I always enjoy your research and loved this post in particular. I hold a (6%) position in stne for similiar reasons.
One thing I often find strange is the usage of wacc and country risk in evaluating businesses.
a) the important factor for value creation is the cost of capital (in relation to the return on capital amd reinvestment rate). It doesn't matter for e.x. that the default rate in a country is high (too much leverage used by other companies) if you invest in a profitable company with ample net cash. It doesn't make the cost of capital greater or the returns of investing in the company smaller
b) In general I find the usage of wacc peculiar. It makes sense to compare the return on capital of projects/businesses to the average cost of capital to understand if the project makes sense. However when buying another company we should compare their return on capital to our cost of capital as we are the ones investing the capital
In my (humble) opinion it makes more sense to use the same discount rate for all companies (our wacc - but it can be any number really as long as we are consistent, I use 10) and just demand more margin of safety for riskier securities.
As for your comments on using WACC vs. a standard discount rate, valuation is not an exact science as it deals with an uncertain future. WACC is our attempt for quantifying risk using capital structure, equity risk premiums, and beta. While not perfect, it takes into account important variables that attempt to measure risk. I also see no issue with your idea to use a standard discount rate for all companies and then demanding a higher margin of safety for "riskier" assets. I would be curious though how you decide (quantitatively) what is riskier. I assume you would be using the same variables that are used in a WACC calculation (excluding beta).
In other words, multiple paths can lead to the same conclusion.
Hi Jack! I appreciate the response and apologize for the late reply, had a crazy couple of weeks.
I agree that having a reproducible quantifiable framework is valuable. Currently I try to find opportunities where a conservative bottom limit on the intrinsic value is multiples of the price.
For position sizing, I analyze balance sheet risk, competitive risk, execution risk and macro risk qualitatively per segment and use it to control sizing. I try to assess the effects individually (Apple is probably more affected by China/US tensions than Baba's China commerce segment).
Regarding wacc (and maybe dcfs generally) I just find too many things I dislike with it:
1. We probably agree that using beta makes no sense
2. Wacc rewards high leverage so it quantifies risk backwards
3. Also, Wacc rewards a higher tax rate that in reality it doesn't make debt cheaper
4. I am fine with the terminal rate assumption as it makes the valuation more conservative but I would want to reward companies with moats/in growing markets where above gdp growth is likely after the first 5-10 years
I am still early in my journey and building the framework.
My current approach is probably too simple at this stage but my thinking is if I buy companies that would earn their EV in a few years with shareholder aligned management teams, good things might follow.
I always enjoy your research and loved this post in particular. I hold a (6%) position in stne for similiar reasons.
One thing I often find strange is the usage of wacc and country risk in evaluating businesses.
a) the important factor for value creation is the cost of capital (in relation to the return on capital amd reinvestment rate). It doesn't matter for e.x. that the default rate in a country is high (too much leverage used by other companies) if you invest in a profitable company with ample net cash. It doesn't make the cost of capital greater or the returns of investing in the company smaller
b) In general I find the usage of wacc peculiar. It makes sense to compare the return on capital of projects/businesses to the average cost of capital to understand if the project makes sense. However when buying another company we should compare their return on capital to our cost of capital as we are the ones investing the capital
In my (humble) opinion it makes more sense to use the same discount rate for all companies (our wacc - but it can be any number really as long as we are consistent, I use 10) and just demand more margin of safety for riskier securities.
Hello Itay! Thank you for the kind words.
As for your comments on using WACC vs. a standard discount rate, valuation is not an exact science as it deals with an uncertain future. WACC is our attempt for quantifying risk using capital structure, equity risk premiums, and beta. While not perfect, it takes into account important variables that attempt to measure risk. I also see no issue with your idea to use a standard discount rate for all companies and then demanding a higher margin of safety for "riskier" assets. I would be curious though how you decide (quantitatively) what is riskier. I assume you would be using the same variables that are used in a WACC calculation (excluding beta).
In other words, multiple paths can lead to the same conclusion.
Thanks again for the comment!
:)
Hi Jack! I appreciate the response and apologize for the late reply, had a crazy couple of weeks.
I agree that having a reproducible quantifiable framework is valuable. Currently I try to find opportunities where a conservative bottom limit on the intrinsic value is multiples of the price.
For position sizing, I analyze balance sheet risk, competitive risk, execution risk and macro risk qualitatively per segment and use it to control sizing. I try to assess the effects individually (Apple is probably more affected by China/US tensions than Baba's China commerce segment).
Regarding wacc (and maybe dcfs generally) I just find too many things I dislike with it:
1. We probably agree that using beta makes no sense
2. Wacc rewards high leverage so it quantifies risk backwards
3. Also, Wacc rewards a higher tax rate that in reality it doesn't make debt cheaper
4. I am fine with the terminal rate assumption as it makes the valuation more conservative but I would want to reward companies with moats/in growing markets where above gdp growth is likely after the first 5-10 years
I am still early in my journey and building the framework.
My current approach is probably too simple at this stage but my thinking is if I buy companies that would earn their EV in a few years with shareholder aligned management teams, good things might follow.