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Valuing Growth, Paying Growth

Lets see if I can clear my head around this.

Suppose we have a firm A traded on the stock exchange. Firm A is rather unique. If you look at the past 10 years of data it has been growing at 10% per annum for the past 10 years.

10% growth is rather good compare to an average  GDP growth of 3%.

In the past year, firm A, who has a market capitalization of 220 mil churns out 10 mil in profit.

Assume that such is this business that firm A is in, such that capex = depreciation, and as such profit = free cash flow. (For more of these terminology do go here and here)

So net profit = 10 mil , free cash flow = 10 mil.

Given the nature of such a predictable business we attribute a discount rate or required rate of return of 8%.

How much would you pay for firm A?

Equipped with the historical  data, most will assume that everything will continue to do well.

But it is utterly unrealistic to think ALL companies to grow at 10% per annum for  the next 20 years.

That would be some firm to buy.

Firms grow but eventually succumb to competition, market saturation, maturing of industry.

After which the growth rate tapers off.

Based on our understanding of the industry, nature of the business, we give  firm A a growth rate of 10% for the next 10 years, there after, it reaches saturation and grows at 3% per annum for the next 10 years.

The theoretical fair value that you should pay for this company is 204 mil.

That doesn’t look that far off from the 220 mil market  capitalization.

Paying fair value for a wonderful business

Warren Buffett likes to say the following:

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price

If you can find a business that can have such consistent EBITDA, Free Cash Flow, Earnings for the past 10-20 years, it is likely

  • have some competitive advantage
  • have some economic moat
  • perhaps a unique lowest cost producer that can’t exist any where else
  • great network effect
  • serious monopoly power
  • regulation induced

It is likely the ROIC of the company is going to be splendid.

Should you pay a fair value? By all means you can follow what Buffett did.

But you got to be sure those advantages that the firm have listed above  continues to be present and strong.

If you Lose those advantages

The reality is that if you enjoy some margins or ROE, your competitors will circle around your turf like a  vulture.

Eventually your super margins will erode.

Unless those 6 points is present and strong, your margins will not be protected from the natural laws of business.

You might say hey its still a rather good business. But what if firm A now can only grow at 5% for the first 10 years instead of 10?

The fair value of firm A then is 144 mil. Now this looks damn far from the market cap.

Lesson here:

  • Put effort  to learn about the nature of the business
  • Correctly identify if the business has any of those edge in the first place
  • Sometimes the business really have no edge, things like brand and fat margins are not an edge
  • Good book to read up is Pat Dorsey’s Little Book That Builds Wealth or any Michael Porter’s books
  • < growth the about optimistic rather>

Being too optimistic of the future

We tend to be interested in companies that

  • have short operating histories (possibly IPO companies)
  • a rather fucking compelling business model

Looking at the prospectus, or past 1 to 2 years  of data, we think that this company if its been growing 20-30% for the past 2 years, an optimistic outlook is that it can grow 10% for the next 10 years.

And you pay 220 mil for it.

In reality, this might be the case:

The growth rate is so haphazard. Firm A turns out to be cyclical, unlike what was written in the prospectus or the analyst report.

Those report are meant to sell and  as thus tend to be more optimistic then normal.

You end up paying over 220 mil for a 109 mil company.

Lesson here:

  • Read, read, and read more about the nature of the business to be familiar about the  problems, known and unknown risks that can arise
  • Compare against overseas or local business of a similar nature, what is their growth rate, are they that cyclical
  • Revisit the previous part, are they going to lose some advantages that will cause such a growth rate
  • If they don’t have such a long history and you cannot find more about this industry, BE AWARE OF THE RISK HERE. Either choose not to take this stock or if you take, recognize that there is every chance you didn’t pay a cheap price for it

The conservative yard stick

Your research would have show you that this is a wonderful business

  • Has some of the 6 edges mentioned before
  • Consistent earnings, EBITDA, free cash flow
  • Management vested interest and alignment
  • Pays out more than they take from minority share holders
    What is the yard stick you would pay for firm A?
    Ideally, enough fundamental research may get you close to a conservative growth rate estimation.
    You might come to a conclusion that optimistically this company can get a growth rate of 10%.
    But what if it can’t grow to that extend.
    You probably compute that should this business grows with GDP, I should expect a  required rate of return of 6% at least.

