor the securities in the portfolio and make trades as necessary. For this service, a mutual fund will charge a management fee.  

One of the big differences between Mutual Funds and ETFs is that most mutual funds tend to be actively managed, which means that mutual funds are devoting resources to identifying attractive securities. This active investment process is expensive, and mutual funds charge higher fees as a result, usually around 1% of the total investment each year.

ETFs (Exchange Traded Funds): The most significant difference between Mutual Funds and ETFs is that ETFs usually focus on passive investment strategies (although this is not a hard and fast rule). Instead of researching to identify attractive investments, passive strategies buy every security in a market or index. This approach of buying everything requires much less labor to execute and allows ETFs to charge lower fees than mutual funds as a result.

Commodities / Futures / Options

As you continue to explore investing, you will likely come across commodities, futures, and options contracts. These are all advanced securities that we will not cover in this course. In the right hands, these securities can be used to reduce risk and allow both investors and companies to fine-tune their investments to specific risk-return characteristics. In the wrong hands, they are used as purely speculative instruments that are much more akin to gambling than investing.  

Most brokerages will allow you to trade these types of securities very easily. I'd suggest that you stay far away from them until you are much more comfortable with investing basics.

Understanding Risk when Investing in Stocks

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Course Section 2 - Lesson 3

The Financial Crisis of 2008

On September 15, 2008, Lehman Brothers, the fourth-largest investment bank in the United States, failed due to large bets they had made in the US mortgage markets. The bank's failure triggered the forced selling of billions of dollars of securities as the financial sector scrambled to reduce its leverage and avoid the same fate as Lehman.  

Banks and hedge funds dug through their portfolios, looking for any assets they could sell to raise cash. This forced selling had a dramatic effect on the price of all financial assets. Two weeks after the selling frenzy began, the S&P 500 (a Large Cap US Stock index) was down over 10%. After three weeks it was down nearly 30%. After nearly six months of extreme volatility in the financial markets, the S&P 500 bottomed out after losing roughly half its value.  

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Streaming Video Overtakes Movie Rental Companies

In the mid-2000s, video streaming services started popping up on the internet, youTube in 2005, then Amazon's Unbox in 2006, Netflix in 2007, followed by Hulu in 2008. At first, consumers and corporations alike thought the internet was a place for cat videos and b-movies, not for a medium for serious content consumption. That opinion changed quickly as consumers discovered how easily they could summon their favorite shows and movies.

While many industries were and continue to be affected by the sudden shift in consumer preferences, one of the earliest and hardest hit industries was the movie rental industry. In the '90s and early '00s three major competitors fought for rental market share: Movie Gallery, Hollywood Video, and Blockbuster. These were not small operations; combined, the three chains had over 15,000 locations in the US. Just five years after youTube's launch, all three chains had gone bankrupt.

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BP Deepwater Horizon's Disaster

In the afternoon of April 20, 2010, an explosion at a British Petroleum offshore drilling rig killed 11 people and triggered an environmental disaster that would eventually release 5 million barrels of oil into the Gulf of Mexico. For three months, BP fought to stem the flowing oil at the damaged well before finally getting it under control. The disaster was the largest marine oil spill in history.

British Petroleum was found guilty of gross negligence as a result of the spill. The company was forced to pay for clean-up efforts and fines that totaled nearly $20 billion. In total, the disaster cost the company around $65 billion. More painful for investors, however, was seeing the value of the company fall from $185 billion before the disaster to less than $85 billion in just nine weeks, erasing 55% of investors' money.

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Investors Always Face Risk

As investors, we take risks. Part of the reason investors earn the returns they do is that they are willing to take on risks that others are not. All risks are not created equal, however. As you invest your financial resources into stocks with an unknown future, it's important to understand exactly what risks you are taking. The three stories above represent three types of risk that investors face. They are also three of the most difficult to protect against.

In this lesson, I want to review three types of risk specifically, which we will call market risk, industry-specific risk, and company-specific risk.

Market Risk

Market Risk is the risk that the price of all assets will fall, with the decline in prices relatively consistent across all assets of a similar type. A broad-based market decline, like that which we witnessed in 2008, exemplifies market risk. Investors had no place to hide. It didn't matter how much research they did into their holdings or how well they picked the stocks in their portfolio. Nearly every single stock fell during this period.

2008 was a dramatic example of market risk. But as investors, we don't have to look back more than a decade to find examples of market risk affecting portfolios. As I write this, we are just a year out from the beginning of the Covid-19 pandemic, which triggered a 30% sell-off in stocks globally.   

Market risk isn't just felt after a market decline. Right now, many investors are worried about how richly priced all stocks currently are—fearing that a decline in investor sentiment may trigger a market sell-off. (As of the date of writing, the market was trading 37x its average earnings over the last ten years, this is among the most expensive valuations of the last 150 years.)

It is incredibly challenging for investors to protect against market risk. The only way to reduce market risk is by taking the risk off the table completely. In effect, for most small investors, this would mean selling at least some portion of your investment portfolio and holding cash instead. This solution presents risks of its own. Namely, the fact that being uninvested for long periods can lead to sub-par investment results.  

Industry-Specific Risk

Certain events can hit specific industries particularly hard while seeming to have little to no effect on others. We refer to this type of risk as industry-specific risk. A shining example of industry-specific risk is the movie rental industry's downfall during the emergence of streaming video services.

While industry-specific risk can seem inevitable in hindsight, it is hard to label in real-time. And as we saw with Blockbuster and its peers, industry-specific risks can decimate an industry in the blink of an eye. Similar to industry-specific risks are company-specific risks. 

Company-Specific Risk

BP's Deep Horizon disaster is a perfect example of company-specific risk. The disaster was devastating to BP shareholders, decimating the value of their investments. Despite this, other companies and stocks fared perfectly fine; the market did drop a bit during the disaster, a few percentage points, but it recovered quickly after the incident was contained. Further, while concerns over increased legislation did spill over other companies in the oil industry, share price declines were primarily concentrated in BP shares.

Company-specific risk, like industry-specific risk, is inherently unpredictable. If it were predictable, investors would simply sell stricken stocks before the risk struck. Investments that you make will succumb to both industry & company-specific risk factors.  

But there is a way to protect yourself against these types of risk; by investing in multiple companies across multiple industries. By not keeping all of your eggs in one basket, so to speak, you limit the degree to which these two risk factors can damage your portfolio. Because we can mitigate these risks by spreading our investment bets, we refer to them as diversifiable risks.  

In the next lesson, we are going to talk more about exactly how we achieve the necessary level of diversification to protect our portfolios.

Reducing Risk Through Diversification

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Course Section 2 - Lesson 4

In the last lesson, we discussed the idea of diversification to reduce risk. Diversification is a word that you hear a lot in the investment arena. It means to spread your bets so that a single event doesn't have catastrophic consequences for your entire portfolio. In this lesson, I want to take a deeper look at why we would engage in the practice and how we execute such a strategy.  

The Why of Diversification

After the last lesson, the why of diversification should be obvious - unexpected situations can quickly impair or even destroy companies and industries. By spreading the risk across multiple investments in our portfolio, we can insulate ourselves from the threat of bad luck striking a single stock decimating our portfolio.

Protecting against losses is essential, and, intuitively, losing money is not a good thing. But it may not be immediately apparent why this is so important.  

Investing is a game of compounding returns. If you are a young lad or lady saving for retirement, you may decide to put away $250 a month to help make future-you comfortable. If you were to stick that money in your mattress for 40 years, you would find that your bed had $120,000 in it on the day you retired. Pretty good, but probably not enough to last you through retirement. Alternatively, if you were to invest it and earned 8% per year, that same $250 monthly investment would turn into nearly $875,000. Much better.

The power of compounding leads directly into why protecting capital is so important. If your portfolio falls by 50%, you don't recover once it rises by 50%.  

To get back to square one, you now need your portfolio to rise by a full 100%. That math works that way for all losses. Declines in portfolio value require a more significant gain to get back to even. Because of this mathematical phenomenon, we as investors must protect ourselves against losses. At the individual stock level, we do this by doing fundamental research on the securities we purchase (more on this in lessons 3 and 4); at the portfolio level, we do this through diversification.

Diversifying Your Stock Portfolio

There is no question that diversification is the key to reducing company-specific risk. However, in practice, the implementation gets complicated. Questions like: 

  • How many stocks should you have in your portfolio before you are adequately protected? 

  • At what point does a portfolio become so diversified that the time-consuming research you have done to find the gems is diminished?

creep in and cause portfolio construction angst.

Luckily, research on the question has been done. Burton Malkiel found that by the time a portfolio reached 20 (randomly selected) securities, the total risk of the portfolio was roughly the same as the market as a whole. That number gives us a rough estimate of the number of securities we should seek to include when building our stock portfolio.  

Including fewer securities will your portfolio will expose you to unnecessary levels of company-specific risk.  

On the flip side, you don't necessarily gain anything additional by including more than ~20 stocks in your portfolio. In fact, you may actually hurt your investment returns by including mediocre investment ideas. When you are researching companies to include in your portfolio, you will be much more excited about your top two or three ideas than idea number 25. Remember, the balancing act we face is neutralizing company-specific risk while still ensuring that your best ideas represent sizable chunks of your portfolio. 

