Price vs. Value
Let’s assume we’ve found a comfortable business. Now how much do we pay for it? What is a comfortable price? Obviously, one that is much lower than how much it’s worth – it’s value. So, we have two variables: Price and Value.
“Price is what you pay; value is what you get. Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down." - Warren Buffett.
In the case of socks and stocks, Market Price is a given. It’s what the online broker or the store-owner tells us. In the case of socks, Intrinsic Value and Margin of Safety are also given. Stores usually tell us something is marked down by giving us a definitive discount – say 30% off. They’re telling us that the socks – now selling at $7 – are actually worth $10. The sock shop just hands us that equation on a platter.
Investing is different. Market Price is given. But Value is most certainly not. And if we don’t have an estimate of Value, we don’t know whether we’re buying something at a discounted price. In fact, even with socks, we just take the store’s word for it that the socks were actually worth $10.
And that’s what this long discussion is about – Valuation. I suggest you take this article in doses. I’ve tried to arrange it episodically. But you’re welcome to binge-read the whole thing – brew a fresh pot of coffee.
Valuation: I know - the very word conjures up images of multi-tab spreadsheets and complicated finance-y models. But my intention here is get to the "why" behind valuation and, in the process, simplify the exercise. When we know the “whys” behind things, they tend to stick. Even some of the unavoidable math, then, doesn’t look ominous. But I’ll try to keep the math at a minimum. The good news is: we don’t need complicated math or multi-tab spreadsheets. In investing, more calculations do not equate to better analysis.
“People calculate too much and think too little” – Buffett, on Wall Street.
There are 2 overarching messages peppered throughout this discussion. If you get nothing else out of this, I hope you walk away with these:
- Valuation is a subjective exercise. It looks numerical, but the meat of it lies in subjective assumptions behind the numbers.
- It’s better to work with real Cash numbers whenever possible. The less theoretical your valuation is, the smaller the chances are (a) of getting it completely wrong and, consequently (b) losing money.
Unfortunately, we’re going to start with some basic math. But this is possibly the most important equation you will need as an Intelligent Investor. If there is a 3rd realization that you can take away from this discussion, please let it be this:
Intrinsic Value – Market Price = Margin of Safety.
3 magic words: Margin of Safety
Why such a fancy name for discount? The term is borrowed from Civil Engineering – it refers to the level of slack that needs to built-in while constructing a bridge to absorb unpredictable stresses such as weather or extreme load. Why is that relevant in Investing? That’s because some slack need to built-in, in our estimation of Value.
Here’s the key takeaway: The Intrinsic Value of a company is not a scientific quantity. There is no indisputable right answer. The best we can do is Estimate. There is a range of reasonable values that can suggest what a company is worth at a certain point in time. And the key to Intelligent Investing is to pay a price that’s well below that range of reasonable values – that’s Margin of Safety. All this sounds a bit wishy-washy. Well, that’s because it is; most things in Finance and Economics are. But that’s exactly why you need a big Margin of Safety – to absorb any estimation errors in an imperfect science about imperfect humans.
“[The] function of margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.” – Benjamin Graham
In construction of bridges and in Investing, Margin of Safety is the simplest and most effective Risk Management strategy. But in investing, people love to over-complicate things. Usually, when people say things like “limit our downside”, we think of limiting “volatility” or “Value-at-Risk” or some such statistical calculation. Those are mathematically elegant (and science-y sounding) definitions of Risk. But the only definition of Risk that matters is this: Chances of Permanent Loss of Capital times Size of Permanent Loss of Capital. With Margin of Safety, our intention is to minimize both these variables at the same time. And we’re trying to limit them because, honestly, we can never quantify these variables with any meaningful degree of accuracy. We can’t quantify them because we don’t truly know the exact value of a firm. And we don’t know whether the market will recognize our estimate of the value of a firm. So, the best defense is to pay a very low price.
The motivation behind thinking in terms of Margin of Safety is best captured in this golden nugget by George Soros in his famous (but awfully hard to read) book, The Alchemy of Finance:
“In my investing career I operated on the assumption that all investment theses are flawed…The fact that a thesis is flawed does not mean that we should not invest in it as long as other people believe in it and there is a large group of people left to be convinced. The point was made by John Maynard Keynes when he compared the stock market to a beauty contest where the winner is not the most beautiful contestant but the one whom the greatest number of people consider beautiful.”
I got 2 lessons from this statement:
- However precise our calculation of “Intrinsic Value” may be, we should assume that it is wrong; but we hope that it falls in a reasonable range of values with which others may eventually agree.
- Eventually, we need the market to come around to our estimate of the value of a company. But it may disagree with our estimate for a while (maybe a couple of years). If it never comes around to our estimate of value, chances are that our thesis is decidedly wrong, and we should move on.
