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Security Analysis

March 23
Dale Wettlaufer

Modeling 101

Valuation Goals and Myths


Aswath Damadoran has a great deck on this:
http://pages.stern.nyu.edu/~iag/workshops/damodaran01.pdf
I didnt re-read. Last looked this piece from him maybe 15 years ago and will say its
great.

But Im not going to read you some other guys PowerPoint presentation, as good as he
and the presentation are. I didnt want to be biased / unoriginal on what I am presenting
today.
So far, the class has turned in assignments on the dangers of DCF and they have been
excellent. So far they are:

Pitfalls of DCFs
GIGO
False sense of precision
Error rate
Terminal growth the perpetuity
Discount rate the domain of every quack in the business (ahem)
Beta more quackery
Reinvestment rate
Stock compensation expense
Others?

We have already addressed some of these, but lots more to do. Get ready for the burn!

Mauboussin on forecasting.
You can Google this (or click here)
This is a very important document. I recommend reading it.

First Principles
You will be wrong. Often.

A DCF is an elaborate
guess at the future. The
output can be preciselooking, but never forget its
a fairly rough guess at the
future.
Small snapshot my models
archived 4+ years ago.
Lets dig up some mistakes.

Berkshire Hathaway My estimates as of mid-2011

Notice anything weird about my 2015 and 2016 numbers?


6

Fairly Decent Error Rate for a Very Complex Model

Made this one of our largest positions

Implies:

10

This has disaster written


all over it. Havent looked at
this company since Q3 2012.

11

Security Analysis
Ouch. Gonna be nasty

12

Actual

13

14

We didnt do anything with Barrick. Risk / reward wasnt there. You have to
realize these are guesses and guessing at a commodity-driven company
can be very hazardous. Also you have to be aware of the macro factors.

15

Notice the unwind (assessed 3-yr and 5-year IRR) from the starting point was no
better in Barrick than Berkshire. Which is riskier? Do we need to look at beta there?
Its not like Im some sort of magician on BRK. Its just a very well-run, relatively
predictable asset whereas gold miners can be random number generators.
$140

$120

Real oil price 1865present (macro actually


matters. Another
unknown, random
number generator.)

$100
$80
$60
$40
$20
$-

16

Of what use is it to archive your models?


Auditing. Why was this a good or bad forecast? Focus on process to improve outcomes,
reduce error rate.
Calibration. Machines are tested and calibrated before being put in service. They are
calibrated periodically as they are used. So should our brains. You probably cant improve
your process if you dont measure its results.

It takes a long time to know whether your fundamental assessments were right. Leaving aside
for a moment that is sometimes 100% irrelevant, just start to save models now to yield results
in 3-4 years.
Mauboussin:

17

Conceptual Understanding and Critical Analysis


Humans are fine at understanding linear relationships. And we can do
nonlinear equations in our head (quick, give me the model on the four seconds that happen in
the mind of a QB on a 20-yard post pattern in dime coverage on 4th and 19 in a 25 MPH wind and driving
rain).

Covering 25 companies with multiple comps for each, being expected to


provide in 1-2 weeks deliverables on assigned names you dont know, and
being curious about critical drivers, you dont want to leave things to
guessing.

18

Revenue Model, PCAR

19

Revenue Model, PCAR

20

Revenue Model, PCAR

21

Revenue Model, PCAR

22

Revenue Model, PCAR


Model backwards to understand key drivers, simplifying in the forecast to critical variables.

Its not supposed to be pretty. This is back-end.


Only the blue numbers are inputs drivers. But each of those data is important in
some way. There are hours of questions to ask analysts, management, oneself.
They inform your reading and future analysis of the company and industry.
Gather, greedily and with extreme prejudice, any data that can shed light on what
has happened in the past, that illuminate value chains, speak to larger drivers. You
never know if edge will come from a small detail or a big concept. Feed your brain
as much as possible. It can take it.

23

Revenue Model, PCAR

What macro factors should I


look at to forecast Paccars
revenues?

