- Non-traditional businesses may have hidden value as compared to traditional ones
- Expenses, depending on their nature, can bring long-term value
- Valuation methodology remains the same, but in-depth understanding is even more critical
Since I’ve started to be interested in investing, I’ve always had a strong inclination towards value investing. This particular investment philosophy traditionally focuses on businesses generating an interesting cash flow, with a strong balance sheet, and which the investor understands well and can easily project its performance in the future. Obviously, there are a multitude of variances to the typical value investing approach, such as the deep-value approach, the net-net approach, etc. However, I’m more of the conventional type. The way I like to value companies is to consider how much the future stream of earnings of a firm is worth as of today – quite simple, not always easy.
Such an approach, applied with consistency, have led me to consider companies which operate mainly in more traditional industries, such as utilities, retail, manufacturing, and others. However, I’ve recently started to feel that there were many companies and industries which I wasn’t considering and which had incredible value, even from a value investing point of view. I felt there was something I was missing. There was a need to grow my snowball further! (The SB effect in action!) As a constant learner, I’ve therefore become interested and curious to know how companies such as Amazon could grow so much in value (market value at least) and barely make any profit. The idea that investors were banking on the fact that, one day, the company would be hugely profitable seemed over simplistic. How can you project 10 or 20 years into the future when projecting even one year is challenging? So the real question is: how can you value a firm and therefore its future stream of earnings if it doesn’t even make any money as of today? (I’m obviously far from being a VC type of investor.) And so, I started reading about the subject, looking at the financials of some of these companies and believe I have found at least a partial answer to my question. There certainly is more to this but it’s a start!
Don’t get me wrong, I’m not saying it’s possible to understand every company in existence and this is not what I’m trying to achieve. And you should definitely stick to your circle of competence. That being said, there are several companies which their business can be understood but their financials are more challenging to get a grasp of as they don’t follow the “typical” model of good revenues, high profit margins and stable and predictable growth – which can be quite a clash when compared to traditional industries. Nowadays, these companies are often operating in the technology space (think Facebook, Alibaba, Amazon, Tencent, etc.). However, it’s important to note that many of these firms today are not necessarily offering or creating revolutionary technologies but instead use technology in a clever way to offer great products or services and they do this at on an incredible scale. These are the type of companies which attract my attention. I’m no scientist and far from having the capacity to judge and value companies offering new cutting hedge technologies. So, what makes these companies different? Where’s the value? How should we look at valuing these companies? Let’s first look at two important differentiating factors.
Nature of expenses
Warren Buffett once said that the valuation ratio Price-to-Earnings (P/E) did not have much importance when he conducted the analysis of a company. This can be rather controversial as so many investors rely heavily on this metric when making investment decisions. But why is that and why is it relevant in this case? The Oracle of Omaha has repeated several times over the years that the net profit of a company (the denominator of our P/E ratio) calculated following the accounting standards can be vastly different from what company owners can end up with in reality. When considering expenses and outflows of cash, this is largely due to the fact that some outflows are capitalized (capital expenditures in our case) and therefore not accounted as expenses but as purchases of assets, which are then depreciated over time. This allows for a lot of manipulations – whole books have been written on this topic. So, when looking at expenses on the income statement and capex on the cash flow statement, the first step is to make sure that, as an investor, you understand the items which are being expensed and the ones which are capitalized. It can be quite straightforward for traditional industries. For example, you buy a machine for your factory, which you will use for 10 years, you capitalize the purchase and depreciate it for 10 years – easy enough. However, it can get much more complex to make the difference between simple expenses and capital expenditures when considering, for example, companies using and/or selling software which are either produced in-house, outsourced, or bought from a third party, or a combination of these. There obviously are accounting standards which need to be followed such as GAAP and IFRS, however it is not always black or white. This is the more boring, accounting side of things and is the first step. The second part of the analysis should be kept clearly in mind while conducting this first step. Once you have a good understanding of what exactly is expensed and what is capitalized, it’s time to look at the business side of the equation.
