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.
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.
- 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
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.
- 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
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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