24

Revenue Model, PCAR


Class 8 units / goods-based GDP (scaled)
70.00

60.00

50.00

40.00

30.00

20.00

10.00

25

Revenue Model, PCAR


Why goods-based GDP?
Goods-Based GDP / Total GDP

YoY Growth, Goods vs. Services

10%

58%

8%
56%
6%
54%

4%
2%

52%

0%
50%

(2%)
48%

(4%)
(6%)

46%

Goods-Based GDP

26

Services

Revenue Model, PCAR

27

Revenue Model, PCAR


Production Five Months Forward Implied by Orders
50,000
45,000

Actual

Regression
40,000
35,000
30,000
25,000
20,000
15,000
10,000
50,000
5,000
45,000
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0

28

y = 1.0196x + 61.899
R = 0.6954

COGS
Same thing. There are
perhaps ten hours of
management conversation
and many more research
inquiries into what you see
on the right.
Manufacturing is all about
unit costs and flows, so this
isnt at all frivolous, as fun as
it is.

29

On Fun
Whatever you do in life,
youre going to be better
at it if its fun at some
level. This isnt hippie
dippy you must be
fulfilled in life advice
you will have an edge if
youre deeply engaged.
Are you prepared to
model a Class 8 truck
producer until 2 a.m. on
a Saturday night? Your
competition (cough,
cough) is.

30

On Colors
Dont. Just dont. Gross
Simple. Identify drivers. Dont pack
tons of calculations into cells. Make
it easy to drive.
Make is as simple as possible so if
you leave the firm or are
incapacitated, someone else can
take it over easily. A fiduciary duty
as an analyst.

31

Avoiding GIGO
Gather data sources. Lay it out. See what makes sense. But dont make critical
drivers a chain of a bunch of data sources working together. Keep it simple.
Start with broader data sets like GDP, population, industry estimates BEA NIPA
tables, trade associations. Wikipedia is very well-sourced; its not a bad starting
place at all. Leverage sellside initiations, industry pieces. 10-Ks, S-1 (IPO) filings.
Do comp tables so you see all the players, including privately held.
Then narrow. How would you estimate home security services? Dental implants?
Truck brokerage?
CH Robinson (CHRW). Is addressable market $350B or $35-50B?

32

Avoiding GIGO
Pick up the phone. A wonderful technology, avoided by many.
People like to share their expertise. Call the number on a government
press release, get in touch with academics who are experts in their fields,
call IR, leverage your personal network.
Yes, Regulation FD and general litigiousness makes people wary, but youll
still be amazed at the response.

For part of this weeks homework, I would like each of you to report back on
two successful research phone calls regarding your case study.

33

Avoiding GIGO
Base rates. Cant stress enough how important this is. Real growth rates,
earnings growth for the market overall, duration of growth, industry size and
intra-industry dynamics anchor us to reality and keep us from the fantasy
state in which the worst companies are expected to grow EPS 10% in
perpetuity and the best at 25%.

Google this (or click here).

34

Avoiding Fantastyland
Study data and seek out theory that helps explain reality, i.e. take with a grain of
salt strategy and case study texts that are all war stories and myth that seek to
provide a general prescription and do not take into account the economics of the
situation or luck.

35

Avoiding Fantastyland
Base Rates, EPS Growth

Mean: 9.7%
Market Cap-Weighted Average: 10.8%
S&P 500 Consensus EPS Growth, 3-5 Years
60%
50%
40%
30%
20%
10%
0%
0

100

200

300

400

500

(10%)
(20%)
(30%)

Who remembers 1871-2000 broad market real EPS growth?


What are inflation expectations today?
36

600

Avoiding Fantastyland
1.5% LT real EPS growth. Inflation expectations 1.5%
Only In Fantasyland will 460 of 500 companies will generate
3% nominal EPS growth over 3-5 years
S&P 500 Consensus EPS Growth, 3-5 Years
53%
48%
43%
38%

33%
28%
23%

18%
13%
8%

1
15
29
43
57
71
85
99
113
127
141
155
169
183
197
211
225
239
253
267
281
295
309
323
337
351
365
379
393
407
421
435
449
463
477

3%

37

Avoiding Fantastyland

What is the quantitative signature


of competitive advantage?

