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No. of Recommendations: 18
Hi Bill - thanks for the good stuff you've been putting out on RM criteria. I particularly enjoyed your Belgium analogy for Sustainable Competitive Advantage :-)

Regarding the use of ROE, you write :'I haven't figured out what to do here yet, but in thinking out loud I'll probably move more towards a Return on Invested Capital type calculation'. My question is - in our quest for better criteria, are we making this too abstruse for the average Fool? In building the latest state of art goldplated idiot-proof RMtrap, are we making it Foolproof too?

One of the things that initially impressed me about the Fool was its conscious effort to speak in laymen's language. Many of the best articles have been written in simple, everyday language - not in the arcane mumbo jumbo of Wall Street analysts or CFAs. That makes them a pleasure to read and easy to understand. Also, the Fool's simplicity and transparency provides safe harbour for ordinary people in a world of increasing financial complexity and technical wizardry where you feel more and more ignorant and stupid by the day.

Same goes for the Rule Maker strategy. With the possible exception of criteria 9 and 10, most of the current RM criteria are in simple, plain English, guidelines which dumFools like me can understand and apply without too much furrowing of the brow. Again that was a major factor in my interest in the RM - if I can both read and digest it in one go, maybe even I can apply it!

Consider Enron. Most outsiders simply didn't know or understand what it was up to. (It might turn out that applied to many senior insiders too!) Many were highly trained, experienced financial analysts and regulators who can smell management shenanigans a mile away. I read somewhere that analysts often went along with Fastow's schemes simply because they (a) didn't understand what he was up to (b) were looked down upon by him because they didn't understand! This is human psychology at work - even though I don't understand it, it must be good because it's so elaborately designed and beautifully presented. I'm sure we're all impressed by the sheer brilliance of Nobel laureate economists and scientists - how many of us have the guts to even read their work, let alone understand it?

So, my appeal to you is - K.I.S.S. - please, no offense intended. Please keep in mind that reading a financial statement is tough enough for most people. Getting past that to financial ratios without breaking a sweat is seriously challenging. If the RM is to be a teaching tool, the best thing you can do is to remember your Belgium analogy - it was graphic, said in a few simple words, almost tangible, and even applies to my backyard. If all your criteria pass that test, I'll personally nominate you for the Nobel Prize in Foolonomics :-)
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No. of Recommendations: 2
"My question is - in our quest for better criteria, are we making this too abstruse for the average Fool?"

Yes! Thank you badsin. I consider myself a fairly intelligent person, but for some stupid reason, I have never been able to follow DCF all the way through! And DCF is an important concept! So is ROIC. But when the criteria becomes so advanced that the average person like me stumbles over every one of them...you just want to count yourself an idiot and go in search of a simpler way.

Flow Ratio was fun. It was an involved concept, but it made sense, and it had a caclulation that was easy to perform and follow. It was that kind of simplicity that drew me to the RM in the first place. Let's try to keep it simple.

Lynn

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No. of Recommendations: 10
Badsin:

Really, really well put. One of the reasons that I had been resisting going the route of Return on Invested Capital is that it is quite difficult to calculate, and somewhat labor intensive.

I'm completely with you and the sentiment that we don't want to overengineer here. Albert Einstein once said "make everything as simple as possible, but no more so." (I'm paraphrasing) This is what I want to achieve with Rule Maker, I want to make it a good teaching tool, one that is accessible to as many people as possible. But we can't make it so simple that it is useless.

That's the problem with sloganeering, for example. The Motley Fool has long said that you are the best person to care for your finances. I believe that this is true, but one must recognize what we are NOT saying. This in no way means "anyone can select stocks". It does not mean "beating the market is easy". It most certainly does not mean that you should completely cut yourself off from any professional financial advice.

We beleive in retaining and paying for professional counsel WHERE IT ADDS VALUE. Most full service brokers and actively managed mutual funds fail to do this. IN NO WAY does this mean that one should pull money from a broker and run willy nilly into picking stocks for one's self. There are plenty of interim steps: determining one's risk tolerance, a frank assessment of one's own abilities, risk assessment, enjoyment and time limitations in managing one's own accounts. Anyone who does not honestly believe that he or she lacks EVEN ONE of these characteristics would be well served, maybe even better served, to seek out a low cost Total Market Index fund.

