Don’t Be A One-Legged Person In An Asskicking Contest – My Answer To Why Valuation Is Important

Don’t Be A One-Legged Person In An Asskicking Contest

My Answer To Why Valuation Is Important

Last week I asked your thoughts on valuation.  If you think it’s important?  Why or why not?  I asked this because I’ve seen a lot of discussion on the topic in recent weeks.  This post is my answer to that question.

Asking if valuation is important to deep value investors like us is like asking if we follow the teachings of Ben Graham and Warren Buffett.  The answer of course is yes.  But why is valuation important?

Once we understand how to do valuation most of us never think about this question again. And it’s important to understand why.

To show why valuation is important let’s continue with an example from the earlier post.  Why The P/E Ratio Is Useless – And How To Calculate EV.

Why Valuation Is Important

Below is an example of two company’s made up for the example.

Company 1 Company 2
Market Cap 100 100
P/E Ratio 10 20
P/E stays the same under the below scenario.
Cash and Cash equivalents 0 40
Debt 40 0
EV = 140 60
EBIT = 10 10
FCF = 10 10
Company 2 is cheaper when considering EV
EV/EBIT = 14 6
EV/FCF = 14 6

P/E, EV/EBIT, and EV/FCF are all relative valuations.  Companies that have lower relative valuation multiples are cheaper than others.  And companies that are cheaper are better to buy.  Why is this?

To find out why lets invert both EV/EBIT and EV/FCF to find each companies earnings yield.  I explain earnings yield in the following section.

Earnings Yield Estimates Expected Rate Of Return

For those who don’t watch the short video above I’ll paraphrase. Earnings yield is the estimated return you should expect to earn in one year on an investment.

The higher this number is the better. This is because the higher this number is the more a company is undervalued.

Company 1 above has an earnings yield of only 7.1%. Not good enough. I look for earnings yields above 10%.

Company 2 above has an earnings yield of 16.7%. 2.35 times company ones earnings yield. And above the 10% I look for when considering an investment.

This means you should earn 2.35 times more if you invest in company two instead of company one. But this isn’t all…

By doing the work above with EV and earnings yield, not only do you see that company 2 will get you a higher return. But doing a bit more work allows you to see that company 2 is a less risky investment.

Company 2 is safer because it has no debt, while having a lot of cash. The saying that the more you risk the more you gain is a fallacy. This “advice” needs to die because it leads many investors into unnecessary danger.

But these aren’t the only concepts you need to consider when evaluating an opportunity.

EBay And Amazon Businesses

Many of you who’ve followed this blog for a while know that I also run an EBay and Amazon reselling business.  The example below is something I found and sold last year.

I use the concepts talked about in this article every day.  And you can use them whether you’re analyzing a stock.  Or buying something to sell in your business.

Let’s say we have two of the same Giorgio Armani jeans.  Same size, color, condition, everything.  And both are real Giorgio Armani jeans.

Each pair of jeans looks brand new but does not have the tags on them still.  These jeans sell for more than $100 brand new.  But for this example let’s use $100 because it’s an even number.

So both pairs of jeans are the same and sell brand new for the same amount.  But what if I said you could buy one of the pairs for $80 and the other pair for $2.  Which would you buy?

The one that’s selling for $2 of course.

But if you had an EBay and Amazon business how would this change things?  You would need to keep thinking…

One pair we bought for $80 and the other we bought for $2. We can resell both for $100. This means we have the potential to make $20 on one pair and $98 on the other.

The pair we bought for $80 and sold for $100 gives us a 20% return. Not bad. But the pair we bought for $2 gets us a return of 4900%. Or a 49 bagger in a short amount of time. We’ll get back to the time aspect later… This is a spectacular return. And is why valuation is so important.

All else remaining equal, the cheaper a company is the higher return you should expect in the long-term.

This is why it’s important to value businesses. Without doing valuation you can’t know if you’re getting a good deal. Or taking unnecessary risks with your capital.