38

Return on Incremental Capital


ROIC is the basic signature of competitive advantage.
It is backward-looking, however. A 30% ROIC company where return on
incremental capital = WACC doesnt deserve any sort of a multiple.
IC
YoY growth
NOPAT
YoY growth
FCF
YoY growth
FCF conversion
ROIC
ROIIC
Ke
Market cap
P/E
NPV
IRR
Average ROIIC - WACC

39

1,000

300

30%

8.0%
7,500
25.0x
$ (3,431)
(0.7%)
(0.0%)
$

1
1,063
6.3%
$
306
2.0%
$
243
$

79%
29%
10%

2
$ 1,130
6.3%
$ 312
2.0%
$ 245
1%
79%
28%
9%

3
$ 1,201
6.3%
$ 318
2.0%
$ 247
1%
78%
27%
9%

4
$ 1,277
6.3%
$ 325
2.0%
$ 249
1%
77%
25%
8%

Warranted
Market cap
$ 3,794
P/E
12.6x
NPV
$
(0)
IRR
8.0%

5
$ 1,357
6.3%
$ 331
2.0%
$ 251
1%
76%
24%
8%

6
$ 1,443
6.3%
$ 338
2.0%
$ 252
1%
75%
23%
8%

7
$ 1,534
6.3%
$ 345
2.0%
$ 254
1%
74%
22%
7%

8
$ 1,630
6.3%
$ 351
2.0%
$ 255
0%
73%
22%
7%

9
$ 1,733
6.3%
$ 359
2.0%
$ 256
0%
71%
21%
7%

10
$ 1,842
6.3%
$ 366
2.0%
$ 257
0%
70%
20%
7%

Return on Incremental Capital


Warranted multiple is even lower if ROIIC < WACC:
IC
YoY growth
NOPAT
YoY growth
FCF
YoY growth
FCF conversion
ROIC
ROIIC

1,000

300

Ke
Market cap
P/E
NPV
IRR
Average ROIIC - WACC

8.0%
$ 7,500
25.0x
$ (3,614)
(1.2%)
(2.1%)

40

30%

1
$ 1,080
8.0%
$
306
2.0%
$
226
74%
28%
8%

2
$ 1,166
8.0%
$ 312
2.0%
$ 226
(0%)
72%
27%
7%

3
$ 1,260
8.0%
$ 318
2.0%
$ 225
(0%)
71%
25%
7%

Warranted
Market cap
P/E
NPV
$
0
IRR
8.0%

4
$ 1,360
8.0%
$ 325
2.0%
$ 224
(0%)
69%
24%
6%

$ 3,597
12.0x

5
$ 1,469
8.0%
$ 331
2.0%
$ 222
(1%)
67%
23%
6%

6
$ 1,587
8.0%
$ 338
2.0%
$ 220
(1%)
65%
21%
6%

7
$ 1,714
8.0%
$ 345
2.0%
$ 218
(1%)
63%
20%
5%

8
$ 1,851
8.0%
$ 351
2.0%
$ 214
(1%)
61%
19%
5%

9
$ 1,999
8.0%
$ 359
2.0%
$ 210
(2%)
59%
18%
5%

10
$ 2,159
8.0%
$ 366
2.0%
$ 206
(2%)
56%
17%
4%

Return on Incremental Capital


Warranted multiple is higher if ROIIC > WACC:
IC
YoY growth
NOPAT
YoY growth
FCF
YoY growth
FCF conversion
ROIC
ROIIC

1,000

300

Ke
Market cap
P/E
NPV
IRR
Average ROIIC - WACC

8.0%
$ 7,500
25.0x
$ (2,229)
3.0%
31.2%

41

30%

1
$ 1,040
4.0%
$
315
5.0%
$
275
87%
30%
38%

2
$ 1,082
4.0%
$ 331
5.0%
$ 289
5%
87%
31%
38%

3
$ 1,125
4.0%
$ 347
5.0%
$ 304
5%
88%
31%
38%

Warranted
Market cap
P/E
NPV
$
0
IRR
8.0%

4
$ 1,170
4.0%
$ 365
5.0%
$ 320
5%
88%
31%
39%

$ 5,093
17.0x

5
$ 1,217
4.0%
$ 383
5.0%
$ 336
5%
88%
31%
39%

6
$ 1,265
4.0%
$ 402
5.0%
$ 353
5%
88%
32%
39%

7
$ 1,316
4.0%
$ 422
5.0%
$ 372
5%
88%
32%
40%

8
$ 1,369
4.0%
$ 443
5.0%
$ 391
5%
88%
32%
40%

9
$ 1,423
4.0%
$ 465
5.0%
$ 411
5%
88%
33%
40%

10
$ 1,480
4.0%
$ 489
5.0%
$ 432
5%
88%
33%
41%

How Often Does This Happen?


