A shortened version of this article was published in Money Management 15 February 2018 issue
A practical framework for analysing the future prospects of a company, without getting carried away with market sentiment.
In this article I want to outline a framework for assessing the future prospects of a company. This controlled framework of thinking will maximise the chances of picking great investments. Importantly, it will minimise the chances of getting carried away with overly optimistic or pessimistic opinions and potential misjudgement.
It’s essential to form an independent judgement rather than rely on the views of others, otherwise the risk of herd mentality increases. Unlike in the African savannah, staying with the crowd does not guarantee safety in the financial world – in fact history tells us that following the financial herd can be extremely risky.
So whilst I don’t profess to be able to predict the exact future earnings of a company, I do offer a way of thinking which may assist an independent thought process. The end goal is to make sound investment decisions which will hopefully lead to long term profit.
First separate facts from predictions
Donald Rumsfeld once said “There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know”
This is not only true in politics, but also in investing. Information about a stock allows us to determine its true value. This information can either be in the form of facts or predictions. Facts are proven pieces of information and should form a core component of determining value, whereas predictions are not guaranteed and come at a greater risk. Less faith should be placed in predictions. The first step is to recognise factual information from predictions / assumptions.
Mixing both fact and prediction taints factual information with subjectivity. For instance, Nike Inc is a world leader in sports shoes and clothing (fact). Given its market leading position, its sales should continue to grow at roughly 8% p.a as it has done for the past 5 or so years. The second part of the statement is a prediction. The amount of revenue growth it will achieve is not clear and not guaranteed. Although Nike is an innovative company that constantly reinvests in research and development, there remains a level of uncertainty that needs to be acknowledged.
The first step of sensibly predicting the future is to determine today’s value based on today’s data. Assumptions can be made but do this separately and attach a separate value for assumptions. Without distinguishing between fact and forecast, we can’t be clear on how much of our decision is grounded in fact or based on blue sky assumptions.
Start with the facts, not opinions
Any prediction of the future should first start with today’s facts. For a company, the current value can be determined with great certainty based on the facts presented in a company’s financial statements. Investigate any other hidden value the company might have. For example, does it have any subsidiaries that need to be revalued? Other assets such as land or options which aren’t regularly revalued may also be a source of hidden value. Companies may also have secured long term contracts with its customers which will have value. Today’s facts should lay the foundation for the overall analysis of a company’s future prospects. At this point, make no assumptions yet, this is the next component of the company’s value.
Nike is a powerhouse brand, its low level of debt and its continuing pipeline of patented technologies is a genuine intangible asset that is a threat to any competitor contemplating entering the sports shoes market. It also has a strong culture through the everlasting spirit instilled by founder Phil Knight via his holding company Swoosh LLC.
To value Nike, we should start by focusing on existing facts and ignore any predictions for the time being. Assuming no future increase to its 2017 reported EBIT, my estimate of value for each Nike share is USD $25-$28. This value is my estimate of what Nike is worth based on its most recently announced earnings – no blue sky assumptions at this stage.
Forecasts – the possible, plausible and probable
The difficulty with predicting the future is because history doesn’t repeat itself. But for certain companies and industries, forecasts can be relatively stable. For example, Nike competes in markets that are more mature and stable than tech companies like Amazon. The markets that Amazon competes in are new and evolving, whereas the demand for sports shoes is relatively stable – weekend warriors will continue to compete in their favourite sports.
Leading New York University finance scholar Aswath Damodaran favours the use of three categories when evaluating a forecast: possible, plausible and probable. By evaluating a forecast as either possible, plausible or probable, it becomes clearer to an investor how much reliability should be placed in any forecast.
In the case of Nike, whilst it is possible that new competitors will take market share away from Nike, I think this is not a plausible scenario over the next 10 years.
The probable outcome is that Nike will remain ahead of its competitors Adidas and Under Armour. It will remain a strong brand through its innovative founder-led spirit and its product lines will continue to expand.
I think it is probable that Nike will continue to grow revenues at an average rate of 8% p.a over the long run and continue to generate it’s very high returns on invested capital (currently around 25%-30% p.a). By separately valuing the growth component of Nike, I think that Nike is worth around USD $60 to USD $65 per share (an additional USD $40 for growth), compared to its current stock price of around USD $59.
A sensible approach to the unknown unknowns
The current value of a company (based on today’s facts) combined with the forecast (taking into account likelihood) gives us a holistic prediction of the company’s future value. This framework minimises the risk of misjudgement but it doesn’t eliminate the risk of unforeseen circumstances – the unknown unknowns.
Unknown unknowns such as wars, political crises, natural disasters may strike and disrupt the original forecasts that were made. These risks will always exist and shouldn’t prevent a sound investment from being made.
Unknown unknowns will always exist in the financial markets. Even the most sensible predictions are never guaranteed. One way to approach the unknown unknowns is to judge how likely the company is to survive any external shocks. Unknown unknowns will affect all companies, but those with low debt, strong market positioning and quality management will survive these unforeseen shocks. These are the attributes I look for to buffer against the risk of unknown unknowns.
Applying the framework
The framework for predicting the future can be thought of like a tree. The current facts form the roots and trunk, forecasts form the branches and the unknown unknowns form the leaves. Sound predictions will be grounded in a solid foundation of facts. Forecasts should be used, but only if the likelihood is high. Uncertainty will always exist but if the prediction is grounded in a solid foundation of facts, it will be clear what impact unforeseen circumstances may have on the prediction.
Be wary of placing too much reliance on predictions and promises of performance rather than proven factual results, especially in volatile environments. Sound investment decisions are rarely made purely on blue sky predictions.
In the case of Nike, my valuation is currently based on a strong foundation of facts demonstrated by its impressive track record and dominant market position. I have estimated the value of the company based on its current financial performance. This forms the basis of the valuation. An additional portion of value is attached for probable growth which is distinct to the base value. It is clear how much reliance I have placed in fact versus prediction. Whilst there are no guarantees in the financial markets, for a company like Nike, I get added comfort that it should be able to withstand any unforeseen risks due to its low level of debt, strong brand and founder-led culture.
This framework doesn’t guarantee investment returns like the sports almanac, but it does provide any investor with a way of thinking about the future in a sensible manner.
At the time of writing, Lumenary was an investor in Nike, but not any other stocks mentioned.