SolarCity: Emerged Experts and Jim Chanos

Hypothetical question: If you think a company is worth $100 per share, buy it at $50, and then someone acquires the whole company at $25, were you wrong?

This is perhaps the most perplexing part of the SolarCity story for me. Also by far the most frustrating. After what was easily 1,000 hours of research – conference calls, SEC filings, articles online, press releases, government documents – I feel as though something that is mine has been taken from me.

Emerged Experts

Equally as interesting is the sudden emergence of experts on the company. 6 months ago I would beg anyone in my inner (and outer) circle to look at the company. Nobody was interested. There were no articles online except for a few by hippie bloggers and the most sophisticated thing about them not directly from the company was what their competitors said about them. In essence, it was a desert of information, and a dry one at that.

Around the time that Jim Chanos and Wall Street started to question the firm and its business model, we started to see real questions being asked. Some of them were legitimate, some were ill-founded, but most importantly, we finally had some discussion. I could compare my work against others who had drawn their own conclusions. And it wasn’t particularly heated, at least at first. The facts really were meant to speak for themselves. And overall the crowd of ‘early emergers’ was really quite a nice group.

Somewhere on the slide down – I don’t know if it was $35 per share, $25 per share, or even sub-$20 per share – but somewhere along the line, there emerged too much information about the company. None of it had any basis in reason, it was all based on feeling, human emotion, trends, and guesswork. But it was also declaratory – far more definitive than the cold, calculating process of investigative work that I had done on the company (or those ‘early emergers’). Even though I had many multiples of time spent on the company vs. these new emerged experts, they were more confident in their approach to communications surrounding the firm.

Any type of discussion or argument I engaged in with the bears was met with little or no detailed discussion. A survey of the emerged experts on the bull side showed a similar level of sophistication. The bulls assumed the bears didn’t understand the long-term growth story and the bears assumed the bulls didn’t know the difference between a balance sheet and a pot to piss in.

A typical argument might look like this:

“You don’t see the $8 billion of debt do you?”

“It’s actually closer to $2 billion because most of it is non recourse.” 

“Yeah well there’s no cash flow, you guys are toast.”

“Don’t you know that in the year 2030 we will have solar panels on Mars?”

“You won’t have money to install solar panels next quarter.”

If this reads as bitter then you are missing the point. It is not that I was suddenly disproven or upset by these new players. It just gave me insight into the process of 99% of financial players, or at least those who communicate their opinions publicly.

A New Culture Arrives from Nowhere

It was like living in a ghost town, only to wake up one day and an entire population had moved in. They were a different culture from my own and didn’t care to learn much about my walk of life (or the company they were actively trading).

It is a group of people who value working knowledge of something over in depth study, short-term ism over long-term thinking, belief in the power of majority rules, and entering/exiting a position many times based on any number of non-business reasons. The most obvious being large daily swings.

Implications

With regards to emerged experts and the paradigm that we’re in, positioning yourself directly opposite to this behavior is how you can achieve results not correlated with anyone else (or the market).

This includes:

  • Long-term thinking
  • 10x time spent on a company vs. an emerged expert (100-200 hours is a good estimate, my 1,000 here was only due to the extreme complexity)
  • Business- and valuation- driven investing
  • Rejection of herd mentality through independent conclusions

Granted, this behavior led me to a loss in this circumstance. But it also how all major successful investors have positioned themselves over the past 85 years. Successful trading and quant-modeling requires a different playbook, I am simply addressing investors.

Blind Spot

One major – massive even – blind spot I had before the SolarCity investment in 2014 was that of takeover risk. It never crossed my mind that a company’s share price could go down (even if for legitimate purposes) and that I could be taken out at a loss. It sounds silly to type this out now, but I really didn’t think twice about it.

