This is the last part of the basics series on value investing. The series in its entirety can be accessed by clicking on the “basics” link under the topics section to the left. I hope this has lent a comfortable understanding of the value investing methodology. I can always be reached with questions or comments via email at “jonathan (at) jonathangoldberg (dot) com”.
In the coming articles I hope to introduce you to a wealth of value investment opportunities and insights to continue to further your education in the field (and to put some money in your pocket at the same time). If there are any companies you feel may be value investments please email me with your suggestions as I may do a complete valuation and analysis along with recommendation. In comparing my notes with yours we may both learn a thing or two.
I do not profess to be an expert in the field, as my learning is ongoing, so I welcome any suggestions for topics as well as additional insights into items which may have been discussed previously.
Subscribing to the RSS feed via the orange button to the right is the best way to stay on top of new articles as I do not plan on posting each day… and some days I may even surprise you with a second helping. Thank you for reading, please continue and enjoy the ride!
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Valuing growth is the least reliable aspect of a valuation. Whereas with the net asset valuation we are valuing assets the company currently owns and with the earnings power valuation we are extrapolating already realized earnings, in valuing growth we are forecasting what we think will happen in the future. It is this forecasting which is highly sensitive to assumptions as well as other behavioral biases. One of these behavioral biases is the fact that investors tend to overpay for growth; the average investor may jump into a stock that everyone likes (also known as “herding”) or assume that they know more about the the stock and its future than they actually do. As Mark Twain said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
As value investors we want this growth for free. Sure we are willing to consider a stock more favorably because of the potential for growth, but we won’t pay for something that we know to be so highly sensitive to assumptions. The most we are willing to pay for a security would be EPV (in the case of a franchise value with growth) – in such a case the value of growth is our margin of safety.
Unless a company meets the following two criteria there is just no way that value investors can consider it to have potential for growth:
- Return on Invested Capital (ROIC) must be greater than the Weighted Average Cost of Capital (WACC), otherwise growth has no value.
- The company must have a fully sustainable competitive advantage otherwise ROIC can not remain greater than WACC.
The valuation of a company that meets the above criteria for growth has two aspects which are different than our basic valuation, as follows:
1. Expenses that support growth need to be added back to the free cash flows that have been calculated. This includes items such as the growth portion of an R&D expense and the growth portion of a marketing expense. These are added back to the cash flows prior to removing taxes (at the EBIT line). We do this in order to adjust EBIT to earnings without growth, the same earnings we try to capture in each valuation.
2. EPV is modified by a multiplier for the value of growth. The equation to arrive at this multiplier can be found using some “valuation algebra” as shown in this book (the details of the multiplier are too in depth for this basics course but may be discussed in a future article). If the growth rate assumption used in the multiplier is reasonable and the modified EPV minus an appropriate margin of safety is greater than the original EPV, we would pay full EPV per share for the company at the most. If the modified EPV minus the margin of safety is less than the original EPV, we would pay at most the modified EPV minus the margin of safety. In this way we are obtaining the growth prospects of the company for free as we are merely substituting these prospects for the (or part of the) margin of safety.
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{ 1 comment… read it below or add one }
Great article but I would like to emphasize somthing. Regarding point 1, I think it is often overlooked by many small investors that it’s the marginal ROIC that must be greater than the WACC, not the average ROIC. Any new capital invested must have ROIC > WACC to promote growth, or if there is no new capital being invested, then the ROIC must be rising. I know this point is implicit in your write-up but it bears some emphasis. I think a lot of novice investors “who want to be just like Warren Buffett” see a company that earns a consistently high ROIC and believe it must be a great company, or see a company that earns a consistenly low ROIC and believe it must a bad company. It’s not that simple.