This is honestly where I learned the most doing my research. Beyond the expense ratios and the trend of these over time, you want to look into the details and understand what exactly the company is spending money on. You want to find out if the cash outflows are in reality investments which will generate additional revenues for the firm in the future or if they are expenses which are necessary to run the business on a day-to-day basis, such as direct costs of sales or G&A expenses. Amazon is the perfect example. Over the years, Amazon has been generating a growing amount of cash out of its operating activities – about $6.8b in 2014 up to $16.4b in 2016. But the company is far from having high profit margins. Year after year, it’s the same story. So how is it that the company isn’t able to increase its margins? When looking into the details, you realize that, it certainly could, it just doesn’t “want” to. In terms of financials, Amazon is very focused on cash flow instead of income statement. And the main reason is that, every year, Amazon generates cash and takes most of that cash and reinvests it directly into the business, whether it is in the form of capex or other relevant expenses. You want to make sure though, that over time, the increasing capex and expenses are used to productively reinvest in the business to generate additional cash inflows and are not increasing because the business is becoming more and more expensive to run. Which brings us to our next item: revenue growth.
We started with expenses and end up with revenue, but hopefully this will make sense to you. In the case of Amazon (and several similar companies), the result of reinvesting so much money is an important growth in sales. The reason behind this is not rocket science. The team at Amazon knows how to reinvest money so that it generates higher sales at a later stage and that’s also why they have been very consumer focused in their approach. Many companies today need scale and are looking to win over a certain market (winner takes it all), so it is very important for these firms to reinvest their cash effectively in order to grow at the necessary pace.
Reinvesting money into a company can also be done in a view to reduce costs in the medium to long run. However, there’s a limit to reducing costs and it can’t be done over several years. On the other hand, with a big enough market, increasing sales can be sustained for a good number of years and this is usually the objective of most “non-traditional” type of businesses today.
One last point in terms of revenue growth is that you want to make sure you also understand the revenue recognition policy of the company you’re considering. Companies sometimes change their revenue recognition policy, which can have a positive effect on their top line. For subscription-based business models for example, this can have a significant impact. However, this is again just an accounting consideration, which has no influence at all on the business itself and which should be adjusted for in your analysis.
So, as an intelligent investor who doesn’t want to gamble with his money, how do you balance all of this? As I always say, you need to make your homework and understand the business you’re investing in. In addition, you want to consider companies with one or several proven business segments. You want to invest in businesses where cash is generated by segments which have been around for a while. Companies such as Alibaba, Facebook and Amazon all reinvest huge amounts of money in their business, but they also have very strong and proven businesses to back them up. They don’t rely only on one product or one new division but mainly on segments which have been in existence since they started operating (with some evolution of course). Nowadays, even large companies can still have venture characteristics and these can be very risky to invest in. In short, look for companies with proven concepts (consistently growing sales and interesting cash flows) who can find ways to channel extra cash into even better opportunities to generate increasing returns. An interesting metric to consider when analyzing a company or part of a company is the Return On Invested Capital (ROIC) which is generated by the investments – that being said, it’s not always easy to have all the necessary data to calculated ROIC accurately. ROIC will also let you know if your return improves or worsens the overall profit margins of the firm over time.
In terms of valuation, you’ve probably noticed that high growth companies with proven businesses don’t come cheap, even if they have low earning numbers. True, but the question in the first place is how do you value this type of company? It might be counterintuitive but you have to go back to the basics – don’t try to reinvent the wheel. This means that we’ll use a fairly simple concept which was first presented by Buffett and explain further. The idea is that the value of a company is the value, as of today, of all the future Owner Earnings generated by the firm in the future. Yep, that remains true! Owner Earnings are defined as (a) reported earnings plus (b) depreciation, depletion, amortization, and certain non-cash charges less (c) the average annual amount of capitalized expenditures that the business requires to fully maintain its long-term competitive position and its volume. For our discussion, the last part of this equation is the most important. Basically, we’re trying to find out how much money will be left at the end of the upcoming years considering a relatively stable business, without trying to grow the business at light speed or revolutionizing it. Investing is an art, so assumptions will be necessary, but the more you know about the business, the easiest it should get. In our example, Amazon, much of its expenses are to grow the business beyond a normal maintenance rate and therefore once these expenses are added back, the owners would be left with a very interesting level of earnings. If, using this formula, the business is struggling to generate any money, you might want to think twice before throwing your money at it. There will be other opportunities.
For detailed valuation calculations, I’ll have to reserve another post. But for now, I hope that helps and that you get the idea. Stay tuned for more!
Author’s bio: Originally from Canada, Alex Lanoie has been based in Asia since 2009 and currently resides in Hong Kong. He is a value investor focusing mainly on Asia-related companies and currently works for a large Chinese conglomerate as part of its global investment team. Alex also actively operates a blog about value investing: The Snowball Effect – www.thesbeffect.com. He has an undergraduate degree in finance from McGill University and obtained an MBA offered as a partnership between Columbia Business School in New York and The University of Hong Kong