I valued SolarCity so highly because of how small the company’s market cap really was: at anywhere from $2.5-5.0 billion, the chance to own the largest future electricity provider in the country at that price seemed like once-in-a-lifetime. And that is how I would describe the deal Tesla is getting on the company, even if the emerged experts don’t agree.

This coupled with the fact that complexity can actually hurt you. When you have to spend as much time as I did (and I’m not a slow study by any means) to fully understand a company, how could anyone else possibly reach the same conclusions? There are around 10,000 public companies in the US after all.

I thought of complexity as a secret friend only I had access to. That I was somehow better than everyone else because of my superior knowledge. In a way, it could have worked out that way, but with the shitstorm of short sellers and emerged experts piling on, it didn’t work out the way I thought it would.

One Final Note: Chanos

This isn’t the fist time I’ve encountered Jim Chanos. He is a particular brand of short seller:

  • His bets are short term in nature (nothing wrong with that)
  • Typically his narrative outweighs his financial analysis in terms of the content of his short theses (think 80/20)
  • His narrative is often right (in the short term, think 1-4 quarters)
  • His financial analysis is often very wrong from a long-term perspective
  • Blatant factual inaccuracies made on television are not corrected later, even after being disproven

The last point is either insidious or it is ignorant. Given the size of his firm I can’t imagine he is the latter.

I’d also like to add that my first encounter with him was in Dell before and leading up to when Michael Dell took it private. It took a 5 minute scan of a 10-k to know Chanos was wrong on the financial analysis and valuation, but his narrative proved correct for a few quarters. We both ended up profiting off the position – mine just took 1 year to play out, his a few months.

In Conclusion

This is a hard one to brush off. I might not have been able to if they were being bought by a private company. Thankfully, I can still participate partially in their future success.

So, was I wrong for being acquired below intrinsic value and underwater? I don’t think so, but the jury’s not out yet. And remember to be aware of these kind of situations.

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Discover Some Wealth: Discovery Communications

Discovery Communications is my latest, which I found while combing through a local asset manager’s portfolio here in Pittsburgh. They are a global media company that provides content in 223 countries and 45 languages with a product portfolio that includes the Discovery Channel, Animal Planet, and TLC. They operate production studios, websites, and curriculum-based educational programs.

The reason I believe they are undervalued is their aggressive share repurchase activity: the share price has not moved, but the underlying growth in value per share has been dramatic. The business has grown its top line and bottom line by 10.5% and 16.4% annually, respectively, since 2008. Additionally, they have repurchased 23.6% of shares outstanding since 2010, after adjusting for stock splits. With a slight decline in the share price over the past 12-18 months, the business looks very appealing to me today.

Shown below are their financial results since 2008:

Screen Shot 2015-12-09 at 11.54.00 PM

What should emerge as highly relevant is the large increase in ROE. This is the result of an increase in leverage, as margins, sales turnover, and asset turnover have remained largely constant. The leverage today is at a healthy 3.5x operating income and 6.0x net income, with borrowing costs at 4.7%.

Additionally interesting is the aforementioned growth in the business, which appears to have slowed for TTM Q3 2015. This is the result of a strong dollar, as underlying sales volumes still have increased between 8-11% each quarter in 2015. This growth is primarily the result of their international expansion, which has been very aggressive and is now 50% of sales, as well as the rise of a number of content distribution businesses like Netflix, Hulu, and Amazon. With more companies vying for Discovery’s content, the amount they can charge increases.

Valuation is also highly appealing at $12.3 billion today. This indicates a P/E of 10.5x and price-to-book of 2.2x. For a business growing 8-11% per year with such a high ROE, low capital costs, and a lot of excess cash flow that is all used for share repurchases, I would be willing to sell around $17-21 billion, or roughly at a 16.5x multiple to earning power. And because this business is growing, there is a buffer to the ultimate value realization, where today’s investor is paid to hold onto their shares.

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SolarCity: Sorry, No More

I finished a 54-page report on SolarCity, which will serve as a replacement to a series on this website. I apologize for promising a longer series and not delivering, but 54 pages is too much and I’ve tired myself out on writing about the business.

