Back of the envelope calculations, are a defense against bad advice. They have saved me many times from making the wrong call.
The back of the envelope calculation only helps you decide if you should take a closer look at the investment. Never make a decision to invest based on the calculation.
So how does the back of the envelope calculation work?
Here's how to do a quick calculation on limited information.
For a listed company you will need the following information. Most of which you can find free online through the ASX or a variety of investment sites.
- Latest Financial Statement.
- Cash Flow.
- Market Cap and number of shares available.
- Dividend information and current share price.
Step 1 – Look at the assets on the balance sheet. Take away from the total assets the amount for goodwill or intangibles. You can't sell goodwill if things go wrong.
Then look at the liabilities. Make sure that the short-term liabilities are lower than the long-term.
Take the total amount of liabilities away from the adjusted asset figure. This gives you an idea of what tangible assets are available for sale if the company fails.
Step 2 – Look at the cash flow for the current year and future years. You need to focus on a couple of key areas.
First, is the cash flow positive or negative? Negative is a red flag so look to see if there was any extra ordinary expense for the year that caused it to be negative.
If the cash flow is positive next look at two things. Was there a sale of an asset or new borrowing which caused it to be positive? Both raise red flags.
If there are no red flags and each year’s cash flow is an improvement, that's good.
One last thing to check. Are dividends paid out of cash flow or is there some borrowings that cover the dividend in total or part. If so, it's a red flag.
Step 3 – Take the figure from Step 1 and divide it through by the available shares. This will give you a Net Tangible Assets (NTA) figure.
In most cases, this will be less than the market price but it is by how much which you need to consider. If market price is $10 and NTA is $1, red flag.
Step 4 – Dividends gross yield is important and you must compare it to the cash rate. If you are taking a risk, you should get a better return than cash.
To gross up the dividend take the dividend yield multiply by 30 and divide by 70 and the amount to the yield. E.G. Yield is 5% x 30 / 70 = 2.14 + 5% = 7.14%.
These calculations give you an insight into the company's financial performance. This is what is important when investing.
What about the PE (Price Earnings ratio)?
You use PE to compare companies in the same sector. But, the ratio is based on price, not value. I only use PE to see if a company is cheap relative to its peers not to its value.
If the above steps raise no red flags then it is time to dig deeper.
This is where a professional will be of help, as it gets a lot more complicated from here in.
'Back of the Envelope' is more about finding the investments you want to avoid.
Another quick way to judge an investment is in the sales pitch. If the company rolls out a famous person telling you to invest, it's red flag time. And time to distance yourself from the investment.
If you want to learn more about 'Back of the Envelope Calculations' please give me a call on (07) 4771 4577.