Category: Financial Analysis

A Reminder to Readers

Published on:
February 14, 2020
Reading time: 4 Minutes.
Last Update:

Readers ask me why I buy individual companies, and not passively invest using exchange-traded fund or a mutual fund that tracks a market index.

First - and this is a personal preference, not a universal rule - I am curious about how businesses work. And buying stocks forces a thoughtful understanding on a company. And writing instills - and tests - my conviction.

(If I can't write about the investment idea, then it's not an idea, but a guess.) 

And sharing this story with a broad audience provides (1) a digital record of the original analysis, and (2) provides me with a greater sense of purpose.

I also believe, and historically it has been the case for me, that over a 3- to 5- year period, buying a select group of businesses [1], will have a greater impact on my financial net worth than any passive investing strategy.

And at this point in my life, it simply does not interest me to earn a 3% to 6% compounded annual return. When I buy individual companies, which are often contrarian investments, my goal is a 15% to 25% compounded rate of return over a five year period [2]. It is an aggressive goal, and I take risks to achieve it.

I skipped class in business school when the professor talked about the benefits of diversification.

I have a very concentrated portfolio of stocks. ( I skipped class in business school when the professor talked about the benefits of diversification.) And over 90% of my net worth is vested in six to seven companies.

Because I am the only research analyst, portfolio manager, chief investment officer, and sole benefactor for that matter, I can't focus on more than a few companies at a single point in time. I also never buy stock on margin, nor do I short stocks.

I want to remind readers that I am not a registered investment advisor. I don't manage other people's money, nor do I give specific advice. I will not comment on your specific situation or the suitability of an individual investment for you. For paid-subscribers, I am happy to explain any of the investing topics on Pen&Paper. But you need to form your own decisions.


The problem with subscription-based services

You don't need me to get exposure to equity markets. You can buy an exchange-traded fund that tracks the S&P 500 index [1]. And if you find passive investing to be boring, there are plenty of subscriber-based investment services.

For example, The Motley Fool offers annual stock-picking subscriptions for as low as $200, and Value Line Investment Survey charges investors about $600 and covers about 1,700 stocks (yours truly subscribes to both services.)

But there two problems with these kinds of stock-picking services. The first issue is that you hardly improve your business understanding because their analysis is too shallow.

The second issue is that these services will always find ways to buy investments. Consider the Motley Fool as an example. The subscription-based service offers us recommendations on options trading, dividend stocks, growth stocks, technology stocks, cannabis stocks, Buffett-inspired stocks, international stocks, and you get the point. So long as there is an interest in the marketplace, there are stocks to recommend. But in investing, sometimes, it's best to sit on the sidelines.

In investing, sometimes, it's best to sit on the sidelines.

And I can't get over the fact that these subscribers follow the advice of  managers that have no skin in the game. It is one thing to recommend the purchase of a stock. But as the legendary value investor Walter Scholls once said, you never really know a stock until you own it.

In Pen&Paper, I only write about companies I am personally invested in, and on topics, I find it relevant to write on. My focus is on businesses that I expect will be around in ten years. And if there are no businesses to buy at reasonable prices, I hold cash (right now, about 25% of the portfolio is in cash.) And I focus my attention on mitigating principal loss versus earning a few extra basis points above an index.

The companies I buy are often unpopular in investing circles. (Trust me that none of my colleagues showed any interest when I bought Carriage Services or Stericycle last year.) The companies I buy are either too small in their market capitalization (see my investment in Town Sports or Nautilus). Or are too uncertain for Wall Street (see GrafTech or Teva.)  

I only write about companies I am personally invested in, and on topics, I find it relevant to write on.

And I am shameless about writing about my failures. Readers often tell me they learn more when I talk about mistakes - what I missed or did wrong. And, while I hope never to supply such material, you can read about my omissions of thought at Orchid Paper's right side of the balance sheet, as an illustration.  

Write to me if you have any questions.

When it is best to avoid buying the stocks

If you need the money in your investable account to operate your life over the next three- to five years, you will be making a mistake buying the common publicly traded stocks [3].

By "need the money," I mean you plan to purchase a home. Or you plan Or plan to pay for your children's education. Or you plan to retire and are relying on the funds.

In The Art of Speculation, legendary value investor Philip Carret tells of "dates which every schoolboy should know by heart". Specifically, he refers to 1814, 1837, 1857, 1873, 1884, 1893, 1907, 1921, and 1929.  

