Like a Bond – Redux
I had left my discussion of “How Buffett Analyzes Businesses” with the notion that he evaluates stocks in very bond-like fashion. This is mind-blowing to a lot of people. Students (including me) have been taught about the stark differences between stocks and bonds, using fancy statistics and intellectual frameworks like the Modern Portfolio Theory. Yes, stocks and bonds are different, obviously. A bond pays a fixed coupon, usually every 6 months, all through the end of a fixed term, at which point you get your full Principal paid back in full. Generally, pretty safe – that’s why they call it “Fixed Income”. Equities are inherently unsafe, because there is no “fixed income” (other than dividends, but they’re not contractual), and your Principal is tied directly to the fate of the company.
You can imagine, then, the valuing a Bond is a lot easier than valuing at Stock – mathematically, at least. Wouldn’t it be nice to be able to value a stock like a bond? Well, that’s what every Discounted Cash Flow (DCF) Equity Valuation model attempts to do. The difference is that stocks have many more randomly moving parts. No fixed terms. No fixed coupons. No money-back guarantee.
In bonds, we know these quantities:
- The Coupon
- The Term - the lifespan of the Bond.
- The Purchase Price
- The Principal we get back.
We punch these into a calculator and get a Yield-to-Maturity (or Yield, for the sake of simplicity). This is the “annualized” rate of return we would get we hold the bond though the end of its term. Now, the Yield could be more or less than the Coupon rate. If we buy a bond at less than 100 cents on the dollar (the dollar representing the Principal), then Yield > Coupon Rate. If we buy a bond at more than 100 cents on the dollar, Yield < Coupon Rate. If we buy at exactly 100 cents on the dollar, Yield = Coupon Rate.
That’s Bond Math 101 for you. In Equity Valuation, there are literally no known entities except the Purchase Price. That’s the only irrefutable numbers. And, of course, if there is a dividend (but that’s not contractual, and a lot less certain than coupons). Here are the variables:
- Purchase Price – the only given quantity.
- Free Cash Flow – assumption.
- The Term – usually assumed to indefinite.
- Discounting Factor – big assumption!
#4 is where Buffett and most of the investment community have a difference of opinion. We’ll get into that later. But here’s a key point between Bond and Equity Valuation:
Mathematically, Bond Yield = Equity Valuation Discounting Factor. The difference is that in a Bond Yield is a calculation. In an Equity DCF model, it’s an input. There are some fancy formulas used to calculate this input. But it is an assumption. So, you wouldn’t be wrong is suspecting that there is some sort of circular loop going on here.
Here’s a dirty truth about Equity DCF models: You can change any input to justify an output that you desperately want to be true. The numerator and denominator are subjective assumptions disguised as scientific calculations. You can change the numerator (Free Cash Flow) or the denominator (Discounting Factor) to justify the desired output (Intrinsic Value). Needless to say, Equity Valuation can be gamed, which means it requires tremendous self-control. This is the real, quantitative representation of “take your emotions out of the equation…”.
Long story short: you can obsess over the Free Cash Flow or the Discounting Factor or both. Buffett likes to obsess over Free Cash Flow – the numerator. His approach on the denominator is surprisingly simple – he doesn’t do any calculations there.
The Coupon: Free Cash Flow
We’ve spent enough time on Free Cash Flow in “How Buffett Analyzes Businesses”. We showed you the Buffett approach of arriving at Free Cash Flow. We showed you ours. We come at Free Cash Flow from two different vantage points but arrive at similar conclusions.
As a quick recap: Free Cash Flow is the amount of cash left over, annually, for Management to pay its shareholders. Now, it’s up to Management what it does with that cash. Broadly, these are the choices:
- Pay Dividends
- Buy Back Shares
- Retain all of it and re-invest back in the business (partially or fully).
