14 January 2023

Clay reviews Aswath Damodaran’s book, The Little Book of Valuation. Aswath has written numerous books on how to value companies and invest successfully. Aswath is the ultimate teacher as he is a legendary professor of finance at NYU who has also made his classes available for free online to millions of followers around the world.

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  • Aswath’s two primary methods for valuing a company.
  • The general truths about valuations that investors should understand.
  • The four most basic inputs to valuing a company.
  • How to go about setting an appropriate growth rate in our valuations.
  • Additional considerations in performing valuations such as a company’s intangible assets.
  • Clay’s intrinsic value assessment of Williams-Sonoma (Ticker WSM).


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

[00:00:00] Clay Finck: Hey everyone! Welcome to The Investor’s Podcast. I’m your host, Clay Finck, and on today’s episode, I’m going to be giving an overview of Aswath Damodaran’s great book called The Little Book of Evaluation. During this episode, I will cover Aswath’s two primary methods for valuing a company, some general truths about valuation that investors should understand, the foremost basic inputs to valuing a company, how we can go about setting an appropriate growth rate in our valuations, the differences between valuing a growth company and valuing a more mature company, as well as the adjustments that we need to make when valuing a company with a lot of intangible assets like many technology companies today. At the end of the episode, I’ll be touching on Williams-Sonoma and why I have started a position in this company. So be sure to stick around until the end to hear that pitch.

[00:00:51] Clay Finck: If you’re a stock investor, learning how to value a company is a critical skill in achieving good returns. I found a ton of value reading through Aswath’s book, no pun intended, as he is often referred to as the Dean of Valuation and he has written so much about how to properly value a company.

[00:01:10] Clay Finck: William Green actually had Aswath on his podcast back on episode RWH005, on the podcast feed you’re on back in April of 2022. If you tune in to that episode, you know that Aswath is a very intelligent and gifted teacher, as he has taught finance at NYU since the 1980’s. Additionally, Aswath made all of his courses free online.

[00:01:36] Clay Finck: I can assure you that there is probably no one better to learn from when it comes to learning how to properly value a company. With that, I hope you enjoy today’s episode covering Aswath Damodaran’s book, The Little Book of Valuation.

[00:01:54] Intro: You are listening to The Investor’s Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

[00:02:14] Clay Finck: All right. Diving right into the book, Michael Mauboussin wrote the foreword to Aswath’s book. He was the Chief Investment Strategist at Legg Mason Capital Management, an adjunct professor at Columbia Business School. In the foreword, he mentions that stock exchanges provide a service that seems pretty miraculous.

[00:02:33] Clay Finck: One can go to the exchange and put down money today for a claim on a stream of future cash flows of a company. In other words, you can defer consumption now in order to consume more in the future. Alternatively, you can go to the market and sell your claim on future free cash flows for a certain sum today.

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[00:02:53] Clay Finck: Valuation is the mechanism behind this incredible ability to trade cash for claims. And if you want to [00:03:00] invest thoughtfully, you must learn how to value these cash flow. He then goes on to say that Aswath is the best teacher of valuation he has ever encountered in that if you’re looking to learn about valuation from the master, then you’ve come to the right place.

[00:03:15] Clay Finck: And when I was recently looking through Aswath’s analysis on Meta or Facebook during my episode, a few weeks back on TIP508. I was going through his site and seeing all the books he’s written, the articles he has done and it becomes clear fairly quickly that this guy has an immense passion and just a gift for teaching.

[00:03:35] Clay Finck: Aswath book addresses the challenges of valuing companies that are completely different from each other, whether that be, you know, different points in their life cycle, whether it be a commodity company or a company that’s just pouring capital in to R&D with little to show for it. The book is relatively short, only around 170 pages, and it has 11 chapters.

[00:03:55] Clay Finck: In the intro, Aswath rightly points out that most investors see valuing an asset as a daunting task that is just too complex and complicated for their skillsets. So they either leave it to the professionals or just ignore it entirely. He believes that valuation is in fact simple, and anyone who is willing to spend the time collecting and analyzing the information can.

[00:04:18] Clay Finck: He says that sound investing is when the investor does not pay more for an asset than what it is worth, and he acknowledges that there are some who believe that value is in the eyes of the beholder [00:04:30] and that any price can be justified if there are other investors who perceive an investment to be worth that amount.

[00:04:36] Clay Finck: When it comes to financial assets, he believes this idea is absurd because people purchase financial assets for the cash flows they expect to receive, and he isn’t referring to assets that don’t produce cash flows such as a painting or a sculpture. This means that purchasing a company based on the argument that other investors will be willing to pay a higher price in the future is not a sound investment strategy.

[00:04:58] Clay Finck: He says that this is the equivalent of playing an expensive game of musical chairs and the question becomes, where will you be when the music stops? Aswath points out that there are dozens of valuation models but only two valuation approaches, intrinsic valuation and relative valuation. Intrinsic valuation is based on the cash flows you expect an asset to generate over its life and how certain you feel about those cash flows high and stable cash flows should have more value than low in volatile cash flow. While the focus should be put on the intrinsic value, most assets are valued actually on a relative basis for relative valuation and assets.

