“Value” Investing

You got to remember, that in our way of thinking, all intelligent investment, is value investment. Because why would you want to buy something which wasn’t worth as much as you were paying for it. And who wouldn’t like buying something for less than it’s worth?

Charlie Munger

With all the hype around the stock market and influx of new “investors” entering the game over the past year and a half, I find myself explaining investing and the stock market to newcomers more often. It’s not easy. Not because beginners aren’t capable of understanding, but because investing is so nuanced. Like many fields, the deeper you go, the more grey the “rules” become. For example, what is the “right” discount rate to use? The risk-free rate? Weighted average cost of capital? Hurdle rate? Opportunity cost? None of the above?

There is no “one size fits all” approach to investing. While some people like to buy stocks based on their quantitative characteristics, others like to jump on the hottest rocketship to the moon and hodl on for dear life. Everybody’s style is different because everybody’s personality is different. No approach will guarantee success. That being said, there is a way of thinking that will more likely to sustainable returns over the long-term and that just so happens to also more accurately describe how the stock market operates. In this post, I will attempt to describe this way of thinking in terms unrelated to the stock market yet applicable to the investing. In fact, it’s applicable to any transactional decision, not just investing.

*** The objective of investing is to lay out cash now in order to receive more cash in the future. Whether it’s for retirement or enjoyment, the objective is the same. The two ways to receive more money in the future are periodic cash flows in the form of interest or dividends, or selling for a higher price. Both of these are dependent on a business’ ability to generate free cash flow. As Michael Mauboussin explains, everything is a DCF (Discounted Cash Flow) model, even if an investor does not explicitly construct one. In a similar vein, as Charlie Munger states above, all intelligent investing is value investing. The value investing mindset is to buy something for less than its worth. For financial assets, “worth” is the present value of the distributable cash flows over the asset’s lifetime, discounted back to the present. The price of a financial asset is simply the market’s estimation of what the asset is worth at any given time. Since stocks represent equity ownership in a business, their value is derived from the underlying business. The stock price is simply what market participants, on average, think at a point in time; where sellers and buyers offset. Therefore, value is driven by what the business does, while price is driven by what the market does. At its core, investing is simply comparing value and price. What do you get (value) for what you pay (price). ***

So, how does this help a person who is new to investing, understand investing? How can this be better understood in a non-investing context? Well, let’s apply this concept to non-financial assets, something everybody can relate to. They too have a price and a value. But for assets without cash flows, value is much more subjective. The value two people place on the exact same thing will differ. There is an emotional aspect to it – how does one feel owning something. Some items will be “worth” more to one person than another due to their utility or status signal. Willingness to pay is influenced by one’s priorities, preferences, and personality.

Art is a perfect example. Or, more recently, non-fungible tokens (NFTs). But let’s take a basic example: buying a T-shirt. A not-so-wrong perception of old-school “value” investors is that they like to buy things cheaply. So when looking at T-shirts, low price is the main priority. For another person, say a “growth” investor, style and brand are the main priorities, so they are comfortable buying higher priced shirts. The price of a shirt is simply the amount the store is willing to sell it for. But how much value is placed on the shirt will depend on the person. So different T-shirts are bought by different people.

If the value you get from something is greater than the price, you buy it. It’s worth it.

If the value you get from something is less than the price, you don’t buy it. It’s not worth it.

Additionally, is it logical to only look at the price of the T-shirt? Would you buy a mystery T-shirt if it suddenly went on sale? Or if it suddenly jumped in price? You might assume that you’re getting a bargain or that it’s a popular item, but without knowing what the T-shirt looks like, it’s a shot in the dark. Without an assessment of whether you’d actually wear it (get value from it), you have nothing to base your buying decision on.

Let’s go deeper. We can also think about whether to buy something in terms of usage. Put simply, price divided by times of use. Buying a $10 T-shirt rather than a $50 one seems like a no-brainer. But if you wear the $50 T-shirt 50 times and wear the $10 T-shirt 10 times, they can be thought of as having equal value ($1 per use). Why wouldn’t you wear the cheaper T-shirt as often? Maybe because it gets worn down more quickly because it’s made more cheaply. Or maybe the occasions you could wear it come around less often. Once again, this can be relevant to any item of use. The more you use something, the more value it provides you. The less use, the less value.

