OT: New concepts for equity evaluation

https://distillatecapital.com/wp-content/uploads/2019/10/Dis…

I think this article is an outstanding distillation of some of Saul’s thoughts in terms of why modern software stocks must be held to different concepts of value than older manufacturing stocks. It goes briefly into the history of accounting to give greater elaboration of why older accounting and stock valuation concepts are inadequate to describe these newly founded companies

Not long reading, very worthwhile.

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It’s a pdf. If you have Kindle, download it and archive it. I didn’t read the whole thing but it makes ample sense, there has been a massive shift from material goods to intellectual goods and neither accounting nor value investing “Security Analysis” (Graham & Dodd) has kept up with the changes. But not everything has changed. In Final Word they say:

Our use of normalized cash yields is rooted in the most basic principle of investing—the value of an asset is the present value of the future cash flows that asset will generate. We start with this bedrock concept and work through the complications that GAAP accounting has created to find a solution that allows for true valuation comparability in security prices. (Page 12).

That is a bedrock that I don’t see how it can ever change. It’s mathematics. The problem is that the inputs to the formula are imponderables. Growing revenue and growing free cash flow are good proxies. Back during the dot com era there was a similar paper that touted cash flow but the market crashed nonetheless. The error of that thesis, I now realize, is that it did not differentiate between cash from investors and cash from revenue. Cash from investors blows bubbles! This is why one has to be careful not to confuse stock price with business performance.

Another thing that probably will never change is how things grow from inception to maturity and that is best described by the Sigmoid or "S curve.

To sum up, for best investing results put your money in asset light “intellectual goods” instead of in asset heavy “material goods.” Do it when the market has accepted the technology, around 15% market penetration, and get out before the market is saturated, around 85% market penetration. The 15 and 85% events coincide more or less with the bottom and top curves of the “S” curve. This way you are invested in the fastest growing and safest part of the technology’s journey.

Slicing and dicing in ever finer detail the minutia of the business is not a great help [the reason I no longer do deep dives]. Understanding the business model, how it fits in with current affairs, how it competes in the market for revenue, are much better indicators of the future.

Denny Schlesinger

Two days ago I got a Foolish question by email about a valuation method. I had been pondering the reply and the above is it. I want to thank the [unnamed for privacy] Fool for the question!

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Denny,
I read most everything you post. I embrace your penchant for looking at investing through a mathematical lens (to the extent that it’s appropriate). You can’t argue with math, at least not the math that applies to investment decision making.

But I have a serious question for you regarding the S curve. Given that “the inputs to the formula are imponderables” for most of the companies we consider on this board, what are the heuristics you use to approximate the 15% and 85% cutoff points?

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I’m interested in Brittlerock’s question as well, and have another (perhaps dumb) question: How is the Price/Free Cash Flow ~>30 calculated

  • is the Price/Free Cash Flow ~>30 calculated with FCF in $M?
  • Do you use quarterly FCF or annual (I’m assuming annual, perhaps the trailing 4 quarters FCF number?)

Taking FSLY as an example, trading at ~$45, with ~$250M in Trailing (4Q) Annual Free Cash flow, results in a Price/FCF ratio = 0.18, well below that ~30 rule of thumb. If we use the last quarter’s FCF number (Q1’20), we get ~7 =$45/$6.4, still well below ~30

I wonder if there’s another benchmark that we could use to assess valuation that includes Free Cash Flow from Operations? I like OPS Free Cash Flow because is a “purer” number, IMO… But, as mentioned on this board, many SaaS companies have negative OPS Free Cash Flow numbers (FSLY’s OPS Free Cash Flow is still negative) so this heuristic wouldn’t/couldn’t apply.

Perhaps there’s a OPS Free Cash Flow quarterly growth CAGR that could be utilized. In other words, say for example, OPS Free Cash Flow improved by 45% from the last quarter, the Price/OPS FCF CAGR (in %) is less than 100, it’s a “good” investment: (e.g. 45/0.45 = 100 - that would be a fantastic sequential quarter for OPS FCF). Note calculating CAGRs with negative numbers is not exactly straightforward.

But I have a serious question for you regarding the S curve. Given that “the inputs to the formula are imponderables” for most of the companies we consider on this board, what are the heuristics you use to approximate the 15% and 85% cutoff points?