[00:05:40] Clay Finck: Value is determined by looking at the market prices of similar assets. Just like when you determine the fair value of a home, you look at similar homes that have recently sold in the neighborhood or to help determine a reasonable multiple for Coca-Cola, you might look at the valuation of Pepsi. Both methods can be used as tools, and there’s no [00:06:00] reason to just rely on one of these methods, whether it be the intrinsic value method or the relative value method. Before diving in to the specifics of how to calculate these values, Aswath presents some general truths about valuation that we should really be mindful of.

[00:06:15] Clay Finck: The first is that all valuations are biased. It’s very rare for someone to value a company based on a blank slate. We all have our own views or opinions on a company before we start valuing it whether that be our own personal experience with that company, a newspaper headline we’ve read, or maybe we are just biased because we heard some other person’s view on the company.

[00:06:39] Clay Finck: Institutional analysts tend to issue more buy than sell recommendations because they need to maintain good relations with the companies they follow, and also because of the pressures that they face from their own employer. If you are biased towards a company having a positive future, then it’s likely that you’ll use optimistic and higher growth rates and probably see less risk when comparing to other companies you aren’t as biased towards.

[00:07:04] Clay Finck: It’s super important to be aware and honest with ourselves about these biases and consider why you’re valuing the company you. What you like about it, what you dislike about the company’s management, and whether you own shares in the company you’re valuing. Because if you own shares, then you’re probably biased towards being overly optimistic rather than overly pessimistic.

[00:07:25] Clay Finck: The second general truth team mentions is that most valuations are wrong. In [00:07:30] school, we’re taught that if we follow a systematic approach, then we will come up with the correct answer, and if the answer is imprecise, then we must have done something wrong. The reality is that you can value a company using the very best data and very best information but valuations require forecasting.

[00:07:47] Clay Finck: Oftentimes, we can be certain about a company’s future over the coming years but the reality is that we will run in to occurrences where the future plays out much different than we expect. Aswath uses the example of Cisco in 2001, and he severely underestimated how difficult it would be for them to continue their acquisition driven growth.

[00:08:09] Clay Finck: This led him to overvaluing Cisco at the time in 2001. You should expect to be wrong in your valuations from time to time. In success in investing comes from being wrong less often than everyone else.

[00:08:23] Clay Finck: The third general truth is that the simpler can be. These large institutions that buy and sell stocks oftentimes use very complicated models. The trade off here is that more detail in your valuation gives you the chance to potentially make better forecasts but it also creates the need for more inputs, thus more potential for more mistakes. In your judgment, Aswath, general rural role is that you should use the simplest model you can with the most relevant variables to the company’s.

[00:08:54] Clay Finck: Moving along, in order to understand how to value an asset, you need to understand the [00:09:00] time value of money. A dollar today is worth more than a dollar sometime in the future for three reasons. First, people prefer to consume today rather than consuming at some point in the future. Two, inflation decreases the purchasing power of cash over time.

[00:09:17] Clay Finck: So in other words, a dollar in the future will buy less than a dollar would today. And three, a promised cash flow in the future may not be delivered so there is risk in waiting. So if we expect to receive $1 in the future, we have to discount that dollar back to today while taking all three of these items in to consideration.

[00:09:37] Clay Finck: So first is people would prefer to consume today rather than in the future. Second is inflation, and the third is the risk of actually being paid that dollar. We want to be compensated for delaying consumption. We want to not lose purchasing power due to inflation, and we want to be compensated for the risks taken because there is a chance we may not receive the cash flows we would expect to receive.

[00:10:00] Clay Finck: This is where the discount rate comes in to play in our valuation, which is the interest rate in which the future free cash flows are discounted to today. So essentially the discount rate is used to take cash flows we expect to receive in the future and convert those cash flows in to today’s dollars. So with the discount of say 10%, $100 one year from now is worth roughly $91.

[00:10:24] Clay Finck: Today, a hundred dollars 10 years from now is worth roughly $38 today using that [00:10:30] 10% discount rate. So the further out in to the future we expect the cash flows, the lower the present value of those cash flow. This is why growth companies are much more sensitive to increases in interest rates relative to value companies.

[00:10:44] Clay Finck: At least it’s because a lot of those cash flows for a value stock are in the near term, while a lot of the cash flows for a growth stock are further out in to the future. Aswath also touches on some of the basics of accounting. One of which I wanted to highlight is two important accounting principles that underlie the measurement of accounting earnings in profitability.

[00:11:04] Clay Finck: The first being accrual accounting, where the revenue and expenses from selling a product or service are recognized based on when the sale took place to help match the actual expenses that are associated with the sale of that product or service. The second principle is how expenses like operating, financing and capital expenses are categorized for a company.