We may be wrong in our appraisal of an asset. But if we buy it at a significant discount from that appraisal value, how wrong could we be? How much money could we really lose? At the end of the day, this is the risk/return profile I’d like: Let me buy this comfortable business at a price that’s much below what I think it should be worth, conservatively calculated, and I’ll hope that I’m approximately right when the market comes around to my estimate. Worst case – If I’m wrong, or the market doesn’t come around to agreeing with me, I shouldn’t lose too much money.
Less Downside equals Upside
Most people would rewrite our magic equation as:
Intrinsic Value – Market Price = Upside
It’s not wrong; I’m not against it. In fact, I use the term “upside” often to save space – I do it in The Buylyst Thesis templates. But “upside” and Margin of Safety are slightly different concepts. The difference lies in our vantage point. It’s best explained using some numbers: Let’s assume the market price is $100. And let’s assume that my estimate of Intrinsic Value is $130/share. Now the $30 difference, in percentage terms, can be shown in 2 ways: 30% up from market price, or 23% down from my estimate of Intrinsic Value. I call 30% my upside, and 23% my Margin of Safety. In other words, I could be wrong about my estimate of Intrinsic Value by more than 20%, and still not lose money.
A 20-25% Markdown
So, what level of Margin of Safety is, well, safe? My rule of thumb is about 20-25%. So, in our example, if my estimate of Intrinsic Value is $130/share, and the market price is $100, it works. I’d really want the market price to be less than $100 for there to be 25% Margin of Safety - $97.5 to be exact. Chances are that if the stock trades somewhere between $97.5 and $104, I’ll go for it. Why 20-25% margin of safety? Normally, I wouldn’t expect my estimate of Intrinsic Value to be wrong by more than 10% on either side of valuation. But there will be times when I’m wrong by a greater amount, and I’d like to leave some more room for error. So, I doubled my “normal” expectation of being wrong. And if that happens I don’t lose money. But what if I’m wrong beyond the 20-25% band? Well, if that happens consistently, then I should just walk away from my decade-long career in investing. As we can see, the key to this whole game is coming up with a good estimate of Intrinsic Value, so we know what to pay.
Now, let's really roll up our sleeves.
Intrinsic Value: Because She’s Worth It
Coming up with an estimate of intrinsic value really means coming up with an estimate of the future; not an accurate one, but a reasonable one. There are 3 major components to intrinsic value, and each involves some degree of rough estimation:
- Free Cash Flow to Shareholders
- Growth of Free Cash Flow to Shareholders
- Discount Rate
At this point I should warn you that the discussion will get a little finance-y and mechanical. Some familiarity with Accounting will be helpful, but it’s not necessary. But I’ll try to explain every move; it won’t be just numbers and equations without reason. What it will all point to is this: at the end of the day valuation is a subjective exercise even if it’s numerical; and it’s kind of liberating to know that we don’t need complicated valuation models to be a successful investor. The giants of investing – especially Buffett and Munger – spend more time thinking and less time calculating.
Let’s get some basics out of the way. Let’s start with this rather finance-y statement: The Intrinsic Value of an asset is the sum of discounted cash flows (earnings) of that asset.
So, the company sells some product or service, which generates some cash flows after all types of costs are accounted for, and we expect this company to keep generating some amount of cash flows into the distant future. The price we pay for this company should be the present value of all these yearly cash flows combined. It’s just like valuing a bond – think of cash flows as coupon payments paid to you annually. Of course, these coupon payments are imaginary, unless a company pays regular dividends. Companies, especially those that are growing, rarely hand out cash to shareholders. And there’s another big difference: unlike a bond, nobody knows the size of these cash flows or how much they will grow; we can only make an educated guess. And that’s why a considerable Margin of Safety between the price we pay and the value we get is so important.
Ok – let’s take on each of the 3 components. Grab a cuppa coffee.
1. The real bottom-line: Free Cash Flow to shareholders
The overused (and often nauseating) term in Corporate America – “bottom line” – comes from the world of accounting. Usually, “earnings” are at the bottom of an Income Statement, below the proverbial line. The term “earnings”, however, is thrown around loosely, as if it has one consistent, scientific definition of it. There isn’t. Some people mean EPS (earnings per share), some mean to say Free Cash Flow, while others mean to say NOPAT (Net Operating Profit after Tax). Warren Buffet works with what he calls “Owner’s Earnings”, which is similar to NOPAT. Among the many definitions of “earnings” EPS is probably the worst metric to evaluate a firm’s performance. It is an accounting measure, that is deemed acceptable according to (pardon the redundancy) the US Generally Accepted Accounting Principles (US GAAP). Yes, these are actual rules deemed acceptable by the SEC (Securities & Exchange Commission). The rules make sense from a reporting consistency standpoint. But they’re not ideal for evaluating investment decisions – far from it. EPS is a theoretical number, not a cash number. Built into it are a lot of accounting assumptions and potential shenanigans that an unethical management could use to game the number. This is a whole other topic by itself, so I won’t tackle it here. The main point is that it’s better to work with real cash rather than theoretical numbers, whether they are “generally accepted” or not.