In the above example is risking your $80 to make a $20 profit worth your time? Or would you rather buy the $2 pair of jeans and get a 4900% return on the same item while risking far less money on a safer investment?

But there’s still more…

You also need to think about the amount of time it will take for your investment thesis to play out. And consider what you can’t invest in while you invest in this opportunity.

This last concept is opportunity cost.

The Opportunity Cost of Investing

As investors we have to consider several choices every time we think about buying an investment.

  • Is the investment safe?
  • Am I getting a high enough return compared to the capital I’m risking?
  • Am I getting a high enough return for the amount of time I expect to hold this investment?
  • Do I already own another company that would be a better investment?
  • If I invest in this company now, am I comfortable holding it for the long-term? Another – possibly better- company may come along and I need to be comfortable losing out on that opportunity.

These are just a few of the many things you need to consider when investing. But for now I want to concentrate on the last bullet point.  It’s the concept called opportunity cost.

DEFINITION of ‘Opportunity Cost’

1. The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.

2. The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment – say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6% – 2%).

Below is a video from giving a real world example of opportunity cost.

The example of choosing between two jobs is too simple.  But it’s a good starting point.

The thoughts I would’ve added to help me decide which is a better job would be: Which job would I be happier at?  Which one has more room for advancement?  How many hours do I have to work at each?  Etc.

When considering an investment you need to consider more than just valuation.

For example: Which one is safer?  Which one is offering a higher return?  Which one do I have more capital tied up in and for how long?  Which company has higher profits and cash flow compared to valuation?  Am I willing to pay up for a better company?  And much more.

This is how you begin to analyze the opportunity cost of an investment.  And get closer to a decision.

But without valuation you’re only considering part of the equation.  And without valuation you’ll have to rely on gut instinct and emotion.  Two things that will kill you when making investment decisions.

Don’t Be A One-Legged Person In An Asskicking Contest

Yes I know when picking businesses and stocks to invest in not everything is equal like in the examples above.  But this is why you need many tools in your mental toolbox while evaluating things.

And if you don’t consider valuation, opportunity cost, and the other concepts in this article, you’re missing some of the best mental investment tools.  Or as Charlie Munger says:

If you don’t have the proper mental tools then you go through a long life like a one-legged man in an asskicking contest.”

To learn more about mental models.  And start adding tools to your mental tool box so you don’t go through life like a one-legged person in an asskicking contest, go to the earlier post. Car Wash Psychology, Mental Models, and The Power of Habit.

What do you think about valuation?  And did I miss anything in my explanation?  Let me know in the comments below.


Don’t forget, if you want to receive two free gifts that will help you evaluate companies faster.  Get all future blog posts. Get future case study information first.  And be entered to win a hard copy of: The Snowball – Warren Buffett and the Business of Life and a $50 AMEX gift card. Sign up for the Value Investing Journey newsletter here.

Lionel Messi Is A Failure

Famous Failures

This post is a continuation of my Famous Failures series.  To view earlier posts in this series go to this link.

The aim of Famous Failures is to show that all successful people are failures.  And that to become great we have to fail, learn, and keep moving forward.

Lionel Messi Is A Failure

In case you don’t know the picture above is of the best football player in the world. Lionel Messi.  The Michael Jordan of soccer.

Leo Messi

The above screen capture is from this video on Famous Failures.  It’s about the best footballer in the world – and my favorite player – Lionel Messi.

Below is an excerpt from this article detailing some of the adversity he faced growing up.

But Messi is no stranger to adversity. Born with an outstanding, audacious talent, nature, almost as if re-dressing the balance, denied him the growth hormone that would permit him to grow the same as most other children.

Messi said: “When I was 11 years old they discovered that I had a growth hormone deficiency and I had to start a treatment to help me to grow.

Every night I had to stick a needle into my legs, night after night after night, every day of the week, and this over a period of three years.”

