The Growth With Value Podcast
By Alistair Cowley
The Growth With Value PodcastAug 05, 2020
GWV 014: Flight Centre Analysis
Download PDF Analysis of Flight Centre Travel Group (FLT) HERE.
GWV 013: Lovisa Analysis
Download PDF Analysis of Lovisa (LOV) HERE.
GWV 012: Nick Scali Analysis
Download PDF Analysis of Nick Scali (NCK) HERE.
GWV 011: Putting it all Together
Over the last nine episodes we covered a number of different topics which together form the basis of valuing a business’ intrinsic value. I began the Investor Education Series in Episode 2 with a brief Overview of my Investment Process. My basic investing concept is to find the best businesses out there and increase my understanding of these businesses so I am ready to invest with conviction if or when the time comes that they trade at or below their respective intrinsic values.
I outlined the process I undertake to find these wonderful businesses over the next eight episodes, where in Episode 3 I explained how I use a stock filter to find the companies that meet my criteria, then in Episode 4 I ran through how to utilise an investment checklist. Episodes 5-9 covered the fundamentals of valuing a business and Episode 10 we looked at the importance of applying a Margin of Safety to your investments.
Thanks very much for listening to my short Investor Education Series and I hope I have been able to help you to better understand a few key fundamental points behind valuing a business. From here you can continue to build your knowledge, which is a never ending process, and begin to make intelligent, fundamentally based, investment decisions.
GWV 010: Margin of Safety
Today we will talk about the Margin of Safety. Basically, the Margin of Safety is the difference between the value of a business, its Intrinsic Value, and the price which you pay for that business, its market price. It is different from the Discount Rate and can vary, depending on the perceived risk of the investment. The Margin of Safety is there to; absorb the impact of any unforeseen events that may adversely affect the business or the market in general, minimise the impact of any miscalculations made during the valuation process, allow for small declines in the company’s future earnings power, as well as taking into account your own risk tolerance. It is imperative not to use the Margin of Safety to justify the purchase of undervalued stocks if their fundamentals aren’t sound.
As a general observation of the market, investors are happy to buy when prices are high, and they see less perceived risk in the market. Then in turn, when the market crashes and prices plummet, they perceive this situation as high risk and sell. Logically, the margin of risk has now greatly reduced as prices are much lower than they were. If you were to purchase quality businesses at this time, your Margin of Safety has greatly increased.
To further increase your Margin of Safety (but not just by purchasing at a lower price) you should stick to businesses that you know and understand. By doing this your evaluations and future earnings predictions will have more meaning and certainty behind them.
To know what Margin of Safety to apply can be difficult. Generally, the riskier the investment the higher the Margin of Safety required. I like to set my desired Margin of Safety after first completing my checklist. I will give each checklist item a rating from 0 to 5, with 5 being excellent, 3 being average, 1 substandard and 0 being non-existent. From here I sum my checklist results to give me an overall rating and then divide that rating by the sum of the total points available. For example, say we have 30 checklist items; each item can achieve a maximum score of 5 points, which would give a total of 150 points (30 checklist items x 5 points for each item). If, after conducting my analysis of the business and giving each checklist item a rating, I arrive at a total of 125 points, I would divide my score of 125 by 150, which equates to 83.3% and by inverting that number I get a Margin of Safety of 16.7%, or 100% - my 83.3% checklist score which equals 16.7%. I will then discount my calculated Intrinsic Value of a company by 16.7% which will equate to my preferred purchase price for that company. For example, if I have calculated the Intrinsic Value of a company to be about $10 per share, I will then discount this price by 16.7% to give me my purchase price for that company, which is now $8.33.
As a side note, my minimum required Margin of Safety is set to 20%, so in this circumstance I would use the greater of the two and apply a 20% Margin of Safety, resulting in a lower purchase price of $8.00 instead of the previously stated $8.33.
I believe this approach is a simple and relatively accurate way to assess a company’s risk and thus allowing me to incorporate a Margin of Safety into my Intrinsic Value calculation.