“Buffett considers earnings per share a smoke screen…To measure a company’s annual performance, Buffett prefers return on equity—the ratio of operating earnings to shareholders’ equity.” – Robert Hagstrom, from The Warren Buffett Way.
Return on Equity is a recurring theme at The Buylyst. We talked about in in “A Comfortable Business” and also in “Coffee and Cash Flow: A first-date screener”. But for the purposes on estimating a company’s Intrinsic Value, we need to focus on cash flow.
Everybody knows (and loves) cash. I do too, generally in life, but especially in investment analysis. This is a habit I can’t shake off from my years as a Research Analyst evaluating High Yield bonds. In that world, cash is king. And from what the giants of investing like Buffett tell me, it should be king in equity analysis as well. So, I don’t think I should shake off the habit – I like to work with real numbers as much as possible. They are easy to understand. Cash is cash. It’s real.
Free Cash flow to shareholders is the pile of cash that’s left over after the firm has collected cash from sales, paid all its costs of running the business, paid all its financing charges (like cash interest), paid its cash taxes, AND, after it’s invested whatever cash it needs to widen the Economic Moat of the firm. At that point, the company’s management is left with these questions: What to do with this remaining cash (hopefully there is some)? Should we give it back to shareholder or should we hoard it on the balance sheet?
We’ll get to those management decisions later. But at this point let’s zoom in to the mechanics of arriving at Free Cash Flow. The table below looks intimidating. But it’s necessary. This is my attempt at making you a legit Research Analyst. If you can get to the end of this discussion, and manage to get the gist of what I say from this point on, you’ll be a pro. No prior experience necessary, other than maybe reading A Comfortable Business.
Grab a second cup.
I will make some introductory points about Accounting, for those of you who are new to this:
- There are 2 main types of reports to look for: 10Qs (quarterly reports) and 10Ks (annual reports).
- 10Ks have much more information.
- Both types of reports have a “Management Discussion & Analysis” or MD&A section, which has a lot of good information.
- Both types of reports have a “Notes” section, which also has a lot of good information.
- There are 3 main types of Statements: Balance Sheet, Income Statement and Cash Flow Statement. We will need information from 3 statements.
- These statements are arranged to be compliant with SEC rules. But we need to rearrange the information, to be compliant with Intelligent Investing.
- The table below is the way I like to rearrange the numbers to get to Free Cash Flow to Shareholders. You will see this table in every Valuation Details page for every company on The Buy List or the Watch List.
1b. The Waterfall
Here’s the most important point about estimating Free Cash Flow to Shareholders (FCF): It’s not enough to just calculate it. What we need is an estimate of a SUSTAINABLE amount of Free Cash Flow (SFCF). When we go through the waterfall in the table above, we can choose whatever data points (Revenue, COGS etc.) we want – this year’s, last 12 months, last year’s, an average of 3 years, and so on. Many analysts love to extrapolate past trends. They take the last 12 months’ data points or an average of the last 3 or 5 years and assume that the future will mirror the past. I think this is a terrible habit. It’s tempting to make assumptions look like they’re based on some sort of scientific method – like assuming the past will repeat itself – but the real world rarely works like that. In my experience, I’ve almost never seen analyst projections based on extrapolation turn out to be even close to what actually occurred. Past data is a guide. But the key question to ask is: WHY is the recent past likely to repeat itself? In most cases, it doesn’t.
To find Sustainable Free Cash Flow to Shareholders, I think it’s better start from the top: Revenue, which must be broken down into some sort of Price X Volume equation. Try to gauge, subjectively and based on past data, whether the firm has some pricing power. If it does, maybe the price the firm charging now is sustainable. If not – because maybe the firm sells a commodity – we should figure out a conservative price estimate that seems sustainable. If the firm sells crude oil, for example, it has no control over price. In that case, it’s imperative to figure out the “breakeven price of Oil for this firm” – at what Oil price does the firm stop making any profits? With volume, repeat the same exercise. Is last year a good indicator of what’s to come? Or was last year an aberration? Why? How much does volume fluctuate? Why? What is a sustainable level of volume?
The questions above should get us a sustainable level of Revenue. Again, the exercise is mostly subjective, which is why it’s important to be conservative. Gauge the ecosystem in which the company operates, the market conditions, the competition, the customers etc., and find a level of sales that makes sense if all those things deteriorate. How will changes in the ecosystem affect pricing? How will that impact volume?
Once we have a reasonable estimate of Sustainable Revenue, keep the fixed costs stable, and adjust variable costs according to the relationship between variable costs and sales. Here, past data is generally reliable for this relationship. For example, if it took $3 to ship a product last year (shipping is a variable cost), chances are it’ll take about $3 to ship a product this year. So, $3 times a sustainable volume, should get us a sustainable variable cost number. Once we’ve deducted reasonable estimates of fixed and variable costs, we get to EBTIDA.
