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How I Value Good Companies

Before I value a company, I place it into one of two quantitative categories: good and… not good. That determination is made by looking at the company’s historical Return on Invested Capital (ROIC). I’ve chosen a ROIC threshold that—while arbitrary—I think is high enough to be indicative of durable competitive advantage(s) if a company exceeds it.

For example, if we think about Apple, anecdotally it would appear to have durable competitive advantages: brand loyalty, intellectual property, scale, network effect, and switching costs. And, I calculate its 10-yr average ROIC to be >30%, which I think is high enough to add quantitative credence to the anecdotal.

As another example, Tesla might seem to have durable competitive advantages: brand loyalty, intellectual property, famous CEO. But, I calculate its 10-yr average ROIC to be <-10%, which is not high enough for me to assume it has competitive advantages.

So, I put Apple in the good category and Tesla in not good.

That doesn’t mean I’d rather own Apple, or that I want to own either. It simply tells me how to value the company. If the company is good I value it relative to its earnings, because I assume its competitive advantages will allow earnings growth. If the company is not good, I value it relative to its liquidation value (Tangible Book Value, TBV), because if the company fails, it can liquidate and return the net value to shareholders.

For Apple, I’d be willing to buy shares at 8x $91.5b, 8 times my approximation of annual Operating Income (OI) using historical results. That equates to a share price of $37.91, my calculation of fair value (MFV).

For Tesla, I’d only be willing to buy shares at <$12.87, my calculation of TBV and MFV.

For a good company, I’m willing to make my initial buy at MFV because I assume MFV will grow. Technically, I’m speculating rather than investing by making such an assumption, but by never paying more than 10xOI, it’s speculation I’m comfortable with because the S&P 500 trades at a much higher multiple to OI. And, I’ll reduce my 10x multiple if the S&P multiple falls or if a company historically traded for less than 10xs. In short, with good companies, I’m only looking to buy them when they are 1)relatively cheap to the S&P AND 2)relatively cheaper than their own historical multiples. This way, even if the company does not grow, I can make money from mean reversion.

For a not good company, I’m solely looking to profit from mean reversion. So, I only buy when 1)the company trades below a reasonable multiple to TBV AND 2) is relatively cheaper than its own historical multiples.

So, I’d be willing to buy both companies (at the right price) and am unwilling to buy either at current prices. This illustrates the fundamental point of true investing. The price you pay to own a company—combined with diversification— is more important than which company you own when it comes to limiting risk (assuming you’re relatively indifferent about how long you’ll own the company, i.e. you buy at a certain relative price to fair value and sell at a certain relative price to fair value, rinse and repeat).

For previous thoughts on the not good category, read here:

*Post prepared using data as of 12/1/2022

Information in this post has not been audited and accuracy is not guaranteed. The post is for informational purposes only and is not investment advice. Consult a financial professional before making investment decisions. The author’s opinions and positions may change subsequently, without notice.

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