A Discounted Cash Flow, or DCF for short, is one of the most common methods employed by equity analysts the world over to determine the value a company. However, Mike Trigg from WCM Investment Management explains why he believes there may be more effective ways to identify companies with consistent compound growth for years to come.
Mike points out that the DCF has a few drawbacks. The first of which is the many factors that a changing company may be subject to that a DCF simply cannot consider. Without this awareness the investor often places too much belief in the final valuation arrived at and falls victim to a false sense of precision created. Another major drawback is the large dependence placed on the long-term growth rate used in the DCF, which as a company matures often becomes equal to a countries GDP. This he terms the “fade”, essentially the slowdown in the expected growth of a company.
Therefore, Mike suggests two methods of identifying companies that are likely to exhibit long term growth that will defy the fade:
Moat Trajectory
Moat trajectory is the combination of a companies existing moat and whether that moat will grow in time. If you’re wondering what a moat is, it’s simply the long-term competitive advantages that a business has. More specifically, there are five types of moats:
Network effects
High switching costs
Economies of scale
Intangible assets
Low cost production
However, WCM realized that simply identifying businesses with a moat wasn’t enough. Rather the investor needs to go back into the history of various companies and identify signals that led to some companies’ moats growing and others shrinking. What Mike found was that the signals may differ by industry. For example, to measure the moat trajectory of Taiwan Semiconductor, a supplier company, four distinct criteria can be applied:
Room for the company to grow its customer base and a large total addressable market (TAM).
What the company provides is not expensive for the client, but it’s very important to their operations.
The supplier has a fragmented customer base, a company that relies on just 3 clients is vulnerable to shifts in consumer behavior.
The service provided can move up the value chain as the supplier begins innovating on the client’s behalf. This in turn results in the client relying more heavily on the supplier.
Company Culture
You may say that a good company culture is one where if you were an employee in that industry you would want to work for that company. While this certainly isn’t wrong, there are two additional factors to be aware of when assessing what company cultures foster success:
Alignment – How well does that company encourage and reward their employees in line with what is good for the business. For example, Tencent is said to reward their employees based on customer satisfaction, ideal for a company developing tech solutions that set out to provide convenience to the customer.
Adaptable – A company that can learn from major mistakes is one that has proven adaptability and is better able to overcome challenges in the future.
Mike warns that evaluating companies by purely assessing their moat trajectory and culture may not help you find the best companies, but it certainly helps you avoid the bad companies. Most importantly, it will help you develop insights that will still be relevant more than 6 months into the future and certainly beyond any DCF.
Personally, I believe it’s too early in my investment journey to make a call on whether the DCF is of value or not when analyzing companies. However, I think it is vital to realize that given that its built on the analyst’s assumptions the predictive power of the DCF does have its limitations. The next time I’m analyzing a company I intend to assess both their moat trajectory and culture as I believe these could be powerful tools to find businesses with long term growth that supersedes their competitors.
You can listen to the Podcast here, I highly recommend it:
Comentarios