A short summary is they have grown at a 94% CAGR since 2012 and are lowering future growth, starting in 2016, to 40% annualized, to focus more on operating costs and being cash flow positive. It is not a result of lower demand, as they will likely be unable to fill all of it next year.

Today’s SolarCity has “earning power” (a very complex metric focused around NPV creation net of current operating expenses) of $222 million on a TTM basis. This places them at 15x earnings. This earnings metric will grow faster than their top line 40% expectation by a large margin and the business will earn nearly $2 billion in 2020, by my estimation. Applying a small multiple to that indicates a huge return on your investment in SolarCity through 2020, which I conservatively estimate at 8.5-11x your money. At that time, I still would not sell the stock, as it has many decades of growth ahead of it.

My full report is not available to general public. I am using it to get hired at an asset management company or to start my own research business.

But again, I’m sorry to not write more. I’m fatigued on this one.

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Pabrai Makes A Killing in FCAU

recently wrote a post about how I believed Mohnish Pabrai to be back. In it, I posited that his resurgence with only 6 major stock positions indicated a newfound confidence in his work, and improved relations with his investors.

As it relates to FCAU – Fiat Chrysler – he has a lot to be confident about.

The Back Story

On October 29, 2014, FCAU announced they would be spinning off Ferrari into a separate, publicly traded company. The spinoff would be a partial spinoff, with 10% of the ownership being a sale in an IPO and 90% being distributed to existing shareholders. On this date, the market cap of the pre-spinoff companies was $13 billion. It was during this quarter that Mohnish Pabrai loaded up, placing 30% of his fund into the stock. By the end of the following quarter, he had 42% of his fund in FCAU, or $225 million. Although I don’t think he had an average price of $13 billion – or $10 per share. I estimate it closer to $12 per share.

At the time of the IPO the following autumn, Ferrari shares traded for $10 billion.This means FCAU received $1 billion from the IPO sale, as well as $3.2 billion from debt that Ferrari took on to pay FCAU a special dividend. Combined, the Ferrari spinoff added a full $13 billion in value, which was the value of FCAU combined with Ferrari pre-spinoff.

In addition, the share price of FCAU actually increased post-spinoff, from $13 billion to $18 billion. In total, the combined $10 billion and $18 billion in Ferrari and FCAU, respectively, indicates that buyers of FCAU for $13 billion made just over 2x their money in just under 12 months.

Other Holdings

Pabrai owns a stake in Google, which I think is a fine example of growth at a discount. It’s also one of the highest quality companies in the world and has an insurmountable technological moat. I used to own this one and I would be happy to buy it again around the prices Pabrai paid for it.

Horsehead Holdings is a zinc miner and processor, which has fallen on incredibly hard cyclical times, and is raising additional money by selling more shares. The stock has dropped from the $9-11 per share that Pabrai paid and it currently trades around $2. While it is unclear how much dilution will occur, the business has a new plant that is expected to generate annual EBIDTA equal to their current market cap. Once it is fully operational – and at full capacity (which is key) – this stock will likely go from the depressed $2 price to something more in the range of $15-25. The risks associated with it being a bad business economically – low returns on capital, cyclical, commodity business, share dilution – seem to be offset by the upside here. I don’t love the company, but I am watching it closely. Pabrai isn’t often wrong and I understand what he sees here.

Posco Steel is a high-quality steel manufacturer in South Korea that has hit a cyclical depressive swing. The average free cash flow generation in the boom years of 2003-2012 were between $3-4 billion per year, and 2014’s numbers were less than $1 billion. While buying cyclically-adjusted earnings is normally a great thing to do, I worry here. China just went through an unsustainable growth period to generate those results for Posco, and with them cooling off for a few years, it seems they may not again see the same level of construction activity for awhile. At $12.5 billion, this company is trading at what may appear to be 3-5x cyclically adjusted earnings, but the value trap potential here is high. I think the cyclically adjusted earnings are much more likely to be $1.5 than $3 billion and as a result, 10x earnings for a depressed steel company doesn’t sound all that appealing to me.

