As said in my last post, a detailed DCF is a highly valuable M&A and marketing tool. But not a sensible approach to value a company. The question then is: what is a sensible approach to valuation?
One that meets the following conditions:
1. Keep it simple. Forget the 50 variable detailed DCF. Focus on sales, profit margins and make sure that the company's asset base is in line with your growth assumptions
2. Focus on the big picture. Just focusing on three variables may seem to be superficial. It is not. If you have a highly complex problem to solve you don't develop a highly complex model to analyse and solve it. That would only create confusion, intellectual distress and lead to poor decision making. It would be the planning fallacy at its worst.
The solution is to follow simple principles for complex problems. And broad framing: take a step back, think hard about what are the critical factors to understand and solve the problem and focus on these. For any problem, explanatory factors 8, 9 and 10 are always pure, simple and irrelevant details. Factors 1, 2 and 3 will explain (almost) everything you need to know in the vast majority of the cases you will be confronted with. And factors 8, 9 and 10 will tend to be highly correlated with 1, 2, 3 anyhow making them redundant. Besides, if you start to focus on 10 explanatory factors you will end up i) not really focusing on any, ii) spend time paying attention to things that are irrelevant, iii) missing out critical information because you are too busy dealing with irrelevant details. Allocate your time to understand what is key. To understand it really, really well. The rest are peanuts.
And what is key? Quality of the business and quality of the management.
Does the business benefit from a moat? Has it true pricing power? (first quick test to answer both questions: has the return on capital employed been consistently above the cost of capital over the entire economic cycle?) Is the entire industry potentially exposed to disruption from outsiders? Is the management team of high quality, i.e. intelligent people with high ethical standards? Are the top managers interests aligned with that of the shareholders? Does the pay structure incentivise managers' long-term thinking and decision-making (way, way beyond the next quarterly report)? Are the top managers respected and admired by the vast majority of their employees or rather resented?
3. Quantify! If you can't quantify reality, your understanding of it is very shallow. When it comes to valuing a company, it is easy to find people that use a detailed DCF and put a number on 20 different variables. However, it is very difficult to find people that actually quantify and challenge the underlying assumptions of the valuation model.
Typically, in detailed DCF modelling there is a macro or mega-trend underlying sales growth assumptions. But this trend is verbose and vaguely quantified. And usually relying on research reports from well know institutions. Something like "Industry experts estimate that the demand for German solar equipment is likely to grow 30% annually over the next decade. The European slowdown won't impact German solar equipment manufacturers as their main clients are Chinese solar panel manufacturers and the Chinese market will keep growing at high double digit rates. The Chinese in turn while being the world's leading solar panel manufacturers, won't be able to compete with the German solar equipment manufacturers (note: solar equipment is, simply said, the equipment needed to produce solar cells for solar panels) because they don't have the technological know-how to do so. They will remain the German solar equipment manufacturers best clients for many years". The issue is that if you simply read tens of research reports and use their main findings to derive a company's sales estimates, the chances are that you will end up way off the mark. And if you are way of the mark for the top line you will be way off the mark in your bottom line estimates as well (and trying to put numbers on 20 variables won't make it any better).
You have to quantify, pin things down, and challenge, with numbers, all aspects of reality. Reading research reports is nice and all you need to do if you are a salesperson wanting to tell your clients a persuasive investment story. But if you are an investor you have to do better. And more. You have to do your own research. Go directly to the sources of information. Get the numbers. Speak with a broad range of people holding different opinions. And challenge the underlying assumptions others are putting forward before you incorporate them in the valuation of the company you are analyzing:
a) The Chinese solar panel producers won't be impacted by the European slowdown as China will continue to grow strongly? Really? How much of their production is sold into Europe? 80%-90%? Interesting....
b) The Chinese won't be able to develop their own solar equipment technology as they don't have the know-how? What do the top Chinese students study? Philosophy or natural sciences? Natural sciences (even because discussing philosophical ideas freely in an one-party system is not really a good idea for career advancement). What's the percentage of Chinese students in post-graduate science programmes in the western world's top universities? 15% to 20%? And China will still not be able to develop its own solar equipment technology quite fast? Interesting....
4. Be sceptical and respect the power of history. Companies, like people, don't change easily. A company's past behaviour - over a 10 year timeframe (one entire economic cycle) - in terms of capital allocation efficiency and return on capital employed will tell you much more about what you can reasonably expect from it in the future than whatever the company's management says and would like you to believe
5. Operate with a margin of safety and learn to say "no". Once you have an estimate for normalized operating results and free cash flow - reached following the principles outlined above - you can start performing a company valuation. Calculate the multiples and compare them with peers' multiples, currently and over time. Try to assess the company's liquidation value whenever you can. And by all means: use discounted cash flow techniques and perform sensitivity analysis - but please forget a detailed DCF. And never, ever forget that performing a company valuation is not an exact science. Therefore, allow for a margin of safety. Don't invest if there isn't at least a 30% discount to what you reckon to be the company's fair value.
The ability to say "no" is no mean feat. And it is one of the most remarkable skills great investors share.
6. Don't overpay for growth. No matter how much a company is able to grow, if the return on capital employed is not above its cost growth has no value. On top of it, even if the return on capital employed is currently above the cost of capital it will tend to converge to the latter over a 5-6 year period, maximum. The exception to the convergence rule only occurs is if you are dealing with a true franchise business, i.e., a company that benefits from sustainable barriers-to-entry in its market. How many companies are true franchises? Let's be optimistic and say that 1% of all companies are. Do you really think that your are one of the greatest investment genius in the history of mankind and able to spot the real franchises, at least most of the time? Think again. And act accordingly.
And hey, if you do are an investment genius (or have a team and investment process in place that allows you to look like one) you just cash in the full benefits of not overpaying for growth.
7. Put in place a decision-making process that explicitly deals with the two mothers of all behavioural biases and bad decision-making: confirmation bias and loss aversion
This means putting Karl Poppers "falsification principle" at work: stimulate an open debate culture within your organisation to foster as many independent, uncorrelated opinions as possible with the aim to reject wrong assumptions and poor investment cases at inception. Remember that good writing leads to good investments: write down the investment case with its main assumptions, potential upside and risks. Especially write down the risks - and how to act in case they materialise to avoid that cognitive dissonance takes over when things start to move in the wrong direction. And learn from Kahnemann and Tversky: explicitly integrate reference-class forecasting and pre-mortems in your decision making.
Finally, accept one advise: be an optimist in all domains of your life. Except when it comes to investing. This will prove to be true genius.
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