That’s partly why quality is so highly sought after; a high-quality asset should withstand more usage. However, because higher quality items are more costly to produce, they are more expensive. Seems logical. Not only is this applicable to products, but also to stocks. Generally speaking, a high-quality business is one that is durable, meaning it can grow at a high rate for a long time, through economic ups and downs, and sustain high returns on capital. Stocks of durable businesses are long term winners, despite their seemingly “expensive” valuations at any given time. Over the long run, durability matters more than price. In other words, the market perennially underestimates the business’ value, so the stock price must rise to catch up.

The problem is, people are notoriously bad at estimating how many times they’ll use something! How often do you wear that item of clothing or accessory you bought a while back? Or how many shows do you watch on the multiple streaming platforms you subscribe to? Or how often do you use that gym membership…? If you don’t use something as often as you expected you would, was it a good purchase? Or was it a waste of money?

Similarly, in the stock market, expectations are also often incorrect. But instead of your expectations for how often you will use something, the market has expectations for how often the world will use the business’ products or services. Essentially, the market is continually guessing how bright or cloudy the future is for every business! Where are these expectations? In the stock’s price. What the heck does that mean? As Michael Mauboussin elegantly puts it, “expectations reflect the future free cash flows a company must deliver to justify today’s stock price.” How can one determine these expectations? It’s not easy! But broadly speaking, they can be approximated by looking at a stock’s multiple, such as Price to Earnings (P/E). A multiple is simply a shorthand for, you guessed it, a discounted cash flow model. The higher the multiple, the higher the expectations are for future cash flows. In other words, the market is pricing the company at a high valuation on current metrics because the future is supposedly wonderful. Whether or not the business surpasses the market’s expectations determines the trajectory of the stock price. If the business has a more successful future than the market expected, the stock rises. If the business falls flat of expectations, the stock drops.

This brings us to the final part: value is solely tied to the future. When buying a product, you don’t know how you’ll truly feel owning it nor have you been able to use it yet. You may have an idea, but you can’t be sure until you buy it. The value that you get from it has yet to occur and the future is uncertain. If you know the product well, the more confidence you can have in your purchase. The less you know, the less confident you should be. Why do people look at product reviews so often? They want to know exactly what they’re getting in order to judge whether buying it is worth it.

Similarly, the value of a business is linked to what it hasn’t done yet; the expected cash flows it has yet to generate. The past can only give you insight into what happened, but the future has many possibilities. Many beginner investors buy a stock because the company had a great year. But the market doesn’t care about last year; it cares about next year, and the year after that, and the year after that, and so on. Investing is about attempting to determine the most probabilistic future for a business and continually updating those beliefs based on new information.

So, that was a lot, and a somewhat tortured analogy. But I hope it makes some sense in that investing is somewhat like any buying decision in that we seek out discrepancies between value and price. We want to buy something for less than it’s worth.

There are, however, some important distinctions. We can somewhat control how much something is worth to us, but we have no control over how much a business itself is worth. Nor can we control how the market adjusts its expectations for the business, which creates stock volatility. We can only perform rigorous analysis of the business model, industry, competitive dynamics, future opportunities, and quality of management with the currently available information. It takes more work, but the rewards can be enormous.

My unsolicited advice would be:

Whenever buying something, consider the value it will bring to your life in terms of how you’ll feel or the usage you’ll get from it, and how realistic your expectations are.

Whenever buying a stock, consider the intrinsic value of a business in terms of its ability to generate cash flows and the durability of it’s competitive advantage, and how realistic the market’s expectations are.

Most people do not think this way, in the stock market or in life. It is much easier and more satisfying to impulse buy things or speculate on where the stock price will go next. I’m not saying that won’t work; the market is a psychological and emotional game and you must be comfortable with your own strategy. But, no matter how many lines are drawn on a chart, the stock price will inevitably converge to the business’ value. Adopting this mindset may prevent you buying assets that actually turn out to be… worth less.