Equities markets swing. Keep in mind that between 1973 and 1974, the market dropped by 43%. Between 1999 and 2002 the market dropped by 35%. And between 2008 and 2009, the market dropped a whopping 65%.

Also, if you can't stomach to see the market price of your companies fluctuate by more than third, you should never buy individual stock.

Consider WW International. The stock traded at $30 a share when I bought it in February 2019. A week later, the price dropped to $20 and didn't climb back before September of that year. Towards the end of 2019, WW International traded as high as $45 a share. And the stock dropped to $36 as I type these words in February 2020. Note that none of these price movements reflected material changes the business, but speculative market movements.  

If you have unrealistic return expectations, you will be disappointed. Understand that a 10% compounded annually is an adequate rate of return; an above-average 15% return is excellent; and an incredible return is 25%.

Capitalism is a system that requires us to adapt to a new business landscape quickly. So you need to be a curious person to own shares in publicly traded stocks and to embraces changes.  

In The Five Myths About Stock Investing, I write that "investing is not looking at the price movements of stocks". If you need daily assurance, whether your investment decision is right or wrong - buying stocks will leave you with many sleepless nights. Caveat emptor!

FOOTNOTES: [1]Through the ownership of their common stock. [2] For example, the Vanguard IX FUN/S&P 500 ETF. [3] The stock price has to double every 3 to five years to get that kind of return. [4] Regardless of what your financial advisor says.

Lessen Your Emotions

Published on:
February 2, 2020
Reading Time: 8 Minutes.
Last Update:

Investment checklist is a set of questions you go over before making an investing decision. The checklist lessens the emotional aspect of investing by forcing you to think before you act. It results in a better decision making process.

Strangely, academia doesn't talk about the value of checklists. It is also strange that in investment circles, hardly anyone mentions the checklist. Google the term' investment checklist,' and you will only find vague, general, abstract thoughts.

I never heard of the investment checklist while in business school. I even studied for the Chartered Financial Analyst (CFA) designation for five years, and not once did I come across the phrase.

So this essay attempts to correct this missing information. My goal is that you will understand why the investment checklist is essential and that you will have a list of over 50 checklist items to use in your research.

As I wrote in The Hats The Investor Must Wear, knowing which stocks to avoid is the first step in investment research. And checklists help to achieve that first step.

How checklists became popular

In Chapter 11 of The Education of Value Investor, Guy Spier writes:

"Even with a well-constructed environment and a robust set of investment rules, we are still going to mess up. The brain is simply not designed to work with meticulous logic thorough all of the possible outcomes of our investment decisions. The complexity of the business world, combined with our irrationality in the face of money-related issues, guarantees that we'll make plenty of dumb mistakes...there is one other investment tool that is invaluable that it merits a chapter it is own: a checklist."

Spier mentions that it was Mohnsih Pabrai that explained to him how valuable was the checklist. And that revelation came to Pabrai after reading Atul Gawande's description of how pilots use checklists. He writes:

"…they came up with an ingeniously simple approach: they created a pilot's checklist, with step-by-step checks for takeoff, flight, landing, and taxiing. Its mere existence indicated how far aeronautics had advanced. In the early years of flight, getting an aircraft into the air might have been nerve-racking, but it was hardly complex. Using a checklist for takeoff would no more have occurred to a pilot than to a driver backing a car out of the garage."

Pabrai [1] followed the technique. And by the second edition of The Checklist Manifesto, Gawande mentioned how Pabrai was using checklists in investment decisions.

An example of a checklist

I keep a checklist in a CODA document [2]. My checklist evolves around items such as balance sheet, income statement, risks, management, product, capital allocation, credit, product, competitive landscape, investment thesis, valuation, and corporate governance.

For example, on liabilities, the following checklist items appear:

-What are the major debt covenants, and is the company meeting those minimum debt requirements?
-What is the company's management experience with capital markets?   
-Is the company placing debt at market terms, or are they forced to raise debt at unfavorable conditions?
-Is there balloon payment over the next five years?
-Does the company have the ability to issue debt, if needed?
-What assets will be used as collateral?
-Is the debt payment floating- or fixed-payments?  
-Has the company's credit ratios improved?
-Does cash flow from operations service the debt payments?
-What is the fair value of the debt?
-What is the peer group's leverage ratios?
-What are the liquidity and capital resources over the years five years?
-What are the debt rating agencies saying?

