The Investing Game Has Changed

The Investing Game Has Changed

When valuing a company, the objective for the investor is to try and find a gap between price and value—between expectations and fundamentals. Expectations reflect the market’s perception of the future free cash flows a company can generate to justify its price in the market. The fundamentals hold the truth to those expectations. The investor generates excess returns by discovering a mispricing between the two.

Of course, in order to do a proper valuation—getting to the core of the fundamentals—the investor must have a firm grasp on the company’s prospects for creating value.

So how does a company create value?

Some say that a company creates value when it turns a profit. This is only a half-truth.

Others say that a company creates value when it generates a positive return on invested capital. This is also a half-truth.

The truth is that a company creates value only when it generates a return that is higher than its cost of obtaining and investing that capital.

Hence, it follows that a grasp of the magnitude, cost, and return on the investments a company makes is central to understanding value. It’s simply imperative.

The other side of the equation is growth. What are the opportunities for the company to reinvest their cash flows in the business while maintaining or improving their returns on that capital?

Two Nobel Prize winners, Merton Miller and Franco Modigliani, clearly outlined this point in their 1961 paper titled “Dividend Policy, Growth, and the Valuation of Shares”. They stated that the investor can think of company value in two components. The first component is the steady state, which assumes that the business can sustain its current level of earnings into the future. The second component is the present value of growth opportunities, which is based on the magnitude of investment, return on investment, and period that investment opportunities are available.

Remember the truth behind value creation: that a company creates value when it generates a return that is higher than its cost of obtaining and investing its capital. Now couple that with growth. The truth also holds that a company can grow immensely without creating a dime of value for its shareholders—and that growth can even be value-destructive to shareholders. If the company’s return on investment equals its cost of capital, the present value of growth is exactly zero and the value of the business could then only be equal to its steady state.

Here’s the conclusion: in order to properly assess a company’s future earnings, cash flow generation, and value creation, the investor must grasp the company’s current and future level of investment a company makes as well as the possible return on that level of investment.

Now, here lies the contemporary problem when doing valuations.

The world of business is not the same as it once was. The world has changed. And that change has been led by the rise of intangibles and a continuous jumble of accounting rules.

Once upon a time, the majority of the value at most companies stemmed from investments made in tangible assets. These were things like plants, machinery, raw materials, and so forth, which were transformed into finished products and sold in the market.

So when the investor looked at a company’s balance sheet, he or she would likely have a fair representation of the operating assets actually invested in the business.

This is hardly true today. The dawn of the information economy has altered the environment and accounting hasn’t been able to keep up even though the amount of rules and regulations has gone up significantly (the average length of an annual report was 45 pages in 1996 which has increased to about 185 pages in 2018).

Intangible assets comprise investments that are expected to generate value for the company in future periods but are not visible. Examples include product design, brand value, software ability, data advantages, and so forth.

Because such intangibles today take up so big a part of the modern economy as compared to the past, the result is a mismatch of what shows up on a company’s income statement and balance sheet. When expenses, which really are investments, are charged to the income statement, it suppresses earnings as well as the asset side of the balance sheet, blurring the investor’s view of the company’s true investment and earnings capacity.

The principle is that the investor can’t project a company’s future cash flows unless the investor knows which assets are in place to generate them. And the investor can’t know a company’s assets in place by just thinking about the capitalized ones. Thus, one of the first things the investor should ask about any business (besides understanding the business) is this: is the balance sheet knowable?

Other issues arise when companies make significant write-offs to lower the depreciation and invested capital base or build reserves that discretionarily smooth out earnings over the following earnings periods. A lower asset base makes returns on capital look higher than their reality and earnings manipulation clouds the investor’s judgment in making predictions about future earnings.

All in all, it’s not a bit easy.

The unfortunate truth is that the accounting earnings for many businesses bear little or no resemblance to the true earnings of the business. So how can the investor value that business properly? The investor can’t. Not with clarity, that is.

So in order to properly value the business, the earnings of the business, as measured by accountants, must be adjusted to get a measure of earnings and investment that is more appropriate for valuation.

Only when the right accounting adjustments are made can the investor approach a valuation with clarity.

Let’s now go through the valuation process.

Any valuation of any business is a function of three core elements: expected cash flows, growth, and risk.