Dampening Industry Specific Risk

There is a big caveat associated with Malkiel's 20 stock rule. When he did his study, the stocks that he selected to gauge portfolio risk were completely random. That means that he likely didn't have to worry about an industry concentration building up in his hypothetical portfolio. You will. The 20 stock rule doesn't hold if your top 20 ideas are all social media companies. Such a portfolio would leave woefully exposed to industry-specific risks like those that wiped out the entire video rental industry in the previous lesson.

When your building your portfolio, work to construct it with companies from many industries. This will ensure that you don't end up with a portfolio that is susceptible to a lightning strike as the world evolves.

But I don't have 20 Stock Ideas

As a new investor, you likely won't have 20 stock ideas that you can immediately put to work in your investment portfolio. Heck, even as a seasoned investor, there were many times where I was unable to build a stock portfolio to a level of diversification that I was comfortable with.

There is a solution to remain properly insulated from industry and company-specific bombs detonating and ruining your portfolio in this scenario. The trick is to realize that if you target a 20 stock portfolio, then on average, you will be investing 5% of your capital in each company. To ensure you don't become overexposed to any one company, limit each investment you make to only 5% of the cash you have available for investing.

For example, if you currently have $500, that means each purchase you make should be approximately $500 x 5% or $25. The $25 position size is what you should target, even if you only have 3 or 4 stock ideas that you are ready to invest in.  

Your Custom Competition Portfolio

So you have made your first four purchases. That's great! But now you have a new problem. You've only invested $100 of your $500 portfolio. What do you do with the remaining $400?

The first thing that you need to realize is that sitting in cash is ok. You don't need to feel pressure to be fully invested all of the time. However, if you do want to be fully invested, you have options for that as well.  

When you are out of stock ideas but want to have your capital "at work, " you seek market exposure. Today, we have some fantastic options available to provide inexpensive market exposure to investors. The way you achieve this is through stock index ETF's.

Continuing with the example above, if you've invested $100 of your $500 portfolio in individual stocks and want the remaining $400 to be invested, you could purchase $400 of an S&P 500 index ETF. Such an investment would give you exposure to all 500 stocks in that index along with proper industry diversification.

As you identify new stock ideas down the road, you could simply sell $25 chucks of your index exposure to give you the proceeds you need to fund new stock purchases.

This strategy allows you to stay fully invested while you are doing the work necessary to identify individual companies and stocks that will eventually fill out your portfolio.

Section Summary - Two

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Course Section 2 - Lesson 5

Portfolio Components and Managing Risk

In section two, we familiarized ourselves with the type of investments you will see available to you in an online brokerage account. 

Our primary focus was on stocks, but taking the time to learn about different securities like bonds, preferred stock, ETF's and mutual funds, helped us better grasp the investment landscape and understand where stocks fit into the greater investment universe.

We learned about the different rights afforded to the owners of a corporation's stock, and while some rights may never be exercised, the fact that they exist protects our investments and the future value we will derive from them.  

We can sometimes fall into a psychological trap where we see stock investments as line items on a computer screen whose prices bounce around randomly. We must be vigilant about reminding ourselves our shares represent a real ownership interest in a company that has sales, employees and generates value for its customers. This knowledge will be our primary defense against acting irrationally during inevitable periods of price decline.

We also learned about the types of risks our investments will face: market, industry, and company-specific, and how we can protect ourselves against these unforeseen risks - through a process called diversification.

While diversification can't eliminate all of these risks, namely market risk, it does go a long way towards protecting us against industry and security-specific issues. Further, it's easy to implement a diversification strategy. By spreading our investments over about 20 companies, we defend ourselves against unforeseen events. In the likely case where we don't yet have 20 investment ideas, we can effectively diversify through position sizing and using passive index ETF's.

These first two lessons laid the groundwork necessary to begin searching and vetting investment ideas. In the following sections, we will be doing precisely that. 

Generating Investment Ideas

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Course Section 3 - Lesson 1

Every time I sit down to write, I go through the same process. I grab my laptop; I find a comfortable chair; I lift the screen, and I open a text document. Without exception, there is a 30-60 second period where I die just a little. The feeling of dread looking into the white void of a blank text editor is real. Where do I start, where do I go, and how do I get there.

You would think that having gone through this process many times, I would be mentally prepared for it. But alas, I never am.  

Starting the process to identify investment ideas is very similar. The first time you do it, and probably many times after, you will sit down and think to yourself, "Where do I even begin." This lesson is for that moment. As soon as future-you finishes that thought, please think back to this very moment and remember what you are about to read.

Generating Investment Ideas

Throughout the following four sections, we are going to review four strategies for identifying investment ideas. By periodically reviewing each strategy, you should have a consistently full hopper of ideas to vet for your investment portfolio.  

Because you never know when a great idea will strike, begin a habit of recording interesting products, brands, and companies for later investigation in the notes app of your phone.

Companies You Know

One of the most obvious places to look for investment ideas is at the companies & products you interact with daily. If you are a typical first-world citizen, products and services that publicly traded companies produce constantly surround you. As a consumer of said products and services, you have first-hand experience with whether or not they are any good. If the quality of your life would materially decline if you lost access to one of these products, then add it to your list you may be on to an idea.

In fact, this strategy is so valuable that you shouldn't just stop at yourself. Anytime someone recommends a product to you, or you see someone choose one brand over another, pause for a second and ask them why that widget is so great. Nine times out of ten, the product won't be associated with a public company, or if it is, it will be such a small part of the companies business as to be almost meaningless to the stock. But on those rare occasions where you find a fantastic product that represents a sizeable portion of a public company's sales, you may just have discovered the next great opportunity.

This strategy is listed first because it is one of the best opportunities to generate unique insights. Unique insights are hard to find, but once you do find them, they can be incredibly valuable.  

Trends You Believe In

A second source of harvestable ideas comes from our beliefs about how the world is changing. We all have opinions about what the future will bring, and we all have experiences that inform those opinions. If we take time to think about what these changes will mean for the world, then we may be able to translate those opinions into investable ideas.

For example, as I write this, society as a whole is recovering from the Covid-19 pandemic. The pandemic has forced us to rethink how we live and work. One of the biggest realizations is that employees for many jobs can be just as productive working from their homes as they can from offices. Remote work makes companies happy because they can reduce their spending on expensive real estate and expand access to talent pools. It also makes employees happy because they can eliminate time-draining commutes and access new employers and opportunities outside of their immediate locale. I believe that the pieces are aligned for a multi-decade change in how employers and employees work together. What might this mean for the future? Here are some ideas:

  • employees & employers will need tools to communicate effectively, like video conferencing and workflow tools,

  • employees, spending more time at home, will consume more content: TV, Streaming Services, Audiobooks, Podcasts,

  • Lunch at home, instead of out or in the office, will raise demand for food delivery or at-home options,

  • Access to high-speed internet will become very important

From this quick list, we can identify at least a few brands and companies that should be in a position to benefit from this trend. For example, Zoom, Slack, Netflix, Spotify, Audible, Blue Apron, Uber Eats, and Starlink immediately come to mind. From here, we can add these companies to our notes app for further vetting.

Companies in the News

The national news cycle can have a powerful effect on publicly traded companies, especially when the coverage focuses on a very visible but likely short-term issue. National or even worldwide media coverage can be enough to cause massive movements in a company's stock price. In some cases, it can be enough to turn a ho-hum investment into a winning opportunity.

The challenge with finding opportunities by following news coverage is knowing when the move in a company's stock price is unjustified given the situation. Gauging this in real-time is almost impossible unless you have some insight into the company, industry, or environment. Because of this, you will likely have to pass on a lot of stocks that see major price declines simply because you won't know if the drop was justified. However, every once in a while, you will see a company that you love make a public misstep and experience a dramatic share price decline. These are the opportunities you want to catch.

Stock Screeners

The last idea generation tool I'll mention is stock screeners. Stock screening tools allow investors to input criteria they desire and outputs a list of investment options that meet those criteria. An example of a free stock screener is Morningstar's tool (Morningstar Login required). Such a tool allows you to quickly identify companies that pay a particular dividend or trade below a specific P/E multiple.  

While screeners provide a source of investment ideas to begin researching, you need to be careful about what you do with the results from screening. Often, companies that filter to the top of the screening results look attractive on paper but face severe business challenges.  

Final Thoughts on Idea Generation

I hope the content of this lesson helps get you over the feeling of not knowing where to start collecting investment ideas. But I also hope that once you have a list of ideas in hand, you will treat them as just that: ideas. Some ideas are good, and others are not.  

Once you have a list of ideas, it's time to validate them. Throughout the rest of this section, we will be validating the strength of the businesses you've identified. Only once we are confident in the strength of the companies we've identified will we begin to figure out an attractive price to make a purchase.

Your First Date with a Potential Investment

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Course Section 3 - Lesson 2

Once you've constructed a list of potential investment options, it's time to establish whether any of the companies on that list are worthy of investment. Making this determination will involve several steps, which we'll walk through over the remain lessons in Section 3. To assist us in driving home the work we will be doing; we will be analyzing the company Texas Roadhouse, ticker symbol TXRH.

The first step in this process is to understand how the company operates and how its customers perceive its products and services.

To accomplish this, we'll be doing some internet sleuthing. Along the way, we'll need to find company filings, conference calls, news articles, and hopefully comments/blog posts from genuine customers.  

Information Sources

Before we dive into what we're looking for in the information we collect, I first want to talk about where we find it. 

