Looking at the table, would it make more sense to multiply the $124m by 1.26 (1+ ROIC) and then discount that at a 10% rate rather than subtracting the 10% from the ROIC?
You could do it that way. It's just my way of thinking about things. If you "pay for" the discount rate what you have left over is growth in present value.
Your write: "And yet a paradox exists here because we’re trying to estimate IV and yet need the figure to make an adjustment. The way I’ve tackled this is to fiddle with the enterprise value figure until it gives me a 10% return. With FAST that came out to about $13bn. That means the $33bn current enterprise value is about 2.5 times too high. "
Tackling a circular argument by making an absurd assumption does not solve anything. If you need IV to solve for IV then you are doing something wrongly. Rather than compound the error by adding an assumption, you should stop and examine your process.
The end result is you have the market paying 2.5x too much. This sort of "I can be correct in calculating IV and completely ignore the market's valuation" because I think I am rational and the market is irrational is precisely what gets people into trouble. The assumption and the conclusion are both silly. Why would you need a 10% earnings yield to own a company with a 30% return on equity, with little debt compounding at 8% per annum? I agree you might like it - but would you demand it?
How about this instead: if Fastenal can compound sales at 8% per annum, maintaining a 20% EBIT margin, paying a 25% tax rate and re-investing about 25% of profits then it should earn about USD 1.5 billion profits in 5 years time. That's about a 5% yield on today's EV. Throw in dividends of 2.5% per annum. Instead of asking if this is right, ask if it seems very wrong. Does it? Not to me.
I don't disagree that it's imperfect. The basic notion is that by paying a premium to the underlying capital in the company you don't get a 1:1 benefit from what the underlying company does.
I can poke holes in your analysis too. You can't just throw out numbers without relating them to the underlying reality. Is 25% of profits enough to grow 8%? To grow revenues 8% would be $467m in additional revenues. FAST requires $0.55 of capital to grow revenues $1. $467 x 0.55 = $256m. That's fairly close to the $220m they have available after paying 75%. What about the time value of money of your 5 years and $1.5bn? That has to be considered. You can't also just "throw in" 2.5% of dividends. They have to come from somewhere. In my analysis it came to just 2% of the then-current EV.
All of this said I struggle with the desire to keep things simple like Buffett, my agreement with Greenwald that DCF's are inherently flawed, and the lure of a DCF model even in its simplest form. I'm currently drafting a stream-of-consciousness post that explores it.
Thank you for replying and for being direct. I should have written that if Fastenal can continue to compound sales etc because that is what they have been doing. So I was not just throwing out numbers without relating them to the reality - I was referencing actual results. Including the dividends.
There is no good answer to the time value of money that I have ever heard (much as the textbooks would like there to be) because the 'risk-free' rate is not risk free at all (there is no such thing) and the risk premium is really about the opportunity cost.
Would I swap the certain outcome of an inadequate return from government bonds for the uncertain return of Fastenal constituting 3% of my portfolio? No.
You're welcome, I appreciate the dialog. I disagree with the premise of holding an overvalued company vs. a gov't bond that's inadequate. In my opinion it's better to have the cash even if you go backward in real terms for a while. Better to wait for prices to correct or you find something else to take its place.
100% agree about opportunity cost in general though. That's the name of the game, finding better investments / raising your opportunity cost.
To continue with FAST using those numbers, FAST has consistently earned 35% pre-tax. Take off 25% of that for taxes (being conservative) and you have 27% after-tax. To grow 8% per year would require about a 30% retention ratio. So NOPAT of $880m x 70% distributed means they'd payout $616m or ~2% of the then market cap of $33bn. If - and only if - the market still values FAST at the same multiple in the future as today will you get 2% dividends + 8% growth or a 10% return. I think it unlikely the company is still valued at 28x EV/EBIT in the future.
Once again, many thanks for your thoughts. This encapsulates the dilemma of investing in very good businesses - they are never cheap. So how to deal with that? Wait for them to become cheap? Sell them when they are outrageously expensive? Or just hold on?
My answer is to hedge the market systemic and systematic risk in an effort to capture the business performance of businesses that are consistently good.
For example: Keyence in Japan has been one of Japan's best businesses for over 40 years - and always expensive vs market and peers. There have been big drawdowns from very overvalued: but look at what happened if you did not own it. No amount of trading in an out of cheap but poor quality businesses has paid you like owning expensive but high quality Keyence.