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For those interested, I’ll provide a personal example of the same company’s product and stock: Tesla.

I recently ordered a Tesla Model 3 because I’m now driving much farther to work and also needed to purchase a new car anyway. My priorities (or what I value) are economic mileage, a great driving experience, ease of purchase, and a little bit of status. I concluded the Tesla model 3 was worth the price of $52,000, paid over 7 years. I could turn out to be wrong! My brother’s girlfriend also bought a new car, but she “could not imagine” paying that price for “just a car.” Fair point! Different personality. In terms of usage, driving the car every day for 7 years comes out to around $20 per day, or just under 50 cents per mile only including the distance to and from work. Obviously this excludes the cost of charging or any expensive maintenance (or collision) repairs. But also assumes that I don’t use the car for more than 7 years or sell it. The future is uncertain; I can only project based on knowable information and react to surprises as they come.

Since I bought the car, would I buy the stock? That question can be re-framed as, “do I think Tesla is worth more than it’s current market valuation?” Or put another way, “do I think Tesla can surpass the market’s expectations for future cash flows?” Tesla’s market cap is currently around $730 billion and its share price is $737. Is it worth more or less than that? Lets do a quick back of the envelope intrinsic value calculation.

Let’s say, over the next 10 years, Tesla was able to grow revenue at an average rate of 25% per year. A fantastic result for any company, let alone an auto manufacturer. For context, they’ve grown revenues at around 35% per year from 2016 to 2020, going from 5.3bn to 31.5bn. But, growth usually slows as businesses become larger due to the law of diminishing returns. (Side note: people always say “law of large numbers” when referencing slowing growth due to size, but that’s completely incorrect. So if you take anything from this post, don’t make that same mistake.) Looking at only automotive sales, in 2020 they generated 26bn from selling 500k cars, resulting in an average selling price of $52k. Wall street expects revenues to grow 60% this year, and then 37%, 24%, 10%, and 20% in the subsequent years, to arrive at roughly 112bn in 2025 (~24% CAGR). But Telsa won’t hit maturity by 2025, so projecting out to year 10 at my assumed yearly 25% growth rate, they arrive at 300bn in revenue. That’s more than Ford and GM’s current revenues combined. If Tesla’s automotive segment stays level at 83% of revenues and the average selling price stays around the same, they would need to sell 4.8 million cars. Or, just under what Ford and GM sold this year combined. But Electric Vehicles are the future and Tesla is poised to take market share. Additionally, we should expect Tesla to generate revenue through other sources (charging, battery sales, etc.). So 25% over 10 years is what I’ll project.

Tesla’s operating margins have historically been negative, which makes sense for a company in its growth faze, but recently turned positive at around 6-8%. What are long term margins for a company primarily selling cars? Around 5-10%. Hmm, okay. But Tesla has revolutionized the manufacturing process and has potential pricing power, not to mention other potential revenue generating product lines. So let’s assume margins continue their upward trajectory and hit 25% by year 10. Outlandish for a car company, but we expect Tesla becomes more than just a car company.

Now, revenues and margins are two crucial drivers of a business’ long term success. But, as investors, we care about free cash flows which can be distributed to investors, not accounting profits. Before we go back to our projections, let’s take a gander at Tesla’s accounting Statement of Cash Flows (YE2020). To get to free cash flow, we start with Net Income, then we need to add back non-cash charges, such as Depreciation and Amortization, account for changes in Net Working Capital (short term assets and liabilities), and subtract Capital Expenditures (investments in long term assets). In 2020, Tesla reported Net Income of 721mm; adding back non-cash items like D&A of 2.3bn and stock-based compensation of 1.8bn, adding the change in NWC of 1.1bn, and subtracting Capex of 3.1bn, gets us to reported free cash flow 2.8bn; a free cash flow margin of 9%. Not too bad, but not too great either. (Side note: A more accurate measure of cash flows available to investors is something called “owners earnings,” a term coined by Warren Buffett, which only subtracts the maintenance capital expenditures, netting out spending on growth initiatives, but that’s for another post.)