[00:11:26] Clay Finck: Operating expenses in theory, are intended to only provide benefits during the current period, whether that be from raw materials that were purchased or the labor costs. Financing expenses are incurred from capital raises through non-equity financing. The most common example here is your interest expenses.

[00:11:44] Clay Finck: Then the capital expenses are the company’s longer term investments, such as a building or a manufacturing. The company receives benefits from a capital expense over many accounting periods in not just one period like we see in the operating expenses section. [00:12:00] Now that accountants can put expenses in to three different categories, they can calculate the operating income by subtracting the operating expenses and appreciation from the revenue.

[00:12:10] Clay Finck: Then the net income is the operating income minus interest and taxes. Finally, we can use these items like operating income, net income, and return on invested capital. To compare one business to another accounting is really important to understand because in order to determine an appropriate measure of a company’s future free cash flows, we’ll want to start with the cash flows the company is producing today, which is what we get from the financial statements.

[00:12:38] Clay Finck: Aswath states that the four most basic inputs we need to calculate the intrinsic value of a company is the cash flow from existing assets, the expected growth rate of those cash flows, the cost of financing the assets in an estimate for what the company will be worth at the end of our forecasting period.

[00:12:57] Clay Finck: Now, to calculate the free cash flow we need to take the net income and make the necessary adjustments to turn that net income amount in to a free cash flow that could be paid out to the shareholders. Luckily, nowadays, free cash flow is calculated for us, so we don’t have to sift through the numbers and calculate it ourselves, but for those interested in learning how it’s calculated, free cash flow is the net income plus depreciation.

[00:13:21] Clay Finck: Since depreciation is not a cash expense, it’s more so just an accounting expense, then you can subtract capital expenditures, add the change [00:13:30] in non-cash working capital, subtract the principle repaid on the debt, and add new debt issue. To measure how the firm is investing in longer term assets, you can compare the capital expenditures to the depreciation in amortization expenses.

[00:13:45] Clay Finck: If CapEx is well above depreciation in amortization, then that tells me that the company is continuing to make long term investments to help fuel that future growth. He also points out that Warren Buffett’s calculation of owner’s earnings does not factor in the net cash flow from. So if the net cash flow from debt was say, 1 billion, an Aswath calculation of free cash flow to equity holders was 4 billion.

[00:14:11] Clay Finck: Then Warren Buffett’s owner’s earnings figure would be 3 billion, since he doesn’t want to include the issuing of new debt as a figure for earnings. After determining the free cash flow for the business, we’ll want to determine what sort of discount rate we want to use. Businesses that are riskier should warrant a higher discount rate all else equal.

[00:14:30] Clay Finck: Aswath lists three factors when considering your discount rate. First is the risk-free rate, which is oftentimes the 10 treasury for a lot of people. Second is the equity risk premium, which is the premium investors put on owning stocks since they are riskier than owning bonds. Between 1928 through 2010, stocks generated a 4.3% higher return than bonds.

[00:14:54] Clay Finck: And then you have the relative risk or the beta, the relative risks should be taken in to consideration [00:15:00] because the more risky a company is, the more uncertain we are of the company’s future free cash flows. The future free cash flows for a company like Coca-Cola are much easier to predict than a company like Tesla.

[00:15:12] Clay Finck: In the book, he calculates the cost of capital by taking a weighted average of the cost of equity. In the cost of debt. He uses an example of a company called 3M in the book. The majority of the cost of capital is weighted towards the cost of equity. I personally try not to get too technical or too cute with the discount rate, and I typically just use a discount rate of 10% in my own intrinsic value calculations.

[00:15:37] Clay Finck: Next, we need to determine the expected growth rate of the company. It’s common to look back at history to predict where this company is trending and where those free cash flows are trending in to the. However, he mentions the relationship between the past and future growth rates is fairly weak for a lot of companies.

[00:15:55] Clay Finck: It reminds me of Charlie Munger saying that less than 2% of companies in the S&P 500 will be better businesses in five years, which really shows just how difficult it is to predict which companies will continue to grow and be in a better competitive position in five years or so. To better understand potential future growth rates, you could also look in to expectations set by Wall Street as well as expectations set by management of the firm. There’s a good chance that these types of sources have access to other information, but we should also be mindful that they may have an incentive [00:16:30] to overestimate or maybe be too optimistic in their projections for future.

[00:16:35] Clay Finck: In order for a firm to grow, it will need to manage its existing investments better or successfully make new investments. The higher the rate of reinvestment back in to the company and the higher the return on equity, the more we can expect a company to continue to grow in to the future. The fourth key piece of the valuation process is the value of the business at the end of the forecasting period, which is also called the terminal value.

[00:17:02] Clay Finck: Having some sort of end date can help make our intrinsic value calculations much more accurate because although a business can in theory, produce cash flows in to perpetuity, it’s much easier to estimate the cash flows for the next, say, five or ten years than it is for the next 50 years.

[00:17:20] Clay Finck: There are two ways of going about estimating the terminal value. The first would be to estimate the liquidation value. If the firm were to sell all of their assets, pay off their debts, and send the remainder of the money back to shareholders. The second method would be to come up with an estimate of what you believe the firm would be worth if the operations were to continue.