Edgar - sec.gov

The first information source we will be utilizing is Edgar, the Security and Exchange Commission's tool for aggregating and disseminating company filings. The home page for Edgar, which can found here, conveniently positions a company search box front and center on their homepage. By typing in a company's name or ticker symbol, we are taken to a page displaying all of the company's filings. The ones we are primarily interested in are the 10K and 10Q filings.

Company Investor Relations Page

Most publicly traded companies will host an investor relations page, which will provide easy access to glossy annual reports and company conference call recordings. You can typically find links to these pages on a company's homepage or by simply googling "<company name> investor relations". To get an idea of the information on these pages, check out Texas Roadhouses' investor relations page.

Google News

There are many outlets to find company news. Still, one of my favorite sources to get a list of all company headlines regardless of the originating outlet is Google News. This tool allows you to search by company name and period to quickly see what stories are talking about the company.

Google / Amazon / Social Media

When it comes time to assess how customers feel about a company, we can turn to any sites that allow real people to post their thoughts about company products and services. 

Answering the Important Questions

Using these free data sources, we seek to answer fundamental questions about what the company does and how stable its competitive position in the industry is.

Let's walk through this process for Texas Roadhouse.  

Start with a 10K Read-Through

The first step when reviewing a company is reading its most recent Annual SEC filing (10K) from the Edgar website. 

It can be intimidating the first time you read one of these documents; they are usually pretty long, 100+ pages, and contain many cryptic tables. But after you read a couple of them, you begin to see that they all follow a relatively similar format: First, in Part 1, they discuss how the company's business operates, then, in Part 2, management of the company provides their interpretation of the most recent periods results, finally in parts 3 & 4 corporate governance issues will be reviewed and the company will provide complete financial statements (or links to financial statements).  

Parts 1 & 2 offer the most value when you're doing your initial evaluation. In these sections, we discover that Texas Roadhouse is a restaurant operator that runs about 640 restaurants across the United States. Each restaurant costs about $6.2 million to open, and once a location is open, it generates about $4.6 million in annual sales. Additionally, we see that while Texas Roadhouse does own and operate a majority of its restaurants, it also franchises about 100 others. Finally, if we deduct food, labor, rent, and other operating expenses from total revenue, we can see that each restaurant generates about 17 cents of income for every dollar of sales.  

At this point, we have a pretty good understanding of what Texas Roadhouse does. We can roughly estimate how much revenue the company generates each year: Total Number of Restaurants x Avg. Sales per Restaurant or ~$3 billion. And how much operating profit the company earns: $3 billion x 17% or $500 million.

From here, we can start to formulate some of the more important questions that we are going to need to answer later on in the process:

  • How consistent are the company's sales?

  • What levers can the company pull to increase sales?

  • For every dollar of sales, how much profit does the company generate?

  • Is there room for the company to expand its current level of profitability?

  • Are there any significant risks to the company's business model?

What is happening in the News?

While the annual report is an excellent source of information on the company, it often fails to provide a sense of its immediate challenges. To fill in these gaps, we turn to google News.  

As you might expect, given that Texas Roadhouse is a restaurant, we see many news stories that discuss the challenges of the restaurant sector during the Covid-19 pandemic. We should note this and keep it in mind when we later analyze its financial results during the pandemic period.

Additionally, we also see stories discussing the recent death of the company's CEO and Founder. This is a major event for the company and can potentially change the company's trajectory. As we continue to research Texas Roadhouse, we want to keep this unexpected leadership change at the front of our minds to make an informed decision about how it will affect the company's future.

Investor Relations Page

Now that we have a general sense of what the business is and what headlines the company has been making, it's often helpful to hear management's take on recent company performance and its current outlook. 

A great way to gather this information is by listening to the quarterly conference calls that nearly all companies host and save to their investor relations websites. 

These calls usually start slowly as the management team walks through prepared comments; however, the Q&A portion of the call is very informative. For one, professional investment analysts are asking the questions, so you can get a sense of what investors on Wall Street are thinking about the company, and two, the answers that company management provides to the questions are usually pretty candid, and it's information that can't be found anywhere else.  

For Instance, on the Q4 2020 Texas Roadhouse call, we heard that:

  • To-go orders are skyrocketing as a percentage of total sales. Even though the company is happy to accept these orders, profit margins on to-go orders are lower than in-house, mainly due to a lack of alcohol sales to-go.

  • Texas Roadhouse expects the mix of in-house and to-go to normalize throughout 2021, allowing margins to expand.

  • The late CEO, Kent Taylor, stated that he expected the current rate of new restaurant openings (25-30 new locations each year) to continue for "many" years.

What are Customers Saying?

Finally, the last overview piece of information that we want to gather is a high-level understanding of how customers view the Texas Roadhouse brand.

Yelp is a primary aggregator of restaurant reviews. If you search for Texas Roadhouse on Yelp, we see that the restaurant has a 4.0 out of 5 rating across 3,000+ reviews, which is high for a chain restaurant.  

Similarly, when I search for Texas Roadhouse on Reddit, most of the results are positive threads (especially about the bread), indicating positive emotions associated with the brand.

These two data points are enough to give me enough confidence at this point the customers view the restaurant positively.

Digesting What We've Learned

In an initial company review, our goal is to develop a sense of what a business does, how well it's doing it, what opportunities or land mines lay in its future, and how its customers feel about its brand.

In just a few hours of work we can accomplish this using completely free resources.  

For Instance, with Texas Roadhouse, we've gone from a simple understanding that the company runs restaurants to knowing that the chain runs 640 dining rooms across the US with plans to open 25-30 new locations each year. We know that each location the company opens costs about $6 million to open then generates a million dollars a year in income for investors. We know that the customers that patronize Texas Roadhouse have positive feelings about their experience with the brand. These are all strong signals that an investment opportunity may exist within TXRH stock. However, there are some pitfalls that we need to watch out for.  

The fact that the company's founder and CEO passed away this year could negatively affect operations going forward. On top of that, we are still in a global pandemic, and restaurants, in particular, rely on customers visiting their locations in person. We will have to come to terms with these two immense challenges before we invest in Texas Roadhouse.

This first phase of analysis is simply about understanding. While Texas Roadhouse is an attractive company that warrents further analysis, we could have just as easily dug into a company that was a complete dud: One whose business lines were failing, revenue was declining, and whose customers abhored it. In such a case just move on.

For now, we'll continue to dig deeper into Texas Roadhouse.

Evaluating an Industry

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Course Section 3 - Lesson 3

In the last lesson, we found a stock, Texas Roadhouse, that had some attractive characteristics: It was operating profitably, growing, and its customers are fans of the brand. Now it's time to dig deeper; the first thing we want to understand is the industry in which the company operates.  

Identifying Direct and Indirect Competitors

Most companies have layers of competitiveness with other products and services. If I want to watch a movie right now, several companies could help me satisfy that desire. Obviously, television manufacturers build devices that are capable of displaying movies. But so do computer manufacturers, and tablet manufacturers, and cell phone manufacturers. All of these devices potentially compete to deliver a movie viewing enabled device to consumers. When we evaluate a companies industry, while we want to be aware of the deeper layers of competition, we are primarily concerned with direct competitors: TV manufacturers in this case.

When we look at a company like Texas Roadhouse, they are obviously in the restaurant industry. But not all companies in this industry are direct competitors; for instance, if I offer to take my wife to dinner one evening, Texas Roadhouse may be an option, McDonald's likely will not.  

Similarly, I used to work at a job that required a lot of travel. Some evenings, I would have a two or 3-hour drive to get home at the end of my day. If I were hungry during one of these late evening treks, It's unlikely I'd want to sit down for an hour-long meal at Texas Roadhouse. However, McDonald's provides just the sort of quick calories I'd need to satisfy my hunger and get me back on the road quickly.

Texas Roadhouse operates within a segment of the restaurant industry referred to as the Casual Dining segment. You discover this as you read the company's 10K filing. This segment sits above fast food in terms of service and price but below fine dining. A couple of google searches reveal that hundreds of restaurants operate in the casual dining space (see this Wikipedia article), but only a few are publicly traded.

Since privately-held companies don't report any business information, practicality says we should define the industry for Texas Roadhouse using a subset of publicly traded casual dining restaurants. For your reference, these companies are:

  • Texas Roadhouse, Inc. (TXRH)

  • Cracker Barrel Old Country Store, Inc. (CBRL)

  • Chuy's Holdings, Inc. (CHUY)

  • Brinker International, Inc. (EAT)

  • Bloomin' Brands, Inc. (BLMN)

  • The Cheesecake Factory Incorporated (CAKE)

  • Dave & Buster's Entertainment, Inc. (PLAY)

  • Red Robin Gourmet Burgers, Inc. (RRGB)

  • Denny's Corporation (DENN)

  • Darden Restaurants, Inc. (DRI)

Notice how this is not an exact science, nor does it need to be. When looking at industry and competitor data, we are attempting to draw general conclusions about the state of our target company's position in the industry.  

Drawing High-Level Conclusions about the Industry

Now that we've defined the companies in our target industry, it's time to start drawing some conclusions. If you think back to Section One -Lesson Five of the course, two concepts were introduced: 

  1. The type of competition that companies faced, and

  2. The stages of an industry life cycle

We want to begin by identifying each of these for our target company.  

