Saturday, 7 November 2015

Modelling Future Growth (It's not easy)

I've started thinking that my ongoing attempts at modelling valuation and determinations of corresponding "possible" margin of safety ranges needs to be constantly refined.

On the one hand, I feel as if I have the beginnings of a working understanding of how to determine a possible range of valuations given different required returns ("Re"), and different possible growth rates.  On the other hand, the market seems to ascribe premium valuations to the most successful current businesses, like Facebook, or Amazon, or Google, which, in all fairness, are fantastic businesses.

The sceptic in me believes, after reading the likes of Seth Klarman and Howard Marks, that fantastically innovative, disruptive businesses such as those above, making 52 week highs almost daily are not fair stomping ground for deep value investors (which I would sincerely like to be).

I've noted previously that in analyzing two stage free cash flows over a range of different growth rates and required returns and aggregating the results of this analysis into a cash flow matrix, that I prefer operating in the upper right hand corner of my valuation matrix.  This means that if the current market price is so despondent as to be pricing known or likely cash flows at a premium to current market price, it's possible that there may be a margin of safety.

Here's the rub though: "define despondency".  The more I think about all of this, the more I realize that there are a heck of a lot of smart people looking at the same situations that I am.  For the most part, they are better capitalized, more experienced and more resourceful.  The only possible edge I may have as a small fish is to buy despondency.  But the act of buying despondency goes against my (and probably most investors') intuitive nature.  The market will likely only get despondent in terms of an individual idea if the idea is in the doghouse.  Case in point, yesterday, a company called Iconix Brand Group was down close to 60% on an announcement of accounting improprieties.  I looked briefly at the company as it was down, and passed on further research as it was levered up almost 3:1 in terms of debt to equity.  The company has a stable of consumer staple type brands though, Joe Boxer, London Fog, Umbro, etc.

Here's a brief comment from a current institutional shareholder (from gurufocus):

'Iconix Brand Group (NASDAQ:ICON) is a brand management company and owner of a diversified portfolio of global consumer brands across women’s and men’s fashion, entertainment and home segments. Iconix has endured a complete change of senior management with the CFO, COO and CEO all leaving in the first half of the fiscal year. In addition, the company has had to adjust earnings expectations down, as continued disappointment in the men’s division and a shift in timing of revenue from the anticipated November launch of The Peanuts feature film made meeting original guidance difficult. We have revisited our key assumptions behind our Iconix investment and are comfortable that the underlying asset-lite, high margin, licensing business model remains intact. While investors have become nervous about the company’s high leverage, Iconix has minimum revenue guarantees from many of its licensees which provides a reliable stream of free cash flow. Our continued due diligence including conversations with interim CEO Peter Cuneo, who has extensive consumer product licensing experience, provides comfort that Iconix is headed in the right direction. We added to our position over the calendar year on price weakness. 

From Wallace Weitz (TradesPortfolio)'s Partners Value Fund commentary for third quarter 2015."

I'm not suggesting anyone buy Iconix, but here's a great real time example of despondency.  

Back to valuation in the context of despondency.  For the most part, I believe that as long as a company is large cap, widely held, firing on all cylinders, and held in high esteem by the investing community, it's going to be a very rare occurence for me to be able to buy such a company at a deep discount to my estimates of intrinsic value, unless the entire market goes into a swoon like 08/09, or something alters the current perception/paradigm held surrounding the company's future prospects.  

All this said, I believe that one of the ways for me to be able to make use of my free cash flow valuation matrix in the context of evaluating large cap, widely held companies is to be able to roughly interpolate what the market is expecting in terms of current valuation, and then be prepared to act when great companies get swept up in an overall swoon and fall into the middle or upper right location of my valuation matrix.

Here's an example using Facebook.

Facebook reported free cash flow of $3.9B for the 9 months ended September 30, 2015.  Annualizing this, I get $4.65B.  Taking just the reported free cash flow as is, with no analysis of the components of free cash flow, here's my valuation matrix:


Sum of DFC'sRe =
G = 8%9%10%12%15%Average, growth, blended Re
0,025.9923.7221.9019.1816.4621.45
1,026.8924.5022.6019.7416.8822.12
2,130.1927.0924.6921.1917.8224.19
3,2.532.8029.1426.3522.3518.5825.85
5,2.539.5334.2530.3830.3820.3430.98
8,456.2245.9739.1439.1423.6440.83
10,576.9058.8748.0548.0526.4751.67
12,6118.5880.5861.5842.6129.9866.66
Average, Re, blended growth50.8940.5234.3430.3321.27
Current107.1107.1107.1107.1107.1


If my assumptions regarding free cash growth are reasonable, then it appears that the market could be pricing in growth of between 10% and 12% from years 1-5, between 5% and 6% from years 6 through 10, and between 5% and 6% terminally.  It also appears that investors may be discounting these cash flows at 8%.

Here are the problems with the analysis:

  • Are 10-12% near term growth, 5-6% intermediate term growth, and 5-6% terminal growth all too low?  If Facebook grows at 20% over the next 5 years, then $107 is cheap.  This is one possible explanation for the current premium valuation.
  • Is it correct to take free cash flow as reported at face value?  See the company's free cash flow reconciliation below and judge for yourself. 
















A careful examination above shows that share based compensation of $2.2B for the 9 months ended September 30, 2015 exceeded "GAAP" net income for the same period.  Although it's standard practice to add non-cash charges back on the statement of cash flow, using common sense, what is the likely future impact of the SBC awarded?  As long as the stock price continues to appreciate, the impact will be dillutive to existing shareholders.  As I don't expect Facebook to stop the practice of awarding SBC, here's the recast valuation matrix starting from FCF adjusted for SBC, equivalent to $3,941 - $2,214, or $1.73B

Sum of DFC'sRe =
G = 8%9%10%12%15%Average, growth, blended Re
0,015.6914.5613.6612.3110.9613.44
1,016.1314.9514.0112.5911.1713.77
2,117.7716.2415.0413.3111.6414.80
3,2.519.0717.2515.8713.8912.0215.62
5,2.522.4019.7917.8717.8712.8918.16
8,430.6825.6022.2122.2114.5323.05
10,540.9331.9926.6326.6315.9328.42
12,661.6042.7633.3423.9317.6735.86
Average, Re, blended growth28.0422.8919.8317.8413.35
Current107.1107.1107.1107.1107.1

As you can see, I'm not even on the map here in terms of interpolating G.  In order to interpolate G over the short term (and for my model to work), I have to assume almost 30% G over the short term and 6% thereafter.


Sum of DFC'sRe =
G = 8%9%10%12%15%Average, growth, blended Re
0,015.6914.5613.6612.3110.9613.44
1,016.1314.9514.0112.5911.1713.77
2,117.7716.2415.0413.3111.6414.80
3,2.519.0717.2515.8713.8912.0215.62
5,2.522.4019.7917.8717.8712.8918.16
8,430.6825.6022.2122.2114.5323.05
10,540.9331.9926.6326.6315.9328.42
27,6108.9073.6055.9838.4026.7560.73
Average, Re, blended growth33.9526.7522.6619.6514.48
Current107.1107.1107.1107.1107.1


Concluding Thoughts

I believe that the art of valuation can only be taken so far, and that common sense has to take over at some point.  One of the major drawbacks to my model is that once I get to the terminal year, I can't estimate terminal growth in excess of my required return as the model spits out a nonsensical result. 

Personally, as an investor looking for ideas which can be bought with a probable margin of safety, I can't afford to play in the arena of chasing growth, as a lot has to go right for companies trading at premium valuations in order for these valuations to persist.




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