How we think about value
Like most value investors, we believe that every security has a fundamentally determined long-term value that can differ materially from its current market price. We seek investments that are trading below their fundamentally determined present values with the hope that the price of a security will converge with that security’s fundamental value over time. While this concept seems simple, it is not. Value is in the eye of the beholder.
We think of equity investments as claims on an equity issuer’s business equity. As businesses generate earnings the result is always a potential increase to business equity. Other things being equal, the greater the earnings potential the greater the potential future equity claim and therefore the present value of the investment. The key is trying to understand as much as possible about potential earnings and cash flows.
While predicting future business conditions is really difficult, we feel that understanding a company’s current business really well can help. We examine as much historical financial information as possible. We seek to gain a good understanding of a company’s target markets, competitive position, competitive environment and how all of these things might change in the next few years. We then forecast earnings, cash flows and a company’s potential financial position based on what we think are reasonable assumptions about the future.
Armed with our financial forecasts we then postulate the potential future value of the equity investment. To do this we examine how the equity market has “valued” the security (and similar securities) relative to business fundamentals in the past. Since there are no good “rules of thumb” for appropriate market valuation, we consider as many fundamental and market valuation factors as we can. We endeavor to come up with the most reasonable potential valuation metrics given what we think will happen with the business in the next couple of years. The combination of these valuation metrics and our financial forecasts yields a fundamental future value for the security.
We think of risk as the collection of things that could go wrong with our investment thesis. Any of our assumptions about the business could be wrong. The market may not value the equity like we think it should. We consider these factors on a case by case basis when we think about potential returns on investments. If the perceived riskiness of an investment makes us uncomfortable, we avoid the investment.
While the long term value of any security can be seen as the present value of future cash flows, we think that applying discounted cash flow (“DCF”) analysis to equities is difficult in day to day applications. DCF valuations tend to be heavily dependent on terminal valuations, which are in turn based on “permanent” long term growth assumptions and financial performance well into the future. Therefore, we derive our estimates of fundamental value based on rolling 12 and 18 to 24 month financial projections (updated quarterly). We believe that the one to three year time frame is the most realistic time frame over which one can confidently project financial results.