Options #1 and #2 are almost as good as cash handouts. Shareholder, essentially, get back some of their “principal” back. Among the two, we prefer share buybacks. Why? Because it’s a signal that Management believes its stock is undervalued. That’s good – if you’re a holder of that stock it should feel good to know that the people who know most about the business – the management – agree with you. However, share buybacks can be done with somewhat nefarious purposes, which we won’t get into now. Option #1 – Dividends – are the least preferred way to get paid. It could signal that Management can’t find any better way to invest the money, so it’s returning money back to shareholders. It’s literally taking a slice of the firm, cutting it out, and handing it out. It’s a value-destroyer. Add to that the fact that the shareholder, then, needs to find a way to reinvest that dividend, either back into that stock or another one. Dividends don’t deter us from investing in a company, but it’s not a property we particularly look for. There are, of course, cases where dividends are welcome. Those are cases where Management has cash left over even after it sufficiently reinvests back into the business. It happens.
Buffett (and we) prefer to invest in businesses that go for option #3. If the company’s Management has demonstrated that it can generate high returns on its investment decisions, then we’d be more than glad if they retain cash flow to reinvest. Please! Why do I bring up the point about “are they reinvesting or not”? Because it helps to estimate future cash flow. If a highly financially productive company retains cash flows and reinvests them, it’s reasonable for us to bet that Free Cash Flow will increase. If they pay everything out in dividends and share buybacks, then we’re less likely to believe that Free Cash Flow will grow much.
In our Valuations template, this reinvestment shows up as “Growth Capital Expenditure”. This is cash spent on new products, or new services, that Management believes will yield positive results. To be conservative, however, we usually deduct Growth Capex completely before arriving at Free Cash Flow. Of course, the subjective assumption is that this investment will result in a positive change to Free Cash Flow.
Unlike Bonds where Coupons are stated contractually, in Equity DCF models, we need to estimate future Free Cash Flows. It’s a subjective assumption, as you’ve seen in the previous worldview article. But this is what Buffett obsesses over – the subjective stuff. He obsesses over whether the firm has a competitive advantage, whether the advantage is durable, and whether there’s a competent management team in place to ensure the first two factors remain intact. That’s what we spend a lot of our time doing.
Here’s another lesson we learnt from Buffett that goes against conventional valuation techniques:
We calculate a “Sustainable” level of Free Cash Flow. In other words, we estimate a level of Free Cash Flow that we find BELIEVABLE. And by that we mean – we’re quite confident that the company can generate this amount of Free Cash Flow going forward. Buffett has a similar approach. He estimates a level of Free Cash Flow that he finds believable. The words he uses are: “quite certain”. In other words, high probability.
How is this different from conventional wisdom? Most analysts “forecast” annual levels of Free Cash Flow with great precision. Many of them have complicated models, forecasting some obscure cost line item to the nth decimal point in a multi-tab, cross-linked Excel spreadsheet. I’ve seen a few of them and have even built a few. They’re very precise, but very precisely wrong. I think forecasting precise levels of cash flow going forward every year is impossible and futile. I’d rather spend time thinking about the competitive dynamics of the company and the industry in which is resides. So does Buffett. He knows that investing isn’t an exact science.
“Our inability to pinpoint a number doesn’t bother us: We would rather be approximately right than precisely wrong.” – Warren Buffett
Bringing it back to the Bond analogy – our method (inspired by Buffett) estimates a “fixed” coupon into eternity. The “Street”, for the most part, estimates coupons that change every year based on their yearly projections or pricing, volume, margins and growth.
That’s too much precision.
“Professionals forget the following reality: It is not the estimate or the forecast that matters as the degree of confidence with the opinion.” – Nassim Nicolas Taleb
Free Cash Flow Scenarios
Now, when we estimate our Sustainable Free Cash Flow number, we try to be conservative. There 4 broad Free Cash Flow “scenarios” as we see it:
- No growth or negative growth.
- Same level as last 12 months.
- Modest growth form last 12 months.
- Fantastic growth.
We can rule out #1 right away. We spend a lot of time figuring out the competitive dynamics of the company and its industry. The point of all those worldviews and detailed theses is to avoid companies that will see a decline in their business.
We tend to stay away from #4. These tend to be companies that generate little or no Free Cash Flow. And their market price, undoubtedly, factors in stupendous growth. Examples are Netflix and Uber. This is where investing morphs into speculation.
