Forecasting: Considering Multiple Angles
There's more than one approach to valuation and forecasting
In Finance 101, we learn that the value of an asset is its future cash flows discounted back to the present at an appropriate rate.
There isn’t much debate about that point, despite grumblings from practitioners that academic finance doesn’t match reality.
As a result, it makes sense for investors to consider what future cash flows a company might produce to solve for the company’s present/intrinsic/fair value.
Even among quality-focused, long-term investors, however, there’s broad debate about the usefulness of forecasting cash flows to determine valuation. Some renounce discounted cash flow modeling altogether, while others consider relative valuation (i.e., comparing multiples among peer companies) to not be value investing.
It’s true that forecasting is hard, and few have shown an ability to do it consistently well. Many behavioral temptations can lead us to build a compelling narrative around a forecast that we hope will occur rather than what’s likely to occur.
On the other hand, as Michael Mauboussin has noted, a multiple is a short hand for a DCF. A given multiple implies a specific future set of cash flows and discount rates. So, even if you swear off doing DCFs, you still make assumptions about future cash flows.
If valuation were easy, markets would be fully efficient. Debates around valuation enable opportunities to generate idiosyncratic returns, and it’s good that there is a debate.
I use a little from all the above and triangulate the information.
In my profile of Medpace (full report only available to paid members), for example, we considered the historical multiples management paid for its opportunistic buybacks (the company has a good track record of this), what the market might be pricing in by solving backwards using expectations investing, and what a DCF using base rates of companies its size and growth rates might suggest are probable outcomes for the company.
Though the results suggested that Medpace was not cheap at the time based on those inputs, we developed a better sense of at what price Medpace would be attractive to buy at size.
It can also be useful to consider what unit economics might be implied in a market price, as discussed in the Howdens Joinery profile (free to all). Aggregated sales and cash flow forecasts can often cloud what’s being implied on the ground. At times, you’ll find the market is implying what appear to be unrealistic (good and bad) outcomes for individual stores, units, or segments.
Whether you are more comfortable with multiples or models or employ both to varying degrees, humility is a key ingredient.
As Philip Tetlock wrote in Superforecasters:
(Intellectual humility) is a recognition that reality is profoundly complex, that seeing things clearly is a constant struggle, when it can be done at all, and that human judgement must therefore be riddled with mistakes. This is true for fools and geniuses alike. So it’s quite possible to think highly of yourself and be intellectually humble.
The markets of the past few years have, for better or worse, not rewarded intellectual humility - or, rather, not as much as they have intellectual boldness.
When I’ve valued higher-growth companies using base rates, the implied market prices typically suggest low-probability outcomes. These set ups make me uneasy. Even if the low-probability outcome becomes reality, it may not have been a prudent investment as you might have been right for the wrong reasons.
It’s possible that historical base rates are less relevant today due to a shift from a tangible to an intangible-based economy. It’s also true that great companies, by definition, buck historical trends.
The ideal situation, however, is to invest in great companies when the price implies average outcomes. These opportunities can be rare and short-lived, so it’s best to be prepared for when they present themselves.
As we’ve been doing with Flyover Stock profiles, that means building a bench of ideas and establishing a sense of fair value for each using multiple angles.
Stay patient, stay focused.
Todd
At the time of publication, Todd and/or his immediate family owned shares of Howdens Joinery.
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