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In this episode of our three-part series, we’re going to dive deep into the world of value investing and valuation methods. So, let’s buckle up and get started!
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Bryce: [00:00:15] Welcome to another episode of Equity Mates, a podcast that follows our journey of investing, whether you're an absolute beginner or approaching Warren Buffett status. Our aim is to help break down your barriers from beginning to end. My name is Bryce and as always, I'm joined by my equity body Ren. How you going?
Alec: [00:00:30] I'm very good. Bryce is very excited for this episode. We're planning a bit of an away game today.
Bryce: [00:00:35] Yes, we're Not in our home ground.
Alec: [00:00:36] But in the away studio. Yes. And we're also wearing our away jersey.
Bryce: [00:00:41] Just loving it. Yes. Giving me some good vibes.
Alec: [00:00:45] For people listening, not watching on YouTube. Bryce is wearing a party shirt. Yeah, and I'm wearing one. We've got ice cream.
Bryce: [00:00:54] Ice cream.
Alec: [00:00:55] And the reason that we're doing that is because there's one person who is trying to pioneer the Finance Party shirt, and we are in his studio.
Bryce: [00:01:03] Yes, we are. Where he and none other than Rask Australia Studio and we are joined by Owen Raszkiewicz. Owen, welcome.
Owen: [00:01:11] Hello guys, great to be here. Yeah. Loving the shirts digging it with your. I got a stern talking to Russell Brand jury. That'll be coming out straight after this.
Bryce: [00:01:22] If you have joined us for the first time here at Equity Mates, welcome. Great to have you as part of the community. We have created a course with Owen that we launched last year called the Value Investor Program. And it is the second course we've done. The first is a get started investing course and this value investor program or VIP program.
Alec: [00:01:46] So we've done that.
Bryce: [00:01:46] Yes. Is it cost designed? If you want to take that next level or next stage of investing and understand valuation of companies? And over the next three episodes, we thought, why not actually put this course to use and do a couple of case studies using some of the information and the tools and resources and lessons in the course. And Alan is going to be guiding us along the way.
Alec: [00:02:10] Yeah, valuing a company is definitely like the last hurdle, like the final boss, the last domino to fall, whatever metaphor you want to use like that. You can learn so much about investing, but actually understanding, Getting your head around how to value a company I think is the biggest challenge for most people. Luckily, Bryce and I don't have to explain it because you're here, Owen But let's, let's start, General, and then we'll get specific. Actually, we should say over this, this is a three part series, This episode we're going to be talking about value investing and methods of valuation. And then the next two episodes, we're going to actually be taking Owen's laptop, looking in his files, and going through two valuations. He's done one on Australian companies zero and one on US companies. You may have heard of it. Apple.
Bryce: [00:02:55] So, Owen, let's start with the fundamentals. Someone has just joined in thinking, What are these guys talking about? What is value investing?
Owen: [00:03:04] Yeah, so obviously different forms of investing. If we just take the two most common, you've got value investing and you've got technical analysis, which is where people look at charts and they talk about trading. The key concept that and the thing to understand is that with value investing, we believe that the share price doesn't match what the value of that share is. So this would be like if you walk into a Nike store and you think, Oh, those pair of shoes, it says 100 bucks on the ticket, that's the price. But maybe you think they're worth 150 bucks, so you buy them. So that's the undervalue. Now, with technical analysis, which is the other side of the coin, in that they assume that the price represents all of the known information. And so that price is an accurate reflection of the value. So there's no difference. But with value investing, then that therefore you could say that if you have a better view on the true value of a stock or a true value of a company, that you could exploit that, right? So if you think something is worth more than the share price, that's something that you should be looking at buying. And so that's the basic principle. And obviously the likes of Warren Buffett and many of the investors that have gone after him. Charlie Munger Many of these famous investors have have popularised this. And then you take lessons from those guys and you bring them forward into the modern era. And now you guys have had people like Joe Jamaica on the show. He comes from the US and spent a long time in Australia and he really introduced this idea that value investing is not so much about spreadsheets, it's actually about qualitative investing. So what I mean by that is in order to get numbers in the balance sheet, in the profit and loss statement, there's a business. So you've got to understand that business and how things get on there. And by doing that, you can actually get in front of the value and you can try and estimate what a company's was.
Alec: [00:04:49] Now, I think there's an important distinction here, because you just said there's two types of investing technical analysis where you believe the price reflects reality, I guess, and value investing where the price does not reflect reality. But people often hear about the distinction between value and growth. So be your looping, your grouping, both of them under value. So just explain that for people.
Owen: [00:05:10] Yeah, sure. So this is in finance. We love to put people in camps as growth investors. This technical analyst is a fundamental analyst. There's all these different words that basically all mean the same thing because we just want growth and we want, you know, income. Those are the only reasons you invest in anything. When you think about it. It doesn't matter if it's a property, it doesn't matter if it's cryptocurrency. You want something from that investment. And so growth is this kind of idea that the value of a company can go up over time. So notice how I said the value of a company can go up over time. Now, some people confuse that with the share price going up, and that may be true. Like you might buy a share sale like Commonwealth Bank for $100 and you sell it 126 months later. And that sounds like growth because it's gone up, right? But when we talk about growth investing for the long term, it actually is indistinguishable from value investing because what we're talking about is the value going up over time, the company building things, doing things, and maybe it's not six months, maybe it's many years. And so it's a key distinction. I was on the table not too long ago and someone challenged me. They said there's a company in the Aztecs called Rural Funds Group, which is just like a trust that owns property, like agricultural property. And I was like, this is not a growth stock in the traditional sense. And the other expert on the show said, Oh, well, I beg to differ. It went up 20% in the last three months. And I was like, that's just the share price. Moving around. Like doesn't actually reflect the value. So value investing kind of encompasses all of that. And I think people get parochial and they tend to get really tribal about this. I'm a growth investor, I'm a value investor. The same thing, we all want the same thing at the end of the day. And if you believe in the tenets of value investing, then you can do it any way you like.