In this case, the type of competition that Texas Roadhouse faces is pretty clear-cut. There are hundreds of companies operating in the casual dining segment, ruling out monopolies and oligopolies, yet each restaurant can differentiate itself through its fare and environment. This differentiation among hundreds of competitors places restaurants firmly in the monopolistic competition category. Indicating that while restaurants have some control over pricing, that control is generally limited.

The industry life cycle for restaurants is also pretty straightforward. Restaurants have been around for hundreds, if not thousands of years. This industry has fully matured, and I would be unable to identify any reason it might have drifted through to the "Decline" phase. In aggregate, we are probably unlikely to see growth from the industry that is significantly greater than the growth of US Gross Domestic Product, or about 2-3% per year.

These two characteristics tell us a lot about what we should expect from an average investment in a restaurant stock. We will probably see relatively tight margins and relatively low growth unless our target company is a great operator, doing something innovative, or taking on a lot of financial risk (leverage).

Diving Deeper into Competitors

With these two questions answered, the next thing we want to determine is where our target company sits in the industry hierarchy. This involves some data collection.  

Generally, what I want to know is, for every competitor we identified earlier, what are their total sales, what is the value of their company, and how profitable are they.

Collecting this data can be time-consuming if you do it by hand. But I've included a google sheets template in the course materials for this lesson that automatically aggregates this information by just entering a group of ticker symbols. Below is a screenshot of the document:

By filling out the template for the casual dining industry, we can see that (of the publicly traded companies) the industry generates about $20 billion a year in total sales. Of that total amount, Texas Roadhouse is responsible for about $2.3 billion. They are not a small player, but not the biggest either.  

If we look at the market capitalization (or stock value of these companies), we see that the industry is worth about $42 billion or just over 2x revenue. What's interesting is here is that even though the average causal dining stock trades for ~2x revenue, Texas Roadhouse's stock is priced at 3x revenue. This is an early indication that either Texas Roadhouse is overvalued or they are generating far more value for investors than the average company in the industry.

Industry Knowledge Sets the Stage

This analysis of the industry may feel cursory, but it provides valuable context as we begin a deeper dive into the financial statements of our target company. In a very short period of time, we've established expectations for growth, margins and got a preview of pricing for casual dining stocks. We've also gained some insight into how the market views our target company, which appears to be favorable since it's priced at 1.5x the average stock in the casual dining industry.

For the remaining lessons in section three, we will be focused specifically on translating & analyzing the financial statements of our target company. We will, however, be coming back to take a closer look at the industry in section 4 when we tackle setting a price target for our company, Texas Roadhouse.

Finanical Statement Analysis for Investors - Part 1

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Course Section 3 - Lesson 4

Every company keeps records of its financial position and the results of operations. However, publicly traded companies are unique in that they must make these records available for anyone to review. Every quarter, all publicly traded companies release four major financial statements: Balance Sheet, Income Statement, Statement of Cash Flows, and a Statement of Changes in Shareholders Equity.  

These documents provide investors with a very clear view of exactly how a business is performing at any point in time. A complete understanding of these documents can require a college degree in accounting and many years of experience. However, investors often don't need to understand every nuance of how transactions are reported in these statements to make informed decisions. In this lesson and the following two, I will walk through how we can use these documents to make better investment decisions.

But before we do that, I want to start with an explanation of each.

The Balance Sheet

The Balance Sheet provides you with a snapshot of a company's financial position at a point in time. The document provides you with a listing of all assets (things they own), liabilities (debts they owe), and equity (what's left for owners) at the end of a given period.

For Each section of the Balance Sheet, line items are listed from the most "Liquid" or the easiest to convert into cash to the least.  

One nuance of the balance sheet that is important to understand is that items are listed at cost (what a company paid to acquire an asset), not at fair market value. At first, this may seem counter-intuitive. Suppose you're looking at this document to understand a company's financial position. In that case, you care much more about what the assets are currently worth than what the company paid for them. However, establishing a fair market value for something like 150 restaurant buildings is tricky. Because of this, regulators have settled on an at-cost requirement to prevent management from aggressively fudging the numbers to make their company look more attractive than it really is.

We will primarily use the balance sheet to determine whether companies are putting themselves in precarious financial situations. 

The Income Statement

The income statement gives investors insight into how a business performed over a given period, typically a quarter or a year. The document begins with revenue and deducts various expenses as the reader moves down the schedule. At the bottom of the income statement, readers will see both a net income line item and net income on a per-share basis.

The income statement is useful because it helps us understand how a business makes money and where the major costs for a business lie. 

We can use the income statement in a few different ways; by looking back at historical statements, we can:

  1. evaluate how well the management team performed,

  2. determine how volatile certain revenues and expenses are,

  3. set baseline estimates for line items to use in forward-looking projects.

We will do all of these as we progress through our analysis of TXRH.

The Statement of Cash Flows

There's an important concept in accounting called accrual accounting. Accrual accounting refers to a methodology of preparing financial statements such that revenues and expenses are matched to the period in which they actually occurred. For instance, imagine you run a bakery. In January, someone prepays for a cake that is to be delivered in February. Under an accrual basis, you would not recognize that revenue until February - even though you actually received the cash in January. Public companies' income statements are prepared on an accrual basis.  

While accrual accounting is excellent for providing an understandable breakdown of a company's operations - it does not provide clarity around when cash is actually changing hands.

The statement of cash flows provides this information and more. The document is split into three sections:

  • Cash Flows from Operations,

  • Cash Flows from Investing, and 

  • Cash Flows from Financing

Cash flows from operations remove the effects of accrual accounting so that you, as an investor, can see precisely how money moved during the course of business.

Cash flows from investing show flows resulting from purchasing or selling long-term assets, such as a factory or a restaurant building.

Finally, cash flows from financing show transactions that occurred in association with debt and equity issuance. 

Types of Analysis we will Perform

There are primarily two ways that we will be reviewing these documents: Vertically, Horizontally, and through Ratios.

Vertical analysis refers to the practice of analyzing a single year within a particular statement. When we do this, we will often convert a given statement to a "common size." This refers to taking every value in the statement and looking at it as a percentage of either total assets (in the case of a balance sheet) or revenue (in the case of an income statement). 

Horizontal analysis refers to the practice of looking at the same line item over many periods (quarters or years) to see how that line item changes over time. 

Ratio analysis is the practice of combining two or more related fields in a given statement to derive a figure that is comparable to itself over time and to other companies.

In upcoming lessons, we will be performing all three types of analysis on Texas Roadhouse and its competitors.

A Note on Aggregating Data

It used to be the case that all of this data had to be compiled by hand. As you can probably imagine, doing the necessary data alignment and calculations this way would be time-consuming. Today there are many tools available to help with the grunt work; one of my favorites is Tikr.com.

Tikr is a web application that makes the process of financial statement analysis easy by automatically aligning statements across periods and conducting ratio analysis calculations. I'd suggest heading over to Tikr to sign up for a free account so that you can do the same.

Finanical Statement Analysis for Investors - Part 2

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Course Section 3 - Lesson 5

Now that we've learned a bit about the type of information we can find in financial statements, I want to walk through some real-world examples of how we might utilize this information. In the second part of our financial statement analysis lesson, we're going to look at review the financial statements of Texas Roadhouse and try to answer the following questions:

  1. How strong is the company's financial position?

  2. How consistently has the company grown, and what do I expect growth to look like in the future?

  3. How stable are the company's margins, and are there opportunities for margins to expand?

  4. Is the company maintaining its fixed capital (i.e., build/equipment/etc.) so that it's on solid ground for future growth?

For this lesson, I will be referring to tables that are pulled directly from my free tikr.com account. Also, Tikr has a great feature that allows you to copy financial statements and paste them straight into google sheets or Excel for easy manipulation.

Evaluating Financial Position

Assessing the strength of a company's financial position begins on the balance sheet. What we want to know is:

  • How much leverage, or debt, has the company taken on? 

  • Is it able to comfortably support the debt that it has?

  • Will the company be able to meet its near-term cash needs?

  • And has there any recent changes to any of the above?

To answer these questions, I'll begin by looking at the company's balance sheet over an extended period, say ten years.  

Before I dive directly into the questions, I first want to understand how the company has grown. To do this, I simply pull the top-line for Assets, Liabilities, and Equity into a spreadsheet and calculate the year-over-year change. When I'm done, it looks something like this:

When I look at this graphic, two things jump out.  

  1. I like how consistent growth has been, especially in the assets and equity sections of the balance sheet. It's indicative of a healthy growing company.

  2. There has been a giant jump in liabilities into 2019 and 2020. The increase is worrying, and I need to understand what was driving this.

I decided to dig into to point number two immediately and figure out what was going on. After some research, it turns out that the lion's share of the increase in liabilities results from a change in accounting standards for how companies must report property leases. This change in standards didn't fundamentally change the business or the amount of risk the company was taking. For now, I'm not worried about this liability spike.

How much debt does Texas Roadhouse have?

Once again, I've carved out a specific portion of the balance sheet to better understand the company's long-term debt.

At first glance, it looks like debt has skyrocketed recently. As we looked at a moment ago, the capital leases have always been there; they just haven't required reporting previously. The $190 million in debt in 2020 is new, and it is far greater than the $50 or so million that the company has carried historically. After some research, I found this in the company's 10K:

Given the pain that the pandemic has caused the restaurant industry, raising $190 million in cash seems like a prudent precaution for the company to take. While the company will have to pay interest on the loan, the interest payments are more than offset by the safety the cash provides during an uncertain period. Given that this is the only true debt the company has, I'm comfortable with this decision.