2013 study by Prof. Wettlaufer indicated the following. Of 500 companies in the S&P 500 at
that time, I looked at how many were able to generate ROIIC > WACC over a number of 5year runs.
Here are the population sizes for companies that existed for all 20 years, 15 of 20 years, etc:
Extent for n
Years
5
10
15
20

42

# of
Com panies
469
438
371
280

Return on Incremental Capital


How many were able to generate returns on incremental capital > WACC
for all four periods, 3 of 4, 2 of 4, 1 of 4, and none of four?
Periods
0
5
10
15
20

# of
% of
Com panies
8
3%
97
35%
96
34%
43
15%
36
13%

If you had perfect foresight, 72% of your models should have had a
terminal multiple no higher than the inverse of WACC.
Moats get killed all the time, cycles fizzle, and bad M&A permeates
markets.
43

Return on Incremental Capital


Distribution of Return Regimes
Within Each Sector
Consum er discretionary
Consum er staples
Energy
Financials
Health care
Industrials
Inform ation technology
Materials
Telecom m unication services
Utilities

44

0
2%
7%
4%
0%
8%
0%
3%
0%
0%
4%

5
44%
34%
75%
33%
27%
18%
16%
41%
0%
42%

10
32%
34%
13%
28%
27%
42%
45%
36%
100%
42%

15
17%
7%
8%
31%
0%
27%
16%
5%
0%
13%

20
5%
17%
0%
8%
38%
13%
19%
18%
0%
0%

Competitive Advantage Period


We just discussed Competitive Advantage Period (CAP), which
Mauboussin and Johnson called the neglected value driver.
The neglected value driver is
duration of competitive advantage,
which is the period of time during
which returns on incremental
capital can surpass their cost
of capital.

45

Competitive Advantage Period


If you vary the CAP term, even without tons of earnings growth, the return
implications are enormous.

Campbell Soup
Heinz
Hershey
Kellogg

CPB
HNZ
HSY
K

IRR
12/31/1982 12/31/1992
24.8%
24.3%
20.8%
29.9%

S&P 500

SPX

16.1%

What do these two data sets suggest to you?

46

Competitive Advantage Period


This is a fancy (and correct) way of explaining multiple expansion and contraction.

CSCO
ORCL
MSFT
ANF
CELG
QCOM
KSU
EMC
BBY
WMT
S&P 500

12/31/1999
184.7x
127.4x
162.2x
27.8x
NM
560.4x
27.6x
116.2x
48.5x
69.8x

12/31/2015
14.4x
16.5x
39.6x
52.9x
61.7x
15.5x
17.0x
25.2x
13.1x
13.4x

29.4x

18.5x

Price
12/31/1999
12/31/2015
$
53.56 $
27.16
$
28.02 $
36.53
$
58.38 $
55.48
$
26.69 $
27.00
$
2.92 $
119.76
$
89.66 $
49.99
$
4.69 $
74.67
$
53.43 $
25.68
$
22.33 $
30.45
$
69.13 $
61.30
1,469

2,044

IRR
(3.4%)
2.1%
2.0%
1.4%
26.1%
(2.3%)
19.2%
(4.2%)
3.4%
0.9%
4.1%

EPS
12/31/1999
12/31/2015
$
0.29 $
1.89
$
0.22 $
2.21
$
0.36 $
1.40
$
0.96 $
0.51
$
(0.01) $
1.94
$
0.16 $
3.22
$
0.17 $
4.40
$
0.46 $
1.02
$
0.46 $
2.32
$
0.99 $
4.57
$

