Tuesday, January 3, 2017

Valuation and investment analysis

I just had a chat with someone who wondered why I did not have a valuation for everything in my portfolio - a buy and a sell price.

My reaction: such (false) precision was silly and ultimately counter-productive.

To demonstrate I will give you a set of accounts for a consumer staples company.


Annual Standardised in Millions of U.S. Dollars
201520142013
Revenue7,6586,9777,212
Net Sales7,6586,9777,212
Total Revenue7,6586,9777,212
Cost of Revenue, Total3,6333,4543,860
Cost of Revenue3,6333,4543,860
Gross Profit4,0253,5233,352
Selling/General/Admin. Expenses, Total2,6652,4462,368
Selling/General/Administrative Expense2,6652,4462,368
Labor & Related Expense------
Advertising Expense------
Interest/Investment Income - Operating------
Investment Income - Operating------
Interest Exp.(Inc.),Net-Operating, Total------
Unusual Expense (Income)36(195)0
Restructuring Charge361800
Impairment-Assets Held for Use------
Loss(Gain) on Sale of Assets - Operating0(375)0
Other Unusual Expense (Income)------
Other Operating Expenses, Total------
Other Operating Expense------
Other, Net------
Total Operating Expense6,3345,7056,228
Operating Income1,3241,272984
Interest Expense, Net Non-Operating(297)(208)(168)
Interest Expense - Non-Operating(297)(208)(168)
Interest Capitalized - Non-Operating------
Interest/Invest Income - Non-Operating336306151
Interest Income - Non-Operating232154151
Investment Income - Non-Operating1041520
Interest Inc.(Exp.),Net-Non-Op., Total3998(17)
Gain (Loss) on Sale of Assets------
Other, Net13597
Other Non-Operating Income (Expense)13597
Net Income Before Taxes1,3641,4051,064
Provision for Income Taxes496471386
Net Income After Taxes868934678







As you can see - it has net income after taxes of just under $900 million.

I am not even going to bother inserting a balance sheet. The company has some debt (as seen by the interest expense) but there is little doubt the debt can be paid - and you can give me a valuation before debt if you want.

There are some substantial (foreign) cash balances as well as well as some investments. The debt and the cash balances and investments are roughly a wash - so you can safely ignore them.

The company has a long record of slow but steady growth - but it has grown a bit faster than that for the past few years. The CEO has been a vast improvement on other CEOs and has done some optimisation.

There is no doubt about the validity of the business. I guarantee you that you have consumed the product.

Also it is a highly stable product and hence should be very amenable to valuation. Volume growth is unlikely to exceed 5% in any year. A volume decline of 5% would be an unlikely disaster. However the last year did have volume growth above 5%.

Before you read any further I want you to write down a range of valuations. Just a lower bound (where on this information you would be falling over yourself to buy it) and an upper bound (where you would be falling over yourself to sell it).

Go on - write it down.






The trick is 40 lines further down - so write down your numbers before you scroll further...









Yes further down.














Further down still.














A little further down.

















Okay - I have changed the dates. The real dates for this are 1987, 1986, and 1985 respectively.

And the company in question is Coca Cola.

These are the accounts Warren Buffett bought his stake on.

The market cap is now $178 billion.

I do not think any of you would have come up with a number anywhere near that high. Even if you had bought the stock at the high range for plausible values (say 30 times earnings) the return from then to now was (highly) acceptable. The stock was trading at about 12 times earnings then.

Net income is now over $7 billion and the multiple has expanded a lot.

--

I do not need to say it - but a valuation was not important in the buy case and would have detracted from the buy case a great deal.

The valuation as such was pretty trivial. Was it realistic to assume that the company over a reasonable time frame could return $12-15 billion to shareholders. The answer to that was a resounding yes.

Was there a margin of safety around that?

Again a resounding yes.

So the stock was easily able to be owned.

--

The questions that mattered (and still matter) is "can the product be taken to the world", and will the next generation think of it in the positive light the last generation thought of it.

