#10 Investing 101: Advanced Valuation
"Valuation is neither an art nor a science, it's a craft." - Aswath Damodaran
This is where everything resolves.
As investors, we put as much effort as we can to pick a great company but if we get it at the wrong valuation… Well, all your efforts will basically be wasted.
Anything, and I mean anything could be a great investment at the right price and even the best company in the world could be a disastrous investment at the wrong price.
How do we decide whether the price is right or wrong? Valuation.
We estimate all the cash flows that could be taken out of the company in its lifetime and discount it to this day. Final sum is assumed to be the intrinsic value of the company.
This process is called Discounted Cash Flow Analysis (DCF).
I have to admit, I don’t do that analysis whenever a stock interests me and seasoned investors also rarely do that. The reason is simple, if you do it enough times, you learn what assumptions go into the multiples and you just use them as a shortcut.
You basically estimate the growth rate for the next few years and attach a conservative earnings multiple that could capture the potential of the business beyond the forecast period. You know what that multiple implies.
However, no matter how advanced you are, you should occasionally conduct a detailed valuation so your valuation skills stay up to date.
On the other hand, if you are a beginner, you should do DCF every time so you’ll get the discipline and earn your right to use shortcuts. If you start using shortcuts without earning the right, you will likely end up speculating.
So, in this final issue of our email investing course, I will try to teach you to conduct a proper DCF valuation step-by-step.
So buckle up! Find yourself a quiet place, get a cup of coffee and free your brain. This will be a challenging ride, but it’ll be extremely rewarding.
Let’s get started!
Valuation Principles
First things first.
You must always keep in mind that valuation is not a science and it’s not an art. It’s a craft.
There are no clear cut rules but there are principles.
You must always keep these principles in mind when doing a valuation:
1) You can’t value everything.
Don’t even attempt.
Valuation is based on predictions. If the asset you chose is an unpredictable one, your valuation will just be a speculation.
How much gold per ounce will cost in 2030?
You can’t know. It doesn’t produce anything and its price is largely determined by supply and demand. It’ll likely be higher because of the limited reserve, but you can never know.
You have to put your utmost effort to pick a company that has predictable earnings, so you can conduct a proper valuation.
2) Intrinsic value is the sum of all future cash flows that the company will generate in the future discounted to this day.
If you don’t agree with this statement, just leave it here.
This is the bedrock of valuation, this is why we assume valuation works in the long term.
3) Valuation builds on a story.
Remember we are making predictions and those predictions have to come from somewhere.
They come from your story.
You will make a growth forecast based on what? Based on the story. Your predictions have to change as your story changes.
You may think Uber will remain mostly as a ride-hailing company or you may think it’ll carry everything that could be carried from people to packages, from groceries to mail… Your predictions have to change depending on which story you adopt.
4) Remain conservative.
Future is uncertain and it’s full of risks.
One of the best ways to protect your valuation from future risks is to remain conservative.
Your story might be based on the assumption that Uber will own 50% of the ride hailing market. That’s great.
Now slash it. Value the scenario where it gets only 35%.
You thought the end operating margin would be 45%? Make it 30% and create your model based on these assumptions.
If you find the company is 15% overvalued, you may still want to pay up for it if it’s a great one.
But if the model leads you to think it’s 50% undervalued, you may get a big exposure and lose too much money even if your predictions miss the mark by a small margin.
Remain conservative. Limiting downside is way more important than maximizing the upside.
5) Your valuation will be wrong.
There is no way, other than insane luck, you can accurately predict what a company will be earning 10 years from now. It’s not doable.
A good valuation gives you the silhouette, not the exact portrait.
Based on that silhouette, you predict whether the complete picture could be something valuable.
Don’t trick yourself into believing that your valuation will be accurate.
Keep these five principles in mind whenever you attempt to value a company. They are our lighthouse.
Valuation Toolkit
Present Value of Future Sum
If you have a child, I propose a solid way to determine whether he will be a finance genius in the future.
