How to Value Companies - Basic Ingredients

Common sense and optionality

Valuing and managing companies: that’s what we do for a living. Understanding how shareholder value creation works starts with the basics. We’ve created the below one-pager to present some key concepts. Let’s unravel them a little more.

To start off this article, we’d like to share one of our quotes:

Investing is about figuring out market expectations, comparing those with your own (realistic) long-term targets and most importantly: thinking about optionality. Life is full of surprises.

Excellent companies will adapt to a changing economic environment. Given that the value of companies is determined by the future cash streams (ROIC and reinvestment rate), we keep an eye on the drivers of future ROIC and IRR for the existing business, and of course growth investments. We're buying the future IRR/ROIC, not the past track record.

We want to own companies that become even more efficient, invest for future growth and strive for the best risk-weighted returns. Optionality is about thinking about what the future return drivers and detractors could look like. Under-promising and over-delivering keeps the share price vs. fair value in check. Agility is what sets great companies and investors apart from the mediocre ones. - The CT

Long-term mindset

Valuing companies should be done with a long-term focus. Short-term stock market returns aren’t driven by fundamentals; they are driven by sentiment (supply vs. demand in the market, i.e. forced selling or ETF inclusion), news (oftentimes not even relevant to a company’s daily operations) et cetera.

Our strategy is based on the long term; through a wide range of common-sense IRR calculations to maximize risk-adjusted returns. What’s the difference between our approach and many others’ quality-investing strategy?

• Contextualization of numbers vs. generalizing stock screener information.We’re looking beneath the surface when analyzing financials;

• We are sometimes contrarian;

• We’ve gathered practical common-sense entrepreneurial insights into private M&A dealmaking and how shareholder value is being created (without financial engineering). We’ll share our field-work experience with premium members;

• Detailed analysis that’s highly appreciated by our members

We’re not interested in cigar butts, we simply stick with good quality growth businesses. As such, a recurring portion of growth embedded in their long-term profile is integral to our overall portfolio strategy (both in public as well as in private markets). Profit/cash flow growth is key to achieving great investment returns. One-off re-ratings (buying at low multiples and selling at high multiples with little underlying NOPAT growth) aren’t sustainable, unless your timing is spot-on over and over again.

What kind of growth are we looking for? Generally, we prefer a total addressable market (TAM) that grows for each and every player in the sector. This way the odds of retaliating with price wars are minimal. Taking market share is the icing on the cake but we still want to select companies that operate within a healthily growing industry, capitalizing on a major secular growth trend (energy transition, aging car parks, modernization of the large installed base of elevators).

From our professional perspective, profitability should be at the core of a high-quality growth strategy. This stance implies that our focus is geared towards companies with pricing power and moderate cyclicality (every company is cyclical to some extent, though). Companies with a sizable cash position or a continuous M&A strategy have several options to reduce cyclicality by moving into adjacent markets.

A company losing sight of sustainable profit (NOPAT) margin improvements will make it increasingly difficult for investors to figure out the intrinsic value. We focus solely on real profits and cash flows, not on rosy adjusted numbers (e.g. corrected share-based compensation) cherry-picked by the management team.

Common sense

Valuing companies should be based on a relatively simple math equation:

• the investment made today (cash outflow)

• all future cash streams before dividends (could be positive or negative number, depending on the reinvestment rate > overall CAPEX/net new leases and M&A)

• the sale of your investment within 10 years from now (cash inflow)

  • certain exit multiple x ending NOPAT (proxy for steady state free cash flow)

  • minus today’s net financial position (adjusted for portion related to non-controlling interests) to reflect the decreased time value of net cash/debt

To us, free cash flow (FCF) is the total change in the net financial position before paying out dividends. That’s why we should subtract recurring lease repayments/renewals, new lease agreements, maintenance and growth CAPEX. New leases are non-cash but ignoring them will lead to serious overstatements.

We should also consider the cash portion destined to NCI, although the cash flow statement is just a fully consolidated overview. The net financial position should include all relevant debt levels investors in primarily serial acquirers will eventually come across: deferred considerations/earn-outs, put-call debt et cetera.

There are lots of unknowns when it comes to valuing companies: profit margin trajectory, reinvestment rate, interest rates (although their impact is very immaterial to the cash flows of the kind of businesses we own) et al. Maybe a little disappointing to hear: there’s no right or wrong; it just depends on your input, expectations and time horizon.

ROIC is key in determining a company’s ability to compound shareholder value over long stretches of time. However, when taken at face value, it’s oftentimes a flawed metric. In particular, we want companies to reinvest and maximize their un-levered IRR on their growth initiatives. A high ROIC is a nice-to-have but frankly, it doesn’t make sense to pay up for a high ROIC company with 0 growth opportunities.

We also shouldn’t extrapolate past growth rates. Companies evolve, risks change, their pool of potential reinvestment opportunities grows and shrinks for a variety of reasons. Past compounding is not indicative of a repeatedly strong future performance.

Valuation methods

There are several ways to valuing companies: shortcuts and full models

• shortcuts: multiple-based approach (gut feeling: comparing present to past, looking at peers). Multiples are too superficial.

• full model: the IRR approach: combining future cash streams (based on reinvestment rates) and an exit-multiple based calculation (at the end of a 10-year period)

The latter is what we present in our deep dives: a base case model to determine whether our conservative input leads to an already satisfying result (>12% CAGR hurdle rate). On top of that, we maintain on a considerable margin of safety(leaving sufficient room for positive surprises, in the end, investing is about managing both up and downside).

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