[00:17:41] Clay Finck: A simple example of this would be to take a relatively stable company like Apple Project out their future free cash flows for say, 10 years, and put a conservative multiple on the business at year 10. I would say a multiple of 15 is pretty conservative in this case. For a company like Apple for its terminal value, assuming that you believe [00:18:00] that they will maintain their competitive position over that time, Then you can discount that terminal value back to today rather than trying to estimate the cash flows from that point forward.

[00:18:11] Clay Finck: After you’ve calculated the present value of the future, free cash flows of the business, as well as that terminal value, there are a number of adjustments you might want to consider as well. The first would be adding back the cash and cash equivalence because the cash, of course, has a real value. The second adjustment would be for minority interests or non-controlling interests, which is an ownership interest of less than 50% of a company.

[00:18:37] Clay Finck: Since minority interests aren’t part of the company’s core operations, the minority interests, revenue and expenses do not flow through the company’s income statement. So adjustments need to be made to account for. For example, if Berkshire Hathaway owned 100% ownership in a business, then this company’s operations would flow through Berkshire’s income statement.

[00:18:59] Clay Finck: But if Berkshire only owned 10% of a private business, then it wouldn’t flow through Berkshire’s income statement if it is privately owned and not a publicly traded company. The third adjustment is to consider the company’s potential liabilities such as any debt or any underfunded pension or healthcare.

[00:19:17] Clay Finck: In the fourth and final adjustment to consider is to subtract the value of management options. Aswath says that the right approach to handle this is to reduce the value of the equity by the value [00:19:30] of the options, since those options are owned by the management. Sometimes when you calculate the intrinsic value of a company, your estimation will be far different than the market value of the company.

[00:19:41] Clay Finck: Common mistakes people make is to make unrealistic assumptions about a company’s future growth potential or the riskiness of a company. A second mistake is to misuses the overall risk premium attached to the stock market. If your estimations of these are truly correct, then you may have found a company that is severely undervalued or overvalue.

[00:20:03] Clay Finck: Chapter four of Aswath’s book covers relative valuation. Relative valuation is essentially just looking at the market prices of similar companies and comparing it to the company you’re analyzing. So to get an idea of the valuation of say, GM, you want to consider the valuation of Ford. When considering the relative valuation, you’ll also want to adjust the values to normalize your comparison between the two.

[00:20:27] Clay Finck: For example, if company A is growing at 20% per year and company B is growing at 10% per year, then you’ll want to factor that in to your relative valuations. When performing a relative valuation, oftentimes multiples are used and multiples are easy to misinterpret when comparing two companies. Price to earnings and enterprise value to EBITDA are common metrics when performing relative valuations.

[00:20:51] Clay Finck: I’d be careful with using price to sales and price to EBITDA as any company with a high debt burden can actually appear to be cheap. [00:21:00] At the time of this recording, the PE ratio of the S&P 500 is around 20. This can give us a reference point to how any company compares to the overall us. In looking at the overall market, there are so many factors that determine the PE ratio.

[00:21:15] Clay Finck: There’s market sentiment, interest rates, economic growth, and inflation. These all play a major role because all of these factors change so much from year to year. The PE ratio of the market overall can shift really quickly. For example, Aswath shows in his book that the median PE in 2000 was 24, and that number dropped to just under 15.

[00:21:39] Clay Finck: One year later in 2005, the median PE was 23, and in 2009 it dropped below 10. I think it’s also important to mention that there is a huge difference between the average PE of the market and the media. The average can be highly skewed by a number of companies that have little to no earnings, whereas the median is historically much lower because it’s looking at your typical company.

[00:22:05] Clay Finck: It is not skewed by the outliers near as much. For example, in 2005 when the median PE was 23, the average PE of the market was 40. When performing relative valuations, the key to finding an undervalued company is to find a valuation mismatch, such as a company with a relatively low PE and a higher growth rate in its earnings per share.

[00:22:29] Clay Finck: Every single [00:22:30] company’s value is based fundamentally on its cash flows, the growth potential of those cash flows and the risk associated with the business. So if company A has a PE of five and company B has a PE of. That doesn’t necessarily make company A cheap, and it doesn’t necessarily make company B expensive.

[00:22:50] Clay Finck: It all really depends on your assessment of the intrinsic value of the company and how that compares to the market price. However, using relative valuation can be helpful in determining whether a stock is under or overvalued to help increase your conviction in the company and further understand, you know, its true value.

[00:23:09] Clay Finck: In Chapter five, Aswath covers the challenge of valuing a young growth company. Valuing these types of companies can be extremely difficult because there is practically no historical data to rely on. They have little to no revenues, negative earnings, and most young companies end up failing because there is little historical information to rely on.

[00:23:31] Clay Finck: If the founders want to pitch their company to investors, then they need to have a convincing story of how the company will be successful at some point in the future. There’s no easy solution to valuing young growth companies but to try and get a good idea, you still have to try and estimate the future free cash flows.

