Discovering Value

Consumer Confidence hits a 12 year low

On Tuesday, the Conference Board reported that consumers’ expectations for the future hit a 12-year low in March. The Expectations Index declined 9.6 points to 65.2, well below the threshold of 80 which they note “usually signals a recession ahead.”

The S&P 500 Consumer Staples index is down nearly 5% month-to-date, and retail stocks like Target, Walmart, Amazon, Home Depot, and Lowes are all down between 6-11% in the same time period.

How do we know when to buy stocks?

Intrinsic Value vs. Stock Price

One common misconception in investing is that the price of a stock represents its true underlying value, or intrinsic value. When there’s a stock market bubble, valuations are described by Wall Street analysts and pundits as being “too rich” “overvalued” or a IPO is “oversubscribed” that simply means the demand for the stock is so much higher than supply, that the price exceeds what the true value of the company is.  Think of Enron in the year 2000 vs. Amazon in 2000: one was amazingly overvalued, the latter was amazingly undervalued.

So how can we determine what the true value of a company is?

One of the most common tools used is the Discounted Cash Flow (DCF) model. Remember that we want to value all of the future cash flows of a company and then discount those future values by the cost of capital to get to a current present value and compare that to the stock price. 

If we have a strong company with a wide economic moat, a history of good financial performance, and/or a history of paying dividends and stock buybacks, PLUS a significantly undervalued stock vs. it’s future cash flow earnings potential is EXACTLY the type of investment we wish to invest in.  Keep in mind that what made Warren Buffet and Charlie Munger exceptional lifelong investors, primarily comes down to a few trades that they made, notably an investment in Coca-Cola (KO) in 1988 after a market crash. They had analyzed a ton of companies, waited for the price of an amazing cash machine to come down, then they loaded up.

Note that there are other methods to value companies, such as the Dividend Discount Model (DDM) or Graham Valuation Model, but it’s important to note that every model is not a perfect solution, so we’ll cover DCF because it’s the most widely used and arguably the most versatile.

Components of Discounted Cash Flow:

1) Free Cash Flow: Firstly, we want to project the future Free Cash Flows. We do not recommend projecting out beyond the next five years, because the further into the future we get the less we will know about the world in terms of changes to the business model. To do this properly involves pulling in historical data on revenues, operating expenses, and capital expenses, and observing how FCF has stayed steady or experienced rapid changes YOY for the past 5-10 years.

2) Discount Rate: next we have to take those future cash flows and discount them to today’s dollar value. For most companies, we will use their Weighted Average Cost of Capital (WACC) to do so.

3) Terminal Value: Include a value of all the cash flows beyond the explicit forecast period (i.e., five years). We do not recommend the perpetuity growth method by which cash flows grow are assumed to grow at a constant rate indefinitely, because, as we observed through the research of Geoffrey West, many companies have finite lives. Thus, we recommend using the exit multiple method, where we apply the P/E ratio to the final year’s cash flows to provide an estimate. 

4) Discount the Free Cash Flows and Terminal Value and Determine Implied Share Price.

To be a true value investor, having a detailed understanding of the companies on your “watch list” and developing accurate estimates based on news articles, industry reports, analyst reports, SEC Filings, and other sources can help you refine your assumptions and thus keep a dynamic database or ledger of what the most promising investments are. If you are uncertain or nothing is looking promising, continue to build your cash reserves. Patience is a key virtue of value investing.

Note: We will revisit DCF in future newsletters and provide more detailed instructions to help novice value investors.

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INTU

Intuit is a financial software company with such timely products as Turbotax, Quickbooks, Credit Karma, and Mailchimp.

The company boasts strong financial performance, with 13% growth YOY from FY 2023 to 2024, and has had YOY quarterly growth 47 of the last 56 quarters (85% of the time), with net profit margins coming in at around 16-18% in recent years.

It has a healthy economic moat, with nearly 40% of US tax filers using TurboTax and many more businesses having their returns filed by the CPA-targeted products Lacerte and ProSeries. With taxes unlikely to go away anytime soon, Intuit is well positioned to continue to capture revenue for the foreseeable future. Additionally, CEO Sasan Goodarzi. stated that the company “made meaningful progress with our AI-driven expert platform strategy that positions the company for durable growth in the future.”

At a PE ratio of 57.5, the firm seems too overvalued vs. its longer-term potential, but like so many companies in the market right now, should that change, this is definitely one to track.

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_{Legal Disclaimer: The Evolved Investor is for information purposes only and is, by law, not personal investment advice. Concepts and ideas are for your consideration only. We encourage our readers to do their due diligence. Investing has inherent risk, and investments can lose value.}