The answers are less obvious now than they were then. Young people it seems drink Red Bull rather than Coke in surprising numbers. They are your future.

--

This is a general quality of investment analysis. Proper valuations are far more art than science. DCF valuations - especially of something growing near or above the discount rate are famously sensitive to assumptions. The right comparison is to the Hubble Telescope: move direction a fraction of a degree and you wind up in another galaxy.

--

By contrast there are some things for which a proper valuation should be done and can be done.

If you own a regulated utility what you really own is a regulated series of cash flows with regulatory risk around them.

An accurate valuation is part-and-parcel of the analysis - because it delineates what you own.

--

The battle here is to work out what the salient details are. Sometimes they are whether young people will continue drinking Red Bull. Sometimes they are working out a technological change.

In rare cases they are working out valuation.

Mostly valuation is simply about bounding a margin of safety. And most of that involves understanding the business anyway.






John

PS. If you work for a shop that requires a valuation for everything quit now. The pretence will either kill you or your performance.

PPS. I do not think there is a margin of safety around Coca Cola any more. Not enough to make me interested anyway.


---

Later post-script:
This is in the comments so frequently that if  you look at Coke's appreciation (and compare to the S&P) Buffett has not done that well. Some even say "if you ignore dividends". But that misses the point.

Here is an extract from Berkshire's last annual report:


 Berkshire has a round 400 million Coke shares at a cost base of $1299 million. The dividend is $1.40 per share - or $560 million per year.

That is a 43 percent yield in dividends on his cost base.

If you wish to ignore the dividends (as my commentators do) may you please give them to me.



J

42 comments:

  1. No consideration of time. Investment is not an exact science - not exactly an original or difficult insight. Compelling writing style though, as always.

    ReplyDelete
  2. I agree with almost the entire post, with one caveat: At extremes, valuation seems to matter.

    I once worked for a fund whose analytical process was very centered on valuation. We derived weighted average estimates of intrinsic value. Here is what I found:

    (i) the process of estimating intrinsic value was more important than the results themselves
    (ii) while the head PM valued, and insisted on rigorous DCFs, as key part of our firm's process, I foudn that their behavior was more complicated: often tiems they didn't trust what the in-house DCFs were saying..

    Their skepticism proved to be right (e.g., homebuilders looked cheapest to intrinsic value in 2006-2007, but they didn't increase allocation to homebuilders)

    ReplyDelete
  3. Warren bought it because he liked drinking it. As good a reason as any to invest :-)

    ReplyDelete
  4. Great post. I think the exercise shows how valuable untapped pricing power is - if taken advantage of within your investment horizon.

    Anything addictive has pricing power. As are products that customers absolutely love - where the value-add is much higher than the products that competitors offer. Customer engagement, volume growth, market share dispersion and brand affinity should give you some clues

    ReplyDelete
  5. It is difficult to enter a sensible estimate without knowing the return on capital.

    ReplyDelete
  6. Reminds me of that saying from "Reminiscences of a Stock Operator": "A stock is never too high to buy and never too low to short." https://jesse-livermore.com/trading-rules.html

    ReplyDelete
  7. My favorite is when analysts "update valuation" for their "long term investment". They either messed up at the beginning putting their "value" too high/low or they are fooling themselves that the latest quarterly earnings revision makes a difference.
    You're right about working for shops that require valuations and argue about the appropriate Cost of Equity - soul crushing...

    ReplyDelete
  8. "The simpler it is, the better I like it."

    If you fall in love with a stock it's so easy to correct your excel DCF model so the margin of safety suddenly is +50% ;)

    ReplyDelete
  9. A simple multiple-based valuation can't properly frame the worth of a good business with a long runway for reinvestment. It's an extremely crude rule of thumb. Even DCF breaks down for such cases because a very conservative terminal value is always used after 10 years max. Of course this is the appeal of "compounders". But the trick is being able to see decades into the future and pick out the ones that will still be compounding. Seems to me only Buffett has this gift.

