Should you invest in Apple? Should you invest in Amazon? Most people would agree that these are both terrific companies. The return on capital that these companies generate is astounding. But are these excellent businesses good stocks to buy? The answer depends on the expectations that are set by the market vs. the true future fundamentals of the company.
The value of a company is simply the sum of the cash it will generate discounted at it’s cost of capital. These future expectations are what influence the share price over the long term. If the market expects a company to generate less cash flow than you have projected, then the company may be a good buy. The inherent difficulty in this is predicting the future cash flows of the company. This is where fundamental analysis and a margin of safety come into play.
One measure an investor can use in order to figure out the expectations of the company is called the present value of growth opportunities (PVGO). This measure is based off of earnings, which is subject to accounting manipulation and may not accurately represent the true economic profit earned by a specific company. However, it should be kept in an investor’s toolbox, nonetheless. The PVGO breaks down the value of a business into two components:
1. The value if the business if it were to not grow at all
2. The value that the market is ascribing to future growth (PVGO)
The formula is as follows:
PVGO = Share Price – (Earnings/Discount Rate)
Share Price = (Earnings/Discount Rate) + PVGO
The higher the PVGO relative to the share price, the more value the market is ascribing to future developments. Ben Graham constantly warned investors not to look at companies through “rose colored glasses” – to be wary of the bright future expectations that the market expects. Rather, he told his students to look at companies with dark blue glasses – to remain conservative when projecting the fundamentals of a company and to protect yourself against your own future projections by buying at a large margin of safety.
There is a fundamental reason as to why Graham warned against looking at companies through rose colored glasses. Economic profits are mean reverting. When a company starts to earn a large profit, it draws in competition. These competitors compete to take market share away from that first mover. The one exception to this rule are companies that have a moat – which is an article for another time. In general, those that tend to earn high economic profits will not be able to continue to do so in the future. If the market expected them to do so in the future, then the shareholders of that company are in for a rude awakening.
One of my favorite Mungerisms is “invert, always invert”. If companies that are earning a high economic profit are destined to have some of their market share taken from them, what is to be said of the companies that are in the doldrums? The companies that the market ascribes 0 PVGO to? The lack of economic profit dissuades companies from investing any further into their operation. These companies tend to close shop. With less competition, there will be room for a company to step in and take whatever market share is left. Economic profit will start to grow and the cycle will repeat itself. Economic profit is mean reverting.
Is a great business a great stock? It depends. When investing, always try and get a feel for what the market is expecting and compare that against your own fundamental projections. This article is not to say that Apple and Amazon are bad buys. Measuring the market’s future expectations against your own should be examined when doing any type of valuation. This method does not discriminate against the statistically cheap (Morningstar value) or statistically expensive (Morningstar growth). If your margin of safety is adequate enough to protect yourself against your own future projections, then buy. If not, keep your bat on your shoulder and wait for the big pitch.