Adam, could you please explain how you arrived at the $13 billion figure using the EV calculation you mentioned in the article? I've been trying to understand it for an hour but haven't had much success.
You can get it by taking the sum of $274, $124, and $880 = $1,278 and dividing it by the required 10% return. Hope this helps. I don't use this method as much as I did before. It's not incorrect I just think it's probably too complicated. As Buffett says, the numbers should just jump out at you, you shouldn't need a spreadsheet. In my case it was helpful to use a spreadsheet to see the pieces in action.
Hi Adam - "You can get it by taking the sum of $274, $124, and $880 = $1,2782" - could you please expand on where the two figures are derived from and why you are agreggating all 3 together?
For the cash return would you not divide the distribution by the market cap as opposed to the EV since the aim is to derive a total return to the equity holder and not all owners of the business?
Hi, regarding the organic growth, I wonder whether to use the nominal GDP growth or the real one (nominal - inflation)? which one (nominal or real one) should i use to calculate organic growth return?
I have one more question. If I wanted to estimate future organic growth based on data from previous years. Let's say the average revenue growth rate of the company is 12% over the last five years. Average net income growth is 13% over the last 5 yeras. Should I subtract the average inflation over the last five years from these numbers and then and then add it to the Greenwald's formula?
If I don't subtract inflation from GDP or historical data (revenue, net income), it seems to me that the returns from organic growth are too high.
I would tend to use real figures. The key is in tying the growth (whether organic or active) to capital requirements. A few things I like to keep in mind are: 1. A company can't sustainably grow faster than its return on capital over time; 2. Growth requires capital which reduces current income. So a company growing forever (to keep it simple) at zero (i.e. no reinvestment) can distribute 100% of its cash. If it grows forever at 3% that requires "fuel" in the form of capital, which reduces the cash distribution. And it's all tied to return on capital. I make a 100% return on capital then growing 3% requires just 3% of earnings. If my return is 50% it's 6%; 25% it's 12%, and so on. There's that tradeoff that I see too many people forget.
Looking at the table, would it make more sense to multiply the $124m by 1.26 (1+ ROIC) and then discount that at a 10% rate rather than subtracting the 10% from the ROIC?
You could do it that way. It's just my way of thinking about things. If you "pay for" the discount rate what you have left over is growth in present value.
Your write: "And yet a paradox exists here because we’re trying to estimate IV and yet need the figure to make an adjustment. The way I’ve tackled this is to fiddle with the enterprise value figure until it gives me a 10% return. With FAST that came out to about $13bn. That means the $33bn current enterprise value is about 2.5 times too high. "
Tackling a circular argument by making an absurd assumption does not solve anything. If you need IV to solve for IV then you are doing something wrongly. Rather than compound the error by adding an assumption, you should stop and examine your process.
The end result is you have the market paying 2.5x too much. This sort of "I can be correct in calculating IV and completely ignore the market's valuation" because I think I am rational and the market is irrational is precisely what gets people into trouble. The assumption and the conclusion are both silly. Why would you need a 10% earnings yield to own a company with a 30% return on equity, with little debt compounding at 8% per annum? I agree you might like it - but would you demand it?
How about this instead: if Fastenal can compound sales at 8% per annum, maintaining a 20% EBIT margin, paying a 25% tax rate and re-investing about 25% of profits then it should earn about USD 1.5 billion profits in 5 years time. That's about a 5% yield on today's EV. Throw in dividends of 2.5% per annum. Instead of asking if this is right, ask if it seems very wrong. Does it? Not to me.
I don't disagree that it's imperfect. The basic notion is that by paying a premium to the underlying capital in the company you don't get a 1:1 benefit from what the underlying company does.
I can poke holes in your analysis too. You can't just throw out numbers without relating them to the underlying reality. Is 25% of profits enough to grow 8%? To grow revenues 8% would be $467m in additional revenues. FAST requires $0.55 of capital to grow revenues $1. $467 x 0.55 = $256m. That's fairly close to the $220m they have available after paying 75%. What about the time value of money of your 5 years and $1.5bn? That has to be considered. You can't also just "throw in" 2.5% of dividends. They have to come from somewhere. In my analysis it came to just 2% of the then-current EV.