“I was so small, they said that when I went onto the pitch, or when I went to school, I was always the smallest of all. It was like this until I finished the treatment and I then started to grow properly”.

A team cut him when he was 11 due to health issues.  But he chose to work and go after his dream of playing for FC Barcelona.  In time he became the best football player in the world.  And one of the best of all time.  The info below is from Wikipedia.

He’s won 22 team championships in eight different competitions.  Has won dozens of awards including being the world’s best player a record four straight times.  And holds – and is still breaking – dozens of records around the world.


For more information on Lionel Messi read: Lionel Messi Is The Best Footballer The World Has Ever Seen.

But to really understand his greatness you need to watch him.  Below is a 6:22 video showing some of the reasons why many think he’s the best football player ever.

And to think, none of us would ever have known anything about Lionel Messi if he gave up when he first failed.

Dream big… Imagine what you can do if you keep pushing forward instead of quitting when you fail.

What do you think of Lionel Messi?  Do you admire him and the way he plays football?  Do you think he’s a failure for not winning a World Cup yet?  Or are you wrong and think Cristiano Ronaldo is a better player?

Let me know in the comments below.


Car Wash Psychology, Mental Models, And The Power Of Habit

Car Wash Psychology, Mental Models, And The Power Of Habit

Getting back from a 33 hour drive across the country left me exhausted.  But I had one thing left to do before resting.

I had to wash my truck…

From the salty and sticky humidity of South Florida.  Through the rain, snow, and ice of Tennessee and Kentucky.  Then the dry wind of Iowa and South Dakota.  And all the bugs and dirt between.  My truck was a disaster after a 33 hour drive through nine states.

Why did I have to wash my truck when I got home?

Because several weeks before this I’d read a psychology and marketing case study about car washes. And I wanted to see if it was true or not.

Exhausted from the three-day drive across country. I waited at the car wash and marveled at the surprising beautiful March day in Western South Dakota.

Instead of negative wind chills. High wind. And blizzards that are common at that time of year here. I came home to a cloudless sunny sky. And 70 degree temperatures.

It was a perfect day to wash my truck. But after getting it into the car wash bay I worried that I’d made a mistake.


Because of marketing, psychology, and habit.

But we will get back to this later…

Building Worldly Wisdom and A Latticework of Mental Models

Why am I talking about marketing, psychology, and habit on a value investing blog?

As a contrarian deep value investor, I’m always looking for ways to gain legal advantages over other investors.  Most of the time this involves working hard.  But sometimes it also requires the ability to think well.

To think better I study a lot of topics.  And follow Charlie Munger’s teachings about gaining Worldly Wisdom.  And building a latticework of mental models.

One of the areas I’ve spent a huge amount of time studying is human psychology. Trying to figure out  why we do what we do.  And what makes us tick to become a better investor.

How To Get People To Buy Things

I know a lot about how to analyze businesses for potential investment.  So when I got hired by the investment newsletter I was not only excited to write an investment newsletter.  But I also looked forward to learning about the investment newsletter business.  And everything associated with it including psychology and marketing.

If I wasn’t at work.  At the beach.  Sleeping.  Or working at home.  I was reading anything I could about marketing and how to improve my writing.  But for this post I want to talk about some of the things I learned about marketing…

Marketers Rule The World

Did you know that shampoo doesn’t have to foam to clean your hair?  What was Listerine used for before marketers got involved?  Did you know that Febreze was a failure until marketers used psychology and habit to market it?  And does your car get cleaner when you upgrade to the “Super Wash.”

I will answer these questions below.  And also answer how marketers use psychology to get us to develop habits.  And buy products.


Below is a marketing case study from Procter & Gamble brand Herbal Essences.  Which before marketers revamped it was floundering.  Emphasis is mine.

I also changed some of the wording to shorten things.  For the full transcript go to this link.

When Procter & Gamble acquired hair-care company Clairol in 2001, it inherited a floundering shampoo brand. By 2004, Herbal Essences was in a “long-term decline,” reports Chairman and CEO A.G. Lafley.