The uses and drawbacks of investment checklists

"If you want to improve the quality of the decision," said Daniel Kahneman in an interview to Farnam Street, "Use algorithms, whenever you can. If you can replace judgments by rules and algorithms, they'll do better. Indeed, when we write an investment checklist, we reduce the emotional aspect of investing.

Another benefit to the investment checklist is it serves as a starting point.  You don't need to invent the wheel each time you research a stock, just follow the lessons of the past. (More on that in the section below.)

The checklist also grounds you. Many times in the past, I felt a high conviction about a company. And just as I was about to buy the stock, I went over the checklist, only to realize that either (1) I missed out on crucial points, or (2) the position didn't meet the criteria I had set for myself.

But there are two drawbacks to the investment checklist, too. First, the checklist gives a false sense of security. As if buying a stock is akin to boarding a plane; that all we need is a checklist, and we will safely reach our destination.

But the truth is that there are risks that we cannot prepare for. Investing is placing a bet on human psychology just as it is on the fundamentals of the business. And we can't predict human behavior, let alone all the factors that will influence the price of a stock.

Investing is placing a bet on human psychology.

This reminds me of how the Oracle from Omaha was baffled by David Sokol's irrational behavior. In the 2011 Berkshire annual meeting, Buffett said that Sokol had given away to a junior partner four times the amount Sokol purchased Lubrizol. In Buffett's words:  

"I witnessed Dave voluntarily, transfer over 12.5 million dollars - getting no fanfare, no credit whatsoever to his junior partner...what makes it extraordinary is that $3 million, you know, ten or so years later, would have led the kind of troubles that it's led to."

Sokol's forerunning Lubrizol was unpredictable and made no sense. Munger summed it best:

"I think it's generally a mistake to assume that rationality is going to be perfect, even in very able people."

The second drawback to the checklist is that the more you rely on it, the less likely you are to follow your conviction. It is almost like the paradox in game theory that shows that no matter how fast the wolf is, it will not catch up with the turtle if both objects are stationary [3].

Similarly, in my view, there is a point in time where the investment checklist causes more harm than good. It becomes an obstacle. Or an excuse to sit idly. And many investing mistakes are mistakes of omission.


Look for a second opinion, especially when considering big changes to your portfolio or strategy. Unbiased, professional insights can help you reexamine your assumptions and reduce emotional decisions.

Join the waitlist to learn more.


A list of investment checklists by great investors  

Trying to think like great investors is an excellent exercise. One of my favorite past time is to ask what great investors would ask me before I buy a stock.

Having this imaginary investment committee is one of the best ways to stretch investing skills. So I gathered a list of the top questions each great investor would ask:

What Phillip Fisher would ask

1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when growth potentials of currently attractive product lines have largely been exploited?
3. How effective are the company's research and development efforts in relation to its size?
4. Does the company have an above-average sales organization?
5. What is the company doing to maintain or improve profit margins?
6. Does the company have the depth to its management?
7. Are other aspects of the business somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
8. Does the company have a short-range or long-range outlook regarding profits?
9. In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholder's benefit from this anticipated growth?
10. Does the company have management of unquestionable integrity?

What Walter Schloss would ask

1. What is the value of the company? You are buying shares in a business.
2. Is the value you get worth the price you pay?
3. Are you comfortable holding- and following the stock for five- to ten-years?
4. Is this company using debt to finance its operations? If so, why?
5. Why are you buying the stock?
6. What are the assets you are buying?
7. Are you willing to hold the conviction for a long time? More than two years?
8. What is the true book value of the company after adjustments?
9. Is the price low relative to a few years back?
10. Don't forget to look at the value of the stock before selling.

What Charlie Tian of GuruFocus would ask

1. Do you understand the business?  
2. What is the economic moat that protects the company so it can sell the same or similar product five or ten years from today?  
3. Is this a fast-changing industry?
4. Does the company have a diversified customer base?
5. Is this an asset-light business?
6. Is it a cyclical business?
7. Does the company still have room to grow?
8. Has the company been consistently profitable over the past ten years, through good time and bad?
9. Does the company have a stable double-digit operating margin?
10. Does the company have a higher margin than competitors?