    ReplyDelete
  10. «The questions that mattered (and still matter) is "can the product be taken to the world", and will the next generation think of it in the positive light the last generation thought of it.»

    The usual story is that W Buffett went long stocks that would benefit from the long-run "bull market" first in the USA middle-income class spending, and then global middle-income class spending; plus usually defensives are undervalued because they are not "momentum" stocks. He identified a solid, long-term macro trend, identified companies with pricing power benefiting from that trend, and bet the farm on less than a dozen of them.

    As an additional note, the rise in market valuation of Coca-Cola from around 10 billion to around 180 billion over nearly 30 years gives a compound growth rate of 10% per year, which is much, much faster than USA GDP growth, or even world growth. Finding a large-volume line of business that can grow much faster than GDP for nearly 30 years is next to impossible; so something else must have happened. If one looks at the long term share price: http://imgur.com/a/wI2hl it is pretty clear that KO benefited like many other stocks by "something" that began in 1980 and surged in 1994-1995 to fantastic levels. That "something" lifted a lot of boats.

    «I do not think there is a margin of safety around Coca Cola any more. Not enough to make me interested anyway.»

    Indeed W Buffett seems to have stopped investing in rising middle-income class spending, at least in the USA.

    ReplyDelete
  11. YAHOO! Finance gives a longer term and more detailed graph of KO: http://imgur.com/a/NZRfY and in it can easily see the quadrupling of price 1994 to 1998 and then its halving to 2003; both seem to me "amazing". Sure "The Coca-Cola Company" has been a good business meanwhile, but such gyrations are hard to square with the value of the business. Exercise for the reader: graph the stock market price together with gross sales. That is as a rule a very good thing to do.

    Note also that the KO valuation in 1998 was $165B compared to $178B today (the FOMC can only do so much), leaving any return in the past 20 years largely to dividends...

    The 1998 annual report proudly notes:

    «A $100 investment in our Company's common stock on December 31, 1988, together with reinvested dividends, grew in pretax value to approximately $1,365 on December 31, 1998, an average annual compound return of 30 percent.»

    A return of 30% compound per year over 10 years for a large staples corporate, as opposed to the Medellin Cartel, is incomprehensible to me. I reckon that no insight into the value of the business or "valuation" estimates can account for such situations.

    ReplyDelete
  12. If I bought the business at $30billion in 1987, I only get Cagr of about 6.6% return until now, excluding dividends.

    ReplyDelete
  13. Excellent post.You sound like a VC investor. I think many value investors can learn a thing or 2 from them. Focusing on current value for a growth company is shortsighted.

    ReplyDelete
  14. If you paid more than 20x earnings you would have underperformed the S&P 500 which has returned ~8% annually over the last 30 years (coke current market cap $178B / 1.08^30 = ~$18B = 20.7x 1987 earnings). So valuation matters if you care about that sort of thing. Of course over such an extended bull market the important thing is to own something in the market. But it is a wrong conclusion I think to say valuation doesn't matter.

    ReplyDelete
  15. Great post! Shows why the world's greatest investor is from Omaha not Manhattan.

    ReplyDelete
  16. Since 12/31/1987, Coke has returned 12.7% annualized vs. 10.3% for the S&P 500. If an investor paid 30x for Coke (instead of 12x) then Coke would have returned 9.4% (underperforming the S&P 500). 8.4% if an investor paid 40x.... and so on. Valuation does matter.

    ReplyDelete
  17. polit2k, are you sure about that ? I've been thinking that he started to 'drink' after he bought it. You see, that's a smart way to do marketing. Who knows.

    ReplyDelete
  18. YAHOO! Finance gives a longer term and more detailed graph of KO: imgur.com/a/NZRfY and in it one can easily see the quadrupling of price 1994 to 1998 and then its halving to 2003; both seem to me "amazing". Sure "The Coca-Cola Company" has been a good business meanwhile, but such gyrations are hard to square with the value of the business. Exercise for the reader: graph the stock market price together with gross sales. That is as a rule a very good thing to do.

