Valuation Matters

Published on 05/06/22 | Saurav Sen | 1,266 Words

The BuyGist:

  • We’ve refined our Watch List again.
  • Our Watch List is a quick but nuanced valuation tool.
  • This article gives a quick overview of how we take stock of the market (bad pun intended).
  • Subscribers have full access to the Watch List.
  • Reasonably priced subscription plans here.

Gauging Expectations

Our Watch List is built upon the principles of Expectations Investing – a concept made popular by Michael Mauboussin. We’ve found this approach to investing to be the most rational, sane, common-sense…you get the idea.

In a nutshell, Expectations Investing is about gauging growth expectations (or lack thereof) that are baked into current stock prices. Then the buy/sell/hold decision is a subjective one – the answer to the question: “are these expectations too optimistic or too pessimistic or just about right?”

After some booster shots of theory, experience, failures, triumphs, and good old sanity, we’ve boiled our Watch List down to “revenue growth we need to believe to consider buying the stock”. The output is simple and intuitive; the data and assumptions are anything but.

We’ll get into the details behind the numbers at another time. In the next section, however, we provide a list of valuation topics it does cover. Valuation nerds among you (we’re one of you) will appreciate some of those details.

We keep refining our Watch List. It’s meant to serve one purpose above all: a quick, efficient, sensible sanity check on investment ideas we get from friends, TV, magazines, books, research reports, or social media.

This is the best sanity tool we can think of….

For nerds like us

The most important variable in our Watch List is “revenue growth we need to believe to consider buying (or holding) the stock”. That’s a mouthful. In time we’ll come up with a cool acronym. For now, we’ll just call it WNTH (what needs to happen).

WNTH incorporates a lot of theory and experience in the art of investing. This is a topic we’ll tackle in another article, so, for now, we’ll just provide a list. Baked into WNTH are:

  1. Required Returns: 50% in less than 5 years
  2. Exit Multiple: 15-20X future Free Cash Flow 5 years from now
  3. Cost Structure: Operating Leverage
  4. Inflation in Fixed Costs – 5 to 10% annualized depending on whether the company is already EBITDA-positive or not.
  5. Gross Margin assumptions – to be conservative, we assume no improvements here.

Ultimately, we get a range of WNTH – a quick but nuanced valuation that gives us an idea of what’s baked into the current stock price. The method is numerical. But the process is more art than science. Nobody can truly know what’s baked into a stock price or what a company is truly worth. Intrinsic value is a mirage, which is precisely why we need some way to calibrate “what needs to happen” in the business for the current stock price to be attractive. Justifying what needs to happen is purely subjective – based on fluffy things such as competitive advantage, economic moat, total addressable market, competition, growth drivers, strategy etc.

Let’s assume that you think all that soft stuff checks out. Let’s say that the company has an awesome product with huge, durable competitive advantage – but it’s not generating any cash profits yet because it’s barely cracked 1% of its total addressable market. What needs to happen from this point on for you to consider buying (or holding) the stock? Our Watch List gives you an intuitive answer to that question.

Another reason we love incessantly refining our Watch List is because we use it to allocate our time more efficiently. It takes us at least a week to have a full investment thesis on a company whose stock we may hold for years. We’d rather spend those 40-60 hours on a company that has sanity baked into it. We love Tesla, for example, but we find it hard to believe that its revenue will grow by nearly 50% per year for 5 years. According to our Watch List, that’s Tesla’s WNTH.

Ultimately, the WNTH is our way of getting a quick but nuanced answer to: “is this stock overpriced?”

Ok, let’s see some results. We’ll show 3 groups of stocks here:

  1. Streaming – because that’s a hot topic these days…
  2. Social Media
  3. In the headlines…

Netf***ed?

We were just writing up our Spotify thesis update when we pivoted to this article after yesterday’s market bloodbath. What’s the WNTH on Netflix nowadays?


The way to read these charts is this: We’d need to believe that Netflix’s revenue will grow by 6-10% annualized over the next 5 years for us to consider buying/holding the stock. The gray marker tells us how it has been doing (annualized revenue growth) in the past 3 years. If historical growth is less than the WNTH range, then the stock is probably overpriced.

If the gray marker is to the right of the blue markers, then the stock is probably underpriced. If the gray marker is to the left, the stock looks overpriced. Netflix looks most underpriced. Disney looks most overpriced. But…

In Netflix’s case, that gray historical marker may not be useful information. We can argue that the same goes for Disney. For some other companies, even with a pandemic, history is a useful marker. As we mentioned earlier, this is more art than science.

Incidentally, we like Spotify’s chances based on this chart.

Social Dilemma

Here are the 4 publicly traded social media stocks as of last night’s price. Incidentally, we’re also updating our Pinterest thesis. Which one would you dig into? Which one looks stupidly underpriced or overpriced? We like PINS; Twitter (now) looks overpriced. We like PINS; Twitter (now) looks overpriced.


Zeitgeist

Here are some popular requests we always get. Not a week goes by when we don’t get a question about one of these stocks…something like, “should I buy the Amazon dip?” Would you? In this chart, Etsy and Google look underpriced. Tesla looks very overpriced.


Have fun with the Watch List here. It has more details. And there are some good deals - with low expectations baked in - out there. Keep calm and invest in progress. Buy low expectations. Sell high expectations.


Many Happy Returns.


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