For me as a value investor the most important imperative is to reduce uncertainty when valuing companies. However, widely used valuation techniques (while theoretically justified) such as the discounted-cash-flow method, usually involve a lot of guessing and forecasting into very distant points of time in the future. I believe everyone who has ever set up a DCF model was surprised about how only minor changes in the discount rate or the growth-rate of cash-flows lead to major variances in the valuation result. That means it is enough to be only off a little in our predictions and a company that is a sell suddenly becomes a buy. Further DCF valuations consist of two parts. The relatively precise estimation of near-term cash-flows and a pure guesstimate-part, also called terminal value that grasps cash-flows into far future. Strangely the model puts most weight on exactly this imprecise terminal value and only little weight on useful near-term projections that require only little assumptions. The result is of course an overall imprecise valuation, since good data is polluted by bad.
For me as a value investor, when valuing companies, it is therefore most important to take out uncertainty by reducing the necessity to make assumptions to a minimum. I like to work with what is save and certain rather than wrapping my mind around question like “what will be the EBIT margin of a company twenty years out”. To do so I follow two valuation steps established by Bruce Greenwald.
- The valuation of assets at reproduction cost
- The earnings power valuation (EPV)
The beauty of the first valuation principle is that it relies solely on balance sheet– rather than income statement data. The goal is to arrive at the price that a would be competitor has to pay to enter the business and successfully compete with the incumbent. Working with assets that the firm currently possesses elegantly bypasses the necessity for imprecise cash-flow estimates.
Since the reproduction value approach is a relatively conservative approach, which does not capture eventual competitive advantages translating into superior profit generating abilities I apply a second valuation technique, namely EPV. Unlike the valuation at reproduction cost EPV, like DCF, relies on income information, making it inherently more uncertain. However, EPV distinguishes itself from DCF in one very important point. It does not require any assumptions for cash-flow growth into the future and also doesn´t put a value on said growth. EPV merely relies on current income and thus needs no forecasting. The EPV or what Buffett calls it Owner Earnings are a proxy for the amount of cash that a business generates for the owner/shareholder of the company. That is the funds that are available to the company, after expenses to maintain the current level of earnings, also called maintenance CAPEX. These owner earnings can then be reinvested into the business or distributed to the owners. For valuation purposes owner earnings are discounted with a suitable required rate of return. I want to work around normally requested WACC (Weighted Average Cost of Capital) that determine the hurdle rate via little useful share price volatility. To do so I use a hand over fist approach by taking the average S&P500 return over the last 20 years of 10% and adjusting up or down based on the stability of earnings of the company. However, since I am only out for largely discounted companies a buy indication should always withstand a slightly higher hurdle rate.
After having applied both valuation techniques I can be reliably sure that a buy at a discount of 20% to 30% (margin of safety) will likely turn out a fruitful investment with little risk.
Successful value investing often requires large investments into conviction ideas, resulting in very concentrated portfolios. Nevertheless, at any time I try to limit single positions to less than 20% of total portfolio value.