[00:23:49] Clay Finck: To do so, you can look at the market potential of the company and consider its total addressable market, oftentimes called tam. From there, you can guesstimate what percent of the [00:24:00] market share the company will capture, and by what year. Then you will also want to determine what sort of margins the company will have once it’s profit.

[00:24:08] Clay Finck: Then when you project out the future, free cash flows, the reinvestment back in to the company will also need to be considered, which further complicates determining the intrinsic value. I think the most important piece when valuing a young company is to really consider the level of risk with such a purchase.

[00:24:26] Clay Finck: It’s really easy to get excited about a company’s potential and overlook the actual risk that is associated since most of these companies end up failing and not being a good investment at. Warren Buffett’s first rule of investing is to not lose money, and that’s why you see most value investors simply stay away from these young growth companies, but from Aswath’s perspective, every single company has some sort of value to it.

[00:24:53] Clay Finck: And if you take in to consideration all of the risks and properly estimate a reasonable intrinsic value, then it may be the case that he purchases a young growth company if the price is appealing. When valuing growth companies, one should also consider the potential for optionality. For example, Apple’s iPod helps lay the foundation for the iPhone and the iPad, so sometimes it pays to put weight on the management team and their ability to execute on their vision.

[00:25:20] Clay Finck: As sometimes you don’t really know what products might come in the future. Aswath concludes this section by stating that you want to invest in young companies [00:25:30] with tough to imitate products that have a huge total addressable market. And the company’s disciplined about keeping their costs under control, and they have access to capital to help fuel their growth.

[00:25:41] Clay Finck: It’s not easy to do, but when it’s done right, it is a high risk, high return pro. Once a company has some operating history and has gotten off the ground, eventually it reaches the status of a growth company rather than a young startup. Growth companies tend to be those that have high revenue in earnings growth, as well as a market valuation that is typically much higher than the book value of the company.

[00:26:05] Clay Finck: The tricky part of valuing a growth company is determining how long the growth can persist because eventually the growth has to slow down as the company matures and is operating from a higher base, and the growth tends to attract a lot of competition as well. Aswath uses the example of Under Armour in his book, which by the way, was written all the way back in 2011, and he uses Under Armour as an example of how he would project forward the future free cash flows for this.

[00:26:34] Clay Finck: He starts with their revenues, projecting out a higher revenue growth rate in year one at 35%, and then that tapers down to 10% growth in year five and 3% growth in year 10, so higher growth rates in the first five years and lower growth rates in the remainder of his projection. Then he also includes the company’s operating margins and operating income after tax, operating income, the required reinvestment each year, and [00:27:00] finally the free cash flow each year as well.

[00:27:02] Clay Finck: The first few years have negative free cash flows. In his example for Under Armour. Then it turns positive and increases each year beyond that, as the company scales up and less reinvestment is needed each year. As with any company, great growth companies can be bad investments if you pay the wrong price.

[00:27:21] Clay Finck: Most growth companies will eventually disappoint investors at some point, delivering earnings that don’t match up to the lofty expectations. When that happens, there will be investors that overreact dumping their shares and embarking on their search for the next growth story. Sometimes these sort of price drops will give investors the opportunity to pick up the company when it hits the right price.

[00:27:45] Clay Finck: This brings us to mature companies, which are much easier to value than young growth companies and your typical growth company because their future earnings are much more predictable, giving us much more certainty in the range of future potential outcomes. Common characteristics of a mature company is that their revenue growth is approaching the growth rate of the economy, say 2 to 3% annually.

[00:28:09] Clay Finck: The company’s margins are stable, with the exception of commodity and cyclical companies. These companies have strong competitive advantages to maintain their market position. They tend to have excess cash, so they’re able to pay dividends and buyback shares, and oftentimes mature companies have their growth fueled by acquisitions.

[00:28:27] Clay Finck: Coca-Cola is a perfect [00:28:30] example of a mature. The acquisitions piece specifically can be pretty difficult for individual investors to judge because it can be hard for investors to assess the success of an acquisition relative to just judging the business’ internal metrics over time. Companies can also play with leverage to do share purchases, so it’s important to be mindful of a company’s debt levels when you’re valuing a company or doing a relative valuation of one company versus.

[00:28:58] Clay Finck: I think a lot of people would gravitate towards the Buffett style of value investing and buying a well-managed, mature company. But Aswath also discusses the strategy of purchasing a company that is a bet on the management. For example, a mature company that has been run poorly but has a new management team coming in or has an activist investor stepping in and pushing for management to make changes within the business.

[00:29:23] Clay Finck: In Chapter eight, Aswath touches on valuing a declining company, which are in the final phase of their life cycle, and he argues that these may offer lucrative investment opportunities for long-term investors with strong stomachs. Declining companies tend to be those with stagnant or declining revenues.