GWV 009: Part B - Valuation Methods
Welcome to Part B of the two part episode on Valuation Methods. In part A we ran through how to value a business using the Discounted Cash Flow model. This method can be used to value the majority of businesses, especially those that are expected to continue operating well into the future. Today we will take a look at the Liquidation Value of a business. Liquidation Value can be used to estimate the potential investment risk of holding a company, as it provides you with an estimated value you, as an investor, can expect to receive if the company was to go out of business and its assets liquidated. Given shareholders are the last to be paid in the event of a liquidation, it is often the case that they will not receive any compensation for their investment in the business, resulting in a 100% loss. If however the Liquidation Value of the business is say $100 for example and you paid $200 for the business, then you can at least hope to get back $0.50 on each dollar you invested, or in other words a 50% loss total, which is obviously much better than a 100% loss.
The Liquidation Value is a method Benjamin Graham developed to estimate a value for the assets of a business if it was to be liquidated. It is basically the Tangible Book Value of a business but adjusted to better represent the liquidation value of its assets. When a business is trading near its Liquidation Value, it obviously has some problems. It would be amiss of someone to expect a struggling business to be able to sell its assets and inventory at Book Value, or the value quoted on the company’s Balance Sheet. This inability for a company to sell its assets at Book Value could be due to the company’s products not being as desirable or in such high demand as it used to, or the industry in which the business operates becoming obsolete. Unless you have the ability to analyse each asset and individually estimate the current market value of the assets, you can instead refer to estimates of the recovery rates for each asset class as determined by Benjamin Graham in his extensive research.
GWV 009: Part A - Valuation Methods (DCF)
In this episode we will look at the Discounted Cash Flow method, we will be applying many of the topics we have discussed in previous episodes such as; Discount Rates, Cash Flow and Growth, so if you have not already listened to those episodes I would recommend you go back now and have a listen.
The Discounted Cash-Flow Method is one of the most popular and widely used valuation techniques. It is basically the addition of all future free cash flows which have been discounted annually by the Discount Rate, which we discussed in episode 5 of the podcast. This will give us the present value of all the future free cash flows generated by the business. The sum of these free cash flow figures is the company’s Intrinsic Value. We discussed Free Cash Flow in further detail in episode 7 of the podcast.
The Discounted Cash Flow formula comprises two parts; the first part is used to calculate the Intrinsic Value of a business during what is generally referred to as the High Growth Period, where the company may have higher but potentially inconsistent free cash flow growth rates. This period is usually calculated to no more than 10 years. The second part is used for the Terminal or Stable Growth Period of the company. This is generally a more conservative estimate of a consistent rate of growth that can be expected for the remaining life of the company. A stable growth rate at or just above inflation is usually acceptable, between 2% - 5%. We discuss growth and how to calculate it in more detail in episode 8 of the podcast.
GWV 008: Growth
Today we will be looking at a company’s growth and how we can forecast its expected future growth rate. We will be using the compound annual growth rate formula to calculate the growth rate. I also have a few additional tools we can use to calculate the expected growth of a business in the value investing spreadsheet I created to help me value a business. It is free to download from my website at www.growthwithvalue.com/tools, I have provided a link in the show notes.
The Compound Annual Growth Rate formula is as follows:
CAGR = ((Ending Value)/(Beginning Value))^((1/(Number of Years)) )-1
Where:
Ending Value = Last published EPS, Dividend or Free Cash Flow figure
Beginning Value = First EPS, Dividend or Free Cash Flow for the chosen period
Number of years = Number of years between the Beginning Value and the Ending Value.