Marketed to all women the line had gone stale, with little distinction from the many competitors it shared on the drugstore shelf.

By 2006, Lafley and P&G’s beauty business chief, Susan Arnold, knew something had to be done with the tired brand.

To find the right new, smaller target market for the brand, Arnold and her team turned to marketers.

There, the team came up with a new target audience for the brand—Generation Y. “In the case of Gen Y, there really wasn’t another hair-care brand that was really meeting their needs,” says Lafley. “The question was: ‘Can Herbal do it?'”

Arnold’s team bet yes. They redesigned the packaging of the product to “fit” this more tailored market: The shampoo and conditioner bottles are curved so that they literally fit together on the shelf. The nesting shape not only helped Herbal Essences stand out from others on the shelf but also encouraged more young women to buy both products, driving up conditioner sales.

To appeal to Millennials, the team also updated the language on the packaging. The ho-hum “dandruff” reference gave way to “no flaking away.” Names for different hair styles were changed to more youthful phrases such as “totally twisted” or “drama clean.” “We totally reframed the proposition,” says Lafley.

P&G made Herbal Essences more relaxed and more quirky, all in the language of young women.

Marketers used psychology and habit to turn this floundering line into a billion dollar plus brand.  And Herbal Essences parent Clariol now controls an estimated 39% of the entire hair care market.

For further information on the revival of Herbal Essences look at this infographic.

Oh and to answer the above question…  The chemical sodium lauryl sulfate was added to shampoo to foam and bubble.  It’s not necessary in shampoo.  And it doesn’t affect how well the shampoo cleans your hair.

Shampoo makers added the foaming agent for marketing and psychology purposes. To help sell product and build habit.

I will explain this more later.

Oh and the foaming ingredient is also what irritates your skin and eyes.  So thank marketers for your dry skin.  And eye pain when washing your hair.

Listerine The Antiseptic

Did you know Listerine was a deodorant and after shave.  A brand of cigarettes.  And used to treat gonorrhea and cuts before becoming a mouth wash?

Below is one of the ads used to promote Listerine after it launched..

But by focusing on cuts, scratches, and gonorrhea Listerine was a failure.

Then marketers got involved.  Made bad breath a terrible thing.  And launched a $317 million brand as of 2013

Until that time, bad breath was not conventionally considered such a catastrophe. But Listerine changed that. As the advertising scholar James B. Twitchell writes, “Listerine did not make mouthwash as much as it made halitosis.” In just seven years, the company’s revenues rose from $115,000 to more than $8 million. From Wikipedia

Instead of saying Listerine will help keep your cuts from becoming infected.  Marketers found out that Listerine also helped get rid of bad breath.  And they used the second ad above to illustrate the point.

Listerine marketers made having bad breath a terrible thing.  Up to that point this wasn’t awful.

In the second ad above marketers said that if you have bad breath you won’t get married.  But if you use Listerine on a regular basis – making it a habit – not only will you get rid of bad breath.  But it will also help you get the guy or girl of your dreams.

So marketers used psychology and habit to help get rid of smelly hair and breath.  What other smells have marketers helped us get rid of?

Febreze The Failure

The below quoted area is from Wikipedia.  Emphasis is mine.

The product, initially marketed as a way to get rid of unpleasant smells, sold poorly until P&G realised that people become accustomed to smells in their own homes, and stop noticing them even when they are overpowering (like the smell of several cats in a single household).

The marketing then switched to linking it to pleasant smells and good cleaning habits instead, which resulted in a massive increase in sales.

Only after the product became well established in the marketplace did the marketing go back to emphasising odor elimination properties as well.

They have advertised it so that people use it for cleaning, and for designing the house air.

Febreze was a failure when it launched.  Even after Procter and Gamble – one of the best product launch companies in the world – spent millions of dollars to promote it.