Ask him whether he prefers $10 now or $13 a month later. If he chooses the latter, don’t waste anymore time and start teaching him investing because he understands the most fundamental concept of finance: Time value of money.
This is why we invest in the first place. We sacrifice a dollar that we can spend today to have more money tomorrow. As a result of this demand of return, $1 today is not equally valuable as $1 a year later.
When we invest in a company, we put our money in work believing that the firm will generate more money in return. To determine whether we should prefer keeping our money or investing in a company for future cash flows, we have to determine the current value of the expected future cash flows.
It’s so intuitive that people without any financial education get it instantly.
If the cost of capital is 10%, $1 dollar next year is worth $90 cents today.
If the company is expected to generate $100 million 5 years from now, you discount it to today at 10% per year. What’s it worth today?
There is a clear formula for this:
Enter numbers in the formula: 100/(1+0.10)^5 = 62.09
Meaning, $100 million 5 years later is now worth $62.09 million.
This is the first tool we need as we discount all the cash flows we find to this day!
Growing Annuity
Annuity is a fancy term that we use to refer to a steady cash flow expected to generate every year.
If the cash flow is set to grow every year, we are talking about the growing annuity.
The company is expected to grow cash flows by 3% every year for the next 10 years. We have an annuity growing at 3% for the next 10 years.
Pretty simple.
Now, if the cost of capital is 10%, you have to first find cash flows for every year and then discount it to this day separately and then add them together.
We have a formula for this too:
Where:
PV = Present value
PMT = First year cash flow
i = Discount rate
m = Number of periods
This gives you the sum of the all discounted cash flows in the forecast period.
However, you will rarely use this formula in our DCF analyses because companies' cost of capital changes over time, so does your discount rate. Still, you can probably use this formula to estimate cash flows of the already mature companies that have a pretty stable cost of capital.
Growing Perpetuity
Well, companies are like humans but they differ in one material aspect: They don’t necessarily die. Coca-Cola has been around since the 1800s.
In theory companies can last forever. This mandates us to value the sum of the cash flows beyond our forecast period.
If your analysis considers just the next 10 years, you have to come up with a terminal value for the period beyond that 10 years.
Well, luckily, we have a formula for this too!
Imagine that we are valuing a company and our forecast period is 10 years. Our discount rate is constant 10% and we assume that the company will keep growing at 2% every year beyond that.
In this case, we have to divide the cash flow at year 11 by the difference between the discount rate and the perpetual growth rate. Assuming that the company makes $100 million on year 10, our terminal value will be:
TV = 102/(0.10-0.02)
= 102/0.08
= 1,275 million
Be careful though, this is not the value of the terminal period today. This is what terminal period is worth in Year 10. You still have to discount it today by using the discount formula:
= 1275/(1+0.10)^10
= 1275/1.10^10
= 491.56
Meaning, all the cash flows in the terminal period is worth $491.5 million in Year 0.
Return on Invested Capital (ROIC)
Let’s get this straight: Return on Invested Capital is a central concept to investing.
If the business can generate high returns on investment, this means that it’s effectively using its capital to grow. As a shareholder, over the long term, you can expect your return on investment to converge to the business’ return on its own investments. Thus, it’s a qualitative measure.
ROIC determines how much you need to invest to generate desired rate of return. Imagine two identical businesses with different ROICs. The one with the higher ROIC will be more valuable because it needs to invest less money to generate the same return. As a result it’ll have a larger free cash flow distributable to shareholders.
Importance of ROIC cannot be overestimated.
Sales-to-Invested Capital Ratio
Most of the time, we build our valuation models based on growth estimates.
But what generates this growth? It doesn’t come from thin air. It comes from investments in the business.
Sales to invested capital ratio basically tells you how much investment you need to make in order to get desired sales growth.
If every $1 invested results in $2 in revenue, the business has a sales-to-invested capital ratio of 2. That's simple.
Calculating it is also not hard:
Revenues / (Book value of equity + Book value of debt - Cash)
This is important because as the revenue growth changes, the company will also spend changing amounts in investments. Best way to tie them together is sales to capital ratio.