    Note also that the KO valuation in 1998 was $165B compared to $178B today (the FOMC can only do so much), leaving any return in the past 20 years largely to dividends. Conversely the 1998 annual report proudly notes:

    «A $100 investment in our Company's common stock on December 31, 1988, together with reinvested dividends, grew in pretax value to approximately $1,365 on December 31, 1998, an average annual compound return of 30 percent.»

    A return of 30% compound per year over 10 years for a large staples corporate, as opposed to the Medellin Cartel, is incomprehensible to me. I reckon that no insight into the investment value of the business or "valuation" estimates can account for such situations.

    ReplyDelete
  19. Great post. Another item I think the market tends to over react to is FX.

    ReplyDelete
  20. Hi John,

    I get your point and love the DCF/Hubble telescope analogy. As I tell my team, the DCF is the world's greatest tool to help sell the story you believed before you started crunching the numbers. It is so laced with bias that it taints almost every single investment thesis, and anchors us all to unrealistically positive or negative scenarios.

    That said, I disagree that valuation is wholly unimportant. In the simplest terms, we will be profitable as investors if the valuation for company X is greater tomorrow than it is today. And then we need to introduce concepts of opportunity costs, dividend payments, discount rates, and (maybe) factor risks into the equation. So, at least in my mind, the business is all about knowing the difference between price and value, or at least understanding where the consensus investor - Ben Graham's proverbial Mr. Market - is underestimating potential.

    And here is my problem with your (admittedly clever) example. You picked one of the biggest winners of all time. You could have done the same with Walmart or only a handful of other companies that today are massive, but back then were much smaller. Yet for every Coca-Cola or Walmart there must have been hundreds of others with similar flattish revenue and choppy earnings streams throughout those same three years, which today are worthless.

    So by selecting Coca-Cola here, and suggesting that valuation doesn't matter, aren't you implicitly suggesting to your readership that every single thing out there that interests them is, or might be, the next Coca Cola?

    From my perspective, especially when you consider Albert Einstein's eighth wonder of the world, is that the smart decision to buy Coca Cola was entirely about valuation. Warren Buffett, and whoever else bought it then and held it for a few decades, basically believed that Mr Market was fading growth too quickly, underestimating brand value, and had a long enough time horizon to see the big picture, and the stock returns that he would likely enjoy. In other words, the Coca-Cola buyer in 1975 profited because the valuation of Coca-Cola was eventually tremendously higher than when he purchased it. And, while difficult to pinpoint ex-ante with this six-deviation winner, there still would have been a price that was too high to pay in 1975 - just as the price for Tesla may be too high today, or it may take over the world and grow like Coca-Cola for the next 40 years.

    I suspect it won't, but the buy or sell decision must at least to some degree be associated with the concept of value.

    Best,

    Drew

    ReplyDelete
  21. My FMV was $18 bil on the numbers you presented.
    KO is valued 10x that now.
    Compare: SP500 is valued 9x the 1/1/88 price now.
    That is not a meaningful difference, considering the higher idiosyncratic risk
    of a single stock pick.

    ReplyDelete
  22. John

    Buffett commented in his 2004 letter to shareholders.

    Nevertheless, I can properly be criticized for merely clucking about nose-bleed valuations during the Bubble rather than acting on my views. Though I said at the time that certain of the stocks we held were priced ahead of themselves, I underestimated just how severe the overvaluation was. I talked when I should have walked.

    Coke's valuation in 2000 was >50x PER and perhaps Buffett would have sold if he held a stronger view of their value.

    ReplyDelete
  23. Lol, the hubble telescope line, and the first post-script - so damn funny, and right on the dot too! I've been years in invt banking doing valuation etc. and most of it is just nonsense.

    ReplyDelete
  24. Dear John
    I think valuation does matter.however,I agree with you on that its difficult to value every business accurately.with regard to coca cola example if valuation does not matter why would buffet wait for COKE to trade @ 12PE .secondly, if you bought the company @PE of 30 its true you generated 8% rate of return but you underperformed the S&P total return index over past 30 years.