Febreze didn’t become the huge success it is until P&G figured out how to market it to us.  And they’ve done a great job… Febreze is now a billion dollar plus brand.

For more information on how marketers used psychology and habit to change Febreze from a flop to a billion dollar brand go here.

Now let’s get back to the story at the beginning of this post…

Car Wash Psychology

So why was I so eager to get my car washed when I got home from my 33 hour cross-country trip.  And how did marketers make me think I’d made a mistake when selecting my car wash?

A few weeks before my trip I was reading about marketing and psychology to improve my knowledge in those areas.  And came across a case study about the car wash industry.

The case study detailed how car washes get us to upgrade to the higher end washes so they make more money.  But the thing that struck me like a brick was that the different color bubbles in the car wash don’t do anything to clean or wax your car.

The colored bubbles only make us think they wash better

The car washes add colors to the bubbles of the higher end washes to make us think they are doing something.  It’s a clever way marketers – in this case the car wash – affects our psychology to get us to upgrade.  But it also builds habits as well.  And habits are what marketers use to get us to buy stuff.

The Power Of Habit

The Power of Habit is an amazing book.  And I agree with Mr. Pink above.

It’s changed the way I think about how I parent.  My investment processes.  Psychology.  And how I do everything in my life.  In short I cannot recommend that you read this book enough.

Below is author Charles Duhigg explaining in a three-minute video how we develop habits.  And how to break bad habits.

The Combined Power of Psychology, Marketing, and Habit

So now let’s get back to why I worried at the beginning of this story.

After my trip I decided to do a little experiment to see if the car wash case study I read was full of crap.  Or if it was right and car washes were using psychology and habit to get us to upgrade to stuff we didn’t need.

When I got to the car wash I picked the basic wash without the colored bubbles to see if the case study was right.  But when I got into the wash I started to worry that I’d wasted my money.

Ever since I was little everyone always told me to upgrade to the “better” car washes.  If I didn’t my car wouldn’t get clean and I would have to wash my car again.

So even though I knew that the upgraded car washes weren’t necessary after reading the case study.  And doing further research to confirm the findings.  As I sat in the car wash bay with the water and soap running over my truck.  I began to worry that I’d wasted my money when I didn’t see the colored bubbles washing my truck.

Marketers have incredible power when they combine psychology and habit when selling stuff…

Even though I knew the colored bubbles were a marketing tactic.  I still worried that I was wasting money.

So the longer I sat there the more anxious I got to see if the basic wash worked…

After I got through the air dryer I got out of my truck to see if I wasted my money or not.

With the water still beading off my red Dodge Ram 1500 I saw that the basic wash got all the salt, dirt, bugs, snow and rain water spots off my truck.  And my truck was as clean and shiny as the day I bought it.

Seeing this brought a smile to my face knowing that I learned some powerful lessons about marketing, psychology, and habit.  Built my latticework of mental models and worldly wisdom up.  And got a bit closer to achieving my goals as an investor, teacher, and entrepreneur.

Still smiling knowing I learned something valuable, I drove my clean truck home and slept for the next 16 hours.

And I’ve shared this story in the hopes that it will help you in some way too.

What quirky mental models, worldly wisdom, or aspects of psychology have you learned that blew your mind when you first saw them?

Please share below in the comments.


Want more information on how marketers use psychology to get us to buy stuff…  Go here.  It looks like an entire college level course about marketing and consumer market psychology.

And if you want to read more about Mr. Munger’s thoughts on psychology and how to think better, read his speech Psychology of Human Misjudgment.

Or watch the 76 minute talk below from YouTube.

This is the best thing I’ve ever read about psychology.  And how to become a better thinker.


Don’t forget, if you want to receive two free gifts that will help you evaluate companies faster.  Get all future blog posts. And be entered to win a hard copy of: The Snowball – Warren Buffett and the Business of Life and a $50 AMEX gift card. Sign up for the Value Investing Journey newsletter here.