[00:29:42] Clay Finck: Shrinking or negative margins, they might be selling off in liquidating parts of the business that are no longer profitable. They may also have large dividend payouts or stock buybacks, and debt might be a big issue because their business hasn’t played out as well as they might have expected. I didn’t want to dive [00:30:00] too much in to valuing a declining company because there can be so much nuance with these, whether it be the assets they’re selling off, the likelihood that bankruptcy comes in to fruition, and so on.

[00:30:11] Clay Finck: The final chapter of his book covers valuing companies with intangible assets, which is becoming more and more important today. I recently read a stat that intangible assets consist of 68% of the value in companies in the S&P 500 in 1995, and that amount has increased to 90% in 2020. This is why more and more investors have shifted away from relying on book value when valuing a company, because it’s much harder to value something like the brand of Google or the intangible value of Google search from an accounting perspective.

[00:30:48] Clay Finck: Many companies in the previous century required investments and physical assets that, from an accounting perspective, were treated as capital expenses because those investments were considered to produce a benefit for many years. Nowadays, many companies are making large investments in intangible assets, such as brand name advertising.

[00:31:08] Clay Finck: We’re the development of a specific type of software technology. However, oftentimes with intangible assets, accountants tend to treat these investments as operating expenses, and as a result, earnings and capital expenditures tend to be understated when looking at financial statements of these companies, technology companies and other companies investing in [00:31:30] intangible assets also tend to be bigger users of options to compensate management.

[00:31:35] Clay Finck: Thus Aswath says that accounting measures such as book value, earnings, and capital expenditures for firms with intangible assets are all misleading and aren’t comparable to the same items for a manufacturing company. Therefore, adjustments need to be made to these companies in order to value them correctly.

[00:31:55] Clay Finck: So the first step in making these adjustments is that the investments in intangible assets should be capitalized. And we need to make an assumption for how long it takes for these investments on average to be converted in to something that is of value to the company. And we need to make an assumption for how long it takes for these investments on average to be converted in to something that is of value to the company.

[00:32:19] Clay Finck: This is referred to as the amortizable life of these assets. After the amortizable life has been estimated, then we need to collect data on past years and estimate how those investments are amortized each year. Then in order to adjust the operating income and net income, you take what is in the accounting statements, add back the capitalized expenses towards intangible assets, and subtract out your amortization.

[00:32:46] Clay Finck: These sorts of things probably weren’t considered back in the two thousands when everyone said that Amazon was totally overvalued and unprofitable. Amazon actually was a profitable company. They were just making investments in [00:33:00] intangible assets that were considered operating expenses. So a lot of investors were looking at operating income numbers that weren’t a true reflection of what was actually happening within the real business.

[00:33:12] Clay Finck: Aswath also rightly points out that consumer products companies like Coca-Cola could make a case to have a portion of their advertising expenses to be treated as capital expenses. Because these are designed to augment brand name value, and for a consulting firm, the cost of recruiting and training its employees could be considered a capital expense.

[00:33:33] Clay Finck: Since the consultants who emerge are likely to be the heart of a firm’s value and provide benefits for the company for many years. However, we still want to be careful about capitalizing some expenses and be sure there is evidence that these investments actually turn in to real benefits for the company over time.

[00:33:53] Clay Finck: I think another important consideration here is that your return on invested capital is also adjusted when you add back to the capital expenses. Because some of these companies are incorrectly placed in the operating expenses category, accountants are understating how much the company is investing in intangible assets.

[00:34:12] Clay Finck: Thus, they are likely overstating the return on invested capital as well. So you can’t always take the return on invested capital at face value. The final piece I will mention in regards to intangible investments is that these adjustments only work well if the investments in [00:34:30] intangible assets generate value and earn high returns.

[00:34:33] Clay Finck: So look for a firm with intangible assets that have a competitive advantage and are difficult for competitors to replicate. I don’t believe Aswath mentioned storytelling in his book, but I think this is a really important piece of how he explains valuation in his classes and on his website, he says that in order to value a company, you need to be able to tell a story, and that valuation is a bridge between stories and numbers.

[00:35:03] Clay Finck: When you’re projecting out growing revenues for a company, you need to be able to explain why those revenues will grow at the rate that you’re projecting. Is the company operating in a growing market? Do they offer a superior product? So that gives them a competitive advantage? Are they at the forefront of a new industry?

[00:35:21] Clay Finck: In order to develop a story for the company, you’ll need to develop a good understanding of the company, what they do, the markets they operate in, the competition they face, as well as the macro environment in the really big picture. Without a strong foundation in a good understanding of the company, you can’t tell a good story.

[00:35:42] Clay Finck: And once Aswath has developed his story, he then wants to ensure the company passes what he calls the three P test. Is it. Is it plausible and is it probable first? Is it possible? The first one is a pretty low bar. I might ask you if it’s [00:36:00] possible that your favorite team is going to win the Super Bowl.

[00:36:03] Clay Finck: For some teams it might not even be possible because you know it’s towards the end of the season and some teams just aren’t eligible for playoffs. The second question is it plausible? If something is plausible, you could argue with reason that something may happen, but it isn’t necessarily certain. The third question, is it probable?

