At the time of writing the S&P500 is down 22% YTD with many thinking we are only about halfway through the pain. Considering the magnitude of the bubble we’re exiting with almost every single asset class participating, worldwide geopolitical tensions and a looming energy crisis; it’s hard not to share the view. The thing to remember is that bear markets/crises bring opportunities. Many of the stocks that have occupied watchlists while investors wait for more reasonable valuations are going to finally become reasonable and in some cases, become really cheap. But what does cheap really even mean? There are so many metrics and techniques out there to value stocks, from Discounted Cash Flow (DCF) models to ratios like Price to Earnings (P/E) or free cash flow (P/FCF), price to sales (P/S) and even price to book value (P/B). Which metrics matter? What’s the best technique?
Let me start off by saying people get way too caught up looking at a few key metrics and often miss the bigger picture. Often an investor may do a screen looking for stocks with low P/E. There’s a few problems with this and one can read an awesome paper about it here. That metric is also based on last year’s earnings. So, something may be cheap based on last year’s earnings, but it might be cheap because people don’t think it’s sustainable, or it may not have any growth. You might decide to buy it, but then you own a stock with a lot of downside risk and almost no upside. Remember the name of the game is risk/reward. Your job as an investor is to get paid as much as you can for taking on as little risk as you can. You want to find trades that are heavily right tail skewed.
The key to money management. It's making a lot of money when you are right, and minimizing it when you're wrong.
- Stanley Druckenmiller
There is also DCF models. But, the problem with solely relying on those are they are extremely sensitive to discount rates and terminal growth rates. Why should an investor with a finite amount of time spend so much of it on a model when a 200Bp change in discount rate could lead to a 25%+ change in the output price? Considering bonds (the 10Y treasury bond yield is a common input in the discount rate) are trading like crypto coins at the time of writing, it makes sense to be skeptical of a technique whose outputs can vary so much on how bonds are trading.
So these popular methods are bad on their own, but what about together? I believe there is two main factors to stock price appreciation: 1) multiple expansion and 2) earnings growth. By creating a model, forecasting future earnings and using that model in conjunction with appropriate multiples, an investor will have a more complete understanding of the potential multiple expansion or earnings growth, and thus a better understanding of the value of the company.
Let’s go back to the popular metrics and how they’re used to screen for stocks. In some cases, stocks that appear to be fairly priced are actually quite cheap! Let’s use an example of a simple retail store chain example. For the sake of the example, I’ll simplify parts of it. Each store costs $3 million to build and takes a year to build. Once built, it produces $6 million in revenues and $600,000 in gross profits. Pre-tax, it takes less than three years to pay for each restaurant. A 20% return on capital is a great business and phenomenal for a retail store. Finally, the business has $3 million in corporate overhead expenses. This is a fixed number for headquarters staff, but it will slowly grow with the company. There are currently 15 stores in the chain and from research you have a rough idea of the economics of each store. Here are some hypothetical pre-tax estimates of what the business will look like at each milestone. All numbers in millions.
If the market cap is $50M at 15 stores, is it cheap? On an initial screen, the stock would appear to be fairly valued at 8.3x pre-tax earnings. However, if the company can get to 50 stores, then it is currently only selling at 2.38x pre-tax earnings. You would 4x your investment provided the company can expand to 50 stores and investors still want to pay the same multiple. That’s the easy part. Can the store concept even support 50 stores? Can management execute that plan? How long will the plan take? How much additional capital would it take to get there?
This is where it gets more interesting because as the saying goes, it takes money to make money. In this example the cost of building a store is $3 million and it’s a static number. That’s one cost of many and it’s a capital expenditure that’s reported on the balance sheet as an investment and not as an expense on the income statement. But opening more stores will incur some costs that will be recorded as expenses. There needs to be employees hired, the new store needs to be advertised and all the costs that are required to get the store up and running are incurred before it generates a single dollar in revenues. Let’s say it costs $300,000 in onetime expenses per store opening. Let’s also say the company is at 15 stores and has plans to expand to 50 stores. The company believes it can expand stores by 10 per year. Going from 15 to 50 stores will cost $5,250,000 in total and will take 3.5 years to complete. Instead of earning $6 million the company will only make $3,000,000 in pre-tax earnings in the base year. At a $50 million market cap the company now trades 16.67x pre-tax earnings. Is it cheap? If it reaches 50 stores then it’s cheap and you will make a lot of money. If it reaches 300 stores in the next decade you will make a fortune. Today it trades at 16.67x earnings because it’s growing. It’s 8.3x static earnings. But, if you believe in the business, it’s 2 or 3x earnings looking out 5 years.
As you can see, it’s really not about this year’s earnings. I’m not even sure next year’s earnings really matter apart from measuring the success of your thesis. After all most people know what this year’s earnings will look and even have a reasonable idea of what next year’s earnings will look like. No one really knows what the earnings will look like in 3 or 5 years and that’s exactly where you should focus your attention. Look for businesses that can earn many times what they are going to earn this year. Look for growth. Identify a management that can deliver that growth. Focus your energies on making sure it is a great business, make sure the store remains popular, make sure the store economics stay the same (or even better, improve).
It’s also important to be reasonable with your projections and expectations. That small cap you’re invested in is not likely to become the next Tesla, Microsoft (insert other generic mega cap growth stories here). They’re either going to burn out, plateau or get acquired by a larger company. What’s a realistic forecast for that company’s earnings for the next few years and what are investors/large companies going to pay for that? Remember that companies will pay more for a company than an investor. Similar problems exist for large caps. Apple is not likely a triple in the next 5 years. Growth stories are also easy to misprice since many investors will assume some massive profitability down the line that will skew their process. It’s important to be very careful with those companies and be very critical in asking yourself how will this company become profitable? Does management have the expertise to execute that plan and consistently evaluate their progress.
At this point in my valuation process I would also do a DCF model. While I won’t go through a DCF example here, I will have models to accompany future deep dives on companies that I research. An interesting exercise for the reader would be to DCF the company from the example I gave with the parameters I gave along with some assumptions the reader will have to make. See how that compares to the valuation I illustrated and see what factors have a large influence on the valuation.
I think it’s important to emphasize that the above example without the DCF is a rough and crude way to value a company and it shouldn’t be the entirety of an investor’s process. It was more to illustrate how to potentially think about a company’s valuation and it’s earnings. I will leave you this video by Aswath Damodaran (google him if you don’t know who he is) showing how to use his spreadsheet on valuing companies here. As a bonus (and because I found it extremely useful), here is a video by the same man explaining how he reads a 10-k to find the information required for him to value a company. You can find that here. I’d also encourage the reader to check out his other videos. They are incredibly useful for modeling and valuing companies.
Thank you for reading! I hope you enjoyed. If you liked what you read, please subscribe! If you have anything you’d like to add or discuss, please leave a comment. I can also be reached on twitter. Alternatively, you can come chat with me and other traders anytime in this discord chatroom here. I don’t have a set schedule, but my next blog will be on the kind of attributes I look for in a company to invest, subscribe so you don’t miss it!