Someone who reads the blog sent me this email:
I recently came across your blog and find it simple and quite informative. I have noticed myself drawn to speaking to other like-minded investors as their experiences and insights are very valuable in developing my own knowledge and skill set rather than just reading a lot of books on the subject.
One of the topics that has been on my mind for quite some time is the required rate of return adequate to compensate investors for being equity holders in a business. I have moved away from the mainstream CAPM and WACC models for pricing the cost of equity but find little alternatives.
From what I understand [Greenwald's class] is that Warren Buffet generally uses 15% for his discount rate, although I am not quite sure how he came up with that number. Also, from some of the class notes from Greenblatt, he mentions using the 10yr bond rate with a 6% floor and compare that to the EBIT/EV of a company.
So my question is how do you determine what is an adequate rate of return? And how do you apply/adopt that to emerging market companies [as most info relates to US stocks]?
Thank you in advance for taking the time to respond.
I usually value a good and low-risk company at 10 times EV/EBIT. At a 35% tax rate, 10 times EV/EBIT equals 15 times unlevered earnings after tax. To make it simple, I assume after-tax earnings are equal to owner earnings. You may need to make some adjustments regarding the DA part and the actual maintenance capital expenditure. And I’ll assume that market cap equals enterprise value.
There are two reasons for using a 15 unlevered P/E. First, an average company often trades at a 15 P/E. So, a better than average company deserves at least 1a 5 P/E. Second, a 15 P/E would mean a 10% nominal return. At a 15 P/E, yield is 1/15 = 6.7%. A good company can raise prices at the inflation rate or higher. That adds up to about 10%. 10% is what the stock market returned in the past. And I think the stock market will return less than 10% in the future.
Two Risks to Consider
What are the risks? I’m concerned about business risk and capital allocation risk
Business risk is about whether earnings will decline. Numerous factors may reduce earnings. It can be the business cycle, which requires us to look at normal earnings instead of current earnings. It can be competitive pressure that would change earning power forever. It can be changes in technology or customers that reduce demand forever.
Capital allocation risk is about whether the management will destroy value. A 15 P/E is equivalent to 6.7% yield only when the company returns all earnings to shareholders. That’s often not the case in reality. Some of the earnings may be used to repurchase shares or pay dividends. But the rest is usually retained by the company to reinvest in the business, make acquisitions, or simply build up cash. So, if the company simply builds up cash, the company is worth less than a 15 P/E. If the business has a lower than 10% return on capital, and if the company keeps reinvesting in the business, it’s worth less than a 15 P/E. If the business has a higher return on capital, or acquisitions create higher return, it’s worth more than 15 P/E.
Some Good Companies Deserve Higher Valuation
There are companies that deserve a 20 unlevered P/E. I think Weight Watchers (WTW) is worth more than a 20 unlevered P/E. That’s because of growth. WTW’s return on invested capital is infinite. Working capital is actually negative. That means they need no money to grow. The question is just about how much they can grow. If you think long-term growth is at least 5%, you’ll get a 10% return at 20 unlevered P/E. You’ll get about 1/20 = 5% yield from dividend and share repurchase (which increase earnings per share). And organic growth contributes 5% earnings per share growth. That adds up to 10%.
Companies like Coca Cola (KO) and Procter & Gamble (PG) always trade at over a 20 P/E because investors believe in their long-term growth and the stable nature of the business.
I think there should be some value in leverage. A stable business should be valued higher than a volatile business. The reward for being in a stable business is the ability to leverage. But it would be too theoretical to figure out the optimal capital structure. So, I would stick to EV/EBITDA or EV/EBIT. Any wise decision about capital structure by the management would be a bonus to investors.
I would value a company at an enterprise value equal to 15 times unlevered earnings for a company with minimal business risk and capital allocation risk. I don’t know how to value a company with more risks than I’m comfortable with.
Intrinsic Value and the Price We Pay Are Different
I think we should notice that the rate of return that we want from an investment is different from the hurdle rate that is used to calculate intrinsic value. Intrinsic value is objective. The price we would like to pay is subjective.
In my 15 EV/unlevered earnings model, the implied hurdle rate is 10%. But you might want a 15% return. So, you can try to calculate intrinsic value of the company to see how cheap the company is. But more importantly, you should have an idea about the return of your investment.
For example, assume earnings per share is $5, and the price is $50. If you think the company is good and should trade at a 15 P/E, and it’s safe to assume that would happen in 5 years. If you buy at $50 and sell at $75 in 5 years, you’ll get an 8.45% annual return. If you assume they can grow 5% in the next 5 years, the stock price would be 1.05^5 * 5 * 15 = $95.7 or a 13.86% annual return over 5 years.
There is another way to do this. You can start by having some idea about the stock price in 3 or 5 years and discount back using the hurdle rate that you want. The result is the price below which you would buy the stock. There’s some assumption/projection in this calculation, but I think that it’s a safe assumption. I think it’s a safe bet that a good company will trade at a 15 P/E sometime in the next 3 to 5 years.
“Understanding” Risk Affects the Price to Buy
Finally, in calculating the price you would like to pay, you should pay attention to another risk. That’s “understanding” risk. How confident are you in your judgment? Against more uncertainty, you’ll need more margin of safety.
I would never buy a company at a 20 P/E even if I think it’s worth 20 P/E. I must be right on everything to get an adequate return. If I’m wrong, the P/E can shrink to 15 or even 10. I think a 15 P/E is a safe benchmark. An average company often trades at a 15 P/E. So, a great company is worth at least 15 P/E. If I’m wrong, and the company is actually not so great, it’s still likely that the stock would trade at 15 P/E.
Same Approach to Emerging Market
I keep the same approach to valuing emerging market companies. I think emerging market to developed market is like hot growth companies to mature companies. But the answer always depend on what the current normal earnings is, and whether retained earnings will create value. I tend to think most growth will destroy value because of too much competition and too much capital required.
The fair unlevered P/E may be different from that in developed markets. That’s because of inflation. Emerging markets tend to have higher inflation than mature economies. That means investors may want a higher nominal return.
For example, investors may want a 15% nominal return in Vietnam. For a bad company without pricing power, a fair P/E would be 6.5. If it has a low return on capital and is growing company, it’s worth less than a 6.5 P/E. A good service company with pricing power may deserve a 15 P/E. Because it can give investors a 6.7% real return. If it has good long-term growth prospect, it may deserve even higher P/E.
So, I think the fair unlevered P/E in emerging market varies with company’s quality more wildly in emerging markets than in developed market. But the market may have the tendency to give companies similar valuations. For this reason, there can be more value traps in emerging market. And there can be more great long-term investments at good prices.