Insights and Thoughts from Dorfman Value Investments
John Dorfman writes a syndicated column that appears weekly in the Omaha World Herald, the Pittsburgh Tribune Review and the web site Guru Focus. In it, he tries to provide original, profitable stock ideas for readers. In contrast to almost all other investment columnists, he systematically reports on past results, both good and bad.
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Moats and Terminal Value
Posted: October 30, 2017
Based on an article published on GuruFocus.com on October 12, 2017
“The ability to make good assumptions about the future is very difficult in the present moment. One small mistaken estimate today can lead to truly horrendous results later. They say a bird in the hand is worth two in the bush. If that’s the case, then you better be really sure about the reproductive qualities of that small avian creature you are holding.” – H. Joseph Davis
Recently, I wrote about the necessity in today’s markets to double your efforts to ferret out risk in your portfolio. I had commented, “When using a discounted cash flow model there are two assumptions that can really skew your valuation – estimated future free cash flow and estimated cost of capital. Both are easy to get wrong.” If you get either of these wrong, it can distort your estimate of a stock’s intrinsic worth, especially its terminal value.
Terminal value is the last step in the calculation of the present value of a stock. To calculate a stock’s present value, you estimate earnings for years 2, 3, 4 and so on, and use a discount rate to arrive at the present value of those future earnings. The calculation is fairly straightforward for the first few years. But what about years 31, 32, 33 and so on? For years distant from the present, analysts conventionally assume that the company will reach some sort of equilibrium. They then calculate the “terminal value” for those later years, and add it to the values previously calculated.
To put it another way, terminal value is a company’s present value at a future point in time of all future cash flows when a stable growth rate is projected forever. Now before you put this article down muttering dark thoughts about this writer, I encourage you to really understand this model. I certainly can’t claim it will increase your investment returns, but it will make you a better investor. So stay with me here.
A common method to calculate terminal value is the Gordon Growth Rate.
In the formula, FCF stands for free cash flow, and the discount rate and growth rate are expressed as decimals.
One of the things that jumps out using the Gordon Growth Rate calculation is the importance of estimating long-term growth rates. The longer the period in question, the more exquisitely sensitive the answer is to the growth assumption. Getting that wrong can make a huge difference in your terminal value. In my 10-year discounted cash flow model any free cash growth created beyond the final (“terminal”) year makes up a tremendous amount of my estimated terminal value.
Of course it’s risky to assume that a company will continue to grow free cash at a healthy rate over the next 15 to 20 years. There aren’t many companies out there that can do it. In my opinion, Coca-Cola (NYSE:KO) is likely to be selling more drinks 20 years from now than it does now. On the other hand, it’s hard to know if Blink Charging (CCGI) will even be selling residential and commercial electric-vehicle charging equipment at all 20 years from now.
The impact of moats on terminal value
One way to mitigate the risk of having an estimated long-term free cash flow growth rate that is too high or too low is to utilize the concept of moats. These are defined as a company’s advantages used to retain its competitive position and pricing power over an extended period in the future. Moats can be achieved through proprietary technology, patents, etc. They have a direct impact on future free cash flow growth as they provide companies with a long runway of steady expansion. Moats can be one of the most important factors when calculating terminal value.
Sticking with the example of Coca-Cola and Blink Charging, it’s relatively clear we could assign Coca-Cola a wide moat. With a 110-year history, enormous brand recognition, worldwide distribution network and enormous market share, Coke is likely to grow its revenue steadily over the next 20 years. Of course, there are threats to this moat even as I write – competitive pricing pressure, supply costs, demographic changes (less sugar required) and regulatory action such as the soda tax. But it’s important to remember Coke has survived two world wars, the Great Depression and many other catastrophic events through its lifetime.
Blink Charging is an entirely different case. A company with a short history (public since 2012), Blink operates in a hypercompetitive marketplace and is dependent upon an evolving technology. With no industry leadership in place and battery technology facing constant pricing pressure from China, Blink has little to no competitive moat to help predict future cash flow. With a return on assets of -412%, no earnings and negative free cash flow, it seems any estimate you develop for a future free cash flow growth rate is in peril at birth.
For which company is it easier to estimate the rate of future free cash flow growth? Perhaps someone with a deep understanding of automotive design, battery design, engineering requirements of the eco-balance of lithium ion storage and government regulations can model Blink’s future better than most. For the rest of us, Coke’s wide moat makes it far easier to model free cash flow over the next 15 to 20 years.
Why this matters
For anybody looking to calculate terminal value, the ability to be as accurate as possible in your estimates is critical. A seemingly small difference can have dramatic impacts on your final estimates. As a hypothetical example let’s use Acme Rubber Band Company. Our company currently trades at $3.00 per share, has 10 million shares outstanding, generates $1 million in free cash and has a weighted cost of capital of 10%. I’ve modeled the company valuation using a 3%, 6% and 9% future free cash flow growth rate. Seen below are the results.
Even utilizing a fairly low estimated growth rate for free cash flow, more than 60% of the estimated value of the company’s terminal value is derived from the estimated long-term FCF growth rate. Assuming 9% growth (quite a high assumption), nearly the entire terminal value is derived from the estimated long-term FCF growth rate. This is clearly not a time to make a serious mistake in your projections.
Of course, the value per share can increase dramatically if you bump up the estimated long-term FCF growth rate. In Acme Rubber Band the company goes from 17% above fair value assuming a 3% growth rate to 76% below fair value assuming a 9% growth rate.
The ability to accurately forecast future free cash flow can be greatly improved if a company has a wide competitive moat. All other things being equal, a company with a wide moat and consistently growing profits will be more valuable than a company that doesn’t have these characteristics. When using a discounted cash flow model, the ability to accurately predict future growth can significantly add to the chances for a successful investment decision. They say a bird in the hand is worth two in the bush. That may be true, but as Davis informs us, the ability to predict the future of a company’s growth accurately can really make your investments take flight.
Disclosure: Neither I nor my clients own any of the stocks mentioned in this article.