At GDP growth of 3%, a good price to purchase at can be 150 mil.

Hell, there are days where you can  calculate what is the rough price if the growth is really stagnating:

This is where only 5 years of really low growth.

Granted, discounted cash flow have too many subjective parameters that people don’t find it practical

  • can a business last 20 years in the first place?
  • what is a reasonable  required rate of return / discount rate for the risk of this business
  • as you can see, growth projection is an art form

Perhaps a better measure are using EV/EBITDA and PE and in this case, the context of EBITDA and E becomes important to calculate both optimistic, pessimistic and base case.

Why will the price get there

The price will get to 130, 150mil during systematic risky situation such as a global sell down.

The mass herd behavior of panic selling will create the kind of mispricing.

Business fundamentals may still be intact that they still command that intrinsic value.

The best situation is that you buy a  company valued  at 10% growth rate (204 mil) at 3% growth rate (150 mil or even 130 mil)

  • At the  worst case scenario (where you estimate a very pessimistic earnings scenario) you get a 6% desired earnings yield
  • At an optimistic case, when business returns to normal, the actual growth rate of 10% makes it  likely the share price will rise to 204 mil

Summary

Valuation is rather  subjective. In the hands of a diligent valuer, realistic growth, pessimistic and optimistic growth are considered, known risks are considered.

A yardstick is derived to know how much is a conservative buy price and whether if you chose to buy it now, whether there are margin of safety.

The story can change with every new development. growth rate can become realistically better or worse and the yardstick have to be re-evaluated.

To get started with dividend investing, start by bookmarking my Dividend Stock Tracker which shows the prevailing yields of blue chip dividend stocks, utilities, REITs updated nightly.

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Matt

Sunday 22nd of September 2013

Hey, talk about valuing companies. Do you have any idea on how to value an insurance company?

I know we have to calculate the float and the cost of that float. I've searched all over but I can't find which item in the balance sheet to include/exclude in the calculation of float. Do you know?

Kyith

Sunday 22nd of September 2013

hi Matt, i have to admit i am not well versed in that. but if i can recommend people to look up to and value this way take a look at The Aleph Blog. Mr Merkel is a value investor investing in insurers and re-insurers

http://alephblog.com/

Man

Saturday 21st of September 2013

Hi,

Is there an error in your calculation?

1. For eg, in the first table, if you stop at year 20, there is still value of the equity at the end of 20th year, which was not taken into calculation. The difference can be quite big.

2. You may consider 3 cases: a. Zero value after 20 years (your example)

b. Zero growth into perpetuity, then there is a present value of = (34.86/0.08) /(1.08)^20 c. 3% growth to perpetuity from 10th year onward, then the PV of cashflows 10th year onwards is reduced to

[26.72/(0.8-0.03)] / (1.08)^10

Kindly correct me if my understanding is wrong.

Cheers. Man

Kyith

Saturday 21st of September 2013

nah man, you are correct. perhaps i have confused. the right way should be the one you provided.

but since it is an artibtary company and the calculator is the same the value should be comparable.

the data after 20 years should be small but still significant.

my question is that when i use the growth to perpetual, every time the intrinsic value look to be so much. its like its always undervalue.

or perhaps the discount rate should have been much higher.

Kyith

Saturday 21st of September 2013

nah man, you are correct. perhaps i have confused. the right way should be the one you provided.

but since it is an artibtary company and the calculator is the same the value should be comparable.

the data after 20 years should be small but still significant.

my question is that when i use the growth to perpetual, every time the intrinsic value look to be so much. its like its always undervalue.

or perhaps the discount rate should have been much higher.

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