Valuation for beginners

The best way to go about ensuring a good result is to pick good businesses. Be right qualitatively about a business and you’re likely to do better than you think.

I’ve made it a point that I don’t really do complex valuation work or Discounted Cash Flows (DCF). There are a few reasons for this, but it primarily boils down to the idea that they are complex, time consuming, and end up being mostly inaccurate anyway. After all, a DCF is mostly about the inputs, and these inputs are just educated guesses.

How I value businesses

My valuation work stems from Pat Dorsey’s idea of understanding how the revenue and profits for a business scale. What are the fixed costs, variable costs, and opportunity set? This is really all you need, especially if you are attempting to value a high growth business.

Finding the margin at maturity (using fixed and variable costs)

If you truly understand the fixed costs and the variable costs (aka Cost of Goods) you will have a good idea of where the net margins should be at maturity. Take a 3P marketplace for example. In this example, you know the stated gross margins are around 80% (20% COG). That leaves us with fixed costs — what are they? People, R&D, S&M, etc. Look at the percentages of each against the revenue and determine where they might be at maturity. So for example, if the S&M costs are around 50%, you might predict that S&M will go down to 30% as it scales and more people know about the brand. If that does end up being the case, that’s an additional 20% in profit at maturity.

Here, knowing the business model and and the competitive position is key. You can’t really come up with a margin at maturity unless you understand both of those things.

Finding the 5 year revenue growth

The second part of the equation is understanding how much the company will grow their revenue in the next 5 years. As Pat Dorsey phrases it: “What is the opportunity set?” Is the end market growing at a certain rate and is this business a leader in that market? Again, in order to make an estimate, it is critical to understand how and why the company is growing in the first place. Put in the work to really understand the business model, the moat, and the end market and its competitive environment.

This leads me to my next point. You cannot do valuation work if you don’t deeply understand the business itself and its competitive position within its market. Most of my valuation work is qualitative. Do as much qualitative work on the business as you can before you even attempt to find the IRR. If you do understand it, the number crunching part is easy.

Putting it all together: Finding the IRR

The final part of the equation is to find a fair multiple for business in 5 years. It’s akin to choosing a discount rate for DCF. Obviously, the better the business, and the faster the growth, the higher the multiple will be. I try to keep things simple and use a 30x multiple (a 3% earnings yield) for good businesses. I won’t even look at bad businesses, so that means I use 30x across the board. Some people think that 30 is too high, and it may be so, but to me that doesn’t matter because I am using the same number across the board and investing is really about opportunity cost — comparing IRRs and investing in the businesses with the best risk/reward.

So the equation is simple. First you get the market cap in 5 years:

[TTM revenue * ((1+revenue growth rate)^5)] * margin at maturity * multiple

“Revenue growth rate” and “margin at maturity” are percentages or numbers between 0 and 1.

The part enclosed in brackets is giving you the total revenue in 5 years, and then you want get the earnings from that, multiplied by 30, which in my multiple. That is the market cap in 5 years. Once you have a market cap in 5 years, you’ll compare with the current market cap to find the IRR. So for example, if the market cap in 5 years is $100B and the market cap currently is $50B, that means it will be 100% return in 5 years, or roughly 15% IRR.

Investing is all about opportunity cost

It doesn’t make sense to look at the IRR in absolute terms. Investing is all about comparing the IRR of a business to what you can get in other places. This is the reason why interest rates matter for the valuations of stocks. As interest rates go up, so too does the risk-free return, which is why the valuations for other assets like stocks come down. After all, why invest in stocks if the risk-free returns are similar or higher?

Putting the concept of interest rates aside, you will also need to compare the IRR of one company with other companies. This can also be resolved by adjusting the multiple depending on the business you are studying, which takes us back to the idea of discount rates: the higher the terminal risk in the business, the higher the discount rate, or the lower the end-state multiple.

But even so, you might find two great businesses at different points of maturity, and while you might want to use the same end state multiple, you will need to compare IRR at the end and decide which stock with a 15% IRR you’d prefer to own. And this is where understanding the business and understanding your own personal style comes into play. You can buy both, you can buy the one that is more optional, or you can buy the one with more certainty around its business model and terminal risk.

Nothing is certain

In the end, the IRRs you end up with will most likely be wrong. It’s important to know that nothing is certain in business and investing and you could be wrong for a variety of reasons. The best way to go about ensuring a good result is to pick good businesses. Be right qualitatively about a business and you’re likely to do better than you think.

Resources

I love this Pat Dorsey talk at Google, and it’s been really influential for me in terms of how I value businesses.