These will forever be present no matter if investors decide not to forecast them, let alone think about them. But that would be a mistake. There should be no disagreement that the value of a business comes from its future cash flows and the uncertainty one feels about those cash flows.

Hence, we can illustrate that every proper business valuation goes through the following process and acknowledge that no valuation is really complete without it.

The process of valuing a company

First, an investor shouldn’t attempt to pursue a valuation of a business without thoroughly understanding the business itself and its industry first. That would be like driving a car without a steering wheel. Logically, this is where the vast majority of the time should be allocated.

If the investor gets that first part right, the valuation part should be rather easy. If it’s not, either the investor shouldn’t proceed with attempting to value the company, or the investor should go back to the first step until it is.

Once that is nailed down, the next step is to recognize that economic earnings are very different from accounting earnings. We have already gone through this issue.

Next, a proper financial analysis requires that the investor studies the company over its lifetime or a minimum history of 10 years. It requires gauging how the company’s value drivers show up in its numbers. The investor should already have an idea about what those value drivers are from the first step in the valuation process but they can only study them with clarity by making the necessary accounting adjustments in step 2.

The next step involves taking the knowledge the investor has about the business, its value drivers, and the industry and attempting to print out the company’s numbers for the next 10, 20, 30 years or into perpetuity with a certain confidence.

These cash flows are then discounted back to present value using the risk-adjusted opportunity cost of capital for each claim holder of the cash flow.

And, to lastly arrive at the value of equity, the investor should add excess cash (or all non-operating assets) and subtract out the value of other claim holders. Again, to properly add and subtract the correct amount from the enterprise value, they will again most definitely need to have made the necessary accounting adjustments in step 2.

need to have made the necessary accounting adjustments in step 2.

Here’s why the Sanity Check model is the perfect tool for the valuation process.

The Sanity Check model is an Excel-based model arranged in such a way that a company’s financial consecutively go through each of the steps in the valuation process.

(To be clear, this is all the work needed to be done after the first step of thoroughly understanding the business and its industry.)

And this is exactly why I named the model “Sanity Check”: it’s a sanity check on your own understanding of the business. That you haven’t missed anything important, be it a red flag or gold nugget. That your valuation of the business simply makes sense.

Using the company’s accounting statements, the Sanity Check model easily helps in making the necessary adjustments all in one tab which will automatically translate into fully adjusted and reformulated statements. Consequently, all metrics used in the financial analysis and valuation will be based on your fully adjusted numbers, allowing you to analyze and value the company with complete clarity.

There are major advantages to this.

First, it mitigates bias in a valuation. Biases often occur in valuations due to incomplete information or lack of overview, leading the investor to base estimates on hunches. The Sanity Check model makes sure that every relevant measure is right in front of you to make intelligent decisions on what estimates to put on your cash flow predictions.

Second, it mitigates uncertainty due to the triangulation of different valuation angles.

Third, it saves a lot of time.

Fourth, and I believe most importantly, it allows you to look at thousands of different companies through the same lens and framework. This is really powerful.

But here comes the very best part.

You don’t need to do your own work to reap the beauty of the Sanity Check model.

The Sanity Check database is a place where you can access all Sanity Check models made for every company I look at. I upload valuation models and full analyses of interesting companies almost every day from all over the world. You will find companies in the United States, China, India, and many more countries. In other words, let me do the hard work for you and uncover investment opportunities in a fraction of the time.

All you need to do is go through the database, find a company you find interesting (and understand), download the model, and you will have my complete accounting adjustments (with up to 20 years of historical financials) and valuation work of the company’s financials right at your fingertips.

After getting a grip with the Sanity Check model and the database, you will know exactly where to focus at every business you analyze. And the more businesses you analyze, the more knowledge you can compare and reflect on. You will very quickly start seeing patterns and how you should think about the value and potential behind each business.

Your learning pace, ability to value companies, intuition, and investing decision making will improve exponentially. Your investing game will never be the same.

You get access to the Sanity Check model and database today by becoming a member of Junto. But that’s not all you get. As a member, you also get: two new company write-ups per month, access to my growing library of write-ups, access to my investment portfolio, and members-only emails for any portfolio changes.

Become a member today by clicking here.

I look forward to welcoming you aboard.

Oliver Sung

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