What Michael Shearn would ask

1. Do you want to spend a lot of time learning about this business?
2. Who is the core customer of the business?
3. Does the business have a sustainable competitive advantage?
4. What are the fundamentals of the business?
5. Are the accounting standards that management uses conservative or liberal?
6. What type of manager is leading the company?
7. Does the CEO manage the business to benefit all stakeholders?
8. Does the CEO love the money or the business?
9. Does the business grow through mergers and acquisitions, or does it grow organically?
10. Have past acquisitions been successful?

What Peter Lynch would ask

1. Is there a raider in the wings to help shareholders reel the benefits of the assets? (for asset plays)  
2. Are costs being cut?  (for turnover situations)
3. Did the company duplicate its success in more than one city or town, to prove that expansion will work (for fast-growers)
4. What is the company's long-term growth rate, and has it has kept up the same momentum in recent years? (for stalwarts)
5. What percentage of earnings are being paid out as dividends? (for slow -growers)
6. What is the institutional ownership? (the lower, the better)
7. Is the p/e ratio high or low for the company and for similar companies in the same industry?
8. Is the product that's supposed to enrich the company is a major part of the company's business?  
10. How is the company supposed to turn around? (for turnaround situations)

Conclusion & further resources

Before I leave you to write down checklists of your own, I want to emphasize three points. First, checklist items are evolving in nature. What used to be important in the past may be outdated in today's markets.

Second, you may need a different set of checklist items for different scenarios. A specific checklist item may apply to a particular industry or company size, but irrelevant to another. Remember that checklists aren't there to remove the thinking from the investment process, the checklist is there to support it.

Third, make the checklist specific to your experience; to your criteria of investing.  

If you are interested in reading more about checklists, the following resources are a good starting point. Written by Atul Gawande, The Checklist Manifesto provides an excellent overview of industries such as the medical profession use checklists.

More specific to investing, I suggest The Investment Checklist by Michael Shearn. In that book, he provides over 50 checklist items. The Manual of Ideas, written by John Mihaljevic, breaks down the questions you want to ask, depending on your acquisition criteria. Specifically: when you buy Graham-style bargains when you look for hidden assets in a balance sheet, when you look at management, and so so forth.  

FOOTNOTES: [1] Not to be taken for granted that an investment manager is reading the New Yorker. [2] I use CODA and not a regular word document, because CODA allows dividing a page into sections. [3] The Zenos paradox.

Against The Gods

Published on:
January 25, 2020
Reading Time: 3 Minutes
Last Update:

It was in Risk, Uncertainty, and Profit, that economist frank Knight first observed the difference between risk and uncertainty. Knight saw the two words are different. He writes: 

The essential fact is that 'risk' means in some cases a quantity of susceptible of measurement, while at other times it is something  distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is present.

He continues: 

It will appear that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.

The difference between risk and uncertainty

Risk relates to what we can measure. And we measure risk with probability and relative frequencies. For example, when we hear in the news that 'there is a 50% chance of showers tomorrow', the anchor is expressing a form of risk management. 

Another example is in the medical profession when we hear that '9 of 10 patients recover from the common cold within seven days." It is worthwhile to note that measuring risk is neutral. It can refer to positive or negative events. 

Uncertainty, however, refers to unknown prospects. That is, to outcomes that cannot be understood from experience. The classic example of why the use of risk analysis in futile in an uncertain world is that of the Turkey illusion [1].

Mr. Market's view of risk and uncertainty

But Mr. Market [2] understand risk differently. To Mr. Market, how volatile the price of a stock defines riskiness. All else equal, if stock ABC goes up and down in price while stock XYZ's price is invariably the same, the market deems the latter stock safer than the former. 

Mr. Market also understands risk as a crucial reason for return [Akin to 'no pain, no gain]. With a mindset of 'no risk, no return.'  Also, the investment management profession, through ideas, such as the 'beta' [3] you can reduce risk by negative beta stocks. 

So often, the stock of these companies, especially when fear of recession looms, becomes expensive [4]. In sum, whether we agree or not, Mr.Market has dealt with the definition of risk.  

But Mr. Market refuses to deal with uncertainty. When Wall Street analysts are uncertain about the financial picture of a company, they cannot explain the prospects of the company. And when they cannot identify future outcomes, let alone quantify them, it is impossible to measure the risk the investor will take. And this inability to gauge risk reduces our confidence in their recommendations.

Mr. Market becomes even more worrisome when the uncertainty expands to the macro-level when interest rate guidelines are fuzzy. Or when little is communicated about the foreign policy. Or when there are factors such as geopolitical tensions and trade wars, the prices of publicly-traded businesses drop. 