We believe in financial planning, we believe in accountants, we believe in trust and estate planning. But that term "you are the best person to care for your finances" has been construed by many to assume the meaning that we believe in none of these things. It is oversimplistic, and thus it is scary how damaging it can be. It scares me to death whenever anything that I or my colleagues write gets misconstrued, but it happens every single day.

So I hear you, loud and clear. The power of the Rule Maker is that it will greatly lower the number of companies that one needs to sift through. You need not depend on CNBC or the popular press to get your ideas. You can simply notice that many people you know drive the extra mile to go to an Outback Steakhouse rather than some other closer option and then think "wow, that's an advantage. I wonder what Outback's economics look like?" But you've got to do some work. "People love Outback" in no way automatically means "Outback is a great investment".

The steps of Rule Maker are an attempt to add a framework to the middle steps. I may overshoot, for which I hope once again to get messages like the one above. I in no way want to undershoot though. The reality is that picking individual stocks takes some work, and that work includes the financial statements. If you want I'll be glad to recommend some excellent resources for helping people get more comfortable with them.

Thanks a million, badsin.

Bill Mann
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No. of Recommendations: 10
badsin - -

I agree with you completely, with the exception that there needs to be a point when a true Investor has to expand his/her horizons.

I am currently a financial analyst for a super regional firm. I graduated from college with a background in finance. I am currently studying for a CFA Charter. I AM STILL LEARNING. Every day. That's honestly why I decided to sign up for the membership - - I believe that the Fool and the community members add value to my knowledge pool.

Nevertheless, the Fool did initially attract me via the simplicity of the formulas, etc. It seems to have a great knack at making difficult things seem simple. But soon after sifting through everything, you realize that the current RM criterion is too simple. It's a great starting point (especially for Joe Newbii), but definitely needs more meat.

The good thing is that (1) ROIC (and DCF for Ev) is not as cumbersome as it appears IF it is explained thoroughly and clearly and (2) once you are familiar with it, you've added one of the most powerful feathers to your cap. These more advanced formulas allow you to look at companies in different ways - - Is this Company really doing well, especially considering the amount of capital it has in the business? Is this stock priced outrageously, reasonably or possibly low? None of these formulas are going to give you the "absolute buy" or "absolute don't buy" light, but they are going to allow you to make a more-educated decision for your purchase.

From what I've seen from Bill thus far, he's a good writer and a good teacher. I believe that these more advanced formulas need to be implemented; however, the caveat is that they need to be explained so that any Simpleton, me included, can grasp them. I think that Bill's up for the challenge.

Cheers,

The Wolf
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No. of Recommendations: 4
The good thing is that (1) ROIC (and DCF for Ev) is not as cumbersome as it appears IF it is explained thoroughly and clearly and (2) once you are familiar with it, you've added one of the most powerful feathers to your cap. These more advanced formulas allow you to look at companies in different ways - - Is this Company really doing well, especially considering the amount of capital it has in the business?

Absolutely.

ROIC and DCF are really important concepts and not that hard to calculate. They can be difficult to interpret across different industry groups. There are also important decisions to make about what to include in DCF, discount rate, etc. The biggest problem with these metrics is a slavish and rigid application leading directly to buy or not buy decisions. Greater value is in helping investors to think more deeply about a stock.

Of course, doing these calculations and thinking about the results requires effort, dedication, some intelligence and a lot of discipline. Investing in individual stocks is not for everyone. While I agree that we should not overly complicate matters, nor should we eliminate or overly simplify something very important if it is difficult. Real benefit usually requires some effort and sacrifice.

Dennis
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No. of Recommendations: 5
"The good thing is that (1) ROIC (and DCF for Ev) is not as cumbersome as it appears IF it is explained thoroughly and clearly and (2) once you are familiar with it, you've added one of the most powerful feathers to your cap. These more advanced formulas allow you to look at companies in different ways - - Is this Company really doing well, especially considering the amount of capital it has in the business? Is this stock priced outrageously, reasonably or possibly low? None of these formulas are going to give you the "absolute buy" or "absolute don't buy" light, but they are going to allow you to make a more-educated decision for your purchase."