For instance, you can assume in early years the business will generate more sales per dollar invested and it’ll decline as the market matures. Changing sales to invested capital ratio will save you from controlling both sales and reinvestments manually.
Reinvestment Rate
Reinvestment rate is the final tool that we need in our kit to accurately value companies.
We need that because the company will need to keep reinvesting in the terminal period to get the expected rate of return.
However, as the earnings change, we can’t manually estimate how much the company will need to invest to sustain growth. Therefore, we use reinvestment rate to tie the growth to required investment.
This works perfectly because reinvestment rate is a function of ROIC. As ROIC increases, reinvestment required decreases and the company generates more free cash flow.
To capture this change, we refine our terminal value formula as follows:
Now the toolkit is full and you are ready to become a valuation ninja!
Let’s get started!
Crafting The Story
This is where the bulk of the valuation happens. And, this is also where you make a difference.
Informational or technical edges don’t exist. There is nothing you can gain from reading all the annual letters of a company including all footnotes. It’s just a must. Everything you could ever find there is already priced in. You can never be the person who knows most about the company.
There is only one advantage you can have, crafting a long-term story for the company and betting on it. If you turn out to be right, you will make money.
When I say this, most people think they have to be more visionary than everybody and come up with a distinct story. No. In the long-term, even small variations in a story make a big difference because they accumulate.
You don’t have an unlimited scope in crafting your story. The story you tell should at least be plausible. If possible, it is better. The best is probable. Be careful though, if you err too much on the plausible side, your valuation will be speculation. If you err too much on the probable side, you will just tell the market story.
Take a look at Aswath Damodaran’s scenarios when he valued Uber when it was still a startup:
The story you tell, will determine the three value drivers of the company:
Growth
Operating margin
Return on invested capital
So, taking these into account, let’s craft a story for MercadoLibre, one of my highest conviction stocks now.
MercadoLibre is basically the Amazon of Latin America.
They are the largest e-commerce marketplace in LatAm.
They have distribution centers just like Amazon and prime delivery.
They have an integrated fintech platform called MercadoPago, that also offers credit.
They offer logistics as a service through its MercadoEnvios business.
They have a product called MercadoShops which is basically a Shopify competitor with MercadoPago and MercadoEnvios integration.
It built a constellation of businesses around its dominant marketplace platform.
These businesses are mostly complementary to its marketplace but over time they have also expanded to other areas in their niches. MercadoPago for instance, is not just an integrated fintech platform today, it’s evolving into a full-fledged neobank.
So, considering the dominant platform and the strong ecosystem of the business, this is how I think it’ll evolve in the next 10 years:
1) Its e-commerce marketplace will dominate LatAm.
Amazon has over 50% market share in the US. Given the more fragmented market structure of LatAm, I think MercadoLibre can eventually have 30% market share. However, it’s still not operating in 15 LatAm countries. Entry to these markets will take time and resources. So, I assume that MercadoLibre will control up to 10% of the LatAm e-commerce market in 2034.
Total e-commerce volume in LatAm is expected to reach $920 billion by 2026. Even if we assume that the market will grow only 5% annually post 2026 until 2034, we will have a $1.3 trillion market. Meaning, Meli can generate as much revenue as $130 billion. This is my ceiling.
2) Mercado Pago will grow into a complete neobank.
As this market is expected to reach $120 billion by 2034, it is also a great opportunity for Meli.
Given its marketplace works as a growth driver for MercadoPago products, I think it can easily own 10% of this market, an additional $12 billion revenue stream.
That pulls my revenue ceiling to $142 billion.
3) Other businesses will act mainly as a growth driver to the marketplace and fintech.
Though those other businesses can also bring in significant independent revenue, I think their contribution largely captured my growth assumptions for the marketplace as they are more complementary in nature.
This is why I am not going to count their contributions separately.
4) MercadoLibre’s operating margin will expand significantly.
Meli currently has 11% operating margin all across its businesses.
As its cost on fixed investments spread over an ever increasing number of users, its operating margin can easily reach 15% levels.