In summary, we have established that it is important to properly understand the business and its operations to help guide our decision on applying an appropriate rate of growth for the business into the future. We use the Compound Annual Growth Rate formula to calculate the historical growth rate of the business, using either Earnings per Share, Free Cash Flow or dividends, or a mixture of all three, with the result being a good basis to use as the future growth rate of a company. We also understand that the past performance of a business does not always equate to the expected future growth of that business. Again, this is why we need to properly understand the business and the economic environment in which it operates. We also discussed the importance of organic versus inorganic growth and how inorganic growth through acquisitions will provide an unsustainable boost to a company’s earnings. Finally, we discussed two separate growth periods, a high growth period and a terminal or stable growth period. The high growth period is used to apply a higher rate of growth to project the earnings of the business over a given period of time, usually less than 10 years. Terminal growth is a rate of growth usually inline with inflation and is used to calculate the projected earnings of a business into perpetuity, after first accounting for a period of higher growth.
GWV 007: Cash Flow
Today we will be talking about a company’s Cash Flow and how to calculate it by using the Cash Flow Statement. We will also look at earnings as reported on the Income Statement. We will compare the two figures to understand the difference between Cash Flow and Earnings. I will also provide a run down on the difference between the Income Statement and Cash Flow Statement. A final point we will be covering is Owner Earnings, this is another earnings figure used by Warren Buffett when he calculates the Intrinsic Value of a business.
You will find I have a checklist in my Value Investing Spreadsheet that will help investors look for any manipulation in relation to falsely recording Earnings and Cash Flow that may be attempted by management. I have a link to download this spreadsheet and checklist:
https://growthwithvalue.com/tools/
GuruFocus is a site which provides vast amounts of data and 30 years worth of financial reports, they also include many of the great Value Investors’ formulae within their historical financial data. Here is a link to the website.
GWV 006: Valuation Overview
Today I will provide a brief overview of valuation and why we need to calculate a business's intrinsic value. In later episodes I will delve further into some of the different valuation techniques such as the discounted cash flow model, providing you with more detail on how to value a business. In this episode we will primarily focus on the difference between price and value.
Intrinsic Value is the calculated value of a business based on its fundamentals such as its level of risk. For example, if the business is carrying too much debt or if the industry under which it operates does not have a foreseeable future, this would greatly increase the risk of the business. Another fundamental item is how much cash flow the business is currently producing or can be expected to produce into the future and also is the business expected to grow and by how much.
Intrinsic business value and market price are not always the same. Market price is the quoted stock price you see on exchanges such as the ASX. This difference in price can be due to many reasons, such as; market hype from investors overreacting to news, a difference in valuations and business expectations between investors and also a lack of volume.
GWV 005: Discount Rate
Today I will talk about the Discount Rate, also known as the Investors Required Return or even Opportunity Cost. By including a Discount Rate in your Intrinsic Value calculation, you provide yourself with a buffer against things like inflation and investment risk. By purchasing a company at its Intrinsic Value, you should expect to receive a minimum return which includes an offset against inflation and also allow for the inherent risk associated with the purchase of the business. It could be a good idea to have a minimum Required Return of at least 8 – 10%, Warren Buffett suggests a minimum required return should be at least 10%, whereas I apply a minimum required return of 12%. Personally, I like to include a mix of inflation costs, long term government bond yields, and an equity risk premium.
I would also like to note that the Discount Rate is what we will be using to calculate a company’s Intrinsic Value. A Discount Rate is used to discount the projected future cash flow of the business to a present value. Basically, one way to calculate the Intrinsic Value of a company is to forecast future earnings for each year for the life of the business, then add these together to give us the Intrinsic Value of the business. But if we don’t discount those future earnings into the present value, the valuation will be grossly overpriced. As we know, due to inflation and other factors one dollar today does not buy you as much as it did 20 years ago.