The GM B warrants are another security I have owned in the past – one in which I made 3.5x my money in under 12 months. The security presents a leveraged way to bet on GM’s shares, and at current prices, is virtually free upside so long as the stock does not go down. With long-term volatility so cheap, you can get a huge advantage in betting on GM’s shares. And should the auto sector finally decide to recover to pre-recession levels (something I don’t see as incredibly likely any time soon), the warrants will earn a multiple on your money without a ton of inherent risk. If I’m not mistaken, these expire in either 2018 or 2019 so there is plenty of time for the stock to go up to ensure a safe sale.

Concluding Remarks

Overall, I love what Pabrai is invested in today. While I don’t love Posco, I think Google, the GM warrants, Horsehead, and FCAU are incredible ideas. The originality here is very apparent, as no other superinvestors that I follow own any of these names – save for Google.

 

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SolarCity Part II: The Business Model

I have been writing an investment thesis on American Express, so forgive the gap since my last post. I don’t mean for a series of articles on a company to stretch on for weeks. My apologies.

SolarCity is a very special type of company, and is uniquely positioned to be the dominant player in residential solar in the country (and later, potentially the world).

Residential Solar, An Overview

Residential solar is the business of leasing solar panels to customers and then installing them on their roofs. The customer ceases to pay anything but a marginal amount to the utility – sometimes even selling excess power back to the utility – and their electric bill is replaced by a solar panel lease contract (or a power purchase agreement). This has several advantages, the main being that the lease payments are cheaper than the electric bill on day 1. That is – the day the panels are installed, your electric bill would fall from, say, $100 to $90, and your payments are a lease to the SolarCity rather than paying directly for power from the utility. Second, utilities’ costs and therefore electricity prices continually rise at the rate of 3-5% per year. This has occurred since the early 1900’s. This means that if a customer locks in a 20-year, fixed rate lease on their solar panels today, the savings they generate will only increase over time as utility prices go up and the lease payments remain the same. Lastly, and not nearly as significant as the immediate savings or economics of the lease contract, there are intangibles such as the ability to generate green energy and show up neighbors in having the latest cool technology.

There are two types of companies entering the residential solar space. The first group are what I’ll call the “legacies” – large solar manufacturers or utility holding companies- some of which have been in the energy industry for 50 or more years. The second group are the asset-light “startups” such as SolarCity, Vivint, Verengo, and SunRun. They are all focused on the same goal of capturing the residential solar customer base, but the first group of legacy companies has less capital invested in making this happen. Additionally, since they have existing businesses – even though they have more resources in some cases – they haven’t invested as aggressively in building out a residential platform. Some have even been accused of chasing growth at the expense of their existing businesses.

The distinction here is simple. Unlike SunEdison or NRG Energy, SolarCity and the other “startups” are focused exclusively on residential solar (and to a smaller extent commercial solar, which I’ll get to later).

Between the residential solar companies, SolarCity is by far the largest. In their latest investor presentation, SolarCity states that they are larger than their next 36 largest competitors combined and have a 36% market share. This share has increased every year from 6% to 7% to 11% to 17% to 25% to 33% to 36% for the years 2009-2015. My expectation is for this gap to continually widen, and that SolarCity may hit 50% market share in residential solar organically sometime in the next decade.

Competitive Dynamics

Porter’s five forces of competition- while crude and rudimentary- are the five forces that impact a firm’s competitive chances for success. The five are the threat from buyers, suppliers, substitutes, new entrants, and existing competitors. Of the five, many have (correctly) posited that by the far most important force is that of new entrants, and the barriers they must overcome to compete in the industry. This is highly relevant in residential solar, as the barriers to compete effectively with SolarCity are virtually insurmountable at this point, and the gap will only continue to widen. This is the main source of their competitive advantage.