Back to our intrinsic value estimation: how is it possible to project these variables for 10 years!? It’s not. We must generalize and average out using a few metrics. Let’s start back with Operating Profit. As a high level estimate, we must net out taxes – the government requires their cut – and also account for the estimated re-investments that Tesla will need to make to generate their expected future growth and in order to maintain their competitive advantage.

Tesla’s 2020 Operating Profit was 2bn and they paid 292mm in taxes. Therefore, we can calculate their Net Operating Profit After Tax was 1.5bn (this measure excludes interest expense because we’re valuing the entire firm). Because Tesla has historically lost money, it’s reported a negative effective tax rate. Without going down the rabbit hole of tax credits and deferred tax assets and liabilities, let’s assume a 10% tax rate for the current year, which as the business becomes profitable will eventually go to 21% (the global average) in year 10. Since Tesla has been burning cash by heavily reinvesting for growth, the historical re-investment rate is of not much use. We can also look at the Sales to Capital ratio (how much Revenue Tesla generates from it’s Invested Capital), which is currently around 0.85. As the company matures, the reinvestment rate will necessarily come down and the sales to capital ratio will rise as it generates more sales off the fixed capital base. Let’s assume Tesla only needs to reinvest 80% of NOPAT this year, a conservative estimate, which steadily decreases to 3% in year 10 as the business matures. As a result, the free cash flow margin starts at 9% and climbs over time to 20% since Tesla’s only re-investment needs will be offset by depreciation. For reference, Ford and GM have free cash flow margins of 10-15%. We project Tesla hits 15% in year 6. Using these assumptions, the year 10 free cash flow is approximately 60bn, a compound growth of 35% over 10 years. For reference, in 2020 Ford generated 18.5bn and GM generated 11bn in free cash flow. But Tesla’s future is much brighter than Ford or GM!

So, what does this all mean?! Well, IF, big if, Tesla can meet our projections of 25% compounded revenue growth and 35% compound free cash flow growth over the next 10 years and then settle into a steady state of generating 3% revenue growth forever with 20% free cash flow margins, we would value Tesla at… $587 per share. But… that’s 25% lower than the current price?? Apparently, the market has even rosier expectations than us! Or, the market is discounting the future cash flows at a lower rate than we are. I used a 9% discount rate, which is around the long term return of the market. And it’s my favorite number (see the first paragraph of this post). If instead we use a discount rate of 8%, our calculated intrinsic value jumps to $738, right around the current price. Said differently, IF Tesla actually does meet our projections, Tesla should generate an 8% return per year for 10 years, lower than the average market return. But the cash flows grew 32% on average over that time! Yes, but the market has already priced in that expected growth.

For one to be bullish on Tesla’s stock price the business fundamentals need to clear an incredibly high bar. This is confirmed by the price multiples. Let’s take EV/Revenue, the most appropriate metric for a growing company in it’s investment phase (aka. no profits). In 2019 EV/Rev hovered around 3.5. It ended 2020 at 21, a 6x increase. In 2020, Tesla grew revenue 28% and it’s stock price went up 650%. Numerator up a lot, denominator up a little. If the multiple were to steadily trend back down to where it was in 2019, the stock price go nowhere until 2028.

With that being said, that doesn’t mean Tesla’s stock price cannot go up. Nobody, including me, knows where stock prices will go. At the end of the day, the market can think whatever it wants. As you can see, calculating the intrinsic value of businesses requires a lot of assumptions. And every person will have different assumptions! In my last piece, I wrote a paragraph about Ark Invest’s fundamental assumptions for Tesla. In 2019, even they did not think Tesla’s stock should get to where it ended in 2020. They’ve since updated their projections, of course, to justify continuing to hold the stock. They now value Tesla around at $3,000 per share, a $3 trillion market cap, based on expectations for 2025 of: 507bn in revenue, 176bn in EBITDA (a 34% margin), selling 5-10 million cars, and rolling out an autonomous robotaxi service. Using their ~5% free cash flow yield (not margin) expectation, they think Tesla will generate 126bn in free cash flow. Meaning, going from 3bn to 126bn in 5 years. Wow. Time will tell if Tesla can deliver! Count me as skeptical. So, when I view Tesla through a value vs price lens, I would not buy the stock.