If I remember correctly I found those numbers in Geoffrey Moore’s writings – The Gorilla Game or some of his other books. These are ball park numbers, not a connect the dots investing method. For example, Moore uses the concept of The Tornado as the time to start an investment. That’s when a technology is catching on and product is flying out the door causing 100% year over year revenue growth. It’s the time when the pragmatists or early adopters get on board with a technology. Before that the long term viability of the technology is not properly established. The Tornado is what creates the bottom of the “S” curve.

Investing is more art than science.

Without any doubt, Zoom got caught a century sized Tornado! When I saw the numbers and how the company reacted to the security issues, it became clear that Zoom was here to stay and to be the dominant player. The recent earnings report certifies that my belief in Zoom was accurate and warranted. To a lesser degree the same goes for Teladoc (TDOC) and Everbridge (EVBG).

What I’m talking about is not an investing handbook but a mental model of how technologies are adopted.

Denny Schlesinger

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I’m interested in Brittlerock’s question as well, and have another (perhaps dumb) question: How is the Price/Free Cash Flow ~>30 calculated
* is the Price/Free Cash Flow ~>30 calculated with FCF in $M?
* Do you use quarterly FCF or annual (I’m assuming annual, perhaps the trailing 4 quarters FCF number?)

I don’t know how Distillate Capital (the authors of the piece) do these calculations. I don’t do the calculation.

I wonder if there’s another benchmark that we could use to assess valuation that includes Free Cash Flow from Operations? I like OPS Free Cash Flow because is a “purer” number, IMO… But, as mentioned on this board, many SaaS companies have negative OPS Free Cash Flow numbers (FSLY’s OPS Free Cash Flow is still negative) so this heuristic wouldn’t/couldn’t apply.

My point is that trying to get “purer” numbers is a fool’s errand. Look at the big picture instead. Are customers signing up? What’s the dollar retention rate?

As for SaaS heuristics I suggest listening to David Skok:

https://www.youtube.com/watch?v=bCBccKfG9U0&feature=emb_…

Denny Schlesinger

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Thanks Denny, great insights! In summary, you’re saying that investing is more art than science, and I appreciate that. I’d just like to have some criteria for evaluating a company vs. another, to apply some discipline to my investing decisions. Thanks again for the insights and YouTube link.
Gary

I’m really glad this thread about valuations has gotten started.

Saul teaches us to focus on the business metrics and not pay attention to the valuations and that seems to be working. But at there has to be some ceiling that’s identifiable with some metric.

In the knowledge base, Saul talks about using 1YPEG as his valuation metric. A lot of the companies we talk about are not yet profitable so we could use 1YPSG, but then the question is, what is a fair number?

If we take ZM as an example, what’s too much to pay?

Saul I’m sure we’d all love to hear you weigh in on this valuation discussion. How do you measure it? And if it’s still 1YPEG / 1YPSG, what does too high look like?

Bobby

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I’d just like to have some criteria for evaluating a company vs. another

And the lesson from I think most people here is that any attempt to rely on such metrics is an exercise in deceit. The evaluation should be about the company, its business, and its market as a whole, not some magic number.

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Saul I’m sure we’d all love to hear you weigh in on this valuation discussion. How do you measure it? And if it’s still 1YPEG

As you point out, most of our companies aren’t profitable yet and are of a different breed, that is piling up revenue and customers and saying “We’ll worry about profits later”

As far as valuation, if you’ll read “How I pick a stock to invest in” on the side panel, you’ll see that valuation just doesn’t come in to it. I simply don’t pay any attention to it, because I don’t know where these companies are going.

Look, Amazon was once at $5. When it hit $10, I’m sure that it looked very overvalued and a lot of the value people got out, if they ever even got in. It’s always been overvalued and it’s now at $2800.

Or for a more prosaic example, I first bought Shopify at about $27 as I remember. Within a couple of months it was in the mid-40’s, and up 70%. A sure sign to “take profits” and run. Overvalued. I sold out after 2 years, up I think it was 440% or something like that.

I literally don’t even check valuation. My method has worked very well for me.

Saul

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Wow! tamhas just said it even better than I did:

I’d just like to have some criteria for evaluating a company vs. another

And the lesson from I think most people here is that any attempt to rely on such metrics is an exercise in deceit. The evaluation should be about the company, its business, and its market as a whole, not some magic number.

And I’d add “and its future!”

Saul

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