The reason for this is that SolarCity is one of, but not the only, the first movers in the industry. All the major residential solar companies started around the same time – between 2006-2009 – and all had differing levels of funding. SunRun had an initially lead on SolarCity, although they did not pursue the same level of funding, and are now significantly behind. Elon Musk, founder of 3 billion-dollar plus companies (PayPal, SpaceX, Tesla Motors), was one of the main funding sources for SolarCity and he remains their largest shareholder (21%). He also serves as their Executive Chairman and provides advice to the Rive brothers, who run the company as CEO and CTO.

Additionally – in the same vein as their competitive advantage through barriers to entry – it is hard to build out a large organization that benefits from economies of scale the way SolarCity does. They have incurred accounting losses and negative cash flows each year since going public late 2012 and this is all in the name of one day having a large sales force, customer panel maintenance team, and access to the cheapest capital. SolarCity was the first – and only – solar company to offer consumer solar bonds that could be bought through their website. They also were the first to get highly attractive securitized solar funding for their growth, which cost far less than borrowing from tax equity investors or the banks. Finally, buying panels in bulk (or one day producing them yourself, as SolarCity currently plans) gets a steeper discount as well. All of these combined, in addition to superior technology on an efficiency and installation cost basis, leads to an insurmountable moat around the business for new entrants.

And if you don’t have to worry about new entrants, all you must do is assess existing competition. The “startups” I discussed earlier are not much of a threat, as they are the same model as SolarCity but far earlier in their development. One – Vivint Solar – was a private equity-owned home security business that leveraged its customer base to start offering residential solar. Now that all their existing customers have been cross-sold to, and that they are only around 8% market share, it seems their growth will slow in comparison to SolarCity, who has signed up all their customers organically since the start. Ultimately, these companies will have a place in the industry but never to be larger than SolarCity.

The second type – the “legacies” – have the resources and access to capital that might be able to disrupt SolarCity’s chance at being the top dog. But as of now, it appears they are missing their chance to build out a full organization and I don’t envision any of them making a major play to be the industry leader.

Commercial Solar

Commercial solar – the business of massive solar farms for utilities – is a very different model. The margins are smaller, the efficiency is lower, and one of the crucial things that make utilities non-competitive with residential solar also apply here. The transmission and distribution of electricity is expensive and inefficient, compared to panels on your own roof. You must maintain the miles of equipment and you lose a portion of your energy before it reaches the source of use. Commercial solar has these disadvantages the same way the utility does today.

However, commercial solar is still an opportunity in states where it is required, and these are often very large projects. Berkshire Hathaway’s regulated utility holding company – previously named MidAmerican Energy – is one of if not the largest commercial solar investor in the country. The returns are virtually guaranteed, partially subsidized by the federal government, and the returns are pretty decent. As a result, money is pouring into these projects around the country.

SolarCity bids and competes for these contracts, and it is roughly 10-20% of their total installed capacity. It presents an enormous opportunity, as both commercial and residential are at <1% market penetration rates, but the focus seems to be more on residential at today’s juncture.

Summary

As should become obvious, there is a lot to say about SolarCity and it is difficult to get it all together in a cohesive form. I have a finished report on them that is 23 pages long and it should likely be much longer. I also have a slide deck on them that is 66 slides long. Needless to say, this isn’t your Coca-Cola or Wal-Mart type investment. It requires significant study and the best I can do is to illuminate the most material aspects thereof.

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SolarCity Part I: Chanos Wrong on Dell, Again Wrong on SolarCity

“The amount of energy necessary to refute bullshit is an order of magnitude bigger than to produce it.”