The Credit World loves EBTIDA. It’s the mother of all metrics upon which lending decisions are based. Even some Equity Research Analysts use ratios like Enterprise Value/EBITDA for valuation. EBITDA is regarded as a non-messy cash-like number that’s representative of the health of the company, before accounting shenanigans (non-cash charges) like Interest Expense take over the Income Statement. One of the biggest non-cash charges in Depreciation. This is an accounting estimate made my Management, and it’s supposed to quantify the depreciating value of the company’s fixed assets – like factories, buildings, equipment and so on. The number is riddled with assumptions, and is easy to game. It’s best to stay away from Depreciation on the Income Statement. But the truth is that in the real-world a company’s property, its plants and its equipment’s do depreciate. Wear and tear is a real thing. EBITDA doesn’t incorporate this very real cost. We should account for it, but not by using Depreciation.
“References to EBITDA make us shudder; does management think the tooth fairy pays for capital expenditures?” – Warren Buffett
The best way to adjust EBITDA for this real cost is to deduct Maintenance Capital Expenditure. This is not a number most Equity Research Analysts look for, because they don’t separate Capital Expenditure into Maintenance and Growth. Many Credit Analysts do, which is why I picked up the habit. I think it’s very important. It’s a cash number, and it is an unavoidable investment needed just to maintain status quo of the firm’s fixed assets. It serves the purpose of Depreciation. The problem is that it’s usually hard to find. Many companies don’t break out Capital Expenditure into Maintenance Capex and Growth Capex. So, this ends up being a subjective call. I tend to sift through the “Management Discussion & Analysis” section of the 10K or 10Q to look for clues. I also read though (line by line and in between lines) as many Quarterly Earnings Call transcripts for clues. In general, I find earnings transcripts to be much more valuable than Ks and Qs.
Once we make that Maintenance Capex adjustment, we get to “Unlevered Cash Flow”. At this point in the cash flow waterfall, we step away from Operations and “running the business” and move into Financing and Investment territory. Usually, the numbers below Unlevered Cash Flow can be taken from the last 12 months; they tend to be good estimates of the near future. Sometimes, however, these numbers will change drastically within a year. Cash Interest in a real number. But it can change – a massive debt pay-down, for example, will reduce the cash interest charge going forward. Changes in working capital requirements tend to be volatile, especially for companies that sell many of their product on credit. Over the medium term – say 2 years – changes in working capital tend to even out. But it is hard to predict on a yearly basis. If working capital swings too much, usually it’s due to the nature of the business. Cash Taxes are odd. They don’t usually match up with up the “corporate tax rate” numbers thrown around in political debates. Cash tax rates are usually much lower. That’s because of loopholes like loss-carryforwards; there are many others and I won’t get into details here. Also, taxes are not my forte, and I won’t spend much time in estimating them.
“Trying to minimize taxes too much is on the great standard causes of really dumb mistakes.” – Charlie Munger
Once we’ve deducted these unavoidable charges, we get to the second major component of Intrinsic Value: Growth. How will Management foster growth? Will their strategy work? How will that impact the value of the firm?
2. Widening the Moat
If we go back cash flow waterfall table, look for the line item: Discretionary Cash Flow. This is the point in the cash flow stream, where Management needs to decide how much will be spent on Growth Capital Expenditure and/or on Acquisitions, which is basically “buying growth”. This is the point where Management can widen the Moat.
Growth Capital Expenditure takes the form of spending money on a new production facility or on launching a new product line or a new type of service or on entry into a new market and things of that nature. If a lot money is spent on Growth Capex, it usually means the firm is doubling down on its competitive advantage – a low price or a superior product – so that it can be miles better than its competition. If the firm is a low-cost leader, the firm could invest in better machinery which, in the long run, reduces the per-unit cost of its product. That investment, if followed by a reduction in its product’s already low price, could drive its competition out of business. If the firm produces a differentiated product or experience, it can sharpen its product to a point where it becomes too expensive for a new entrant to produce a similar product at scale. Firms that sell a differentiated product are often protected by regulation or things like patents. Pharmaceutical companies, for example, produce drugs are protected by patents. But usually, that’s just true for the first few years of a drug’s time in the market. Competitive destruction is just held off for longer After a few years, the patents roll off, and any competitor is allowed to reverse-engineer the drug and sell it as a “generic”. For the pharma company to remain in business, it must reinvest to fund research on other drugs (a drug pipeline), some of which the FDA will hopefully approve so the company can market them under patent protection for a few years at sky-high prices. I will leave the issue of drug pricing out of this discussion because that’s a flammable topic.
The point is that management will often plough back some cash flow from the firm’s operations to fund projects that would strengthen the castle and widen the moat. When they make these decisions, they hope that each $1 spent as Growth Capex will yield maybe $1.2 back, preferably quite soon. And that extra yield – of 20 cents – accumulates is future Free Cash Flow, thereby increasing the value of the firm.
The 20-cent return type of assumption is a big assumption. The calculations made to arrive at that number look very scientific and complicated. But it’s often a crapshoot, even for Management. Sometimes consultants are employed to answer the question “Should we spend $X million dollars on this new product?”, and on many occasions, they do a beautiful job of just confirming managements’ hunches. This goes back to the section about Management in “A Comfortable Business” – a good quality management is often intellectually curious and an expert in their industry. These are important attributes in deciding how to spend millions widening a Moat. The more well-rounded Management’s worldview is, the better the chances that its hunch will be correct.