Look for a second opinion, especially when considering big changes to your portfolio or strategy. Unbiased, professional insights can help you reexamine your assumptions and reduce emotional decisions.

Join the waitlist to learn more.


How auction-driven markets price uncertainty

You rarely buy a house, and after a month of ownership, someone offers you 40% more or less than you paid for it. Real estate, for the most part, is an open marketplace, with relative ease in comparing the price you pay to the value you get. 

But in auction-driven markets [5], mispricing happens more often than you think. I believe the confusion in the definition between risk and uncertainty is the main reason why you can buy a dollar for 40 cents in the stock market.


I suggest reading TEVA's annual report for a current example of the difference between risk and uncertainty. Here is a shortlist of the uncertainty TEVA faces: 

Price-matching lawsuits, lawsuits for the U.S opioid crises, a considerable debt burden as a result of an M&A-gone-bad. TEVA is also in the midst of restructuring plan and turnover in executive management. 

But I bought a few TEVA shares nonetheless. Over the next few weeks, I will write in greater depth about the risk and uncertainty of TEVA. Write to me if you would like to be notified when I upload these essays. 

FOOTNOTES: [1] The belief that every problem should be solved with probability theory. [2] A euphemism of the stock market by Benjamin Graham. [3]The sensitivity of the stock to the market[4] Campbell soup, for example. [5] a market in which buyers indicate the highest price they are willing to pay and sellers indicate the lowest price they are willing to accept.

Net Asset Valuation, Funds from Operations, and Intangibles

Published on:
January 17, 2020
Read time: 9 Minutes
Last Update:

***This is a free chapter from my guide on how to value REIT stocks. Subscribe to access the rest of the guide, and so much more.***

The Income approach

Funds From Operations

Funds from operations are the REIT's net earnings without non-cash or non-operating expenses. To the net income, we add (1) depreciation and amortization, (2) gains and losses from real estate sales, and (4) any impairment write-downs of real estate.

Because GAAP accounting requires an annual depreciation of real estate [1], the intent behind FFO is to get us closer to the economic truth. Yet funds from operations exclude capital expenditures. And omitting this expense results in an optimistic measure of earnings.

Adjusted funds from operations

So the real estate industry includes a second earnings measure called adjusted funds from operations (AFFO). It is often reported by management in the annual report.

In AFFO reporting, management discusses the amount of cash spent on the maintenance of existing properties and the development of new properties and acquisitions.

To calculate the adjusted funds from operations, we use the funds from operations minus capital expenditures. We then adjust for straight-lining of rents and any one-time loss or gain. We then add back amortization related to stock compensation and other deferred costs.


AFFO is a superior measure to the FFO because the maintenance of real estate, whether it is renovating the lobby or replacing the roof, is a real and frequent cost that affects cash flow. To see the difference between net earnings, funds from operations, and adjusted funds from operations, I will use Plymouth Industrial Reit as an example.

For 2017, Plymouth reported a net loss of $14 million. But if we add back depreciation of $14 million and remove the gain of $231 thousand from real estate sale, we arrive at FFO of $260 thousand. To arrive at AFFO, we further deduct for the recurring capital expenditures, straight-line rents, and add back non-cash interest expense, acquisition costs, and stock compensation. We get an AFFO of $818 thousand.

So we found three numbers that tell a different story. Returning to Plymouth, the 5-year average net loss was $25 million. The 5-year average loss from funds from operations was $17 million, and the 5-year average loss from adjusted funds from operations was $9 million. In 2017, all three numbers improved, and the company showed a profit in AFFO.

Similar to the price to earnings ratio, REIT investors estimate whether a REIT stock price is a bargain or expensive using multiplies such as price to FFO ratio or price to AFFO ratio. And observing these ratios over time provides a signal of how the stock market values the company. It also allows us to see the relative value across companies. Judging by the price to FFO ratio, the stock market believes that Essex Property Trust is superior to Mid-America Apartment Communities.

For Essex, between 2013 and 2017, funds from operations were as low as $7.6 (in 2013) and as high as $11.191 (in 2017). And during this time, the average price to FFO ranged between 20 and 23 times.

For Mid-America, FFO was as low as $4.34 and as high as $6.15. The 5-year average price to FFO was 15 times. For over five years, the stock market felt Essex was worth 33% more than Mid-America.

What are some of the reasons that a REIT stock is priced higher?