Earnings Growth vs. Returns


25.0%
20.0%
15.0%
10.0%
y = 0.3828x - 0.0212
R = 0.1937

5.0%

(10.0%)

47

(5.0%)

0.0%
0.0%
(5.0%)

(10.0%)

5.0%

10.0%

15.0%

20.0%

25.0%

49.93

110.54

CAGR
12.4%
15.5%
8.9%
(3.9%)
20.6%
22.5%
5.1%
10.6%
10.0%
5.1%

Competitive Advantage Period


Everybody knew these companies were going to be winners. They were,
generating 2x the EPS growth rate of the S&P 500.
QCOM EPS growth rate was 405% that of the S&P 500.
Kansas City Southerns was 443%.

The problem was?


Everybody in the stock market knew that. And more. The growth rate was
either going to be higher or CAP was going to be much longer than what
actually happened. Tell me about these companies moats today.

48

Competitive Advantage Period


Best Buy, Cisco, and Wal-Mart are trading at 13-14x. What are their moats?
IC
YoY growth
NOPAT
YoY growth
FCF
YoY growth
FCF conversion
ROIC
ROIIC

1,000

150

Ke
Market cap
P/E
NPV
IRR
Average ROIIC - WACC

8.0%
$ 2,025
13.5x
$
(77)
7.4%
1.6%

49

15%

1
$ 1,030
3.0%
$
153
2.0%
$
123
80%
15%
10%

2
$ 1,061
3.0%
$ 156
2.0%
$ 125
2%
80%
15%
10%

3
$ 1,093
3.0%
$ 159
2.0%
$ 127
2%
80%
15%
10%

4
$ 1,126
3.0%
$ 162
2.0%
$ 130
2%
80%
14%
10%

Warranted
Market cap
$ 1,943
P/E
13.0x
NPV
$
(0)
IRR
8.0%

5
$ 1,159
3.0%
$ 166
2.0%
$ 132
2%
80%
14%
10%

6
$ 1,194
3.0%
$ 169
2.0%
$ 134
2%
79%
14%
10%

7
$ 1,230
3.0%
$ 172
2.0%
$ 136
2%
79%
14%
9%

8
$ 1,267
3.0%
$ 176
2.0%
$ 139
2%
79%
14%
9%

9
$ 1,305
3.0%
$ 179
2.0%
$ 141
2%
79%
14%
9%

10
$ 1,344
3.0%
$ 183
2.0%
$ 144
2%
79%
14%
9%

Competitive Advantage Period


These have at times traded at 10x earnings. Investors will often say it
doesnt have to grow to be a good value.
Zero is NOT the lower boundary of growth.
IC
YoY growth
NOPAT
YoY growth
FCF
YoY growth
FCF conversion
ROIC
ROIIC

1,000

150

Ke
Market cap
P/E
NPV
IRR
Average ROIIC - WACC

8.0%
$ 1,500
10.0x
$
(96)
7.0%
(16.1%)

50

15%

1
1,030
3.0%
$
147
(2.0%)
$
117
$

80%
14%
(10%)

2
$ 1,061
3.0%
$ 144
(2.0%)
$ 113
(3%)
79%
14%
(10%)

3
$ 1,093
3.0%
$ 141
(2.0%)
$ 109
(3%)
77%
13%
(9%)

Warranted
Market cap
P/E
NPV
$
0
IRR
8.0%

4
$ 1,126
3.0%
$ 138
(2.0%)
$ 106
(3%)
76%
12%
(9%)

$ 1,397
9.3x

5
$ 1,159
3.0%
$ 136
(2.0%)
$ 102
(4%)
75%
12%
(8%)

6
$ 1,194
3.0%
$ 133
(2.0%)
$ 98
(4%)
74%
11%
(8%)

7
$ 1,230
3.0%
$ 130
(2.0%)
$ 94
(4%)
72%
11%
(7%)

8
$ 1,267
3.0%
$ 128
(2.0%)
$ 91
(4%)
71%
10%
(7%)

9
$ 1,305
3.0%
$ 125
(2.0%)
$ 87
(4%)
70%
10%
(7%)

10
$ 1,344
3.0%
$ 123
(2.0%)
$
83
(4%)
68%
9%
(6%)

Competitive Advantage Period


These have at times traded at 10x earnings. Investors will often say it
doesnt have to grow to be a good value.

