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Todd N Kenyon
Todd N Kenyon

Avoid Heroic Assumptions

May 31, 2007 | About:

As value investors, we should all have long time horizons, seek to understand the intrinsic value of our investments, and buy when the market puts our picks on sale. Certainly DCF analysis is a key tool in understanding intrinsic value, but one to be used with caution and applied conservatively, since any price can be justified by tweaking growth rates and discount rates. I like to look at a potential investment from as many valuation angles as I can in an attempt to shoot holes in my own thesis. Hence I use a many-faceted model to paint a “valuation mosaic”. One simple model that can quickly help you determine if a particular company might be attractive is a future earnings model. It can clearly show you if heroic assumptions about future fundamentals are required to achieve a decent return.

We all know that reported earnings are subject to wide distortions relative to economic reality. However, the market tends to put great emphasis on EPS growth and hands out earnings multiples and hence stock prices based on past and expected future earnings growth. At some point in the future, most any company’s stock (other than special situations like Berkshire) will trade based on a multiple of its earnings. You can use a bit of knowledge about the company and it’s past history to conservatively determine if it is likely that the stock price will reach a level in the future that will provide your desired return. Note that I said likely; as we all know just about anything can happen, especially over the short term.

As an example, let’s look at Anheuser Busch (BUD) (note that I hold this stock in some of my portfolios at the time of this writing, but that could change at any time). The future earnings model works well for large stable companies like BUD. Let’s say you are trying to determine if $52 is a good price to pay for the stock. I like to look five years out and try to conservatively estimate what EPS will be and hence what the stock price could be and whether this will give me my desired hurdle rate of return (I use 12%, but this is up to you). Then I add an additional margin of safety discount before I buy the stock.

You can generate future EPS by making a few key assumptions, starting with revenue growth rate. If we look at BUD’s top line growth over the past several years, it tends to be low-mid single digit. Since most of its products are sold into a mature market, this makes sense. Hence one might expect that it is unlikely that BUD will grow its top line at more than 4% for the next 5 years. Next, you need to pick a net margin. Over the last several years, net margin has peaked at 14.7%, and has averaged 13.4%. Recently it has been as low as 11.6%. Here you need to decide what level you are comfortable with and what level makes economic sense. Yes, BUD has inherent earnings leverage in its model, but it needs decent top line growth to realize it. To be generous, I would pick 14%. Next, you need the share count. I look at the history of share buybacks, the consistency of free cash flow generation, and also what management is saying and doing relative to buybacks, and I come up with an approximate share count in 5 years. It is very possible that BUD’s share count will be reduced by 15% over the next 5 years. So with these assumptions in place, I get a December 2012 EPS of $4.12. Finally, what multiple should we place on these earnings? You can use a historical market multiple of 15, or something more in line with recent multiples. Remember that in 5 years the company may be even more mature and slower growing, so it may make sense to award it a lower multiple. Since BUD tends to trade at forward multiples in the mid to high teens, I will assign a 16 multiple.

This little exercise generates a stock price of $65.30 in mid 2012 (I assume the stock anticipates 2012 earnings 6 months before they are reported). Unfortunately, the IRR from current prices is only 4.6%. Add to this a 2.25% yield (assuming a constant yield over the five years) and you are looking at barely a 7% return. Hence I am not buying the stock here (my DCF’s confirm this low return potential). In order to get the return over 12%, I would have to assume 6% top line growth, a 16% net margin, and retirement of 22% of the shares outstanding. These assumptions are far too heroic for me – they are possible but not likely.

There are several caveats here, and this is where the “art” of valuation comes into play. You need to decide what inputs make sense, what your return requirements are, and whether a particular company’s stock trades based on EPS. You need to know if the starting numbers are an anomaly, either high or low, as this will invalidate the result. You need to understand what is driving sales and margins so that your inputs are reasonable and conservative. You also need to know whether a company generates enough cash to consistently reduce its share count. One approach is to run the model several times for a wide range of inputs and then determine what the most likely range of outcomes is.

This simple model points out some very important lessons. Multiple contraction and margin contraction will kill your returns, especially since they tend to be positively correlated. If a stock is currently trading at a heroic multiple of peak earnings, you are in big trouble if any degree of mean reversion occurs. Only rapid top line growth will bail you out (that or a private equity firm with tons of cash burning a hole in its pocket). Conversely, if you buy at depressed margins and multiples you can get excellent returns off of relatively low revenue growth if the company is able to improve its margins.

The elephant in the room here is the S&P 500 – I don’t sit around trying to forecast the market, but I would be remiss if I didn’t point a few things out regarding the market’s valuation relative to this model. Page D1 of today’s WSJ echoes the zeitgeist regarding the S&P 500’s valuation: it is reasonably valued at 18 times trailing earnings versus a historical average of 16. Reuters states that the TTM PE of the S&P 500 is actually 20.4, while knowledgeable folk such as John Hussman state that the average trailing PE over 50 yrs is 15. Note that financial companies now make up an abnormally large 20%+ of the S&P 500. Since financials typically trade at multiples below the market average, this means that the non-financial component of the market is even more highly valued. Sales growth for the S&P 500 has been robust over the past 5 years, at 13.16% according to Reuters. Let us not forget that such growth was achieved from a recessionary base – Dr. Hussman states that average historical sales growth for the market has been 6%. Finally, and perhaps most importantly, the current profit margin of the S&P 500, according to Reuters, is at a historical high of 13.6%, versus an average of something like 6-8% depending on what your definition of net income is. Let’s plug these values in then: 5yr sales growth = 6%, net margin = 8%, PE = 16, and a generous dividend yield of 2.5%. In this case, our simple model spits out an average annual return over 5 years of MINUS 7%! In order to approximate historical market returns, we will need to assume 10% revenue growth, margin EXPANSION to 14%, and a continued high PE multiple of 18. I for one am not willing to bet on such extraordinary numbers. Even worse, if you require a margin of safety, you will either need to accept these heroic assumptions and then wait for the market to decline by 20% or more, or make even more outlandish assumptions.

The takeaways here are that you will do a lot better if you consistently wait to buy at prices that don’t require heroic assumptions about the future to generate decent returns. Buy when fundamentals are below historical trend with a good chance of at least reverting to trend. The S&P 500 is not even close to an attractive level currently based on this thesis.


About the author:

Todd N Kenyon
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now pre-order his book Invest Like a Guru on Amazon.

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