Let's look at three reasons. The first is growth expectation. If REIT's A portfolio of real estate is earning below-market rents, future earnings will likely to grow. Another reason for a growth premium is that the portfolio of real estate is in areas in high demand — for example, apartment buildings in San Francisco or Vancouver.

The second reason is associated with risk. Say REIT's A portfolio of real estate consists of apartments. And let's assume REIT B owns single, anchor-tenant shopping malls. Then investors will demand a discount for the additional risk [2] they take by holding REIT B.

The third reason is the capital structure. If REIT A carries more debt than REIT B, then investors will view REIT A to be riskier and will demand a discount to the net asset value.

If REIT A has preferred stockholders who are paid a dividend before the common stockholders, then investors demand a discount too.

Funds from operations do not include the value of land, for example. So, if a REIT has a substantial number of projects under development, which currently are not generating any income, then the price to funds from operations may appear artificially high.

Adjusted funds from operations are supposed to bring us closer to the real earnings of a REIT. But capital expenditure varies each year. It is impossible to compare a single year's AFFO. And since many REIT companies do not report AFFO measures - and since there is no standard calculation of the metric - for now at least, AFFO remains a subjective number.

The asset approach (net asset valuation)

The math behind the net asset value calculation is straightforward. We look for the net operating income, as reported on the REIT's public filings. And based on the capitalization rate for similar assets, we then determine the value of the real estate by dividing the net operating income by the capitalization rate.

To that number, we add any cash the REIT holds and any other assets that represent an actual economic value, such as account receivables. We then remove the total liabilities as well as the value of the preferred stocks. The result is the REIT's net asset value.

An illustration: Equity Office Properties Trust (EOP on Nasdaq), reported a net operating income of $271 million last year. Based on recent comparable transactions, we can estimate a capitalization rate of 7.0% and thus determine a value of $3.8 billion for the portfolio of real estate.

We then add the reported cash balance of $65 million, the land of $34 million, the accounts receivable of $46 million, and other prepaid assets of $23 million. We get $4.04 billion in estimated market value. The reported total liabilities were $1.2 billion, and so our net asset value is $2.9 billion or $52 per share [3]  

Let us return to Equity Office to examine that statement. During 2018 the common stock of EOP traded hands as low as $44 and as high as $56. In other words, during this time, the stock's discount was 15%, and the stock's premium was 7%.

The discount or premium to book value also allows us to compare among REIT companies and across industries. We see the stock market finds the ownership of retail riskier than the ownership of industrial properties. For example, Rexford Industrial is trading at an implied capitalization rate of 3.4% while Weingarten Realty Investors (WRI on Nyse) is trading at 6.3% implied capitalization rate.

(We can see retail's gradual devaluation over the past few years because of Amazon.)

Four years ago, Retail Properties of America (RPAI on Nyse) traded at an implied capitalization rate of 6.6% while today it is trading at an implied capitalization rate of 7.7%. Similarly, Weingarten Realty Investors (WRI) traded in 2013 at a capitalization rate of 5.4%, while today it is trading at a capitalization rate of 6.3%.

How to calculate an implied capitalization rate

Consider Rexford Industrial Realty. Instead of estimating a capitalization rate to find the value of the real estate, let us name the market value of the real estate at X. To that we will add $6.6 million cash, $19.5 million of receivables and deduct total liabilities of $746 million and the $90 of preferred stock.

We find a value of $3.5 billion for the real estate portfolio. And since the company reported an NOI of $118.2 million, the implied capitalization rate is 3.4%. The estimated implied capitalization rate is between 3% and 10%, which is a minuscule rate of return. An implied capitalization rate of 15% or higher should pick our interest.

Because we determine the market value of the real estate by dividing the net operating income by the capitalization rate, we fail to see whether the rental rate is below- above- or at the market.

Seritage Growth Properties (SRG on Nyse) serves as an another example. As of its most recent public filing, the company average annual rental revenue was, I estimate, about a quarter of the market rents. This is because 54% of the rental is from Sears Holdings, which has a master lease.

The second issue was the non-linear sensitivity of the estimated value of the real estate portfolio to changes in the assumed capitalization rate. If the capitalization rate changes from 5% to 4%, a 20% difference, for a real estate portfolio that is generating $100 million in NOI, the value would increase from $2 billion to $2.5 billion, a 25% difference.