Scenarios #2 and #3 make up a bulk of our holdings. We either factor in no growth (ex. IBM, Micron) or modest growth (Nvidia, Canadian Solar) to estimate our Sustainable Free Cash Flow.
The point is: We need to be reasonably confident of our Sustainable Free Cash Flow. That happens when we’re clear about a company’s competitive advantage and its durability. And if we are, then we can believe that from this point on Free Cash Flow can remain steadfast or even grow at a modest rate. If we can’t be confident of that, we don’t invest in that story.
“Focus on the future productivity of the asset you are considering. If you don’t feel comfortable making a rough estimate of the asset’s future earnings, just forget it and move on. No one has the ability to evaluate every investment possibility. But omniscience isn’t necessary; you only need to understand the actions you undertake.” – Warren Buffett
The Yield: Discount Rate
OK. Now we’ll get slightly theoretical and possibly philosophical. Sorry.
A lot of time and energy is spent in business schools, investment banks and asset management firms on this topic: Cost of Capital.
Cost of Capital is another term for Discount Rate. If we go back to the Bond analogy, we know that the denominator – the yield – is our output. In equities, it’s an input. What does that input mean? The most common description of this discounting factor is Required Rate of Return.
This input variable in the denominator – Required Rate of Return – has 3 main layers:
- Risk-Free Rate
- Cost of Debt
- Cost of Equity
#1 is the most intuitive layer. This is where we factor in Time Value of Money. Simple reason – money loses value over time because of inflation. #2 is also pretty logical. Most firms borrow money and they must pay interest on that debt. It’s a cost of running the business.
#3 is where Buffett (and we) parts ways with “conventional wisdom”. Academics have come up with a concept called Cost of Equity. This is a very theoretical number that depends on a host of other assumptions about volatility, correlations, regressions, and other statistical pontifications based on past data. The intuitive reasoning for Cost of Equity is that higher risk stocks should have a higher hurdle rate. Fair enough.
But Buffett doesn’t approve of this “hurdle rate” mentality. He says:
“The trouble isn’t that we don’t have one [a hurdle rate] – we sort of do – but it interferes with logical comparison. If I know I have something that yields 8% for sure, and something else came along at 7%, I’d reject it instantly. Everything is a function of opportunity cost.”
Opportunity Cost is the key phrase. This how we think of our customary denominator of 5%: Opportunity Cost. To us 5% is our “cost of money”. If we invest our money in a particular company, the stock should return at least our Opportunity Cost. Ours is based on long-term inflation (the cost of money) + a safety measure of around 2%. Roughly, this ends up being equal to the long-term 30-year US Treasury Rate (the highest yield risk-free rate, although not so high these days) or an 8-year average US Corporate bond yield (also considered reasonably safe). For us, 5% is a good hurdle rate.
For Buffett, his Opportunity Cost is the long-term 30-year US Treasury Rate. He says:
“In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value – in our case, at the long-term Treasury rate. And that discount rate doesn’t pay you as high a rate as it needs to. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses.”
Now, the key word I’ll hang on to is: “Common Yardstick”. By assigning a common denominator, Buffett can compare all his investment opportunities on a level-playing field. This is a much better approach than comparing all investment opportunities with different hurdle rates attached to them. To us (and to Buffett), it makes the math easy. A 5% discount rate, into perpetuity, is a 20X multiple. At The Buylyst, we’re prepared to pay 20X our estimate of Sustainable Free Cash Flow. Simple. Is it any wonder that Buffett doesn’t calculate much either? His partner Charlie Munger says:
“Warren often talks about these discounted cash flows, but I’ve never seen him do one. If it isn’t perfectly obvious that it’s going to work out well if you do the calculation, then he tends to go on to the next idea.”
“But what about RISK?”, I can hear the murmurs.
Let’s go back to our 3 intellectual layers of discounting:
- Risk-Free Rate
- Cost of Debt
- Cost of Equity
At The Buylyst, we take care of #1 and #2. We’ve talked about #1. As for #2, you may have noticed in the previous worldview article that we subtract “Cash Paid for Interest” en route to Free Cash Flow. What about #3?