Value Trap Central


IC
YoY growth
NOPAT
YoY growth
FCF
YoY growth
FCF conversion
ROIC
ROIIC

1,000

100

Ke
Market cap
P/E
NPV
IRR
Average ROIIC - WACC

8.0%
$ 1,000
10.0x
$
(203)
4.3%
#DIV/0!

51

10%

1
2
$ 1,050 $ 1,050
5.0%
0.0%
$
95 $ 62
(5.0%)
(35.0%)
$
45 $ 62
37%
47%
100%
9%
6%
(10%)
#DIV/0!

3
$ 998
(5.0%)
$
52
(15.0%)
$ 105
70%
200%
5%
18%

Warranted
Market cap
P/E
NPV
$
0
IRR
8.0%

4
$ 898
(10.0%)
$
52
0.0%
$ 152
45%
290%
6%
0%

781
7.8x

5
$ 898
0.0%
$ 52
0.0%
$ 52
(66%)
100%
6%
#DIV/0!

6
$ 898
0.0%
$ 53
1.0%
$ 53
1%
100%
6%
#DIV/0!

7
$ 916
2.0%
$ 54
2.0%
$ 36
(32%)
67%
6%
6%

8
$ 943
3.0%
$ 56
4.0%
$ 29
(20%)
51%
6%
8%

9
$ 971
3.0%
$ 58
4.0%
$ 30
5%
52%
6%
8%

10
$ 1,001
3.0%
$
61
5.0%
$
32
7%
53%
6%
10%

Competitive Advantage Period


These have at times traded at 10x earnings. Investors will often say it
doesnt have to grow to be a good value.

Bad M&A: The Widowmaker


IC
YoY growth
NOPAT
YoY growth
FCF
YoY growth
FCF conversion
ROIC
ROIIC
Ke
Market cap
P/E
NPV
IRR
Average ROIIC - WACC

52

1,000

100

10%

8.0%
1,000
10.0x
$
(356)
3.7%
#DIV/0!
$

1,050
5.0%
$
95
(5.0%)
$
45
47%
9%
(10%)

$ 1,470 $ 1,617 $ 1,779


40.0%
10.0%
10.0%
$ 100 $ 103 $ 102
5.0%
3.0%
(1.0%)
$ (320) $ (44) $
(60)
(812%)
(86%)
36%
-321%
-43%
-59%
7%
6%
6%
1%
2%
(1%)
Warranted
Market cap
P/E
NPV
$
0
IRR
8.0%

615
6.2x

$ 1,832
3.0%
$ 100
(2.0%)
$ 46
(177%)
46%
5%
(4%)

$ 1,887 $ 1,698
3.0% (10.0%)
$ 101 $ 96
1.0%
(5.0%)
$ 46 $ 284
(1%)
522%
45%
297%
5%
6%
2%
3%

$ 1,698
0.0%
$ 99
3.0%
$ 99
(65%)
100%
6%
#DIV/0!

$ 1,749
3.0%
$ 101
3.0%
$ 51
(49%)
50%
6%
6%

$ 1,802
3.0%
$ 103
2.0%
$
51
1%
49%
6%
4%

The Bottom Line


You cant model just the income statement. You need to cast a balance
sheet and cash flow statement.
Those need to work together to produce ROIC and ROIIC outputs that
allow you to examine whether those make sense from the standpoint of
competitive strategy.
You can also reverse-engineer stock prices to solve for CAP at given
growth rates and capital intensity.
Lets look at the short case for Amazon.

53

Amazon
Without a doubt, an amazing company and CEO. It will dominate a number
of profit pools classically associated with the company and will hunt down
without remorse additional lazy profit pools in the future. I was a bull from
1995 through last summer.

Its not about whether I think its a bad company. It is without question a
great company.
Its about whats embedded in the stock.
Thats what investing is always about.