    ReplyDelete
  25. It was once alleged that 60% of tasters in blind tests preferred Pepsi (me too).
    The power of advertising and strategic placement of vending machines ?

    ReplyDelete
  26. Same guy that short sold Aussie banks 9 months ago due to 'valuation issues' .... and they have since gone up 25%+

    Why do we listen to another fund manager who lectures from the pulpit on theory using hindsight ... but has no real insight in practice

    A post designed to equate the writer to Buffet ... yet the writer hasn't owned Coke (other than on paper and using hindsight)

    ReplyDelete
  27. For those who commented on returns - please include dividends.

    (Have a look at the addendum to this post.)

    --

    Oh, Aussie banks - broke even. WIll put them on again at some stage. Freight train continues here.

    ReplyDelete
  28. Stocks behave in a noisy manner, so one should be cautious about asserting that the example of KO implies that valuation generally does not matter.

    Nick de Peyster
    Undervalued Stocks

    ReplyDelete
  29. The Coca-Cola example just shows that if your investment horizon can stretch beyond 25yrs, you're going to find some entry valuations which make sense at truly eye-popping multiples. If you're working with that sort of horizon, Hempton's point is fully valid - it's a waste of time forcing yourself to come up with sell valuations.

    For those of us whose bets need to pay off over 3mo / 1yr / 5yrs, I think it does make sense to come up with a "sell" price.

    I work in private equity and we always have a sell price on all our assets.

    ReplyDelete
  30. Betting against Aussie banks is mostly betting on monetary policy failure which isn't your core competency. Even the Paulsons of the world who got the subprime market short right only made F You money because of monetary policy mistakes that expanded the fall-out from some fraud/over-valuation into a failure of a lot of other borrowers who had jobs and reasonable mortgages, but ran into financial problems when unemployment hit 13%.

    Australia hasn't had a monetary policy failure in I believe 20 years or so. Since the last recession. In 2008 the FED was concerned with inflation (Remember $130 oil) and reacted very slowly to the subprime crisis which should have been a contained crisis. On Aussie banks shorts barring a monetary policy mistake its far more likely that you could see defaults increased if valuations correct, but in that scenario you are only talking about a bump in earnings for the banks and a correction not a meltdown.

    ReplyDelete
  31. I don't think John is suggesting that valuation doesn't matter. This isn't black or white. The point is that the business matters most and it drives the value. If you're confident in the business prospects then the valuation need only be reasonable on straight forward metrics. In my experience investors tend to spend a lot of time on building precise (but inaccurate) valuation models, when some of that time might be better spent on scuttlebutt or just thinking.

    ReplyDelete
  32. Dear John even on total return basis if you value Coca cola based on exit multiple of 30x it will underperform the S&P total return index since buffet bought it in 1987/88.

    Look at coca cola when it was trading at PE 30X in 1999, for next 10 years it lagged the market. Its true that you don't need to buy them at single digit but valuation does matter for buying franchise business.

    ReplyDelete
  33. «The Coca-Cola example just shows that if your investment horizon can stretch beyond 25yrs, you're going to find some entry valuations which make sense at truly eye-popping multiples»

    As I mentioned above, KO quadrupled between 1988 and 1998, mostly between 1994 and 1998, and then halved, and then went sideways. There was no 25yrs horizon.

    A somewhat accurate view is that those who happened to be long blue chips in 1994 turned out to be investment geniuses, regardless of whether they had otherwise good reasons to do so (like Buffett did) or not.

    ReplyDelete
  34. «I don't think John is suggesting that valuation doesn't matter. This isn't black or white.»

    I think this is indeed out blogger's point: that an apparently high price is worth paying for a fast growing business; that what matter is forward PE over decades, or PE/expected growth, another popular measure:

    «The point is that the business matters most and it drives the value. If you're confident in the business prospects then the valuation need only be reasonable on straight forward metrics.»

    Good words, but our blogger does not actually give an example about investing in business prospects and "intrinsic" value; his example is about trading on the Coca-Cola share price, and the Coca-Cola share price seems to have been rather detached from business prospects or value, ballooning really fast in a few years, and then falling dramatically and going sideways.