Before starting this post, I just want to point out this quote. In order to disprove erroneous ideas and improperly understood facts, a significant amount of energy is required. However, as I’m pretty outraged by this latest smear campaign by Jim Chanos, I’ve decided to start a series of posts on SolarCity. This first one will focus on Chanos’ credibility. Hereafter, I will focus exclusively on SolarCity’s business and valuation.

—————

If you’re wondering who Jim Chanos is, he’s the infamous short seller who is often brought on CNBC because of his bold, and often wrong, predictions about the various stocks that he bets against. He got his reputation by betting against Tyco and Enron, two of the most celebrated short positions any investor could ask for in starting a career in shorting.

The reason I know who Chanos is is simple. He has now shorted two companies that I invested in long-term. The first was Dell, which if he kept his position in, he had to have lost a fair amount of money, because he was short throughout the deal talks when Michael Dell ultimately took them private. He doubled down on his statements throughout the merger talks, saying he wondered if Mr. Dell was even looking at the numbers. Well, as a fundamentalist value investor who owned the stock, it was obvious Mr. Chanos didn’t understand what he was looking at. At a 25% premium to the previous price, at $24 B, the stock was roughly taken private around 8x earning power. I bought in closer to 6x earnings, maybe even 5.5x. But regardless, it was fairly obvious to me that the business had enough earning and staying power to do well in the future. Mr. Dell took it private to further realize the same vision.

Another investor who uses television to their advantage, Carl Icahn, was asked about Chanos. Just as with my suspicions, this was his reaction to Chanos being short Dell:

“I’ve been on the other side of him [Chanos] many times and I’ve made fortunes being against him,” said Icahn. “I don’t mean this in a derogatory way, but I don’t see Chanos on the Forbes 400 list.”

Even more importantly, however, is the current maelstrom surrounding SolarCity, my top stock position today. Chanos has recently, and very loudly, come out short against them.

SolarCity

SolarCity is the most misunderstood stock in the market today. With everyone fixated on short-term profits, it’s no surprise that this business is punished for not having any. Despite the lack of accounting profits and very confusing cash flows, I believe SolarCity to be of the highest caliber business, one day likely to reach a market cap of >$100 billion. Comparing that to today’s price, that’s roughly 25-30x your money or more.

The problem with someone like Chanos shorting this stock is that it is too complex for him. If he got Dell wrong, he certainly will (and did) miss the mark on SolarCity. The business will take me many blog posts to explain – and I do plan on doing exactly that now that the business is so cheap. You’ll have to take my word for it now, but GAAP losses are not what they appear. Nor are the incredibly convoluted cash flows that the business generates each year.

Chanos called the company a subprime lender on television, only to have the CEO come on later to say the average FICO score of their customers is 750 (my father is a surgeon and he may not even have a FICO score this high). Rather than rescind his comments, Chanos found other areas to complain about.

Chanos thinks that as solar panels get cheaper, and give consumers a better deal, early adopters will be frustrated with their old contracts and seek to default on them. However, the bulk of the hardware cost declines have already been realized. They will continue to get cheaper, yes, but it will not be half as cheap or whatever percentage Chanos has concocted up.

Additionally, he is valuing this business based on book value, just as he did with Dell. This is pretty stupid, as the business is not a bank and worth far more alive than dead. It really is just a lazy way to measure the worth of a business.

Lastly, and I rarely give analysts credit, an analyst at Raymond James had some great thoughts on Chanos’ short: “Chanos’ position shows a lack of understanding of SolarCity’s business model,” Pavel Molchanov, an analyst at Raymond James Financial Inc., said in a phone interview. He has the equivalent of a buy on the stock. “Utility rates keep going up, and so for the SolarCity customer, it’s almost certainly going to be cheaper.”

To sum it up perhaps best in the words of the SolarCity CEO:

“I think it’s a high risk to take a short position in a company that’a growing 50 percent a year,” Rive said in a phone interview. “Every part of the business is operating extremely well.”