All of this said I struggle with the desire to keep things simple like Buffett, my agreement with Greenwald that DCF's are inherently flawed, and the lure of a DCF model even in its simplest form. I'm currently drafting a stream-of-consciousness post that explores it.
Thank you for replying and for being direct. I should have written that if Fastenal can continue to compound sales etc because that is what they have been doing. So I was not just throwing out numbers without relating them to the reality - I was referencing actual results. Including the dividends.
There is no good answer to the time value of money that I have ever heard (much as the textbooks would like there to be) because the 'risk-free' rate is not risk free at all (there is no such thing) and the risk premium is really about the opportunity cost.
Would I swap the certain outcome of an inadequate return from government bonds for the uncertain return of Fastenal constituting 3% of my portfolio? No.
What do you think? Sensible? Where am I wrong?
You're welcome, I appreciate the dialog. I disagree with the premise of holding an overvalued company vs. a gov't bond that's inadequate. In my opinion it's better to have the cash even if you go backward in real terms for a while. Better to wait for prices to correct or you find something else to take its place.
100% agree about opportunity cost in general though. That's the name of the game, finding better investments / raising your opportunity cost.
To continue with FAST using those numbers, FAST has consistently earned 35% pre-tax. Take off 25% of that for taxes (being conservative) and you have 27% after-tax. To grow 8% per year would require about a 30% retention ratio. So NOPAT of $880m x 70% distributed means they'd payout $616m or ~2% of the then market cap of $33bn. If - and only if - the market still values FAST at the same multiple in the future as today will you get 2% dividends + 8% growth or a 10% return. I think it unlikely the company is still valued at 28x EV/EBIT in the future.
Once again, many thanks for your thoughts. This encapsulates the dilemma of investing in very good businesses - they are never cheap. So how to deal with that? Wait for them to become cheap? Sell them when they are outrageously expensive? Or just hold on?
My answer is to hedge the market systemic and systematic risk in an effort to capture the business performance of businesses that are consistently good.
For example: Keyence in Japan has been one of Japan's best businesses for over 40 years - and always expensive vs market and peers. There have been big drawdowns from very overvalued: but look at what happened if you did not own it. No amount of trading in an out of cheap but poor quality businesses has paid you like owning expensive but high quality Keyence.
Adam, could you please explain how you arrived at the $13 billion figure using the EV calculation you mentioned in the article? I've been trying to understand it for an hour but haven't had much success.
Thanks in advance.
You can get it by taking the sum of $274, $124, and $880 = $1,278 and dividing it by the required 10% return. Hope this helps. I don't use this method as much as I did before. It's not incorrect I just think it's probably too complicated. As Buffett says, the numbers should just jump out at you, you shouldn't need a spreadsheet. In my case it was helpful to use a spreadsheet to see the pieces in action.
Thank you for your help. I agree, the simpler you make it the easier you can win the so called complexity bias.
Hi Adam - "You can get it by taking the sum of $274, $124, and $880 = $1,2782" - could you please expand on where the two figures are derived from and why you are agreggating all 3 together?
For the cash return would you not divide the distribution by the market cap as opposed to the EV since the aim is to derive a total return to the equity holder and not all owners of the business?
Hi, regarding the organic growth, I wonder whether to use the nominal GDP growth or the real one (nominal - inflation)? which one (nominal or real one) should i use to calculate organic growth return?
I have one more question. If I wanted to estimate future organic growth based on data from previous years. Let's say the average revenue growth rate of the company is 12% over the last five years. Average net income growth is 13% over the last 5 yeras. Should I subtract the average inflation over the last five years from these numbers and then and then add it to the Greenwald's formula?
If I don't subtract inflation from GDP or historical data (revenue, net income), it seems to me that the returns from organic growth are too high.
I would tend to use real figures. The key is in tying the growth (whether organic or active) to capital requirements. A few things I like to keep in mind are: 1. A company can't sustainably grow faster than its return on capital over time; 2. Growth requires capital which reduces current income. So a company growing forever (to keep it simple) at zero (i.e. no reinvestment) can distribute 100% of its cash. If it grows forever at 3% that requires "fuel" in the form of capital, which reduces the cash distribution. And it's all tied to return on capital. I make a 100% return on capital then growing 3% requires just 3% of earnings. If my return is 50% it's 6%; 25% it's 12%, and so on. There's that tradeoff that I see too many people forget.