The other big assumption is the timing of the 20-cent return. This is a bit easier to estimate compared to the magnitude of the 20 cents. That’s because, it’s easier to peg a product or service as Fast Cycle or Standard Cycle or Slow Cycle. I’ve borrowed this from Jeffrey Williams’s very underrated book on strategy: Renewable Advantage. He introduced us to the concept of Economic Time – how long does a company’s competitive advantage last? In our example, how long will it take for this 20-cent yield to materialize and how long will it last? That has direct consequences on the discounted cash flow exercise.
As I see it, we have 3 main choices about making growth assumptions:
- No Growth – this is the easiest one.
- Enough Growth to roughly match the inflation rate for the next few years, which means that in “real” terms – adjusted for inflation – there is no growth. This is applicable in companies that have a fair amount of pricing power; they can raise prices with inflation.
- Amazing Growth – 20, 30, 40% yield on growth capex, which would increase Free Cash Flow by a smaller number, but still a significant one.
I like #1 the best, because it’s the simplest. That’s my default assumption.
I like #2 as well, but I need to have a convincingly positive view of the business because assuming a growth rate, however small, does veer into the “theoretical” and speculative territory.
As for #3, I am too uncomfortable making such lofty growth assumptions even if I have a very positive view of the business.
If I base my valuation on #1, and the market price is still well below this valuation – that there is significant margin of safety – it’s a steal. That’s when, as Buffett says, you “reach for a bucket, not a thimble”. But I suspect there will be very few of those “gimmes”. I’m fine with that.
“Big opportunities come infrequently. When it’s raining gold, reach for a bucket, not a thimble.” – Warren Buffett
If I base my valuation on #2, I will be assuming some growth, for a few years – maybe 2 or 3 years. In most cases, this type of an assumption will be well within a conservative threshold. If I have a positive view of the Castle, Moat and Management, a growth rate that matches inflation for a few years is hardly a demanding ask. Beyond a few years, though, anything’s possible. I can’t possibly look that far ahead – managements change, markets change, governments change, the ecosystem changes etc. Nobody can look that far ahead; not even Management.
#1 will be my default starting point. Again, it’s the simplest, and it’s the least susceptible to wild speculation. However, in some cases, taking approach #1 may be too conservative. In some industries, like Software, I may never see enough Margin of Safety to invest in them. In some cases, I will start looking toward approach #2 – factoring in a modest, inflation-matching, growth for a few initial years. I should be clear – the point of this pivot won’t be to twist the data to suit my story. Yes, I could succumb to that, because I’m human. But I must watch myself. I must be “Intelligent” about it, in the Graham-esque sense of the word. The point of pivoting to #2 will be to, as Charlie Munger puts it, “invert”. If I pivot to approach #2, the two questions I’ll be looking to answer will be these: (1) How much initial growth do I have to assume to get to a 25-30% Margin of Safety? (2) Can I believe this growth rate? If I can back into a growth rate that I can believe, I may put this company on my Buy List. As you will see later, by going from #1 to #2, I won’t be giving myself too much slack – about a 10% concession on Margin of Safety.
Ground rules: I will never base my valuation on anything that resembles #3. As I’ve mentioned before, I will never invest in anything which has a less than 20% Margin of Safety, which means I will the Market Price of an asset must be at least 20% cheaper than my valuation of the asset based on assumption #2. For many companies, I will base that 20% Margin of Safety off assumption #1.
It’s now time for third leg of valuation: The Discount Rate.
Grab cup #3. Maybe a double-espresso this time?
3. The Discount Rate: A Total Crapshoot
We need to discount future cash flows to bring them back to present value. Why? Because money – say $100 – will be less valuable next year than it is today. The present value of $100, 5 years from now will be worth less than that – maybe $90 – in today’s terms. So far, discounting is not a complicated concept.
But in Finance, the discount rate – also known as Cost of Capital – in an intrinsic value calculation has been a victim of a lot of important but practically useless theoretical mumbo-jumbo. Take a Finance class, and it will hard to escape a series of tedious lectures on concepts like “Capital Asset Pricing Model (CAPM)” and “Weighted Average Cost of Capital (WACC) and so on. Much of this is an offshoot of an important but flawed theory in Finance called the Modern Portfolio Theory (MPT). That’s a massive topic, which I won’t get into here. The point is that when most analysts discount Free Cash Flow to calculate Intrinsic Value they use some highly theoretical number. I’m always suspicious of that. So are the giants of investing.
“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.” – Charlie Munger
As I see it, the choices for using a discount rate are these:
- Use some theoretical finance-y number like WACC or Cost of Equity or some such thing.
- Use Opportunity Cost – the return you’d expect to get from investing in something else.
- Use Rate of Inflation – the simplest alternative.