The last two things that I look at are the proportion of debt to assets for the company and how many times the company's earnings could pay its interest payments, also known as interest coverage (Earnings before Interest & Taxes / Interest Expenses).

The company's debt to assets ratio is currently at 60%; once this ratio climbs above 50%, a company can be considered highly leveraged. This is higher than I would like to see for a company that I invest in. However, three things give me comfort.  

  1. The bulk of the company's debt is due to leases, which can be renegotiated or exited during difficult periods.  

  2. The company's interest coverage ratio is over six times, which is perfectly acceptable.  

  3. About 25% of the debt was raised as a pandemic safety net. Given the trajectory of the pandemic, it's reasonably likely to be paid back soon.  

Overall, I'm comfortable with Texas Roadhouse's financial position.

Assessing Growth and Setting Expectations

When we refer to growth, we are referring to 1 thing - revenue growth. We want to know how quickly a company can sell more stuff. One line item, in particular, provides insight into the company's growth record, that is, the total revenue line item on the income statement.

Texas Roadhouse's record is impeccable. For the last decade, the company has grown total sales by more than 10% each year, excluding the pandemic. In fact, the company's track record of solid growth goes back a lot farther than 2011. This is precisely the type of consistent growth that you love to see as an investor.

Of course, this level of growth can't continue forever, or eventually, there will be a Texas Roadhouse on every block in the United States. However, we can look for clues for how much runway the company has left. These clues can't be found in the financial statements, however.  

At this point, it is necessary to make a judgment call about how many Texas Roadhouse restaurants the market can support. Given that there are currently 875 Olive Garden locations in the US, I'm confident that there is still a lot of room for Texas Roadhouse to expand its 611 locations. Still, even if the restaurant hits its target of 25-30 new locations per year, that only equates to about 5% revenue growth due to new locations. If we add another 2-3% for inflation-based menu price increases, we should expect to see about 7-8% growth in revenue for at least the next five years. That's very strong, but not quite the double-digit growth seen in the past.

Evaluating Margins

Before digging into margins, I want to take some time to explain what they are. Margin, or profit margin, is the amount of profit that each sale generates. If you sell a sweater for $100, but it costs $40 to make the sweater and $20 to market and sell it, then your margin on the sweater sale is $40 ($100 - $40 - $20 = $40). Because comparing products with different selling prices can be difficult, margin is usually expressed as a percentage of sales. In this case, we can easily convert the $40 profit margin to a percentage by dividing by the sales price, $100, to determine that our profit margin on every sweater sale is 40%.

Profit margins come in a few different flavors. You will see management and analysts discussing gross marginsoperating margins, and net margins when discussing their operations. Each type of margin refers to a specific point on the income statement.

Gross Margin is the highest level of margin, and it refers to the profit that exists after deducting costs that are directly attributable to the sale of the product. This measure provides a sense of profit each additional sale generates for the company.

Operating margin is the second-highest level, and it refers to the profit that exists after deducting directly attributable costs and the indirect costs required to run the business. These would be items such as marketing, rent, employee expenses, etc. This measure provides insight into how much profit the company generates.

Finally, net margin is the lowest level, and it refers to profit that is available after deducting direct and indirect costs, as well as interest and tax payments. This final measure gives investors a sense of how much of each sale remains for them after the payment of all expenses.

Obviously, higher margins are better. But as investors, we also care about margin stability and the potential for a company's margins to expand. 

Texas Roadhouse exhibits very stable margins. Aside from the most recent period, which includes the Covid-19 pandemic, gross, operating, and net margins have only fluctuated by a percentage point or two.  

Because margins have been so stable historically, unless we anticipate a change in the environment for restaurant operators, it's reasonable to assume that margins will remain roughly the same going forward.  

Ensuring Fixed Asset Maintenance

Nearly every company relies on fixed capital to run its business. It could be a factory, a warehouse, equipment, or any other assets that are integral to the company's operation. These fixed assets are typically expensive, and they require upkeep if the company expects to continue using them indefinitely.  

It can be tempting for a company's management team to forego the expenses necessary to maintain and upgrade these assets. Ignoring such costs would make the company more profitable today, at the risk of potentially ruining the company in the future.  

Before we invest in a capital-intensive company, we want to ensure that the management team is allocating resources to maintain the companies assets.

We can do this through an examination of the statement of cash flows. Within that statement is a line item titled "Capital Expenditures" in the Cash from Investing section. I've broken out that line item on a year-by-year basis for the last decade below.

While annual expenditures do bounce around a bit, we see two strong signals that management is taking care to maintain its fixed capital. First, yearly capital expenditures tend to be around twice the company's annual depreciation expense. Depreciation represents an estimate of the dollar value deterioration of capital assets. Second, on average, capital expenditures are growing at between 8-10% each year, right in line with the company's sales growth.

Usually, companies will provide further detail around their capital expenditures in their 10K filing and Texas Roadhouse took this step. As I was reading the filing I came across this table:

Again, this reinforces my belief that management is taking care of their capital.

Spending Time with Statements

While I attempt to cover some of the highest impact components of financial statement analysis in this lesson. This type of analysis is a very deep subject. There are many great books on conducting a thorough analysis of a company's books, and I recommend that you make time to read more on the subject. However, don't let the fact that you are not yet an expert stop you from diving in.  

10K's and 10Q's along with their accompanying financial statements are written in a way that allows laypeople to understand a business and the results of its operations. You will have to take notes while you read and google terms you are unfamiliar with, but you will learn a lot in the process, both about your company of interest and how to better read these documents.

Ratio Analysis

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Course Section 3 - Lesson 6

Financial ratios allow us to leverage our understanding of financial statements and efficiently analyze the operations of our target company and its competitors. These ratios distill key data points in financial statements down to a single number that is easily comparable across time and companies. In this lesson, we will look at how we can use this tool to learn about a company's operations more quickly and more accurately.

The idea behind all financial ratios is the normalization of data. By connecting two related data points and combining them into a single figure, we end up with a result that is both meaningful and comparable.

For example, say we wanted to know how efficiently a company was utilizing its assets. One method of measuring this would be to ask the question: "How much revenue does a company generate for every dollar of assets it has control over?". This is a calculation we could perform across every company in an industry and derive comparable results. For instance, if we ask this question for every company in the casual dining industry (using pre-pandemic numbers), we find:

So what does this table tell us? Well, for every dollar of assets that Cracker Barrell has control of, it generates nearly two dollars of sales. That's great; in fact, it's far better than the industry average of 1.2x. We like to see companies utilizing the capital that they control efficiently. Our target company, Texas Roadhouse, isn't quite as strong, but at 1.4x, it still ranks among the top of its peer group.

Let's take a look at how we utilize ratios to better understand our target company's liquidity, leverage, efficiency, and profitability.

Liquidity Ratios

Liquidity ratios help us understand how prepared a company is to meet near-term obligations. Two of the most popular ratios for understanding liquidity are the current ratio and the quick ratio.

The Current Ratio calculated as Current Assets / Current Liabilities, attempts to determine how likely a company is to meet upcoming obligations by comparing all of a company's most liquid assets to liabilities that are to be paid within ~ 1 year. 

The Quick Ratio attempts to answer the same question. But it recognizes that inventory and current assets classified as "Other" are more difficult to convert to cash than other current assets. Its formula is a slightly tweaked version of the current ratio: (Current Assets - Inventory - Other Current Assets) / Current Liabilities. This ratio is the more conservative of the two. 

Leverage Ratios

Understanding how much debt a company has assumed is critical to understanding how risky a company's stock is. While debt is not necessarily a bad thing, too much debt is. We can use leverage ratios to understand how a company is financing its operations and how its capital structure compares to its peers.

The Debt / Equity Ratio compares a company's debt to its total equity. This ratio provides an investor with an indication of how prevalent debt is in financing a company's assets. A high Debt / Equity ratio, may be an indication that a company has become too leveraged and is taking excessive risk.

The EBIT / Interest Expense Ratio calculates the number of times a company could pay its interest payments from earnings before interest and taxes are deducted. An EBIT / Interest Expense Ratio of 1 indicates that a company will just meet its interest payments with earnings from the core business. 

Efficiency Ratios

Efficient companies utilize capital effectively. They are good at turning investor's money into more money. When we make investments in companies, we want to make sure we are investing in management teams that have proven they can operate efficiently.

The Asset Turnover Ratio calculated as Total Revenue / Total Assets, tells how many dollars of revenue a company generates for every dollar of assets the company controls. Higher ratios indicate that the company is utilizing assets more efficiently than lower ratios.

The Inventory Turnover Ratio, calculated as Total Revenue / Average Inventory, tells us how many times the company sold all of its inventory, replaced it, and then sold it again during the year. A high inventory turnover ratio indicates that a company efficiently produces and sells its merchandise to customers.

Profitability Ratios

Profitability ratios help us figure out how effectively a company can convert sales into income.  

Return on Assets, calculated as Net Income / Total Assets, tells us how much profit a company generates for every dollar of assets the company controls. A high ROA indicates that a company can more profitably deploy assets than a lower reading.

EBIT Margin, calculated as EBIT (Earnings before Interest & Taxes) / Total Sales, indicates the proportion of a company's sales that are converted into profit. Higher EBIT margins are preferable to lower margins because of the reduced likelihood that a business will suddenly turn unprofitable.