5) MercadoLibre’s giant moat will allow it to have 15% return on capital in the terminal period.
MercadoLibre has one of the strongest moats I have seen in any company. I think this moat will allow them to profitably deploy capital in the terminal period and create cheap growth.
6) MercadoLibre’s cost of capital will decline significantly.
Given that it’s still a fast growing company, its cost of capital is still higher than the mature businesses in the market.
As the business matures, its weighted average cost of capital will converge to average for all US listed mature companies.
Here is how this story looks like on a diagram:
Now that we have our story, the rest of the valuation is largely running our assumptions on a spreadsheet.
Discounted Cash Flow Analysis
We have forecasted a $142 billion revenue stream that could be captured by Mercadolibre in 2034. How much of this can be captured?
Let’s look at the recent revenue growth: In the last 12 months, it posted 35% revenue growth. To be conservative, I’ll assume that it can deliver 30% revenue growth next year and this will slowly decline over years, converging to terminal growth rate at year 10.
As the business grows, it’ll also expand operating margin from 11% now and will converge to 15% by year 10.
MercadoLibre has been a profitable business for quite some time so its effective tax rate is already pretty high at 24.33%. It’ll also converge to 25% in year 10.
The business is currently generating $4 revenue for every $1 invested, giving it sales-to-capital ratio of 4. As it grows, it’ll be harder for it to drive additional sales. I assume that it can keep its current reinvestment efficiency for 4 more years and then it’ll start to decline, converging to 2 at year 10. Yet, thanks to its wide moat, it’ll maintain its above average ROIC in the terminal period at 15%.
After running these numbers, we also have to add back cash and deduct the debt and current value of the management options.
Here is how the above assumptions play out in my model:
Now, you see two final values on the model: Implied share price and option value.
Here is the difference: Implied share price doesn’t incorporate any chance of failure. You create your story and value it. Final value is what that story is worth per share.
But in real life, it can fail.
How do we adjust for the chance of failure?
We have to estimate how much the business will be worth in case of failure and what’s the chance of failure.
I assume, in failure, Meli will be worth 30% of what it would have been worth in case of success because of its valuable assets as distribution centers. As it’s already an established business, I think the chance of failure is not more than 10%.
In this case, final option value will be:
(Enterprise value x Chance of success) + (Enterprise Value in Failure x Chance of Failure)
On top of that, we still add cash, deduct debt and management options. Then we divide it by the shares outstanding. Which gives us $2,050 per share.
This means that, per share value of this bet, where Meli grows according to our story with a 10% chance of failure and a 30% enterprise value in failure, is $2,050.
Here I am attaching my model. Just change the inputs to create your own DCF valuation.
You can use this model to value most established fast growing companies.
Always keep in mind though, this is just a convenience. The real work is telling the story. Without the story, you just have a spreadsheet which has no additional value.
Conclusion
“Valuation is neither an art nor a science, it’s a craft” says Aswath Damodaran and I couldn’t agree more.
One of the most fundamental results of this is that you can’t get better at either by just thinking or by learning. You have to practice. This is how people get better in their crafts. Value companies, value a lot of them and you’ll get better.
Always keep in mind that the story is what matters and you don’t hold either a technical or an informational edge. Don’t try to predict what’s going to move the stock in the near term, so called “catalysts.” You can’t predict them better than professionals.
Story is where you have an edge. You can see the long term story more accurately and you could be more patient. Only thing you should avoid in the quantitative part is making logical mistakes, other than that it’s not rocket science. The story is what counts.
How do you create better stories? You have to read a lot. You have to know the incumbents, what they do, how they got there, what’s possible, what’s unimaginable. Only then you can gain the discipline to consistently tell plausible stories.
Always keep in mind:
Story without numbers is a fairytale.
Numbers without a story is a spreadsheet.
Story + Numbers = Valuation
As usual, thanks for your nice analysis. My question, since anything and everything has value and can be valued, how can we or do we value a non-profitable business? or a business running at loss? or a stock running at loss