    ReplyDelete
  35. Bloomberg's TRA gives a KO return of 3100% between 1988 and today with dividends reinvested.

    SPXT has had a return of about 1600% over the same period.

    Pay double what Buffet did (24x versus his 12x) and you've underperformed. Pay 30x and your returns have been garbage - so you're dead wrong there - I don't know where you're getting your numbers from.

    You're off your rocker when you say valuation doesn't matter. The people who say that are the people too lazy to get into the weeds and put together a decent model and shouldn't be managing money professionally.

    ReplyDelete
  36. KO has had a total return with dividends invested of 3100% between 1988 and today, you can check this with Bloomberg's TRA.

    SPXT has had a return of 1600% over the same period.

    If Buffet paid 12x and you paid twice that you'd have underperformed. If you paid 30x and held to today you'd have underperformed massively. I don't know where you're getting your numbers from but you're dead wrong.

    Anyone who says valuation doesn't matter is a fool and shouldn't be managing money professionally.

    People who disparage models generally too lazy to into the weeds or can't do basic math and likewise shouldn't be handling the money of others.

    ReplyDelete
  37. I thought around mid teen Bln for market cap. Came up with it thru multiple on operating profit and then growth rate + profit margin for a conservative TV. Kinda squares with Buffett's aversion to paying much over 10x pretax. Valuation matters but only as an anchor for the margin of safety and to serve as an expected distribution of TV. Good analogy on the Hubble telescope and DCF; it's especially applicable these days in low/zero/negative rates when DCF projection sensitivity is so much higher and longer dated cash flows and TV assume more importance.

    But ultimately it's about sustainability of the business and the ability to reinvest at high rates of return. And that's where the ability to identify a solid business is so important. As Buffett says, investment is at its best when most business-like and business is at its best when most investment-like. Business managers tend to use some kind of DCF for projecting IRR in selecting projects, even though these generally turn out very different.

    Buffett and KO in the late 80s serves as a great example of Graham's Mr. Market overreacting to something short-term (New Coke) and Buffett/Munger pouncing on it. It's also demonstrative of one of Shiller's great contributions to finance in empirically showing the S&P to excessively bounce around trend earnings & dividends. New Coke was a disaster but it was quickly jettisoned and wasn't enough to damage the core franchise earning power. Of course that's always easy to see in hindsight...

    ReplyDelete
  38. "Anything addictive has pricing power."

    Internet porn seems to be highly addictive to many people, yet has zero pricing power.

    ReplyDelete
  39. Coke's moat is still extremely wide - brand name and distribution system cannot be duplicated. Problem recently is that Kent decided to buy and restructure all the bottlers. But the business of selling syrup is a great business - if you are Coke. Easy to make, easy to sell, low capex - forget the bottlers (deworsifying).

    BTW, how can you say Coke's moat is not wide enough to interest you, yet you own VZ? VZ's moat shrinks by the hour, its customers hate it, T-Mobile eating its lunch, not to mention all other competition on the horizon. I switched from VZ to TMUS and thank god I did - $30 less per month and unlimited data (versus 5GB for VZ). Also cancelled my FioS - constant price gouging and Time Warner under Liberty ownership is now undercutting it. VZ blows.

    ReplyDelete
  40. I suggest that (as usual) Scott Adams puts it best:
    http://dilbert.com/strip/1993-02-11

    S

    ReplyDelete
  41. I think that link didnt work ... try this one
    http://assets.amuniversal.com/347412509ab5013331d7005056a9545d

    S

    ReplyDelete
  42. This post is amusing. You should be able to come up with a value in your head within a minute.

    You need the ROC (from the Balance Sheet which you didn't see fit to include).
    Since the return's so high, you can distribute cash while you grow.

    And there's no point of saying what it's worth now, that wasn't the question.

    Really, this is an example of how value investors don't know how to value companies.
    Nothing more.

    ReplyDelete