My take on Valuation

Investment Analysis Clubs Saul’s Investing Discussions
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Continuing the discussion from Bear's Portfolio through 05/2024:

I wouldn’t mind a (brief) discussion about valuation…I’d actually love to know how others think about it. For myself, I think this sums it up:

Another example: CRWD is a $78b company right now. Let’s imagine the best couple years we can dream of. Let’s say they grow their ~$3.1b annual revenue by 30% this year and next. They’d have about 5.2b in revenue. Let’s say they somehow have a 40% margin (FCF or net income…bottom line, basically) that would be ~2b in profit. So today’s $78b price is ~40x the profit 2 years from now in a dream scenario. It’s just too much. But, if all that actually comes to pass, and CRWD doesn’t slow down at all the next 8 quarters, it would probably mean the market would give it a multiple of more than 40! That’s basically what you have to hope to own CRWD now. I just don’t think it’s a realistic scenario.

Riding the wave vs being a price-enforcer
It’s a mathematic fact: a company can’t really be worth $20b one morning and $21b by afternoon. But such is the stock market every day. Whether to the upside or the downside, everything is always mispriced to an extent. Some people (Saul) just ride the wave. I try to take advantage of the constant mis-pricings. But of course, I mis-price things too! My back of the napkin math could just turn out to be wrong. Suppose CRWD accelerates and grows 50% the next 2 years, $78b today would probably turn out to have been a bargain! It would mean the market would turn out to have been right all along, and I would have been wrong all along.

If you’re not impressed by my back of the napkin math and my track record of often selling out of companies before the share price hits a high water mark, I don’t blame you. Do what Saul does and don’t worry about valuation so much. But this is what works for me.

To boil all this down to something I think we can all agree on: I think the valuation math is pretty simple. It’s just that changing a few input numbers leads to VERY different results.

If anybody disagrees with that, or thinks about it totally differently, I hope you’ll explain how you think about it.

Bear

PS - I want to add 2 points:

  1. A company is valuable because of the profits (cash flows) it will throw off. If you could know them, you could discount them and come up with an absolute value. But you can’t know them, and you can’t even come up with the right rate at which to discount them.

  2. If you pick the wrong company, no valuation is cheap enough. I probably don’t have to even give examples, but I looked at BILL this morning who will do 1.3b or so this fiscal year with a ~20% bottom line margin and has a mkt cap of 5.5b. That’s a PE of just 21 or so. But it is not a buy IMO, because growth has slowed almost to a halt, and the competitive threats could kill it altogether (or at least, it could have less revenue and profits in future years). Maybe they bounce-back, but in my experience Buffett is right that “turnarounds seldom turn.”

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Thank you Bear for sharing your process. It’s very helpful for newbies like me. Valuation is a very hard thing for me to grasp. And currently I use a very simplified formula to help me assess valuation. My confidence level in this formula is about 5/10. I am still working on improving it.

So here it goes:

  • Part 1: NTM Growth% - FCF TTM% (gives a range to work with)
  • Part 2: Multiple this range with GrossMargin% (rewards high margin and punishes low margin businesses)
  • Part 3: Add back to the current FCF TTM% (this allow all businesses to start at their current FCF situation and rewards them for high growth, high margin or dings them for vice versa)
  • Part 4: Add a margin of safety, for me it’s a haircut of 30% (since I know this is only 5/10 of my confidence level. As the confidence level grows with change of formula, I will reduce the marginOfSafety)

The formula as constructed fully looks like this:

(FCF TTM% + ((NTM Growth% - FCF TTM%) * (Gross Margin %))) * MarginOfSafety

Let me explain why I did what I did:

  • I needed something that works for three situations. 1) High Growth but negative FCF 2) Similar Growth and FCF numbers 3) High FCF but low growth. This formula spits out a relative number taking all these three scenarios into account. Meaning I now can use one scale to value all these three types of businesses. Hence, I said it’s super simplified.
  • and this takes into account the three most important things I have seen being highlighted for growth businesses, revenue growth, profit margins and free cash flow.
  • since a lot of the businesses I invest in are turning from negative cash flow to positive, this formula helps me.