Inversely, the difference between a 5% capitalization rate and a 6% capitalization rate changes the value of the portfolio from $2 billion to $1.67 billion, a 16% difference. In short, the value of the real estate assets was highly sensitive to the capitalization rate estimate.

The qualitative (intangible value) approach

To properly value REIT stocks, calculating numbers is not enough. There are intangible variables, such as management experience and corporate culture, which are at least as necessary as the variables that we can count.

In searching for excellent management, we focus on four things. The first is to look at management's track record in real estate ownership and in communicating on the state of the business with shareholders.

The second is to find out how much ownership stake management has. If you look at Simon Properties Group (SPG) on Yahoo Finance, for example, you will quickly learn that management owns less than 1% of outstanding shares.

The third is about incentives. Here we ask is management's interest aligned with the wellbeing of the investor?

Returning to the example of Simon Properties, over the past two years, executives of the company have sold 8,189 shares and did not purchase a single stock. A possible interpretation is that if management is not buying its shares, then management expects the stock price to drop.

To estimate future rental income and potential growth, we should look at the operations of each property in the REIT's portfolio. The most popular indicators of value are the location of the property, the occupancy rates, and whether the in-place rents are higher or lower than market rents.

Consider the retail REIT Saul Centers (BFS on Nyse). BFS owns 49 neighborhood shopping centers and six mixed-use properties, and no single property was more than 10% of the total portfolio of 9.2 million in square feet. But about two-thirds of the shopping centers were anchored by a grocery store.

What this data point means is that while the portfolio of real estate is well diversified, it is sensitive to how we will shop in the future; i.e., the more consumers use Amazon Prime, the harder it will be for Saul Centers in the future. This information is not reflected in the reported FFO or estimated NAV.

The right side of the balance sheet

Whether a REIT carries variable or fixed debt will affect its future financials also. This information is readily available in the footnotes section of the annual report filed with the Securities and Exchange Commission.

With a dormant interest rate environment, as the one we saw between 2008 and 2017, whether the REIT financed its operations using fixed or variable debt was not as important as it is today.

But today, the 5-year Treasury, an index often used to price commercial real estate loans, has increased from 2.25% to 2.85%, about a third increase in the cost of debt.

The rising interest rate environment affects all companies. But companies that carry variable debt will be hurt. Saul Center's debt is fixed at a weighted average of 5.25%. Compare that to CBL & Associates (CBL on Nyse), which is paying a lower weighted average of 4.75% - but that is because a third of its outstanding debt is variable.

In The Corporate Governance of Listed Companies: A Manual for Investors, the CFA Institute writes that board members should be independent from management. Board members should have appropriate experience and expertise. And internal mechanisms, such as an authority to hire external auditors, are required.

Simon Property Group has outstanding corporate governance. Each member of the Board's audit, compensation, and governance and nominating committees is independent. This is an example of a qualitative variable that is absent from the financial statements.


While there are additional qualitative variables, such as franchise value and what I call the "capital expenditure biography," which aims to understand how well management has acquired and managed real estate, I would like to end this chapter on valuation with Seth Klarman's 80/20 rule. In his words:

"Some investors insist on trying to obtain perfect knowledge about their impending investments, researching companies until they think they know everything there is to know about them. They study the industry and the competition, contact former employees, industry consultants and analysts, and become personally acquainted with top management. They analyze financial statements for the past decade and stock price trends for even longer."

He then continues:

"This diligence is admirable, but it has two shortcomings. First, no matter how much research is performed, some information always remains elusive; investors must learn to live with less than complete information. Second, even if an investor could know all the facts about an investment, he or she would not necessarily profit...Information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent."

If I leave you with one thing, it is to remember that to understand a business requires both math-skills and thought-skills. The math-skills require us to look for net asset value and to determine what are the funds from operations. The thought-skills require us to observe the business and the industry.

FOOTNOTES: [1] In reality, real estate often appreciates in value. [2] If one tenant leaves, the shopping center is vacant. [3] There were 55.6 million outstanding shares.

EV to EBITDA Ratio

Published on:
November 30, 2019
Reading Time: 3 Minutes.
Last Update:

Enterprise value (ev) is the market value of the debt and equity less cash held by the company. Earnings before interest, taxes, depreciation, and amortization (ebitda) is a proxy for how much cash flow does the business generates. By dividing the enterprise value by ebitda numbers, you discover how long will it take for the company to pay back the initial investment.

The shorter the period the better it is. For example, a business that generates $33,000 a year is more attractive than a business that makes $14,000, assuming both will last and cost the same.