First we have inflation. Inflation is basically the rate at which the value of your cash is decreasing each year due to the cost of goods rising, this could also be expressed as the loss of purchasing power. The Discount Rate should take into account expectations of inflation, which has averaged 3% per annum over several hundred years. At the conservative end an inflation rate of 5% would be appropriate. It is important to include inflation in your discount rate as not to do so would mean that the calculated future returns would be overstated when expressed in today’s dollars. The International Monetary Fund website has historical inflation data for each country. http://www.imf.org/en/countries
Our second component is the Risk Free Rate. The risk-free rate is accepted as being the current yield of a long-term government bond, generally of 10 years or longer duration. Value Investors deem this as the highest risk-free return that you could receive from an investment. That is why it is used in calculating your Discount Rate, for it wouldn’t make any sense to invest in a risky investment like the stock market, if you didn’t take into consideration other returns that are available to you that have next to no risk. The reason it is deemed ‘Risk Free’ is because it is backed by the government. The chances of the government defaulting and not repaying your loan is slight, although not unheard of. To obtain the current Risk Free Rate, I use a website called Market Risk Premia. http://www.market-risk-premia.com/market-risk-premia.html
Finally the last component of the Discount Rate takes into account the risk of the investment, known as an Equity Risk Premium. The Equity Risk Premium is the difference between what you expect to receive on your investment compared to a long term ‘no risk’ government bond. To obtain the equity risk premium you simply calculate the expected return on an investment, minus the risk-free rate. This figure is included in your Discount Rate to ensure that the price you pay can be expected to exceed the returns you would have otherwise achieved from a risk-free bond. The market’s Equity Risk Premium over the last few decades has ranged between 4% and 6% per annum.
GWV 004: Checklist
Today we will be talking about the importance of having a sound checklist. I see the checklist as the most important step in my investment process. Having a checklist ensures you have minimised as much risk as possible by answering a list of questions you have developed over time from your research and past experience. I know that without my checklist I would forget to look for half of the important points I have listed.
Often these checklist items will force you to go looking for answers as to why some things don’t add up. A checklist will also make you realise whether or not you actually understand the business. I like to have a written answer as well as a rating out of five for each of my checklist items.
The written response is very important, as it will reveal just how well you understand the question and also the business. This is because we can easily brush over a question, thinking we know the answer and understand the consequences, but until we attempt to put these thoughts into words, we could be fooling ourselves with overconfidence in our ability to properly understand the question.
The rating out of five allows me to calculate how well the business has performed after running it through my checklist. For example I have a list of questions which fall under certain categories like growth, management, financials, income statement, balance sheet etc. After completing the checklist I am able to calculate a score for each of these categories to give me a result of how well the business has performed in relation to each category, as well as an overall rating for the business. This overall rating is shown as a percentage, with 100% being the highest rating. I can then use this rating when deciding what margin of safety I should apply to my calculation of the intrinsic value for the business. A higher score will result in a lower required margin of safety, and vice versa, a lower score will require me to have a higher margin of safety to account for the greater level of risk. I will go into more detail about the margin of safety and how and when to apply it in a later episode.
I have compiled a list of a few checklist items that I use which are available on my website at growthwithvalue.com/value-investing, I also go into more detail about checklists in my eBook, ‘How to Value a Business’. Please also note that I am continually adding to this checklist as I learn more about different businesses and investing in general. You can download this free ebook as well as my other ebook, ‘An Introduction to the Stock Market’ and my ‘Value Investing Spreadsheet’ at https://growthwithvalue.com/tools/. You will find the spreadsheet has the most up to date version of my checklist.
GWV 003: Stock Filters
A stock filter is a way to screen out any undesirable businesses by using a predetermined set of metrics like low debt and high returns on capital. This will help save you time when it comes to analysing in which business to invest. As you could imagine, trying to analyse each of the roughly 2,000 businesses listed on the ASX, one by one, could take you years, but by applying a simple filtering process you can eliminate many businesses which would almost certainly not meet your criteria.
I like to keep my filters pretty broad and not too restrictive. I have provided a link in the show notes to the stock filter available on the gurufocus website for you to play around with. This link has some filters already in place, these are; debt-to-equity of less than 2, Return on Equity of greater than 8%, Return on Capital greater than 8% and the removal of 47 different sectors and industries which do not meet my ethical criteria or fall outside of my circle of competence. With just these three filters, which are not at all restrictive, has already reduced the number of businesses from around 2,000 to less than 200. You can also view my watchlist which is available on my website at https://growthwithvalue.com/watchlist/. This is a list of businesses which I follow and believe are better than the average business listed on the ASX.