Hi Wolf,

I'm fairly skeptical as to how much of a more educated decision these formula's would make in light of the lack of fundamental thought that frequently seems to be used as a basis for these calculations.

More often than not it seems that the overly optimistic assumptions of marginal businesses are somehow validated by running them through the mechanics of DCF or supported by comparative expected Returns on Capital.

In my opinion, getting a well informed view of the underlying company, proposing a little skepticism on expected growth, making necessary adjustments and using longer term average earnings with reasonable P/E's, and making sure one has some Graham like "margins of safety" can easily help get as equal an educated decision as running dubious assumptions through the motions of these formula's.

So while I don't have any problem with the use of these formula's per se, I don't think that they would be all that helpful (and might even be a disadvantage) to those who aren't fully clear as to the basics one needs to know before believing the "magic" numbers these formula's tend to spit out.

Just my opinion,

ZB
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No. of Recommendations: 1
ZB - -

You say:

So while I don't have any problem with the use of these formula's per se, I don't think that they would be all that helpful (and might even be a disadvantage) to those who aren't fully clear as to the basics one needs to know before believing the "magic" numbers these formula's tend to spit out.

While I may agree that you can manipulate certain numbers in the DCF, I'm not sure I understand where you'd get "magic" numbers in an ROIC calc.

Even with the "magic" numbers in the DCF calc, a stock is only worth the discounted value of its future cash flows - - so why wouldn't you attempt to try to measure this? We are not always going to be right on the money, actually probably never will be, but with an honest, conservative evaluation of the business fundamentals, we should be able to get an idea of where the price should be.

I know that I've seen you (or I guess read you) on the BRK board, so I'm sure you've heard WEB's saying: I'd rather be vaguely right, than precisely wrong. I think that this applies here.

In the end though, I don't believe that any of us can say that there is this "right" way to calculate whether a stock is a good purchase or not, as too many people do this in different manners and still make a lot of money.

I like the DCF and the ROIC. I find that the more that I delve into the numbers of a business, the better I begin to know it.

The Wolf
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No. of Recommendations: 0
TMF Otter,

Along the same line as Albert Einstein, the contemporary popular (?) American philospher and writer, Sam Keen, said, "prefer simplicity, but respect complexity".

While searching for companies that have a sutainable competitive advantage (the "be-all end-all", it may be that most such companies share qualitative characteristics. The problem to me seems to be in trying to develop numerical criteria valid across a reasonably large set of companies. The value of the numeric criteria is to sift through a large number of companies to find those for closer examination, including qualitative assessment.

Reviewing the RM holdings, one could be forgiven for assuming that the RM criteria prefer Into-Tech and Drug companies (8 out of 11 companies). According to S&P information these eight companies are from a set of about 120 S&P companies compared. Of the remaining three, two are financial for which the RM has in the past admitted the numerical criteria apply somewhat poorly. Whatever, the new criteria would happen to be they must have better balance in terms of identifying potential RM from a reasonalbe range of sectors.

I'm not an investment professional, but a defence analyst. So, I can respond to at least your analogy. A defendable fortress must take into account the capabilities of your opponents. Remember what happen to the French and Belgian fortifications in 1940. Extending this to the RM's problem, I postulate that the RM can develop simple numerical criteria, but these would differ from sector to sector. If the RM tries to develop a grand universal set of criteria, then it will become too complicated.

Excuse me, but my day job calls.

P Chouinard
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No. of Recommendations: 11
The discussion about whether or not to include metrics such as ROIC and DCF is an important one. When Rule Maker (Cash King) was first conceived it was presented as an investment philosophy that anybody could follow along with. Valuation was given little consideration. The idea was to pick quality companies, check out a few simple to calculate metrics, get a basic understanding of its business and prospects, compare it to its key competitors and make a decision to buy or not.