Choice #1 is my least favorite. But it’s the one that’s used most often for of discounting, especially among Equity Research Analysts. The thinking goes something like this: Future cash flows must be discounted by the cost of capital because that’s the cost of all that capital that’s being used to generate those cash flows. So, there is a cost of debt and there is a cost of equity. Cost of debt is a real number – it is actually the interest rate on debt capital. So, I have no complaints there. Cost of equity – which is used to discount Free Cash Flow – is what bothers me. Charlie Munger is right. It doesn’t make much sense. It’s a purely theoretical number based on the MPT (or some other equally flawed theory) to come up with a threshold or a Risk-adjustment measure for cash flows to equity holders. Yeah, it’s as ridiculous as it sounds.
I look at Cost of Equity as a Risk-Adjustment mechanism. This goes back to the Growth section above. If an analyst bakes in some crazy growth assumptions into the future Free Cash Flow stream, it’s a risky proposition. What are the odds of that actually happening? Usually not much. So, some adjustment is surely needed. Rosy projections in the numerator must be tempered with draconian discounting in the denominator. It takes “something” to fund that growth. Then we must put a number to that something! It partially makes sense to me. I see the theory behind it. But it’s just not real enough for me, or Charlie Munger, or Warren Buffett. I’d rather listen to what they do, than to some academics.
Choice #2 – opportunity cost – is more logical. This is what it implies: I need about X% return a year; I can get that with some other investment. Does this cash flow stream cross that hurdle rate? Does it give do one better than my next best alternative. I like this approach but the only problem is choosing this hurdle rate. How do we what some other investment choice will return over a period of 2,3,5 years? We can make assumptions like “equities will return about XYZ% a year over the next 5 years” or something vague like that. But then we get into theoretical and speculative territory. Predicting what some other stock, bond or an entire asset class with return over the next few years is maybe just a shade above pure guessing. And I’m not comfortable with making investment decision based on guesses. Having said that, it is miles better then Choice #1.
Choice #3 – cost of money or rate of inflation – is a tangible, predictable number, in my opinion. It’s predictable, as long the central bank in my country has credibility. In most of the developed world, the risks of hyperinflation or prolonged deflation are muted. The same is true even in many big developing countries. Central banks have better data (and hopefully better analytics) now. So, what is a good assumption for rate of inflation? It’s subjective, despite all the precise calculations made by your central bank. Think about how much poorer you feel every year. That is your rate of inflation. My rate of inflation is about 2-3% a year. That’s how much poorer I feel every year, assuming a fixed pool of money. That’s how much, I feel, the value of my money, based on my specific consumption, depreciates. Others, in a less-developed countries, may feel about 5-6% poorer every year.
You might say that this is theoretical as well. Yes, but less so that the other 2 choices. If we “guess” about our specific rate of inflation, we’re likely going to base that off our experience in the past few years. Implicitly, when we use this approach – choice #3 – our decision is: Should I invest in this or should I keep this cash aside for another investment about which I have more confidence? The opportunity cost is not investing. And if we don’t invest, we lose a little bit as the value of our money depreciates. Yes, the choice of inflation rate has some error built into it. So, for the sake of margin of safety, double my estimate. So, I use a rate of 5%.
A big advantage of this approach is that it is simpler and more intuitive. It has direct connections to my choices in consumption. Should I invest? In other words, should I forego current consumption (buying a car or new TV or something else) for the possibility of greater (much more) future consumption? If I choose the latter, my choices are save or invest. Saving, I know, will not help me beat inflation. It will not lead to financial freedom. Investing might help me get there.
Warren Buffett normally uses a version of Choice #3 when he makes investment decisions. He tends to use the 30-year Treasury Bill rate as a proxy for the long-term rate of inflation. That makes sense. When we use a Discounted Cash Flow model, we generally discount a cash flow stream that’s 30 years long, or longer. There is one caveat. It’s better to use a long-term average of the 30-year t-bill rate. The rate – at a given point in time – isn’t all that useful. Using the current rate (in mid-2017) or an average over the last 5 years, is not representative of a longer-term rate of inflation. But the good news that the 30-year rate doesn’t fluctuate as much as the 5 or 10-year Notes.
There is one big advantage to approach #3 that’s worth mentioning: It puts all investment choices – past, present and future – on a level-playing field. All cash flows of all assets or companies are discounted using the same rate. Again, the question we ask ourselves with this approach remains consistent: Should I invest some money in this idea, or should I wait?
Come Together. Right Now. Value Me…
Ok. If you’ve been binge-reading this, take a break. Get some food. Get a massage.
Now let’s put together the 3 components – Free Cash Flow to Shareholders, Growth of that Free Cash Flow, and The Discount Rate – to get to reasonable estimate of Intrinsic Value.
Let’s do a quick recap:
- Free Cash Flow to Shareholders: We need to find a Sustainable level – one that we think the company can generate even if market conditions or pricing power gets worse.