The ev to ebitda ratio represents this idea. "What a ratio of eight times ev to ebitda," writes Michael Shearn in The Investment Checklist, "is that the investment will pay itself in eight years."

Read how to calculate ev to ebitda ratio on Investopedia or visit for ways to compare ev to ebitda ratios among companies.

In this essay, I describe the ratio's main weaknesses and how you can better prepare for them. I end the article with a few examples of companies trading at low ev to ebitda ratios. 

The flaws of ev to ebitda 

There is a reason why Charlie Munger called ebitda earnings "bullshit earnings." In his mind, ebitda misses out on two key points: the amount of leverage and the amount of capital expenditures required to maintain the business.

If ebitda portrays a distorted reality, then the ratio that uses ebitda in its denominator must obstruct reality, too.

Another flaw of the ratio is that it looks at a single point in time. But what matters to investors are trends over time. That is, whether earnings will grow in the future is more important than current earnings or last year's earnings. 

For example, in June of this year, I bought the stock of Signet Jewelries (SIG on Nyse) One of the reasons I purchased SIG was because for the prior seven years, the average  was $800 million. But because the 2018  was loss $579 million, the stock had more than halved.  to  cannot pick up such a discrepancy. 

Like most things in life, the problem does not lie in the ev to ebitda ratio but how the user intends to use it. I typically use ev to ebitda ratio to quickly screen for cheap stocks[1]. Other investors use the inverse logic; they use the ratio to estimate how valuable a company is. They assume that the higher the ratio, the more valuable the company. 

The uses of ev to ebitda 

Yet, even with the flaws mentioned, ev to ebitda ratio is widely used, and ebitda figures are widely accepted. Read any loan covenants of a publicly-traded firm and you will see that lender covenants that address  ebitda figures. That is, if ebitda for a quarter falls below a specific number, a higher interest rate will be charged. 

And so, to use Silicon Valley nomenclature, this ratio exhibits a "network effect." One of its strengths is that it is widely used by both companies and by Wall Street analysts.

One of the strengths behind the ev to ebitda ratio is its popularity by both lenders and analysts.

Take, Luca Franza of Ausonio Fund as example.In the now famed investment thesis for Rain Industries, he writes: 

"Rain trades at a P/E of 2.7x and EV/EBITDA multiple of 5.1x. Using cyclically adjusted earnings and EBITDA, which we will assume to be the average over the last five years, Rain trades at a P/E of 1.7x and EV/EBITDA of 4.2x."  

Another use of the ev to ebitda ratio is that it allows us to observe a company's valuation over time. Canterbury Consulting shows, in a quarterly asset class report, that for the Russell 2000, a popular index, /  was 16 times, while the 10-year average ratio was 14 times, and. For the S&P500, Canterbury researchers show that the current TDA was 1mes, while the 10-year average was ten times. You can download the Canturbury report.

When bored, I enjoy finding out the ev to ebitda ratio of portfolio companies owned by asset managers I admire. For example, a few weeks ago, I reviewed Third Street Avenue Capital Management. I saw that for the 31 companies Third Street owned as of the second quarter of this year, most portfolio companies ev to ebitda was in the double digits. Only Carter Bank Trust Advansix Inc. traded at a ratio of six times; MYR Group at a ratio of seven times. The other single-digit companies, at nine times the ev to ebitda, were Seaboard Corporation, Comfort Systems and TRI Pointe Group and Kaiser Aluminum Corporation.


In Pen&Paper, I only write about companies I am personally invested in, and on finance topics, I find it important to share.

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Examples of companies trading at a low ev/ebitda

I often screen for stocks trading at low ev/ebitda. While it is insufficient to make an investment decision based on the ratio, it does serve as a starting point or as a filter mechanism. I conclude this essay with three companies in my portfolio that are trading below three times the ev to ebitda ratio.

EV to EBITDA in my stock portfolio
Some low EV/EBITDA ratio companies in my portfolio

First, the sport-equipment manufacturer Nautilus' enterprise value is $54 million, and ebitda is $31 million. Second, Flexsteel Industries, the sofa manufacture, enterprise value is $102 million, and 2018 ebitda is $33 million. Third, Gulfport Energy, a producer of natural gas, enterprise value is $2,670 million, and 2018 ebitda is $1,046 million.

[1 ] A ratio of EV to EBITDA less than 3 times is considered a bargain valuation.