Putting the Ratios to Work

Now that we have some familiarity with basic financial ratios let's put them to work on the companies in Texas Roadhouse's peer group to see if we can draw any conclusions about the industry.

The chart below looks at the companies in Texas Roadhouse's industry across the ratios we've identified above. Additionally, I've highlighted more robust ratios in green and weaker ratios in red.

Let's walk down this chart. We'll start with Texas Roadhouse's liquidity situation. At the end of 2020, the company had a current ratio and a quick ratio of about 1. Indicating that total current assets offset current liabilities. Further, because the company's quick ratio was also near one, we can also say that they are just about able to settle current liabilities with their most liquid assets. This is a great signal, and it doesn't give us any cause for near-term liquidity concerns.

As we move down the chart, the next component we come to is leverage. Texas Roadhouse has a debt/equity ratio of .88, indicating that for every dollar of equity the company has, it carries 88 cents of debt. This level of debt is modest, and it is the lowest in its peer group. Further strengthening the argument for a strong financial position, is the fact that TXRH can pay its interest payments more than six times from its 2020 earnings before interest and taxes. Again, this is among the strongest in its peer group. These numbers give us no reason at all to think that the company is over-leveraged.

Continuing on to efficiency, Texas Roadhouse does a great job of translating assets to sales. During the year 2020, which was dominated by Covid-19, the company managed to convert every dollar of assets into revenue. It also managed to turn its inventory over nearly 100 times, about every 3.5 days. These are both excellent numbers and give us confidence that management are good stewards of investor capital.

Finally, if we look at profitability, we see that Texas Roadhouse returned .8% on assets and generated an EBIT margin of 1.1% during 2020. These are the weakest numbers of the entire set, and while it's good that they were positive, they were just middle of the pack compared to the rest of the industry.

In aggregate, compared to its peers, Texas Roadhouse looks strong.

Section Summary - Three

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Course Section 3 - Lesson 7

Generating investment ideas and thoroughly researching those ideas is an essential piece of ensuring that businesses that make it into your portfolio are situated on solid ground.

In this section, we walked through 4 strategies to produce investment ideas for companies you and those around you believe in. Starting from the perspective of "This is a great company whose products I love." is one of the best tools that individual investors have to generate unique insights in their portfolio and produce market-beating returns.

With ideas in hand, we then walked through actionable steps that you can take to develop an understanding of how those businesses operate, what opportunities lie ahead, and what risks you need to be on the lookout for. This initial company review helps to understand the qualitative nature of the company.

By building an understanding of the company, we are then prepared to look deeper into the competitive landscape that our target company operates within. We look at competitors to understand what growth and profit margins industry participants should expect on average. And by defining the close competitors of our target company, we can use this comparison group to benchmark how well our target performs.

Finally, we learned to dig into the raw financial statements that public companies make available for all to see. This information allows us to refine our expectations for growth and profit potential for the companies we seek to invest in. Further, we then utilize financial ratios as a tool to make this analysis more efficient.

The work that we've done in section 3 helps us to identify great companies. In the next section, we're going to take that a step further and validate whether or not those companies are priced attractively so that we might initiate an investment that will outperform the market as a whole.

Estimating the True Value of an Asset

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Course Section 4 - Lesson 1

What is something worth? There are annoying economists out there who say something is worth what others are willing to pay for it. But that answer leaves a lot to be desired. What we're really asking when we want to know what something is worth: is what a "fair" value for the item is? For most items, it comes down to supply and demand. If there are just a few of the thing and many people want it, the price is high, likewise for the reverse. It can be hard to pinpoint a fair value for most assets.  

Financial assets are different. Because financial assets' primary feature is the cash flows they generate, it's possible to estimate what their "fair" value might be. Pay special attention to the word estimate. It is impossible to know the actual value of an asset beforehand. The best we can do is make an estimate.  

The Time Value of Money

Giving up control of money requires compensation. If you lend $100 to someone that they could start a business, it's unlikely that you would be ok with them just paying back $100 five years from now. You would want something extra in addition to the initial loan amount. That additional amount is what we refer to as interest. Interest has two components: a risk-free component and a risk premium component.  

The risk-free component of interest compensates the lender because they no longer have access to the money to spend on other things.  

The risk-premium component compensates the lender for the risk that they might lose some or all of their initial investment.

Estimating the Value of Risk-Free Asset

Before we tackle the complexities of valuing a complex asset, like a stock, it's important to understand the theory behind how we would compute the price of an asset if all of the future cash flows associated with the investment were known at the time of purchase. There is a financial asset that meets these criteria: a US Government Bond.

US government bonds are the defacto risk-free security because the likelihood that the US will fail to pay its interest and principal on the bonds is so small as to be non-existent. Also, because these bonds have a predefined schedule of payments, both interest and principal, an investor knows exactly what amount and when they will receive cash flows from the bond.

Because everything about these bonds is so predictable, they allow us to anchor a key parameter for valuing all other assets: the Market Interest Rate. If a US government bond pays 1.7% interest over ten years, then we can say with near certainty that the lowest risk investment available will produce a yield of 1.7% for its investors. With this knowledge, every other asset is priced against this risk-free security.

Applying a Risk Premium

If a very safe company, like Walmart, issues bonds, even though it is a near-certainty that they will repay the interest and principle they owe on the bonds, they are still just a hair riskier than US government bonds. Therefore, market participants won't be willing to purchase a Walmart bond unless it offers a yield advantage over a US government bond. We can see this if we compare the two securities: A ten-year government bond yields 1.7%, and a ten-year Walmart bond yields 1.9%. This same principle applies to every financial asset, even those with hard to estimate cash flows.

For instance, if we look at Walmart's stock, we could attempt to estimate every single dividend Walmart will pay from now until the end of time (or when they go out of business). Once we have that long list of estimated cash-flows, we could then "discount" or apply an appropriate interest rate to each individual dividend payment that would properly compensate us for giving up access to our investment and for the risk we might not receive the amount we expected.

This is a valid valuation technique; it's referred to as discounted cash flow analysis. While it can produce a perfect asset valuation, it requires an investor to make many challenging assumptions. For instance, an investor would need to perfectly estimate:

  • Future earnings of the company in question

  • What proportion of profits the company will pay out to investors, and

  • the appropriate risk premium to apply to each dividend 

Each of these is extremely hard to estimate, and to make matters worse, small changes in any of these factors will lead to dramatic swings in the estimated "fair value" of the company.

The Volatility of Value Estimates with DCF Analysis

To demonstrate the volatile nature of DCF analysis, if we were to assume that Walmart was to grow their dividend by 3% each year from now until the end of time and that these dividends should be discounted by a rate of 4.5% to account for their risk, then we can calculate at an estimated value of Walmart's stock of $144. However, suppose we adjust each of these parameters by just 1% and estimate that Walmart will only grow by 2% and that an appropriate discount rate is 5.5%. In that case, we then calculate a fair value of just $64 for Walmart's stock: Less than half of the original estimate.

While it's important to understand this theoretical framework for calculating the value of an asset, because of its extreme sensitivity to the inputs being used, Discounted Cash Flow analysis is not typically a practical methodology to value a stock.  

A Practical Approach to Valuation

In the remaining lessons in this section, we will identify the key drivers of company value and explore a valuation approach that allows us to directly compare companies against each other to find attractive stock investments.

This approach is not only easier to conduct, as it requires making far fewer estimates, it is also more resilient against flaws in judgment that will inevitably find their way into our predictions.

The Key Drivers of Value

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Course Section 4 - Lesson 2

As we learned in the last lesson, making an accurate assessment of all of the necessary inputs to a Discounted Cash Flow model to calculate the "true" fair value of a stock is, for practical purposes, impossible. But that doesn't mean that we can't learn something about the drivers of stock value from these types of models.

Ultimately what matters in any valuation is:

  • What are the company's future cash flows?

  • How much risk is associated with those cash flows?

What Do We Mean by Cash Flows?

When we refer to cash flows, we are specifically referring to cash flows that accrue to investors. For stock investors, this consists primarily of dividend payments.

From the perspective of an investor, we care about the things that affect these cash flows. Generally, there are two levers that companies can pull to increase cash flow. 

Sales growth - A faster-growing company is worth more than a slower-growing company, all else equal.

Profit Margins - A company growing its margins is worth more than a company with stable margins, all else equal.

Dividend Growth Levers

Two understand why these two levers matter, imagine a company's income statement.  

Hypothetical Company

Revenue: $1,000,000

Cost of Sales: $500,000

Gross Income / Gross Margin: $500,000 / 50%

Operating Expenses: $200,000

Operating Income / Operating Margin: $300,000 / 30%

Interest & Taxes: $200,000

Net Income / Net Margin: $100,000 / 10%

If this company pays out 50% of its net income as dividends, shareholders will receive $50,000 in dividend payments this year.

Think about what could change to cause investors to receive higher dividend payments.  

First, the company could simply generate more sales. If the company sold $1.1 million worth of product instead of $1.0 million, assuming margins stayed the same, profits and dividend payments would immediately increase by 10% - making the company 10% more valuable.

Similarly, if the company only had to spend $400,000 producing its products instead of $500,000. Assuming operating expenses stayed the same at $200,000 and Interest and Taxes increase to 225,000 (more profit = more taxes), Net Income is now $175,000 instead of $100,000: Meaning dividends are now $87,500 instead of $50,000. This increases the payment to shareholders and the value of the business by 75%.  