How do I account for relative safety:

  • if NTM revenue is less than 20%, I just don’t bother investing in it. So I don’t have to worry about really low growth businesses, which anyway I am not interested in.
  • Obviously, the marginOfSafety at 30% provides some cover to be wrong
  • Also, I like to see a 100% return on the formula over the next 12 months. This allows for another layer of safety. So once I own a business and the next 12 month return starts to drop below 100%, say 50% or 20%, I start to look for exit.

Examples:

CRWD

  • (31% + ((29%-31%)*75%)) * 0.7 === P/S 20.65
  • Given that crowd is trading at 23.55 P/S, so the upside based on this formula for me is 9% returns in the next twelve months. So I love CRWD but too expensive for me currently.

HIMS

  • (6% + ((37% - 6%)*82%)) * 0.7 === P/S 21.99
  • Given HIMS is at 4.17 P/S, this suggests 588% upside over the next 12 months
  • OFCOURSE THIS IS WRONG. But it shows me the business is undervalued with the same metrics we used for crwd.

TMDX

  • (-68% + ((91% - (-68%))*62%)) * 0.7 === P/S 21.3
  • given TMDX is trading at 15 P/S, the upside is 201% over the next 12 month
  • again most likely I am inflating the valuation a lot but it still seems to have some upside.

I hope I was able to explain my theory of valuation.

I realize this might be sooooo off topic from what this forum is about. Please feel free to delete this post, if this is not adding value to this thread.

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I see no reason to delete it but, to others: Please no comments on @ryshab’s method. We don’t want to debate math, or argue over which assumptions we agree or disagree with.

Bear

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Just a few thoughts on the topic,

  • It is interesting to me there is no universally accepted formulas for valuing a growth company. Looking what methods people use to value growth companies: using discounted free cash flow, Rule of 40, market comparison approaches, and probability weighted scenarios
  • Some of the growth companies we follow don’t have any earnings, some are break even, and some have large earnings. For the non-earnings ones do we use P/S and the earnings ones use P/E? The break even ones present particular issues for putting through a traditional P/E based valuation framework because they might have a P/E like 2,000 if they earned one cent.
  • Valuation is going to change by industry and business model. For example we probably wouldn’t want to value a SaaS company on par with an energy drink company
  • The market seems to mis-price growth companies often enough that we can capitalize and this is where the board’s edge over the market mostly comes from. The market prices in growth rates slowing at some point, and when we are able to find growth companies which can continue the growth in revenue and earnings longer than expected we will profit.
  • Interest rates have a huge impact on valuations probably more than most of us realized before 2022. How much is this company worth in a 0% interest rate environment versus a 5% interest rate environment is a world of difference
  • How can we value things like announcements of an unexpected product line? The fundamentals and metrics haven’t changed at all but the story or TAM has grown. If we went purely off of numbers after every positive announcement that would lead to a company getting more overvalued.
  • The market can value a particular industry with high multiples which can breed a sense a complacency that the valuation is not too high because other companies in the industry also have a high valuation

My general approach is to look at the revenue growth rate, market cap, EPS/EBITDA growth rate, historical prices, and the competitors same metrics. I’ll look at P/E if there are earnings and P/S if it’s a pre-earnings company. Ultimately I’m just making judgement calls on the valuation of the companies I invest on based on heuristics. I’d be interested to hear more from board members who have a more sophisticated approach.

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I would say that valuations cannot be discussed without discussing macro, which has long been OT here. But as a guideline I think everyone needs to answer certain questions for themselves. There are studies by reputable institutions that can be found via Google search showing that valuations do not matter over the long run OR that valuations matter in very rare cases (like less than once per decade, 2000, 2021). The one I recall immediately was from Vanguard–and that was about the stock market in general, not tech.

