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That’s a possibility.

Buffett has this concept of “owner earnings”: how much cash can be safely taken out of a business each year without hurting it?

Take out more than this, and we risk hurting the business’s competitive position, earning power, unit volume, etc.

1/

Get a cup of coffee.

In this thread, I'll show you how the P/E ratio of a portfolio is related to the P/E ratios of its individual stocks.

The math here is beautiful. It involves harmonic means and a super elegant theorem known as the Cauchy-Schwarz Inequality.

2/

Earlier this week, I conducted a poll where I asked this question about P/E ratios.

Over 6,000 people responded.

Unfortunately, most of them got the answer wrong.

That's why I'm writing this thread. To (hopefully) correct some of the misconceptions that led people astray.

3/

To answer questions like this, it's always a good idea to go back to first principles.

In this case, we should ask ourselves: what exactly does a P/E ratio capture?

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We know that the P in P/E stands for Price. In other words, the amount we need to pay to acquire an asset today.

And the E stands for Earnings. The amount earned by our asset in the last 1 year.

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Note: P/E ratios come in more than 1 flavor.

For the E part, some people use earnings during the *last* 1 year. This is called the *trailing* P/E ratio.

Others use an estimate of earnings during the *next* 1 year. This is called the *forward* P/E ratio.

1/

Get a cup of coffee.

In this thread, I'll walk you through the key differences between *earnings* and *cash flows*.

The punch line: Just because a company reports $1 of *earnings*, it does NOT mean the company has $1 more *cash* to distribute to owners.

2/

Before we look at a company's *earnings*, it's useful to understand the concept of Net Worth.

Net Worth (also called Book Value, or Shareholder's Equity) is simply the difference between what a company *owns* (ie, its assets) and what it *owes* (ie, its liabilities).

3/

Companies typically *own* a bunch of assets.

These include cash, "accounts receivable" (ie, money owed to the company by customers), "inventory" (ie, raw materials and finished products), "property, plant, and equipment" (ie, land, buildings, and factories), etc.

4/

Also, companies typically *owe* money or services to others (liabilities).

These include "accounts payable" (money owed to suppliers), "wages payable" (ie, money owed to employees for work they've already done), debt taken out by the company that has to be repaid, etc.

5/

Net Worth is what remains after we net out what a company *owns* against what it *owes*.

Companies that *own* more than they *owe* have positive net worth.

Companies that *owe* more than they *own* have negative net worth.

1/

Get a cup of coffee.

In this thread, I'll walk you through the basics of Capital Allocation.

The better we understand how capital moves in and out of a business, the better we can predict the business's future cash flows and its stock's long-term performance.

2/

Businesses generate *cash* through their operations.

For example, Apple generates cash by selling iPhones.

Starbucks generates cash by selling coffee.

Google generates cash by selling ads.

IBM generates cash by doing things I don't understand.

Etc.

3/

Capital Allocation is the step that comes *after* generating all this cash.

That is, once the cash is available, what does the CEO *do* with it?

What projects does he invest in? What acquisitions does he make? Does he return any cash back to shareholders? Etc.

4/

Capital Allocation can make a tremendous difference to a company and its shareholders.

For example, at Berkshire Hathaway, Buffett took the cash generated by textiles and allocated it towards operations that produced much higher returns. Like insurance and candy.

5/

This transformed Berkshire Hathaway from a lowly bunch of textile mills to the super successful giant diversified conglomerate that it is today.

Along the way, long term shareholders reaped rich rewards.

That's *good* Capital Allocation.

1/

Get a cup of coffee.

In this thread, I'll help you understand the basics of Binomial Thinking.

The future is always uncertain. There are many different ways it can unfold -- some more likely than others. Binomial thinking helps us embrace this view.

2/

The S&P 500 index is at ~3768 today.

Suppose we want to predict where it will be 10 years from now.

Historically, we know that this index has returned ~10% per year.

If we simply extrapolate this, we get an estimate of ~9773 for the index 10 years from now:

3/

What we just did is called a "point estimate" -- a prediction about the future that's a single number (9773).

But of course, we know the future is uncertain. It's impossible to predict it so precisely.

So, there's a sense of *false precision* in point estimates like this.

4/

To emphasize the uncertainty inherent in such predictions, a better approach is to predict a *range* of values rather than a single number.

For example, we may say the index will return somewhere in the *range* of 8% to 12% (instead of a fixed 10%) per year.

5/

10 years from now, this implies an index value in the *range* [8135, 11703]:

when a stock you own becomes expensive, you rationalize holding on by calling it a compounder. base rate says v v few stocks are real compounders , rest are just pigs with lipstick.

Ben Graham's "The Intelligent Investor" is a horrible book if you're using it purely for the quant formulas in today's Markets, but probably THE BEST BOOK if you're interested in learning about the core investing concepts, and eternal truths about the Markets & its participants.

Below are few of my fav quotes organized by topic.

1⃣ Discipline

2⃣ Investing vs Speculation

3⃣ Mr. Market

4⃣ Bear Markets

Successful investing is hard work because it means disciplining your mind to do the opposite of human nature. Buying during a panic, selling during euphoria, and holding on when you are bored and crave action.

Investing tid bits...

Being an investor does not mean your Investment decisions are based on quantity or no of investments per quarter or year. It is all about Quality of investment decisions.

It may be just 1 or 2 per Q/HY/Y

Investing tid bits..

Size of your
REWARD and TALENT

Stock market is the only place where the size of the REWARD is far higher than the TALENT

I am an above average ordinary individual. But the markets have rewarded me hugely.

All it needs - Passion, Learing & temperament