Always Look to the Future

While investors want to see sales growth and profit margin expansion, the only way for these two levers to affect the current valuation of a company is if they occur in the future.

A company that has experienced extraordinary growth in the past but is looking forward to mediocre growth has no reason to trade at a higher valuation than a competitor who has grown at a modest pace all along.  

The same holds for margins. As an investor, it doesn't matter if a company has expanded its margins for the last five years straight. If margin expansion will be flat in the future, there is no reason to get excited about a company's ability to grow future dividends through efficiency gains. 

But My Target Company Doesn't Pay Dividends.

Many publicly traded companies, especially smaller companies, don't currently pay dividends. But that doesn't mean that these two valuation levers don't still apply. Even if a company doesn't pay dividends today, you should expect it to pay them in the future.  

Because the expectation is that dividends will come, even if checks aren't cut for many years in the future, how quickly a company grows and how efficiently it can deliver its products to customers matters when valuing its shares.

Applying Valuation Drivers to Texas Roadhouse

How might this knowledge on the key drivers of growth affect our current target company, Texas Roadhouse. Suppose we look back over the last five years (before the pandemic) at the casual dining industry.

Texas Roadhouse put up solid growth numbers. Over those five years, it has grown nearly 75%, putting the restaurant in the top 3 fastest growing restaurants.

As we talked about in section 3 - lesson 5, it's likely Texas Roadhouse won't continue to grow at such a breakneck speed. However, it should continue to grow faster than its peers.  

Additionally, operating margins for Texas Roadhouse have been right in line, if not a hair better than average for casual dining companies. Moreover, because TXRH is aggressively opening restaurants right now, the company will likely see margin expansion in the future as new restaurants settle into stable operations.

These factors are both positive signals for where the company's stock should price relative to its peers. In the next lesson, we are going to at how we can compare the valuations of similar companies to find the most attractive stocks in the industry.

Valuation Multiples

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Course Section 4 - Lesson 3

Every stock trades at a different price. Every company is a different size. No two companies generate the same revenue or earn the same profit. Yet, as investors, we are somehow supposed to dig through thousands of companies and identify attractive opportunities.  

If you've made it to this point in the course, you should have a good idea of how to identify promising companies. But how do you know when the stock of these companies is trading at an attractive price? We could always attempt to estimate and discount future cash flows. But as we learned a few lessons ago, DCF is far too sensitive to estimation error to generate actionable valuations. Enter valuation multiples.

What are Valuation Multiples?

Earlier, we learned how to analyze financial statements by creating ratios that compare business metrics through time and across companies. These ratios are easy to compute and facilitate quick and easy comparisons.

Valuation multiples are similar to financial statement ratios, except that the primary input is the company's current market value. The market value of a company can be defined in a number of ways: current stock price, total market capitalization, the value of the enterprise (including debt). What makes this metric particularly useful is the fact that it can be observed in real-time.

Without question, the most popular valuation multiple is the Price to Earnings Ratio. This ratio reflects the current price of a company's stock divided by its earnings per share. The P/E ratio provides investors with an indication of how expensive a stock is. 

If Company A earns $1 in profit this year and its stock trades at $20, we can compute its P/E ratio is 20x. If Company B earns $2 in profit this year and its stock trades at $30, we can calculate its P/E ratio to be 15x.  

According to this valuation methodology, we would say that Company B is less expensive than Company A, even though the stock price of Company B is higher (at $30). We say this because investors only have to pay $15 for every dollar of earnings that Company B generates, compared to $20 for a dollar of Company A's earnings.

Flavors of Valuation Multiples

While the price to earnings ratio is the most popular valuation multiple, there are many ways to combine a company's characteristics to determine its value. In the next lesson, we are going to explore why you should choose a specific multiple. But for now, I'd like to look more closely at what figures we combine to create these multiples.

The first figure we need to select when creating a valuation multiple is the metric by which we will determine the company's value. In practice, we have three choices: the price of a company's stock, its total market capitalization, or its enterprise value.  

Price Based Ratios - Price ratios are simple to compute. A stock's price is always readily available and easy to find. The only thing that you need to be aware of when calculating price-based ratios is that everything is measured on a per-share basis.  

Market Capitalization Ratios - The market capitalization of a company is equal to the value of all of its outstanding stock. To find this figure, you simply multiply the price of a company's shares by its stock price. Market capitalization-based ratios will give investors the exact same reading as a price-based ratio, without the need to convert operating results to per-share figures.

Enterprise Value Ratios - The enterprise value of a company is equal to the total value of a company's business. This figure includes the value of both debt and equity after removing cash. Enterprise value provides a more complete assessment of a company's total value than market cap because it includes both debt and equity. Enterprise value ratios can alleviate some of the difficulty of comparing two companies that utilize significantly different debt levels.

Once a valuation metric has been selected, you must then decide by how you will measure a company's current valuation. It's common to see valuation ratios calculated on Sales, EBIDTA, EBIT, and Earnings. Each of these ratios provides useful information about how the market values certain companies in specific industries.

Why So Many Valuation Ratios Exist?

At this point, you're probably asking yourself why so many valuation ratios exist and what each of them could possibly tell us over another. There are a couple of answers to this question, but let's begin to answer it by looking at a chart:

The chart above plots Texas Roadhouse's P/E ratio against its EV/Revenue ratio from 2010 to today. Something that jumps out immediately is the fact that the EV-to-Revenue ratio is significantly more stable than the price-to-earnings ratio. Why is this?

The excess volatility arises from two areas: 

  1. a company's stock price is much more volatile than the total value of the organization, and 

  2. a company's earnings are much more volatile than its revenue.  

The volatility of the P/E ratio can make it difficult to compare over time and across companies. Because of this, I tend to gravitate towards valuation ratios that remove as much uncertainty as possible from my estimation of the company's true value.  

This preference leads me towards a bias to multiples based on Enterprise Value and metrics that occur higher up on an organization's income statement.

Earnings are a Weak Predictor of the Future

When you think about the most commonly used metrics in valuation ratios: Revenue, EBITDA, EBIT, and Net Income. As you move down the income statement, making forward-looking estimates about each metric becomes more and more difficult. On top of that, the benefit you receive, as an investor, for using a more precise measure of operational success is low.  

What we care about as long-term investors is whether or not a business can operate profitably. Making that determination can occur from looking at a company's earnings before interest, taxes, depreciation, and amortization (EBITDA) or in the case of capital intensive business earnings before interest and taxes (EBIT). We shouldn't need to introduce the volatility that occurs by deducting interest and taxes from a company's operating profits to assess its current valuation.

Ratios I Recommend

Throughout the rest of this section, we will be looking at valuation ratios for Texas Roadhouse and its competitors. I'll be focusing on three ratios in particular: EV/Revenue, EV/EBITDA, and EV/EBIT. It's been my experience that these three valuation ratios can tell investors what they need to know without bogging them down with needless and difficult to interpret information.

In previous lessons, we've discussed how Tikr.com makes it easy to find and aggregate data on companies you are analyzing, and that continues to hold for valuation ratios. They have an entire page of valuation ratios, including those I referenced above, that are automatically calculated for every publicly traded company.

Comparable Asset Analysis

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Course Section 4 - Lesson 4

Any time you make a purchase, especially if it's a big dollar item, you will inevitably go through a process of comparing the thing you want to the other alternatives available.  

If you're thinking about buying a car, say a Toyota Camry, then you'll probably also look at a Honda Accord, or a Chevy Malibu, or even a Ford Fusion. In your mind, you'll be comparing the features of each model and weighing those against the price of each sedan. What you wouldn't do is suddenly throw a Porche 911 into the comparison set. It simply doesn't provide any relevant data for the decision you're trying to make.  

In day-to-day life, we humans seem to be pretty good at identifying comparable assets to help us gauge value when we buy the things we want. That seemingly innate ability we have all but disappears when we start looking at financial assets.

When we see a stock trading at 20 times earnings, we suddenly feel the need to compare that company against every other stock on the market to figure out if it's expensive or not. This is not an effective strategy.

Value a Company Relative to its Peers

Just as we would do with the Camry we are thinking of buying; we need to benchmark potential investments against a lineup of peer companies. Throughout this course, we have been evaluating Texas Roadhouse. We've established that it is a solid company. We're now to a point we can begin thinking about whether or not we want to make a purchase.  

In making this decision, it would not help us to compare Texas Roadhouse's market valuation to Walmart or Google to find out if it's priced attractively. Those companies run businesses that are too different from Texas Roadhouse to generate meaningful insights.  

Instead, we should stick to the casual dining industry when trying to figure out if the stock is priced attractively. From our earlier lessons, you'll remember that we defined the casual dining industry as: 

  • Texas Roadhouse, Inc. (TXRH)

  • Cracker Barrel Old Country Store, Inc. (CBRL)

  • Chuy's Holdings, Inc. (CHUY)

  • Brinker International, Inc. (EAT)

  • Bloomin' Brands, Inc. (BLMN)

  • The Cheesecake Factory Incorporated (CAKE)

  • Dave & Buster's Entertainment, Inc. (PLAY)

  • Red Robin Gourmet Burgers, Inc. (RRGB)

  • Denny's Corporation (DENN)

  • Darden Restaurants, Inc. (DRI)

By looking at how the market currently values all of these companies, we can get a sense of whether or not our target company is priced attractively. To do so, we can leverage the valuation ratios that we learned about in the last lesson.