54

Amazon
AMZN Sales / Global Gross Economic Product vs. WMT Penetration
0.80%
0.70%
0.60%
0.50%
0.40%

0.30%
0.20%
0.10%
0.00%

WMT

Revenue
Gross margin
EBIT margin
FCF
ROIC
$ in millions
55

2005A
$ 8,490
24.0%
5.1%
$
442
86.9%

2010A
$ 34,204
22.3%
4.1%
$ 1,687
48.9%

AMZN

2015A
2020E
$ 107,007 $ 268,411
33.0%
33.5%
2.2%
7.6%
$
(341) $ 2,883
4.6%
32.2%

2025E
$ 455,461
33.5%
9.1%
$ 25,777
40.7%

2030E
$ 643,751
33.5%
10.8%
$ 42,361
48.2%

Amazon

ROIC
60%
50%
40%
30%
20%
10%
0%
(10%)
(20%)
(30%)

56

Amazon

57

Amazon
By 2030, captures about 20-25 years of competitive advantage.
And to be fairly valued here, has to achieve return on incremental invested
capital of 63% for retained earnings and find 15% IRRs on $241B in capital
I assume it doesnt need.
Possible, but base rates are against it and that gets you no excess (riskadjusted) return from here in what I believe will continue to be a greed &
fear stock.
The goal is to achieve excess returns, otherwise you dont commit capital.

58

Value Dump
No such thing as perpetuity insofar as Gordon Growth Model:
(1 / ( k g)) = terminal multiple is concerned.
Cost of capital = 8%, perpetuity of 3% = 1 / (5%) = 20x. Goofy, especially if stock trades at 10-13x. Magically
it will go to 20x? The math doesnt work and it implies increasing returns on capital with no increase in
invested capital.
IC
YoY growth
NOPAT
YoY growth
FCF
YoY growth
FCF conversion
ROIC
ROIIC

1,000

150

Ke
Market cap
P/E
NPV
IRR
Average ROIIC - WACC

8.0%
$ 3,000
20.0x
$
(617)
4.5%
#DIV/0!

59

15%

1
1,000
0.0%
$
155
3.0%
$
155
$

100%
15%
#DIV/0!

2
$ 1,000
0.0%
$ 159
3.0%
$ 159
3%
100%
16%
#DIV/0!

3
$ 1,000
0.0%
$ 164
3.0%
$ 164
3%
100%
16%
#DIV/0!

4
$ 1,000
0.0%
$ 169
3.0%
$ 169
3%
100%
17%
#DIV/0!

Warranted
Market cap
$ 2,334
P/E
15.6x
NPV
$
(0)
IRR
8.0%

5
$ 1,000
0.0%
$ 174
3.0%
$ 174
3%
100%
17%
#DIV/0!

6
$ 1,000
0.0%
$ 179
3.0%
$ 179
3%
100%
18%
#DIV/0!

7
$ 1,000
0.0%
$ 184
3.0%
$ 184
3%
100%
18%
#DIV/0!

8
$ 1,000
0.0%
$ 190
3.0%
$ 190
3%
100%
19%
#DIV/0!

9
$ 1,000
0.0%
$ 196
3.0%
$ 196
3%
100%
20%
#DIV/0!

10
$ 1,000
0.0%
$ 202
3.0%
$ 202
3%
100%
20%
#DIV/0!

Multiples vs. DCF


Multiples embed implicit assumptions. You can be roughly right with a
DCF and precisely wrong with multiples too.
At least with a DCF, you are making explicit judgments about the critical
drivers of a business.
Thats one of the essences of investing tying an assessment of the
business to a value and acquiring that business (wholly or in fractional
ownership amounts) at a discount to intrinsic value sufficient to create a
margin of safety and excess return.
Low multiples do not necessarily mean something is a good value, I hope
weve imparted. And vice-versa.

60

Multiples vs. DCF


In 2011, CAT traded at 11-14x 2012 guidance and 6-7x 2015 goal. Any problems here?

Theyre not selling chocolate bars. Earthmoving and mining equipment can last a long time when capacity utilization drops.
Equipment sales per capita and as a % of GDP were at 30-year highs and above prior peaks.
These cycles are very long. You need to be very resourceful to understand the full cycle.