Unfortunately, investing is not as easy as many of us would like it to be or believed it to be in the not too distant past. I know that the more I learn, the more I realize there is to learn. Like Wolf, I'm studying for the CFA right now. I've also been reading a number of investing books (the latest was Graham's The Intelligent Investor).

It is important that we understand a company's financial statements (an area I hope I helped many to understand better in the past with my columns). It's important that we understand what type of returns a company is able to generate from its investments. It's important that we have an idea of what the value of a business is. We can't simply pull the wool over our eyes and invest blindly. While concepts such as ROIC and DCF can be quite difficult to understand, they can be explained in ways that we can all understand. It just takes time and patience on the part of both the teacher and the student.

ROE is fairly simple to calculate, but the results that it brings are not as valuable as we find with other metrics. Bill pointed out a number of the issues around ROE in his last column. Unfortunately, accounting as first conceived was based on a world with little in the way of intangible or knowledge assets. Criterion such as ROE are less valuable in analyzing today's companies than they were in the past. This doesn't render them meaningless -- it just makes them less meaningful.

Even ROIC is not without its flaws, but it is worth investigating. If you're uncomfortable with DCF and your ability to correctly assign all of the appropriate values to growth rates, discount rates, etc., try the approach outlined in Expectations Investing of making an assessment of what rate of growth is implied in a stock's current price.

Understanding how the cash flows through a business is important. Performing these types of calculations will better enable you to understand the value of a business. It's also likely to lead to greater success for you as an investor. Investing in individual stocks requires work. It's part of an ongoing learning process.

Okay. I'll get off my soapbox now.

Phil
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No. of Recommendations: 5
"I know that I've seen you (or I guess read you) on the BRK board, so I'm sure you've heard WEB's saying: I'd rather be vaguely right, than precisely wrong. I think that this applies here."


Hi Wolf,

I agree with you that the ROIC and DCF looks can be helpful to an investor. Especially the use of historical ROIC and ROA as part of an overall value. But I really think they are only helpful in a prospective sense if the investor uses extraordinary care in conservatism and discipline. In that case the investor might be vaguely right in their result.

On the other hand, with an overly optimistic viewpoint and a lax attitude on valuation, the resulting answers from simply running the numbers may be disasterously precisely wrong.

So I don't have any problem with discussing ROIC or DCF techniques, both pros and cons, but given the results of these analysis (and all others) are basically the product of quality assumptions grounded in historic operations, I'm inclined to believe that it's more useful for the site to stress first getting a grip on understanding historical operations and making quality assumptions than starting to enter dubious projections going out a number of years.

But if many are interested in ROIC and DCF techniques I would propose they first make some written forecasts on their particular investment idea for each of the next 8 qtrs and estimate Rev $, Pre tax Income, Operating Cash Flow, Capital Expense, Share base, & Total Debt and Equity amounts. I think that if one could feel comfortable doing this and they have proven to themselves that they are reasonably close in their predictions, they might then be able to say they understand the company enough to project out years. Given my experience with the "Street", if they (or any investor/analyst) have a tough enough time estimating revenues 9 to 12 months out, how comfortable am I to be with their estimate of earnings and cash flow years out?

So I guess I'm not saying that any of these more technically complex tools aren't useful for any single investor but for this site, which frankly has demonstrated a tendency to be a bit overoptimistic on business potential, a little lax on valuation, and a little less than precise on operating expectations, I think the educational value proposed just isn't served by a jump into trying to value with prospective ROIC's or DCF's without spending some substantial time on the groundwork.

Again, only an opinion,

ZB

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No. of Recommendations: 0
But I really think they are only helpful in a prospective sense if the investor uses extraordinary care in conservatism and discipline. In that case the investor might be vaguely right in their result.

I couldn't agree with you more.

I think the educational value proposed just isn't served by a jump into trying to value with prospective ROIC's or DCF's without spending some substantial time on the groundwork.

I think that if these calcs are going to be used, then they need to be explained thoroughly. This is supposed to be a "for everyone" site, so everyone should be able to follow, as long as they take the time to try and understand the techniques.

Forecasting anything is difficult, and I never use the DCF as my end answer. I do, though, use it to help me understand what range this stock should be trading, given conservative projections on its growth.

Winston

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