To speed up data collection, I'm pulling the ratios for each company directly from Tikr.com into an excel spreadsheet.

Comparing Casual Dining Competitors

Now that we've aggregated the necessary data for Texas Roadhouse and its peers, we can begin to dissect whether or not the company is an attractive purchase right now.

The table above is informative, but it's hard to make heads or tails of in its current format. To make things easier to digest, I'll convert the table into three separate charts: one for EV / Revenue, one for EV / EBITDA, and one for EV / EBIT.

For each of the above charts, the appropriate multiple for each restaurant is graphed against its peers. To aid in the interpretation of graphs, I've split the background of each graph into 3 equally-sized sections. The green section represents the lowest, most attractive valuations, yellow represents the middle of the road valuations, and red represents the highest valuations.

A lot is going on in the three charts, but the first thing I want to do is establish which of the charts offers the best information for us as investors.  

If we look at the first chart, EV / Revenue, we see a lot of variance across the companies. Some stocks trade at around 1x revenue (BLMN & RRGB), while others trade at ~4x revenue (DENN & PLAY). That's a huge gap that you shouldn't expect to see if EV / Revenue was a good proxy for value in the industry. Indeed, if we look closer at the underlying businesses, we would see that the most expensive companies (DENN & PLAY) are also the companies with the highest operating margins, around 13%, and the least expensive companies (RRGB & BLMN) are those with the lowest operating margins, around 3-5%. This gives us a clue that would should take a step down the income statement and instead look at multiples based on EBITDA.  

Looking at the EV / EBITDA multiples, we still see some variance, but generally, all of the companies are within about 30% of the industry average. This is a strong indication that we've found an appropriate multiple for the industry, and we don't have to move any further down the income statement.   

If we were to continue down to an EV / EBIT multiple, we once again see the deviation in multiples across companies widen out. This is explained by the fact that EBIT deducts depreciation, a massive expense for some of the companies, like Darden (DRI) and Texas Roadhouse (TXRH), while having little effect on others like (DENN). This further confirms that we have indeed found the correct multiple to focus on with EV / EBITDA.  

Interpreting Casual Dining Valuations

Now that we are confident that we are looking at an appropriate multiple for the industry let's assess how these companies are priced. I'll begin re-organizing the EV / EBITDA chart we looked at a moment ago by lowest to highest multiple.

Immediately it's evident that casual dining companies are falling into three pricing tiers:

  • the questionably cheap stocks (BLMN & EAT)

  • the average stocks (CBRL, DRI, CAKE, RRGB, and TXRH), and

  • the expensive stocks (PLAY, CHUY, and DENN)

Interestingly, when we were evaluating Texas Roadhouse's business earlier in the course, it ranked among the strongest in the category. Yet, here we see that the market is valuing the stock in line with its much more average peers.

Let's take a look at a chart we built back in section 4 - lesson 2 comparing the growth and margins of companies in the casual dining industry. Only this time, let's also include the EV / EBITDA ratio for each of the companies.

Texas Roadhouse has been among the fastest-growing casual dining restaurants in the peer group, with more room to grow in the future. On top of that, as we discussed earlier in the course, we have reason to suspect that TXRH could experience margin expansion as the brand continues to mature. It does not make sense that Texas Roadhouse is trading at levels consistent with much weaker casual dining operators.

A Great Company at an Attractive Price

It appears that we've identified a great company, in an industry we believe in, that is trading at an attractive price. All of the pieces have come together into an investable opportunity.  

In the next and final lesson of section four, we are going to define our investment thesis for Texas Roadhouse. This will involve stating our beliefs about the company and committing those beliefs to paper. This is an important step in the process that will allow us to make sure that this investment stays on track as we move forward through time.

Constructing An Investment Thesis

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Course Section 4 - Lesson 5

We have finally reached a point where we have identified a strong investment opportunity. The last step that we need to complete before we execute a trade is documenting our investment thesis.

Why Write an Investment Thesis

Before we jump in and start writing, let's first establish what this documentation step accomplishes.

Inside our investment thesis, we will commit to writing all the critical points we have learned while researching our target security. We will define our beliefs about the industry, the stock, and how it should be valued so that we know what our thought process was months or even years down the road when we review this investment.

Suppose our investment doesn't perform as well as we planned. In that case, this document will serve as the reference point that helps us evaluate whether our initial analysis was flawed.

Similarly, if our investment performs well, we can look back to this document to decide if a continued opportunity for market outperformance exists with this security going forward.

What Information Belongs in an Investment Thesis

Your investment thesis should contain the key points surrounding the company's environment and what you believe about the company and no more.  

This document is only for you and should serve as a reference point to revalidate the investment in the future. It should contain a few bullet points on the industry, the company itself, and the current valuation of the stock. Each bullet should allow you to quickly state whether or not it remains true when you revisit each of them in the future.

Finally, you should include a thesis statement summarizing all of the ideas in the document and directing the action you take.

Going through this process with Texas Roadhouse might look something like the following:

Texas Roadhouse (TXRH) Investment Thesis

Industry

  • The casual dining industry is a mature market that should grow roughly in line with GDP.

  • It is competitive, and operating margins are tight, but the best operators should generate profits.

  • The industry was hit hard by Covid-19, but as transmission rates fall in the US, industry sales should recover to pre-pandemic levels.

Company

  • Texas Roadhouse is one of the premier casual dining operators in the space.

  • Management at the company has exhibited a consistent ability to open new and profitable restaurants at a much higher rate than the industry.

  • Revenue at Texas Roadhouse should recover inline (or slightly faster, due to new restaurant openings) than the industry.

  • Once revenue recovers, management should grow sales at an annualized 7-9% rate for the foreseeable future.

  • As the company's restaurant base matures, operating margins should have the potential to expand from their current level of 8% to ~9-10%.

Valuation

  • The company currently trades at 18x EV / EBITDA. I believe the company should be valued in line with the best restaurants in the casual dining category at 20-22x EV / EBITDA.  

  • Such a valuation would equate to a stock price of between $104 to $140, with a target of $121.

Stated Thesis  

As of April 30th, 2021, the market is valuing Texas Roadhouse in line with weaker peers who have not exhibited the same level of growth potential or the same opportunity for margin expansion. I believe that the company will be among the fastest-growing, most profitable companies in the category, which will justify an expansion in the company's EV / EBITDA multiple to 20-22x. This multiple expansion equates to a target stock price of $116 - $140.

Reviewing the Thesis

Notice how each bullet in the thesis is stated as a belief based on the research conducted throughout the course. This makes it easy for us to confirm or invalidate our investment thesis when we review this document in the future.

Imagine that we get 12 months down the road. Every restaurant in the category has recovered from the pandemic except for Texas Roadhouse. That would be an unambiguous indication that something about our thesis was wrong, and we either need to reevaluate or sell our position. The same goes for every other statement that was made.  

Reviewing the thesis for every company you hold should be a regular part of your portfolio review process. By structuring a short writeup of each security you own in this way, you make it easy to revisit your ideas and ensure that your positioning remains valid.

Section Summary - Four

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Course Section 4 - Lesson 6

When all of the cash flows from an investment are known in advance, valuation is straightforward. It's a simple math problem. As stock investors, we will never encounter a situation where cash flows are known with certainty before an investment is made. 

We can do our best to estimate what dividends we are likely to receive in the future. But the sensitivity of valuation equations to slight changes in cash flows and risk makes mathematical valuation techniques unreliable and difficult to use in practice.

Instead, we rely on comparable asset analysis. By defining closely related assets, in our case, competitors' stock, we can assess how expensive our target company is relative to other potential investments.  

This valuation methodology removes many of the stickiest issues that plague computational techniques like discounted cash flow analysis. By comparing our target company to peers, we only have to estimate the future strength of the target vs. its competitors to evaluate an appropriate valuation level for the company.

Once we have estimated an appropriate valuation range, using multiples such as EV/Revenue, EV/EBITDA, or EV/EBIT, we can then convert those valuation ranges into explicit price targets that guide our buy/sell decisions.

Never Start with Valuation

It's important to remember that the investment process never begins with valuation. If we are to select companies that generate long-term value for their customers (and investors), then we must start with businesses that we understand, believe in, and stand up to scrutiny. Only after we have found a company that checks these boxes should we move on to valuation.

If we instead start the process with valuation, we run the risk of identifying what appear to be attractively priced stocks that seem so because they are terrible companies.

Characteristics of Great Companies

All great companies have two things in common: they grow sales and sell their products and services profitably. Growth and profits happen because of an attractive offer and effective management.  

Great companies that do both of these things deserve to trade at a valuation premium compared to weak companies. The degree of the premium they deserve depends on the strength of their growth relative to the industry and their ability to expand profit margins.

Texas Roadhouse

As we've seen throughout our work in the course, Texas Roadhouse is a great company. They've been consistent, profitable, and growing faster than the industry. They've done this while delivering a service that their customers love.  

If nothing changes about its business, then it's reasonable to expect growth and profits to continue into the future. Because the company is growing faster than the industry, then, of course, its dividends will grow faster than the industry. Finally, because its dividends are growing faster than the industry, the company should trade at a valuation premium relative to other casual dining companies.  

When, as we did in section four, you look at valuations for casual dining restaurants, and you see that a company like Texas Roadhouse is valued the same as peers that don't offer the same growth and profit potential. Then you know you have found a valuable investment opportunity.