1/ Can secular trends explain all of tech out-performance over the last decade+? And if they do explain tech, then what explains BTC becoming the best performing asset in history? It has been 15+ years, so irrationality cannot be the answer. We have seen that stock and crypto manias are measured in months, maybe a year at most at a time.

2/ Do tech stocks trade on fundamentals exclusively, on fundamentals first, or on fundamentals secondarily? The answer to this question will dictate how one views valuations, too.

If one answers"yes" to 1 and thinks that tech trades on fundamentals only or fundamentals first, then that’s what it is. Then you look for valuation metrics that can be backtested with success.

If one answers “no,” then one has to go into Central Banks and that goes further than just interest rates. That part of central banks activity is already reflected in traditional approaches to understanding and valuing the old economy sectors.

Even in 2020-2, IMO, the importance of valuations in tech came with an asterisk. Better growers went further than lower growers all the way despite crazy valuations towards the end. And yet, all tech baskets did great relative to traditional stock baskets in 2020-21, low and fast growers, cheaper and pricier, all but boats leaking water. Then in 2022 all tech sank and no valuation was too low not to contract way, way further. If all boats fall and rise with the tide, then it really is the tide that matters first and the seaworthiness of the boat only second.

I am ultimately a top down person while this board has had exceptional success with bottom up approaches. That’s fantastic, we are all different; all that maters is to find what works for what person. But I think valuation discussions cannot stay within a bottom-up discussion because valuations demand discussing the tide, they do not allow to focus the discussion on the individual boats alone.

EDITED for a typo.

My 2c.

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I’ll share my thoughts in a bit, but first I’d say that 30% revenue growth for CRWD in each of the next two years is hardly a dream scenario. I own a not too large position in CRWD, and I expect CRWD to grow at 30% in each of the next two years at a minimum or maybe as a base case. I think a “dream” growth rate for CRWD would include an acceleration to 40%+ growth. Sure, it’s difficult to reaccelerate that much at this scale, but that’s what I would call a dream scenario for CRWD. I’m not holding CRWD because I think it needs the dream scenario of 40%+ growth but because it’s winning in the cybersecurity market when some of its peers are posting weaker and less consistent results. I believe CRWD will growth at >30% for a long while.

I think great companies are hard to find, but when I find them I want to try to stick with them rather than sell them when the valuation might seem to get a bit frothy. Sometimes making predictions about the future turns out to be very wrong or a gross underestimate. So what makes for a great company? For me, it’s a dominant company that’s the leader in its market. There may be competitors but these are by far inferior to the market leader than I like to own. Examples of dominant companies that I own include MELI, NVDA, CRWD, TTD, and AXON. High gross margins maintained over many quarters/years are a sign that the company has pricing power. High free cashflow combined with a strong balance sheet enables the company to control its own destiny and acquire new products and technologies without significantly diluting shareholders. I don’t like companies that are likely to get disrupted. I care a lot more about growth, competitive position in the market, and drivers for growth going forward than I care about valuation. Valuation is the last thing that I look at but sometimes it plays a role into whether I want to own the company and how much I want to own. For example, I see CRWD and TTD as expensive when considering the growth rate so I only own about 5% of each. Other times valuation can be a judgment call and different investors have different views of what the future holds. The current poster child for this NVDA which some say is in bubble territory while others say it’s still inexpensive. Investors in each of the camps will have a wildly differing view of what the future holds.

GauchoRico

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For me, first Bear, your calculation that CRWD would earn 2B after two years of 30% growth is too pessimistic. It’s going to have 1.6B in operating cash flow this year alone, and that is likely a conservative figure. Cash is king so I wouldn’t look at EPS or adjusted EPS, I just look at cash. I would say it’s very very likely that CRWD would have a 2B two years from now, far from a dream scenario. Secondly I would say it’s totally fair to trade at 40x cash flow after that growth record. Today CRWD trades at 66x trailing cash flow, ZS trades at 38, SNOW trades at 49x. 40 does not at all seem unreasonable from a valuation standpoint for a clear leader with that awesome growth record.