61

Multiples vs. DCF


Turns out I wasnt bearish enough, though this was a big position for me. Roughly right via DCF. Its a non-linear problem.
Multiples are not a big help. Though generally useful to remember to buy cyclicals ugly and sell them pretty.

62

Multiples vs. DCF


In 2014, SLB traded at 12-13x 2017 guidance. Any problems here?

63

Multiples vs. DCF


When your customers are cyclical, youre cyclical. Energy E&P is a trend following industry.

$120.00

$16.00

20.0%

140.0%
ROIC

$14.00

$100.00

15.0%

$12.00
10.0%

$80.00

$10.00

$60.00
$40.00

5.0%

$6.00

0.0%

100.0%
80.0%

40.0%
20.0%
0.0%

(5.0%)

(20.0%)

$2.00

$-

$-

(10.0%)

CO1 (LHS)

Production cost / BOE

(40.0%)

(60.0%)
(15.0%)

64

120.0%

60.0%

$8.00

$4.00
$20.00

Oil (RHS)

(80.0%)

Multiples vs. DCF


When your customers are cyclical, youre cyclical. Energy E&P is a trend following industry.

$100

Brent spot
SLB

140

$10

120
100
80
60
40
20
y = 0.6574x + 15.394
R = 0.7564

0
0

65

20

40

60

80

100

120

140

160

Multiples vs. DCF


Weve been here before. SLB is as dominant today as it was in the early 1980s. This has been a technology leader for 100
years. Headlines about this being different, less sensitive are an exact replay of what the press was saying in the early 1980s.
People want bargains and these look like value at the end of a cycle.

$35

$15.00
$14.00

$30

$13.00
$12.00

$25

$11.00
$10.00

$20

$9.00
$8.00

$15

$10

66

WTI Spot

$7.00

SLB (RHS)

$6.00
$5.00

Multiples vs. DCF


If you went for picks and shovels in 2001 (CSCO, ORCL), during the .com implosion, you missed these losers.

67

Multiples vs. DCF


You did fine, but you didnt get 29-83 baggers.

68

Multiples vs. DCF


Sales multiples are some gross valuation metrics may have helped you with AMZN or PCLN, but the
earnings and FCF werent there and the markets narratives on these was overwhelmingly negative.
You had to have a variant perception on the potential competitive advantages of these companies and you
had to believe in the long-term cash flow outlook.
Apparently, I excoriate on occasion. BTW, dont miss stock splits in your historical analysis. Duh. BTW, yes I
was young(er) and a bit of a jerk on occasion.

69

Discount Rate
Should bear relationship to growth rates, as base rate embeds GDP per
capita growth and inflation. Those play into almost any company forecast.
Nominal vs. nominal, real vs. real should make sense in your model. Why
should a mature food or cement company grow revenue at 8% and
earnings at 10% when real GDP is growing 2%, nominal is growing at
3.5%, and 10-year yields are 2%?
Different schools of thought on setting WACC equal to market-weighted
return expectations or your desired return. Both are valid, as long as you
have a consistent process. Caution: the market isnt going to serve up lots
of opportunities today that give you 15% 5-10 year IRRs. You risk
contorting forecast to produce those expected returns if you dont want to
be 20-30% invested.
70

Reinvestment
Rollups or platform companies CAN invest such that IRR on ROIIC is > WACC, which is one
of the circularities of a DCF that can hold back its usefulness.
This is the Amazon alt case discussed earlier. Not that Amazon is a roll-up, but I think it fits the
definition of a platform that links and leverages core strengths to pursue intelligently
adjacencies and vulnerable profit pools.
Dreams DO come true! But this is
very, very rare. Pay attention to
how often deals are done, realism
of management. My favorite

question on these is: Tell me


about the best deal you didnt do.
If they tell you what the
quarters going to be, get
out!
71

Other
Stock comp. Treat it as a cash expense. Easiest way to recognize a real
expense.
Contingent liabilities. Pension, OPEBs. These you can tax effect.
Judgments, penalties, and other liabilities usually are not.
NOLs. Can NPV or run it through as a tax shelter as time passes.
Offshore cash tax effect for repatriation. Mark future effective tax rate
closer to US statutory rate if US-domiciled corporation.

72

Pension, OPEB

73

Practicum

74