Hi TK,
I’m glad you came here to ask about valuation. Lord knows it’s forbidden on the Saul board. I’ve been trying to figure out why questions of valuation are so taboo over there and I can’t, for the life of me, figure it out.
The first thing to know is that the way Saul understands value investing is a straw man. He defines it as investing in low PE stocks or “value” funds. All investing is value investing. All value investing means is that you take into account a reasonable estimate of the owners earnings that are likely to flow to a shareholder over the period of their investment. Those earnings can flow in one of three ways: (1) dividend payments, (2) share buybacks (if bought back at a reasonable price), and (3) earnings growth over time. This last is the real source of value for a company, the growth of its earnings power over time. When buying a companies stock we need to make an estimate of what that earnings power is and how it is likely to change over time. In doing so, we need to be conservative.
For example, let’s start with a popular hyper growth company like Snowflake, of which Berkshire Hathaway owns a slug. Snowflake earned $1.2 bil in revs in 2021 and had a market cap of $45 bil, so it’s trading at around 40 times sales. What assumptions are baked into the shares at its current price? Let’s assume that Snowflake can grow earnings consistently at 30% per year for the next decade. If they did that, sales would grow from $1.2 billion to $16.5 billion. Not many companies can grow at consistently high rates like that, but that’s what the hyper growth board is looking for in a company. While sales are great, profits are what matter because it is profits that are returned to owners in the form of dividends, buybacks, and increased earnings power reflected in rising stock prices. What net profit margin can we expect for SNOW a decade from now? It’s hard to say, but we can look at the most successful SaaS company in the world as a best case scenario–Microsoft. MSFT has net margins of 35%, so let’s assume that SNOW achieves those margins in a decade. That would mean earnings of $5.75 bil in 2032. What should the market cap be in 2032 based on these assumptions? If we give SNOW’s future earnings of $5.75 bil a 25 PE multiple, we’re looking at a future market cap of ~$145 bil. Under these assumptions, SNOW is likely to return ~12% per year over the next decade. Not bad, but is it worth the valuation risk?
Let’s look at what could go wrong with these assumptions. First, 30% annual growth in sales is pretty rich. In fact, I think most of the posters on the SAUL board would bail on SNOW if the growth rates were this low! Look what happened to Upstart today? There is no margin of error in the growth rate assumptions of hyper growth investing, and if a company hits even the slightest bump in the road the share price craters. I’m not sure 30% is sustainable for a decade, but the current price requires it for the purchase to work out. Second, net margins. Is it reasonable to assume that SNOW will hit 35% net margins in the future? What would be a safe net margin rate to expect in a decade? I’m not sure what it will be, but I know that this estimate is definitely NOT conservative. Anything short of 35% will be a disaster for the future market cap. Finally, what multiple to earnings can we expect in a decade? If these growth assumptions work out then 25 might be too conservative, but I think it is reasonable, and I wouldn’t what to bet on the whims of Mr. Market a decade from now to determine if my purchase is safe and reasonable.
This valuation exercise tells me that SNOW is a risky venture even after the recent price collapse. Worse than that, there are much safer alternatives available. Google is likely to return 12% + over the next decade at current prices and it is making money hand over fist while growing those earnings faster than a rabbit runs in the shadow of a hawk. If I were to consider an investment in SNOW, which I wouldn’t, I’d need to see prices that eliminate most of the risk of high growth assumptions (hence the reason I would never invest in money losing hyper growth stocks). I might consider throwing a tiny amount of money (maybe 1%) at SNOW under $40. This would be a price that assumes 15% annual growth for a decade with terminal net margins of 10%. Ridiculous, you might say, but that is why value investors avoid these kinds of speculations. They need prices that would almost guarantee a profit in the worst case set of assumptions.
PP