Differentiate a Good Investment From a Bad One
How to differentiate a good from a bad investment? A good investment is one that will make you money, or grow in value over time. A bad investment is one that will lose you money, or decrease in value over time. There are many factors to consider when determining whether an investment is good or bad: the risks involved, the potential return, and your own financial goals and preferences.
Investments are good if they have a positive rate of return and are low-risk. On the other hand, investments are bad if they have a negative rate of return and especially if they are high-risk. Of course, there is no such thing as a guaranteed investment, and all investments come with some degree of risk. However, by doing your research and understanding the potential risks and rewards of an investment, you can make informed decisions that are right for you.
How Academics Measure Risk
In the academic world, because of the underlying assumptions of the efficient market hypothesis, risk is defined as volatility. The efficient market hypothesis suggests that prices in financial markets are fair and accurate. It also presumes that it is impossible to beat the market because all information is already reflected in prices. Risk is therefore measured by how much the return on an investment can fluctuate. The higher the risk, the higher the potential return, but also the higher the potential loss.
A prevalent method in academia is to calculate the standard deviation of the return – looking at the historical volatility of an investment. This measures how much the price of an investment has fluctuated in the past. This measures how much the return varies from the average return over a period of time. Another common way to measure risk is to use value at risk (VaR). This measures the maximum loss that could be incurred over a given time period, given a certain level of confidence.
Investing in the Real World (Good vs. Bad Investment)
In the business and in the real investing world, there is often an asymmetric relationship between risk and return. Taking equity in a business that is consistently producing negative to meager cash-flow yields and that has disadvantageous unit economics will almost assuredly produce negative results. That is irrespective of what the past price fluctuations were or what the measured volatility was. You might also be wondering what is the ideal PE ratio?
An example of a bad investment with high volatility would be Lightspeed (LSPD). No matter how high the Beta of the stock is, there is very little real likelihood to be making money by buying equity in that company. MTY Group is an example on the positive side. Their Beta is nearing 2 but they consistently have good cash-flow yields, their business model has profitable unit economics and they have rewarded investors over time. An example of low beta, high yield business would be Pfizer. They brought consistent results to shareholders for the last decade at very low Beta. Pfizer’s Beta is under 0.7 and they have 8% free cash-flow yield.
In the real world, risk isn’t volatility: risk is your likeliness of losing money. Companies with difficult, unsound or non-shareholder-friendly businesses tend to lose money for their investors.
Free Cash-Flow Yield: The Best Metric to Measure Value
The free cash flow yield is a company’s free cash flow divided by its market capitalization.
This metric is used to gauge a company’s ability to generate cash flow relative to its market value. A higher free cash flow yield indicates that a company is generating more cash flow per dollar of market value, which could mean that it is undervalued by the market. Having a high free cash-flow yield is the best measure of how good an investment can be.
However, it is important to note that a high free cash flow yield does not necessarily mean that a company is a good investment 100% of the time. For example, a company may have a high free cash flow yield because it is in the midst of a turnaround and is selling off assets.
What Is The Formula For Free Cash-Flow Yield?
- Free Cash Flow: Operating Cash Flow (OCF) − Capital Expenditures (CapEx).
- Market Capitalization: Current Share Price * Total Number of Shares Outstanding.
- Divide #1 by #2. The yield should be expressed as a percentage.
As an example, Suncor has a Trailing Twelve Months OFC of $14,371M, CapEx of $4,962M and therefore a FCF of $9,409M as of September 30, 2022. With a $65,832M Market Cap on November 15, 2022, that makes for a FCF Yield of 14.3%. It is higher than its earnings yield of 11.4% – a sign that cash earnings follow or exceed earnings.
Checklist To Validate If An Investment Is Good
- Does the business have high FCF yield?
- Does the business have consistently positive earnings?
- Has the leadership team shown shareholder-friendliness, either by buying back shares, not diluting or giving dividends?
- Does the business have higher margins than their competitors?
- Can the business grow?
- Is the revenue of the business predictable?
- Does the addressable market allow for the business to grow to multiples of its current size?
- Does the business have a sound balance sheet?
- Does the business deliver ROE above its peers?
- If the business is acquisitive, are these acquisitions done at reasonable prices and are they adding value?
Disclaimer: Investors should always perform due diligence before investing in any company.