The only thing I can say about absolute valuations is that our companies at their bottoms of valuations traded at about 10x sales. These were dark days. I think 10x sales for a consistent grower north of 30% is worth at least that much (you could do DCF calculations to convince yourself with varying assumptions) – but that is what the market has said they are worth. In bad times, our companies will trade for this amount. In good times, they will trade for 20-25x sales. So if you buy a 30% grower at PS of 12, your downside is likely 20% (if they can sustain that growth which is not easy, as growth falls under 20, a PS of 5 is more appropriate).

PS of 12 is Zscaler by the way. The upside is big if they can continue to grow at this rate (the stock price has to go up by the growth rate). Those are the situations that I look for.

Thanks,
Rob

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My concern is that introducing valuation and anchoring to one or another presumed floor within a bottom up analysis of tech does not work because it assumes that traditional valuation metrics and DCF suffice.

Until late 2021, SaaS rode a confluence of monetary, tech, and business trends to the moon. While the secular trend in cloud remained, monetary and business backdrops went into cyclical corrections that made our heads spin.

This is why the thread below is so painful to revisit now:

We all proved it so very convincingly that tech was cheap in Jan 2022!

If monetary conditions are the wave, then there is no bottom until we hit traditional ranges like 1-2 P/S. Or ceiling, until everyone and their cat is invested in SaaS.

So the interesting question is whether in highly volatile moments a company or two get mis-priced, which is not supposed to happen, but it does temporarily as with ZS in the 80s. So this is where the amazing strength of this forum lay, I think. But that determination would come from putting together reasonably expected future company business performance relative to price and sentiment and sure, valuation contraction, but not by measuring against a fixed valuation “floor.” And what would invalidate that analysis regardless of its quality with respect to company and sector is a paradigm shift in underlying monetary conditions.

No worries, done with this topic on my end:)
Cheers

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I can imagine why that’s true. Peter Lynch, starting a little after 1 min into this video, explains:

Coca-cola is earning 30 times per share what they did 32 years ago; the stock has gone up 30 fold. Bethlehem Steel is earning less than they did 30 years ago; the stock is half its price of 30 years ago.

In the very long run (like 30+ years), all of these are barely blips on the radar:

  • your cost basis
  • inflation
  • fed policy
  • bear markets
  • bull markets

You can probably think of more things that don’t matter in the ultra long run. But of these 5, the only thing you can control is your cost basis. Even though it doesn’t matter over 30 years, it can absolutely matter over 3 years. Ask anyone who bought Snowflake in 2021.

A couple years ago, we thought our companies could grow at 50%+ for a few years. I’m not gonna argue that CRWD won’t stabilize here around 30%…I guess I was just showing what might be priced in.

Ahh but if it does, then the shares would still be around $300 – a year and a half from now!

Brief conclusion (to the thread, unless anyone has anything they just have to add): I think I was right in the first post. Whether we think a stock’s multiple is too high or too low has a lot to do with what we expect for growth and profits. I think conservatism is probably smart. We’ve seen expectations come down a lot. Stocks where the price (multiple) implies that too much is expected seem unlikely to go up a lot in the next couple years.

Bear

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Bear,

If you buy CRWD today on the basis that it would be fair for it to trade at 40x cash flow in two years, then you are buying one of the best businesses around at a “fair price”. I am not at all saying it’s a bargain at this price. If you are a value investor, stay away.

But if your play is to hold the very best businesses that are fast growing, then CRWD is a pretty good pick. It’s not crazy over valued by those metrics and it IS a great business.

That is my play. The best businesses that are rapidly growing at a fair price. However, I do tend to rotate into other “best” businesses that have lower valuations (in my case, ZS).

Thanks,
Rob

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