Best advice I can give to you is to avoid Chanos. He’ll only lead you astray.

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Valuation: Thinking Like an Owner

One area academics seem to confuse significantly is the subject of valuation. Sitting through my finance courses in colleges did little, if anything to help solidify my views on how to value a business. Theoretical models of discounted cash flows, residual income models, and regression analysis seemed to skirt the crucial issue of valuation. That crucial, and yet often-overlooked view of valuation, is exceedingly simple but not necessarily easy to figure out. It is this:

As a potential owner, what am I willing to pay for this business?

This eliminates much of the noise that typically arises in classrooms. The risk-free rates, risk premiums, securities market line, and beta all attempt to use outward-facing metrics to understand individual securities. They all ask what other market participants are paying for securities as opposed to what you, the individual, would pay for them. If you were looking to engage in market arbitrage this would be a different discussion, but alas, the valuation we are pursuing is for that of an owner, not someone looking to buy and sell quickly for a short-term, potentially riskless profit.

To take this fallacy a step further, would the collective opinions of home values from everyone living on a street influence your purchase decision? I sure would hope not. That decision to buy a house is yours and yours alone to make. You can ask what property values are in the area to get relative valuations, but at the end of the day the purchase decision should come down to absolute numbers and qualifying information that influences you. Businesses are not any different.

One quote comes to mind before I proceed into my thoughts on valuation, which is a quote from Warren Buffett:

“It has been helpful to me to have tens of thousands turned out of business schools taught that it didn’t do any good to think.” ~Warren Buffett

his is a powerful comment directed at the academic work on valuation over the past 50-70 years. Unfortunately, this is what most financiers come inundated with when they reach the real world. They may have the tools as provided by highly complex applied statistics and market theory but the intuitive thought behind buying a business is largely absent.

So in attempting to answer the question of what I am willing to pay for the business, I focus on a few key areas.

Business Quality

This gets the most attention from me and encompasses a significant amount of my analysis. I look to returns on capital in a few different forms to drive this from a quantiative and consistent methodology. But additionally, and just as important, I study competitive dynamics, customers, cyclicality, industry trends, and management, to name some major categories. The collective qualitative information I gather, alongside the returns on capital metrics, helps me to place a business into one of a few categories for valuation. The low quality businesses get far less respect than the higher quality ones, as quality significantly influences corporate performance over the long term, and I adjust strictly for it with my valuation model.

Future Growth

This is also highly important to me, as a business growing quickly will become worth far more than one that stagnates over the next 5 or 10 years. But in tying this back to business quality, that growth must come from a productive source. Share issuances, dilutive acquisitions, or other value-destructive means of growing the business should still be avoided. Retained earnings in high return businesses account for additional premiums I will place in my valuation, assuming the growth is sensible and in line with my expectations for the industry in question.

Although there are many ways to divide up the way I approach valuation, these 2 categories take the lion’s share. This is especially the case for business quality, as so much goes into that assessment.

Pulling It All Together

From here, it comes down to asking yourself about what you want from a business. Are you buying it for the assets the business owns? If so, it is likely the business isn’t earning a reasonable return on those assets and you would do best in an orderly liquidation scenario. The majority of us buy businesses for the stream of earnings over time, with the belief being the business is worth more alive than dead.

In assessing earnings, an analyst should look to understand the differences between the cash flows and income statement. There will be major non-cash items deducted that shouldn’t be, or just as important, some cash items that are not deducted which should be. This is more of an art than a science, although repetition a few hundred times helps to cure any struggle that might arise. Ultimately you are trying to come up with the economic value created each year by the enterprise in question.

Once you can come up with 1) an approximation of annual earning power 2) business quality and 3) future expected growth, you are well on your way to sensible and intelligent valuations. And just as you would prefer to walk around inside a house you are looking to purchase, rather than ask the neighbors, so too should you attempt to “walk around” inside the businesses you are looking to buy stock in.

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