- We’ll stay away from factoring in any ridiculous growth assumptions for our Sustainable Free Cash Flow to Shareholders. If we must – because this rare company is doing all the right things – then we’ll just assume that they’re keeping up with inflation, for a few years. Beyond that, nobody can make any reasonable assumptions of growth. Our default assumption will be a “No Growth Scenario”.
- We won’t overcomplicate the discount rate. We’ll use a reasonable rate of inflation plus some Margin of Safety as our discount rate. Implicitly, we’re asking the question: should I invest in this company or should I just keep my cash in my Savings Account?
Now here’s the really good news: In most cases, the intrinsic value will lie between 20 and 25 times Free Cash Flow to Shareholders. Once we hone in on it, the math is simple! You may not believe me, so I’ll draw it out.
Most Discounted Cash Flow models finish with this concept: Terminal Value. This concept, when translated into English, essentially says this: After the firm has gone through its gangbusters growth phase, it’ll settle down to sustainable level with a certain “long-term” cash flow profile, a certain long-term growth rate and a certain long-term cost of capital. Mix all those together and you get a “long-term” Terminal Value, which will be added to the sum of all the “high growth” cash flows prior to the “terminal year”.
The algebra to get to Terminal Value is simple: (Terminal Cash Flow) divided by (long-term growth rate – long-term cost of capital). That’s the mathematical representation of “this is going to happen forever”. And that’s exactly why our Buffett-esque valuation approach is so much simpler than all those other complicated valuation models. Our default starting point – a no-growth scenario – is just like Terminal Value at the onset. We’re not wasting time calculating on some ridiculous growth rate for 5, 10, 20 years or on some complicated cost of capital. And even before all that, we’re already starting with a Sustainable Free Cash Flow number. That’s already a conservative, long-term number. And one more thing – our default growth rate is 0%. So, our math is pretty simple:
Intrinsic Value = SFCF divided by long-term discount rate.
If our discount rate is 5% (which is reasonable), Intrinsic Value will be 20 times SFCF. Boom. Done.
Now, in the case where we pivot to our Growth approach # 2 – assume SFCF grows enough to match inflation for a few years – our computation needs another step. But it’s still simple. Bear with me here: Remember that when we pivot to growth scenario #2, our growth rate will be same as the discount rate – remember that we’re just trying to match inflation, and our estimate of inflation is our discount rate. So, if our growth rate = discount rate, the “discounted” SFCF number for the initial “growth” phase will basically be the sum of the SFCFs for the number of years that we’ve assumed it will grow. This is the part – No. of high growth years times SFCF – that we will add to our terminal valuation. There is one other small wrinkle. The SFCF number that we now use for our terminal valuation will be slightly higher than our original SFCF number. That’s because SFCF has now grown for 2 or 3 years. If we started with $100 of SFCF, after 2 years of 5% growth, the SFCF of the firm will be $110.25 2 years from now. That’s the SFCF that we’ll use for our Terminal Value calculation. But then our Terminal Valuation is now at the end of year 2. So, we’ll have to discount that back to Now. That will negate the growth (which is equal to the discount rate) that SFCF has accumulated over 2 years. So, essentially, our Terminal Valuation will still be 20X our initial SFCF. The only thing we need to add to 20X is, in this case, 2x. So, we’re left with 22x SFCF as our estimate of Intrinsic Value. Boom. Done.
Let’s use real numbers to pound this in our heads:
- Initial SFCF: $100
- Growth = Discount Rate = 5%
- Growth Phase = 2 years
- Intrinsic Value = Initial Growth Valuation + Terminal Valuation (discounted).
- Initial Growth Valuation = Initial SFCF X No. of years in Growth Years = $100 X 2 = $200.
- Terminal Valuation = Initial SFCF X ((1 + growth rate) raised to the power of no. of years in growth phase)) divided by discount rate. So, we’re left with:
- Terminal Valuation = $100 * (1 + 0.05)2 divided by 0.05.
- Terminal Valuation (discounted) = Terminal Valuation, discounted back by no. years in growth phase. So, (1 + 0.05)2 cancels out in the numerator and denominator. We’re left with:
- Terminal Valuation (discounted) = $100 divided by 0.05 = $2,000.
Intrinsic Value = $200 + $2,000 = $2,200 = 22 X SFCF.
Boom. Done. We didn’t even need Excel.
If our assumption of inflation = discount rate = growth rate = 5%, our base valuation WILL be 20X SFCF. And the, depending on our assumption of how long this growth can last, we tack on 2X or 3X to our initial valuation of 20X. Or we tack on nothing, and keep it at 20X. As simple as that. No need for complex Discounted Cash Flow spreadsheets. The math is virtually done for us.
Back to the most important equation in Intelligent Investing:
Intrinsic Value – Market Price = Margin of Safety.
Now we have all 3 components. Market Price and Margin of Safety are given. You can get Market Price from a thousand sources. We assume a Margin of Safety threshold of about 20-25%. If we have a reasonable estimate of Intrinsic Value, we’re good to go. We now know how to find a comfortable price.