GWV 002: Overview of my Investment Process
Today I am going to give you a brief overview of my investment process:
First I look to investment in quality businesses which I understand and that have long term prospects.
My idea is to find the best businesses on the market and analyse them to give me a better understanding of how they operate. I will continue to monitor and follow these businesses, waiting for the right opportunity to buy. You will find that great companies rarely trade at or below their intrinsic values, but on certain occasions, such as the Global Financial Crisis or more recently with the COVID-19 Pandemic, these wonderful businesses will present you with an opportunity to buy them at discounted prices. Through in depth analysis and a solid understanding of the business, you will create the conviction that is required to buy big and continue to hold these investments through volatile markets.
To help me find these wonderful businesses I will apply the following steps:
- Reduce the number of investable businesses through a stock filter, looking for low debt and high returns on equity and invested capital. I will also apply an ethical filter. I have found the best screener available is through GuruFocus, I have provided a link in the show notes. Basic Screen
- I will then create a Watchlist from the stock filter of businesses which I understand and have met my criteria
- I begin the investment process by selecting a business from my watch list and then read through the companies ASX announcement history and obtain Annual Reports and any other relevant data from investor presentations etc.
- I then record all relevant data into my spreadsheet, this will help me when it comes to working through my checklist and also provides me with a better understanding of the company’s financials and make any necessary adjustments. I again use GuruFocus to download companies financial reports. They offer up to 30 years worth of data on individual businesses, providing you with the Income Statement, Balance Sheet and Cash Flow Statement, as well as a whole heap of other calculated metrics and ratios.
- Work through my checklist to establish a quality rating of the business
- Last stage is to calculate the intrinsic value of the business, in this step I will use a predetermined cash flow figure, an estimated growth rate for the company and will apply an appropriate discount rate and margin of safety to account for the perceived risk of the business
- When it comes to selling, I will only sell when there is a fundamental change within the business which is likely to result in long term difficulties for the business to continue to operate and produce good returns
- I will then create a Watchlist from the stock filter of businesses which I understand and have met my criteria
In summary, I look for quality business which I understand. I then compile these into a watchlist to enable me to closely monitor and perform in depth analysis. This will help build the conviction needed to buy big and hold, provided your analysis and the fundamentals of the business have not changed.
GWV 001: Welcome Episode and Podcast Overview
Today's episode will provide you with a brief guide of what you can expect to gain from this podcast.
First I'll provide you with about a 10 episode series on Investor Education, sharing with you the things I have learnt over the last few years while researching the art of value investing. We will be covering fundamental tools and investing principles such as Stock Filters, Checklists, Discount Rates, Valuation Methods and the Margin of Safety.
I also have a free eBook titled, How to Value a Business which is available to download on my website. This book covers all of the information I will provide in the Investor Education Series. I also provide you with the spreadsheet I created to help me analyse businesses and another free eBook titled, An Introduction to the Stock Market which covers some basic principles to help you better understand the stock market. All these are free to download from my website.
Once we have completed the short Investor Education Series, we will then begin the crux of this podcast which is to work through in depth analysis of businesses I have on my watch list. I will create an episode for each business I analyse and present my investment case to you with the hope you will then go and conduct your own research into the company, using my analysis as a starting point to build on.
You can access my Watchlist on my website https://growthwithvalue.com/watchlist/.
As well as conducting in-depth company analysis, I would also like to seek out interviews with CEO’s and Management of businesses we cover in the analysis episodes. This will give us the opportunity to ask them any questions we may have and they can provide a more detailed description of the business, its operations, how it makes money and where they envisage the business will be in ten years time.
Thanks very much for listening and I hope this podcast will provide you with some benefit and help you to become a better investor. If you enjoy the podcast please share it with your friends and don’t forget to check out my website where you can find loads of information on investing including my free eBooks and investing spreadsheet.