While I was being taught Cost of Equity in college, it made sense to me mathematically but not intuitively. That’s because it wasn’t a cash-cost. And it wasn’t even an accounting cost. It was this nebulous philosophical argument about risk and return. Higher risk = higher required rate of return. This view was based on the Modern Portfolio Theory, which was a foundational moment in Finance. But that theory has since been proven to just that – a theory. Cost of equity, as it is taught in academia today, has 2 glaring flaws:
- It’s based on the Modern Portfolio Theory.
- Because of #1, it uses volatility (standard deviation) and it’s cousins like Beta as measures of Risk.
I won’t get into Financial Theory here, but I will leave you these observations from Charlie Munger and Warren Buffett. Don’t take my word for it, take theirs:
“Beta and Modern Portfolio Theory and the like – none of it makes any sense to me…how can professors spread this? I’ve been waiting for this craziness to end for decades. It’s been dented and it’s still out there.” - Munger
“The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period.” – Buffett
“Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.” – Buffett
“Buffett thinks the whole idea that price volatility is a measure of risk is nonsense. In his mind, business risk is reduced, if not eliminated, by focusing on companies with consistent and predictable earnings. “I put a heavy weight on certainty,” he says. ‘If you do that, the whole idea of a risk factor doesn’t make sense to me. Risk comes from not knowing what you’re doing’.” – Robert Hagstrom in The Warren Buffet Way.
This last point about tying Risk to cash flow instead of stock prices is a significant one. This is what Buffett does and it is what we do. We account for Risk in the numerator – the Free Cash Flow – rather than in the denominator based on a theoretical framework. The main risk is investing in companies that face declining cash flows because they’re not competitive; NOT because their stock price swings around a lot. This is a simple but shockingly unpopular notion.
Higher Yield: Margin of Safety
Things can go wrong. Buffett has been wrong. We will be wrong. Our estimates of Free Cash Flow may not come fruition. We may overestimate the competitive advantage of certain companies. It’s bound to happen. One way to minimize this risk is to buy something much cheaper than what it’s worth. I’ve covered the concept of Margin of Safety in The Buylyst on Risk but here’s a different perspective on it.
Back to our Bond Analogy: A Margin of Safety – buying something for a discount – increases the Yield on the investment. If we buy a bond at 70 cents on the dollar, it adds several percentage points to a bond’s Yield. The same applies to equities.
Our discount rate is 5%. If our investment – the company – earns 5% on its equity internally year after year, the math would suggest that the current stock price is just about fair. There would be 0% “Yield” left in this investment. But even if that’s the case, and we buy this stock 20% or 30% cheaper (let’s say because there was a market correction), our expected Yield on this investment goes up by several percentage points.
The function of Margin of Safety is not just Risk Management but also Return Enhancement. They’re two sides of the same coin. Howard Marks puts it best – as a corollary:
“Whereas the theorist thinks return and risk are two separate things, albeit correlated, the value investor thinks of high risk and low prospective return as nothing but two sides of the same coin, both stemming primarily from high prices.”
The Buffett Difference
To summarize this long discussion, let me list out the main differences between The Buffett Valuation Method and “conventional wisdom”. Here are the lessons:
- Never use Earnings. Use Free Cash Flow.
- Equity Valuation is a lot like Bond Valuation.
- Don’t project Free Cash Flow year-by-year, pretending that it’s a precise science. Estimate a Sustainable Free Cash Flow number that’s believable.
- Don’t waste time calculating a precise “Cost of Capital”. Use the Opportunity Cost mentality. What is your next best alternative?
- Cost of Equity is nice intellectual framework but it’s highly unreliable in the real world.
- Don’t compromise on Margin of Safety. Think of it as picking up a $100 Par Value Bond at 80 or 70 cents. The difference can result in an extra 7-10% per year in returns.
I must say that if you’ve made it this far, you deserve a certificate in Finance. I wish I could give you one. But I hope to make it up to you in Returns if you follow our Buy List.