[00:36:24] Clay Finck: This is when you’re much more certain that something will play out in a certain way and you have strong evidence to back that claim up. I might say that the Kansas City Chiefs making it to the Super Bowl is probable. Given that they’re in the top two in the power rankings, they’ve been to the Super Bowl multiple times in recent years, and if everyone stays healthy, then they probably have a good shot.

[00:36:45] Clay Finck: A lot of companies can show the possibility of something happening, but not near as many have a bright future that is probable. In thinking about stories, I think Tesla is a perfect example to use here. Many people have their own opinions on what the story is of the. The investors who say Tesla is far too overvalued might have a story that says something like, Tesla is a company who makes the majority of its revenue from cars.

[00:37:13] Clay Finck: And cars historically are a very difficult business to be in. Even if the world goes to fully electric vehicles and Tesla captures a hundred percent of the market, Tesla’s valuation is not justified today. On the other side, the Tesla Bowl is telling an [00:37:30] entirely different. They might say, Tesla is an incredible company, and Elon Musk is setting them up to be one of the world’s most powerful technology companies.

[00:37:40] Clay Finck: Rather than Tesla being limited to only being a car company. They are a technology company. Just like how Amazon wasn’t limited to retail, they expanded in to other businesses that made sense for them, such as online advertising and AWS. Tesla will be able to monetize other business units such as their battery technology, self-driving tech, car insurance.

[00:38:04] Clay Finck: The list goes on. I honestly don’t know which story will end up playing out, but you want to look at the facts and the research that shows which story is based on reality. I think that’s a really important point. You want research that shows your story is based on reality and not based on how you want the future to.

[00:38:24] Clay Finck: This also reminds me of Howard Marks and how he talks about second level thinking. Your average investor might look at Tesla or whatever high growth company and see their massive sales growth and say, this company’s doing something right. I auto own shares in this company. Second level thinking says that Tesla is a great company, but the market is pricing it as if it’s going to be one of the greatest companies in the world, so I’m going to sell it because there is just too much risk.

[00:38:52] Clay Finck: So you need to figure out your story that makes the most sense to you based on the objective data and facts, and then run the [00:39:00] numbers yourself. So let’s talk about a story and weave it in to the valuation of a company. One company I was quite intrigued by when I started researching it was Williams-Sonoma.

[00:39:12] Clay Finck: I first discovered this stock when Tobias Carlisle pitched it in Q1 of 2022 in the Mastermind meeting during episode TIP418. And in my mind, this is just your classic value purchase. Back when Tobias pitched it in early 2022, the stock was trading at around $150 per share. And at the time of this recording, it sits at around $116 per share.

[00:39:39] Clay Finck: This is a 24% decline. While the business fundamentals have held up quite well, in my opinion, it’s not a glamorous growth story and it’s not going to make you rich overnight, but I think it’s a company that has strong, stable, and growing free cash flows, and the company is trading at a pretty attractive multiple.

[00:39:58] Clay Finck: They’re EV/EBIT is under seven, and their free cash flow yield is nearly 12. The stock is even trading at a historically low multiple, even slightly lower than March, 2020. Williams-Sonoma is a leading consumer retail company that is most well known for selling kitchenware and home furnishings, and this is all under eight different brands within their business.

[00:40:23] Clay Finck: They adjusted quite well post Covid, and they’ve accelerated their growth in revenue and earnings ever [00:40:30] since. The business has grown every single year for the past decade as well. Their revenue growth over the past 10 years is 7.4% per year. While the growth in their free cash flow per share has increased by 25% per year, which again, really accelerated from 2020 through 2022.

[00:40:48] Clay Finck: Their average return on invested capital over the past five years is 24%, which is really good to see. I also like that the company is positioning themselves to benefit from the trend to online shopping as 66% of their business is done online, their e-commerce sales have gradually increased over time, which is another thing I like to see as it’s not a dying physical retail company.

[00:41:12] Clay Finck: They did 8.7 billion in sales in the trailing 12. In a total addressable market of over 800 billion, so they have a 1% market share of a highly fragmented market, meaning that there’s a lot of room for potential growth. Additionally, none of their competitors have more than 5% share of the overall market management is shooting to grow their annual revenue to 10 billion by 2024.

[00:41:40] Clay Finck: The relatively cheap price for the company today gives investors quite a bit of downside protection, I believe. Of course, earnings could decrease with the recession in 2023, but I don’t expect the decrease to be permanent. So for anyone that is able to hold on for say five plus years, I think they will do [00:42:00] quite well Holding the stock when it’s bought at today’s price of around $116.

[00:42:05] Clay Finck: In fact, I would expect the company’s business and stock to really pull back if there in fact is a recession and it’s as bad as some people are anticipating. The company’s stock actually declined by 90% during the great financial crisis. But I don’t think this business is going anywhere because they’re a retailer that’s adapted to the age of online shopping and they understand where retail is trend.