Possible Shenanigans: Dividends and Buybacks
There is a point in the cash flow “waterfall” where Management has some more discretion, after investing in growth. Everything that needed to be done (hopefully) for strengthening the castle and widening the moat has been done. All that cash has been spent. Now is there any cash left over? If there is, should it be distributed to shareholders? If so, how much? Usually, there are 3 main choices at this point in the cash flow waterfall:
- Pay Dividends: Many investors like dividends, especially those depending on current cash income from their investments (retirees, for example). Dividends look attractive because it’s cash in hand. But it’s not the best use of a firm’s cash flow. It seems counterintuitive, but here’s why – dividends are cash out of the firm. That means value – the firms’ net worth – is being chopped off and sent to you on a platter. What you’re left with as a part owner, after dividends are paid, is a firm that’s worth less than it was yesterday. The firm is basically taking a part of your investment – and giving it back to as a “dividend”. At that point, as a shareholder, you better hope that the firm has invested enough to at least protect its castle. Otherwise, the value of the firm will keep decreasing, which dividend payments will just amplify.
- Share buybacks: This has been quite the rage over the last few years. Normally touted as a judicious use of shareholder capital, it can be done for nefarious reasons. The idea is this: the company makes a tender offer or buys shares in the open market with the pitch that management believes the shares are severely undervalued. The “market” then takes this as some valuable “insider signal”, which causes more trading and that often props up the stock price. In the meantime, several metrics used by the industry – such as EPS – receive a boost. Share buybacks reduce the denominator in the EPS calculation – number of outstanding shares – while the numerator – earnings – stays the same. Other metrics such as Return-on-Assets and Return-on-Equity get affected too. But none of these measurement “improvements” happen because of positive changes in the fundamentals of the business. The improvements happen because money is moved from one account to the other. This may not sound that nefarious, but we should remember that none of this “creates” any value. It’s just signaling, which props up the stock price. Management could have more nefarious reasons to use the firm’s cash to buy back shares. Management could prop up stocks prices just in time to cash in on those stock options it was awarded a few years ago, so they walk away with millions in compensation. One of the keys to evaluating Management is to dig into compensation practices – are incentives aligned? Management could also want to prop up stock prices just to stop a downward spiral. There may be other reasons that have nothing to do with strengthening the Castle of widening the Moat. The point is that share buybacks can be a good or bad use of cash.
- Cash on the Balance Sheet: This is the least sexy option. Cash comes in, all the bills are paid, some money is reinvested into the business, and the rest is put in a savings account i.e. the balance sheet. The positive spin on this approach is that it is the simplest of the 3 choices. Value is not hacksawed in the form of dividends, nor is cash used for potentially nefarious reasons behind benign-looking share buyback programs. The negative side is that this cash on the balance sheet doesn’t earn much, especially nowadays with interest rates close to 0%. So, some people argue that the cash should be returned to shareholders to give them the choice of what to do with it. The most famous debate of this sort was between a group of activist investors led by Carl Icahn, and Apple, which was sitting on a massive pile of cash a couple of years ago. The activist investors argued that the huge pile of cash was just collecting dust, and that Apple’s shareholders could have better use for it. Tim Cook and Apple argued that the cash was a savings account waiting to be deployed on new and exciting projects in the company’s pipeline. In these sort of debates, I normally like the “potential re-investment opportunity” side of the argument. In the case of Apple, I favored Apple’s argument. My humble suggestion would have been to deploy all that cash on R&D for a longer-lasting cellphone battery. Time to charge my phone.
So, there is no right answer. Among the 3 choices, my least favorite use of cash is to pay dividends. Of the two choices left, the answer is, it depends. That is not a definitive statement, but most things in Finance are not definitive, despite all the definitive math it uses.
Here’s the takeaway: Normally, I don’t deduct Dividends or Share Buybacks to arrive at Sustainable Free Cash Flow to Shareholders. The reason is simple. As much as I’d prefer that Management spend money on useful things – like growing the business – dividends and buyback ARE cash back to shareholders. Ultimately, isn’t that the theoretical assumption that a discounted cash flow valuation goes by? We assume that cash comes back to us yearly – like a bond that pays coupons. It’s not how the real world works, but for the purposes of valuation, it “satisfices”. Just to recap – cash generated by the business is either ploughed back to grow the business, or stored on the Balance Sheet, or paid out as Dividends or used to buy back shares. Management doesn’t have many more choices than these. And most companies will use cash in some combination of the above.
Congratulations! You’re a pro.
You’ve just completed a crash course in Valuation. If you’ve understood the logic behind the buylyst way of valuation, which is borrowed heavily from the way Warren Buffett and Charlie Munger do things, you’ve already achieved Elite Status in the world of investing. You’re already more Intelligent than most investors out there. This was a long and tedious discussion but once all this becomes muscle memory, you’ll be primed to confidently pounce at the right opportunities.
“Opportunity meeting the prepared mind. That’s the game” – Charlie Munger
You deserve a vacation. Many Happy Returns.