🎯 In 30 seconds: A thesis is a short written argument for why a stock is worth more (or less) than its price, what has to happen for you to be right, and what would prove you wrong. Writing it down stops you from buying on a feeling and selling in a panic. This chapter gives you a one-page template, walks through a simple discounted cash flow (DCF) valuation with every number shown, explains margin of safety, and sets out when to sell.
From idea to thesis
Ideas come from anywhere: a product you use, a screen, a news story, a chart. An idea is not a reason to buy. A thesis is.
A good thesis has four parts:
- What the market believes. What does the current price assume about growth, margins and risk?
- What you believe differently, and why. If you agree with the market, there is no edge. The stock is fairly priced.
- What would prove you right, and roughly when: a margin improvement, a new product's sales, debt paid down.
- What would prove you wrong. Specific, checkable signs that the thesis has broken.
The work behind each part comes from earlier chapters: the statements, business quality, moats and management and valuation ratios. The thesis pulls them into one decision.
The one-page template
| Field | What to write |
|---|---|
| Company and date | Name, today's date, today's price |
| The business in two sentences | What it sells, to whom, how it makes a profit |
| Why it is mispriced | What the market believes, what you believe, and the evidence |
| Quality check | Margins, ROIC, debt, free cash flow, share count trend |
| Moat and what could break it | One sentence each |
| Valuation | Your value per share (low, base, high) and how you got it |
| Margin of safety | Your buy-below price |
| Catalysts | Events that could close the gap, with rough dates |
| Bear case | The three best reasons the stock could fall by half |
| Exit rules | What makes you sell: thesis broken, target reached, stop level |
| Position size | How much, and the most you are prepared to lose |
| Review dates | After each earnings report, and at least every quarter |
Keep it to one page. If you need five pages to explain why a stock should go up, the idea is probably too complicated to act on.
What a DCF does
A discounted cash flow (DCF) valuation estimates what a business is worth today from the cash it will produce in the future. Two ideas make it work:
- Free cash flow is the cash a business produces after paying for its operations and investment: cash from operations minus capital spending. It is what the owners and lenders could take out.
- The time value of money. A dollar next year is worth less than a dollar today, because today's dollar could be invested. To convert future cash into today's dollars, you discount it: divide by (1 + r) once for each year of waiting, where r is the discount rate, the yearly return you require.
The discount rate is your required return. It starts from a safe rate (the News and economy page shows today's 10-year Treasury yield) and adds extra for the risk of owning a business. Riskier businesses deserve higher rates. A DCF is only as good as these inputs, which is why you always test several.
Worked DCF: hypothetical Company K
Company K produced $100M of free cash flow last year. Our assumptions, all made up for the example:
- Free cash flow grows 10% a year for five years.
- After year 5, it grows 3% a year forever (the terminal growth rate, roughly in line with a mature economy).
- Discount rate: 9%.
- Net debt (debt minus cash): $200M. Shares outstanding: 50 million.
Step 1: project and discount five years of free cash flow ($ millions).
| Year | Free cash flow | Discount: 1.09 to the power of the year | Present value |
|---|---|---|---|
| 1 | 110.0 | 1.0900 | 100.9 |
| 2 | 121.0 | 1.1881 | 101.8 |
| 3 | 133.1 | 1.2950 | 102.8 |
| 4 | 146.4 | 1.4116 | 103.7 |
| 5 | 161.1 | 1.5386 | 104.7 |
| Total | 513.9 |
Each present value is free cash flow divided by the discount. Year 2: 121.0 / 1.1881 = 101.8.
Step 2: the terminal value. The business does not stop after year 5. The value of all cash after year 5, as of year 5, uses the same growth formula as in The economy and stocks:
| Year 6 free cash flow: 161.05 x 1.03 | 165.88 |
| Terminal value at year 5: 165.88 / (0.09 - 0.03) | 2,764.7 |
| Discounted to today: 2,764.7 / 1.5386 | 1,796.9 |
Step 3: from business value to value per share.
| Present value of years 1 to 5 | 513.9 |
| Present value of terminal value | +1,796.9 |
| Enterprise value | 2,310.8 |
| Less net debt | -200.0 |
| Equity value | 2,110.8 |
| Divided by 50 million shares | $42.22 per share |
Notice the uncomfortable fact in that figure. Most of the value sits in the terminal value, which rests on two guesses: the growth rate forever and the discount rate. That is normal for DCFs, and it is the main reason to treat the output as a range, not a number.
Test the assumptions
Change the two inputs that matter most and recalculate. Value per share for Company K:
| Discount rate | Terminal growth 2% | Terminal growth 3% |
|---|---|---|
| 8% | $43.84 | $51.73 |
| 9% | $36.78 | $42.22 |
| 10% | $31.50 | $35.43 |
Reasonable-looking inputs give anything from $31.50 to $51.73. A DCF that produces one precise number and no range is hiding its uncertainty.
You can also run it backwards. Take today's price and ask what growth rate would justify it. If the price only makes sense with 25% growth for ten years, you know what the market is betting on, and you can judge whether that is likely.
Margin of safety
The margin of safety is the gap between your estimate of value and the price you pay. It protects you against your own mistakes, and you will make some.
Margin of safety = (value - price) / value
| K at a price of $30: ($42.22 - $30) / $42.22 | 28.9% |
| Buy-below price for a 25% margin: $42.22 x 0.75 | $31.67 |
At $30, even the most pessimistic case in the table ($31.50) is above the price. That is what a margin of safety looks like: you can be somewhat wrong and still not lose much.
Bigger margins suit businesses that are harder to predict. A steady business you understand well might justify 15% to 20%. A young, unprofitable or cyclical one might need 40% or more, or a pass.
When to sell
Decide your exit rules when you buy, while you are calm. Good reasons to sell:
- The thesis broke. One of your "what would prove me wrong" signs appeared: margins fell instead of rising, the key product failed, debt went up. Sell even if the price has not fallen yet.
- The price reached your value. The margin of safety is gone. You can hold if your value estimate has genuinely risen, but write down why first.
- A clearly better use for the money. Another idea with a bigger margin of safety and similar risk.
- The position got too big. A winner that grows to a large share of your account adds risk. Trimming is a valid choice (see Position sizing).
- Your risk limit was hit. If you use a stop level, respect it. Stop losses covers how to set one that fits the time frame.
Weak reasons: the price fell and you are scared, the price rose and you want to "lock in" a gain without a reason, or someone online said so. Also count taxes before selling a winner in a taxable account. Gains on positions held a year or less are usually taxed at higher short-term rates (see Taxes for traders).
Try it
Build a DCF for Company K in a spreadsheet and match the numbers above to the cent. Then change growth in years 1 to 5 from 10% to 5% and recalculate. (Answer: about $33.43 per share at a 9% discount rate and 3% terminal growth.)
Next, pick a real company from your Watchlist and fill in the one-page template, including a low, base and high value. Do not buy it. Instead, put it in the Paper trading portfolio at today's price, set your review dates, and see over a few quarters how your thesis holds up.
- What are the four parts of a good thesis? Answer: What the market believes; what you believe differently, and why; what would prove you right, and roughly when; and what would prove you wrong.
- Your value for Company K is $42.22 and the price is $30. What is your margin of safety? Answer: About 28.9% (($42.22 - $30) / $42.22).
- What is the buy-below price for a 25% margin of safety on a $42.22 value? Answer: $31.67 ($42.22 x 0.75).
- One of your "what would prove me wrong" signs appears, but the price has not fallen yet. What should you do? Answer: Sell. The thesis broke, and that is a good reason to sell even if the price has not fallen.