[00:42:30] Clay Finck: Williams-Sonoma also has an interesting executive compensation model where the compensation is partially determined by the return on invested capital, which really aligns the shareholder interest with that of the executives. I also really like that management is taking advantage of the stocks decline in 2022.

[00:42:49] Clay Finck: As they aggressively bought back shares and over the past four quarters, they’ve allocated over 1 billion to share repurchases, which is quite substantial for a company that’s worth just shy of 8 billion. Earlier in 2022, they announced that they would be allocating 1.5 billion to share repurchases, and they announced they’d be increasing their dividend by 10%, stating that these actions reflect our commitment to execution in the resulting return of value to our shareholders.

[00:43:19] Clay Finck: Now, let’s talk about the valuation. I’m going to keep the valuation fairly simple, doing a base case and then a case where the company does worse than I would expect, and I’m simply going to project [00:43:30] out the future free cash flows using our TIP Finance tool to give me a rough idea of the intrinsic value of the company.

[00:43:37] Clay Finck: This reminds me of two quotes, the first being from Albert Einstein. Everything should be made as simple as possible, but not simpler. Now, I’m going to take that approach here and only use the free cash flows rather than pulling in the projected revenue, operating margins and such. The other quote is by John Keynes is one that I think refers to modeling in general, and that’s it is better to be roughly right than precisely.

[00:44:04] Clay Finck: I’m not trying to get the exact value of Williams-Sonoma. I just want to get a general idea and factor in a margin of safety as well. So turning to the valuation, I’ll be using our TIP finance tool again, which is a tool that TIP created that allows anyone to analyze a company and calculate its intrinsic value or expect a return.

[00:44:24] Clay Finck: The future free cash flow for the trailing 12 months for Williams-Sonoma is 851 million. That is already down from fiscal year 2022 of 1.1 billion. For my base case, I’m going to assume that the free cash flows declined by 20% to 681 million due to the recession and macro factors, and then I’m going to assume that those cash flows grow on average by 9% per year for the next 10.

[00:44:53] Clay Finck: Inputting these numbers in to our TIP Finance tool on our website. The expected internal rate of return under the [00:45:00] scenario is 14.2%. This is quite good, even when you assume the decline in earnings. In a more bearish scenario, let’s say the earnings declined by 50%, which might seem somewhat crazy, but it’s important to remember that the free cash flows more than doubled from 2020 to 2020.

[00:45:19] Clay Finck: So if we see free cash flows cut in half and we project just 5% growth going forward, the expected rate of return is still 6.6%. So unless something catastrophic happens to the economy or Amazon totally disrupts Williams-Sonoma’s business, all of a sudden, I’d expect investors to at least earn a decent return from this.

[00:45:42] Clay Finck: To put the story simply for Williams Sonoma. I think it’s a high quality business with durable revenues, long term, a strong brand and competitive advantage, and consistently high returns on capital. They have a strong balance sheet with no debt outside of their leasing obligations, so they will really be able to weather through any type of economic downturn just fine, I believe, since they operate in a large market and they’re well position.

[00:46:07] Clay Finck: I believe management will be able to hit their targeted revenue growth of mid to high single digits, while also continuing to return capital back to shareholders through dividends and share purchases rather than finding a turnaround business that is trading for cheap. I believe that Williams-Sonoma is a great business that is currently trading at a cheap to fair.[00:46:30]

[00:46:30] Clay Finck: To round out the discussion on Williams-Sonoma, I think this is also a good opportunity to mention our policy the investor podcast network has around trading stocks we discuss on the show. To avoid any conflict of interest, I am not able to buy or sell any stock that has been mentioned on the show for the first two weeks that the episode has been release.

[00:46:53] Clay Finck: There have been times in the past where we’ve talked about smaller companies and the stock has moved substantially after the episode was released, so I just want to make it clear that I will not be buying or selling any stock that I mention on the show for the first two weeks after any episode of mine is released.

[00:47:10] Clay Finck: For full transparency, I have started a small starter position in Williams-Sonoma and I purchased it at a price of around $116. I for the most part, been on the sidelines lately, building more cash in my portfolio, and I’m really seeing how these macro factors end up playing out with high inflation and higher interest rates.

[00:47:32] Clay Finck: Again, I’m not able to purchase any more shares in Williams Sonoma for the first two weeks that the episode is out to avoid any conflict of interest and to be fully transparent. But if the stock trades lower throughout 2023, I will definitely consider increasing my position gradual.

[00:47:48] Clay Finck: All right. That wraps up today’s episode. If you don’t already, be sure to click follow on the podcast app you’re on so you can get notified of all of our future episodes coming out. Also, if you have any [00:48:00] comments or questions about Aswath’s book or Williams-Sonoma, feel free to tweet at me, letting me know or shooting me a dm. I would really love to hear from you.

[00:48:09] Clay Finck: My username is at @Clay_Finck, C.L.A.Y underscore F. I. N. C. K. If you’re interested in connecting with me there. With that, thank you so much for tuning in to today’s episode and I hope to see you again next week.

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