“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 are, however, some fundamental “laws” that new investors should be aware of.

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 work all the time. That being said, there is a way of thinking that is more likely to lead to successful investing over the long-term and that also more accurately describes how the stock market operates. In this post, I will describe this way of thinking in terms unrelated to the stock market but applicable to the stock market. 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. There are two primary ways to receive more money in the future: periodic cash flows in the form of interest or dividends and/or selling for a higher price than where you initially you bought. But, how can one be confident the price will be higher in the future? Well, that depends on a lot of factors, but primarily on a business’ ability to generate free cash flow from which they can distribute as interest or dividends to investors. 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 discounted cash flows over the asset’s lifetime. For stocks, the price is simply the market’s estimation of what the business is worth at any given time. Therefore, value is driven by what the business does, while price is driven by what the market thinks. At its core, investing is simply comparing value and price. What 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 same exact thing can 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. Willingness to pay is influenced by one’s priorities, preferences, and personality.

Art is a perfect example, and more recently, the NFT craze. But let’s take a more basic one: 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 could be the main priorities, so they are comfortable buying higher priced shirts. The price of a shirt is simply what level the store offering it at, but how much value is placed on the shirt will depend on the person. So, different T-shirts are bought by different people.

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

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

Additionally, is it logical to only look at the price of a 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 you’re getting a hot product, but without knowing what the T-shirt looks like, it’s a shot in the dark. Without an assessment of whether you’d get value out of the shirt, 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 over 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 are of 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 can wear it come around less often. This train of thought is relevant to any item of use. The more you use it, 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, they are more expensive. Seems logical. Not only is this applicable to goods, but also has important implications for 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. In general, stock prices for durable businesses are long term winners, even if the stocks are seemingly “expensive” at any given time. Thus, over the long run, durability matters more than price. In other words, the price perennially underestimates the business’ value, so it 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 piece of clothing or accessory you bought a while back? Or watch shows on one of the multiple subscription services you subscribe to? Or 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 the product you buy and expect yourself to use, the expectations for companies are set by the market. Where? In the stock’s price. 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 price multiple. A price 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. 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 price rises. If the business falls flat of expectations, the stock price drops.

This brings us to the final part: value is 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 can think you know, but you can’t be sure. The value you get 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 if it’s worth it.

Similarly, the value of a business is linked to what it hasn’t done yet; the expected cash flows it will generate. The past can only tell you what happened, but the future has many possible outcomes. 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. The crux of investing is determining the most probabilistic future for businesses and continually updating those beliefs based on new information.

To summarize, 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. The difference, however, is that we have control over how much something is worth to us, but have no control over how much a business itself is worth. We only have control over our own analysis of the business model, industry, competitive dynamics, future opportunities, and quality of management with the current available information. It takes more work, but the rewards can be enormous.

My advice would be:

Whenever buying something, consider the value it will bring to your life in terms of how you’ll feel or how many times you’ll use 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 its durability, 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 eventually 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 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 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 it 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 thereafter. 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 TSLA? That question can be re-framed as, “do I think Tesla is worth more than where the market is pricing it?” 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 730B 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 context, they’ve grew at around 35% per year from 2016 to 2020, going from 5.29B to 31.54B. 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 a completely incorrect usage, so if you take anything from this post, don’t make that same mistake.) Looking at just automotive sales, in 2020 they generated 26B off selling 500k cars, resulting in an average selling price of $52k. Wallstreet expects revenues to grow 60% this year, and 37%, 24%, 10%, and 20% the years after, to arrive at ~112B in 2025 (~24% CAGR). But Telsa won’t hit maturity by 2025, so projecting out to year 10 at an average 25% growth rate, they arrive at ~300B. That’s more than Ford and GM 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 4.8M cars. Or, just under what Ford and GM sold this year, combined. But, the future is Electric Vehicles, Tesla is poised to take market share, and we can expect Tesla to generate revenue through other sources, so that’s what we’ll project.

As for operating margins, historically they’ve 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 think 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 cash flows, not 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 721M; adding back non-cash items like D&A of 2.3B and stock-based compensation of 1.8B, adding changes in NWC of 1.1B, and subtracting capex of 3.1B, gets us to reported free cash flow 2.8B, a margin of 9%. Not too bad, but not too great either.

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 the future growth we are projecting and to maintain their competitive advantage.

Tesla’s 2020 Operating Profit was 2B and paid 292M in taxes, resulting in an effective tax rate of 25%. Therefore, we can calculate their Net Operating Profit After Tax was 1.5B (this excludes interest expense because we’re valuing the entire firm). Because Tesla historically lost money, it had 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 this year, eventually going to 21% in year 10. An optimistic case. 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 next year, a conservative estimate, which steadily decreases to 3% in year 10. 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, this results in a year 10 free cash flow of approximately 60B, a compound growth of 35% over 10 years. Wow. For reference, in 2020 Ford generated 18.5B and GM generated 11B in free cash flow. But Tesla’s future doesn’t look like 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 with 20% free cash flow margins, we would value Tesla at… $587 per share. But… that’s 25% lower than the current price?? Indeed. Apparently, the market has even rosier expectations! Or, the market is discounting the future cash flows at a lower rate than we are. We used a 9% discount rate, which is around the long term return of the market as a whole. If instead we use 8%, our calculated value jumps to $738, right around the current price. Looked at a different way, IF Tesla hits these projections, Tesla should generate an 8% return, lower than the average market return. But the cash flows grew 32% on average for each of the next 10 years! Yes, but the market has already priced in that future.

For one to be bullish on Tesla’s stock price the 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 fast growing company. In 2019 it 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%. For the multiple to get back to where it was in 2019, the stock price would have to remain at it’s current level 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 value Tesla as highly as the market ended up pricing the stock. They’ve since updated their projections, of course, to justify continuing to hold the stock. They now value Tesla around at $3000 per share, a $3 trillion market cap, based on expectations for 2025 of 507B in revenue and 176B in EBITDA (34% margin) from selling 5-10 million cars and rolling out an autonomous robotaxi service. At their expected ~5% free cash flow yield (not margin), they expect Tesla to generate $126 billion in free cash flow. 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.

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