Alec: [00:06:49] A company like Zoom that's growing its revenue, I don't know what it grows through the pandemic, call it 50% a year or something. Or a company like CBA that's growing at 3% a year. You know, one might be considered a value play. One might be considered a growth play. But at its core, you still have to value the business. And then you invest when you think the market is undervaluing the business.
Owen: [00:07:10] Exactly. Yeah. Great, great examples. And you know, and then it depends on your time frame, right? Like with Zoom, Zoom went from a company with these share price, but it basically went up like fourfold during the COVID pandemic and then it came crashing back down. So if you had, you know, five year window, you'd say, oh, maybe it's a growth stock. But then if you took a six month or a 12 month view, then maybe it's like a rapid growth stock. You know, maybe if you'd go ten years, who knows where Zoom is in ten years? Maybe it's not a growth stock at all. Maybe it's in decline. And that's where you've got to do that fundamental analysis, that value and then follow the value investing principles to determine that.
Bryce: [00:07:46] So we all like investing in different things. Ren loves mining, small caps.
Alec: [00:07:51] I love losing money.
Bryce: [00:07:53] I just love crypto. Others love the top end of the market, which is you. SABR is your blue chips. Yeah.
Alec: [00:07:59] Who loves.
Bryce: [00:08:00] You? Do you love it all? Does this valuation approach apply and work across the board? Or how do you think about this when you segment the different types of markets and I guess asset classes as well?
Owen: [00:08:14] Yeah, sure. So we're going to show some examples in the next two episodes. But I would say that when it when you're investing in early stage companies like companies that maybe are not profitable, but they've got sales and they're growing, you can value them using simple heuristics like the price to sales multiple, which is where you just get the share price of the stock price and you divide it by the sales per share. And you can look at that in the early stage and you say, well, revenue is really important for this company. It's really early, so it's not actually creating a profit. But there is a way that I can kind of put a yardstick in and say, okay, it's here at this day. I think it's going to be over there in a couple of years, but then when the business matures, you can see more of the fundamentals. And what I mean by that is like on the financial statements, when you're in the annual report, you can see more of the money falling down the income statement. So at the top you've got sales and revenue, then you've got costs and then you have expenses like marketing and admin and all that sort of stuff like offices and whatever. And as a company matures, you can see the money basically dripping further and further down the income statement until eventually it becomes a profit. And that's when a business, you know, is inflecting and it's hitting maturity. And so depending on the stage of the company that we use different principles. So we'll talk about, for example, Apple. With that company, you probably want to use a discounted cash flow, but it's also you can also use just the simple price to sales If you want to do that with Xero, which does not have a profit, it's a bit harder to do a DCF and it's very much harder to do like a price to earnings or, you know, that's just a basically a profit, a profit multiple. And so different companies require different, I guess, tools. Some people do have one favour tool. It's clear around the world that discounted cash flow DCF analysis is the most popular.
Bryce: [00:10:00] And what about things like ETFs, cryptocurrency venture, private investments like how how someone sitting there going, Yeah, I want to understand valuation, I want to apply it to these parts of my investing as well.
Owen: [00:10:13] Yeah, I know you guys have had the likes of Nicki Spivak on the show, Australia's Best Venture Capitalists. Yeah, and you know, if you ask someone like that who's investing at the very beginning of Canva, like when it was even pre-revenue didn't even have anything, which is not nice. Yeah. So you look at that, right? And you go, Well, how could you possibly think of like, how do you decide if it's good value or not? And basically you just backing the idea at that stage. And so what tends to happen to venture capital world is it's not necessarily based on cash flows and profitability and all that. Of course, that will most might be based on an idea, but the way value is constructed in that environment is actually more like a after the fact. So these founders would go around and try and get money in for their business and they would say, I want to sell 10% for $100,000. So 10%, $100,000 means the whole thing's worth a million right now. The next round they might go, we want $1,000,000 and we're selling 10%. Now it's worth 10 million. And so you can see how to value the implied value, because what's happening in that instance is it's basically just who's going to. Give us money at what valuation, and that becomes the valuation that the market is the valuation, whereas in the stock market we can actually see prices and value deviating when we have a valuation in play. But cryptocurrency, if I just answer that separately, that doesn't produce income. So you're limited in your toolset and you obviously can stake and do things like that. But for the most part you require a different set of tools. And there are there's academic theory around how you can do that. And basically it's like it goes back to this thing called I don't want to geek out too much, but it's called arbitrage pricing theory. And what it basically means is like you have a different set of outcomes and can you exploit that?
Alec: [00:11:53] Mm hmm. Now, Bryce also mentioned ETFs.
Owen: [00:11:56] Oh, yes.
Alec: [00:11:57] ETF, That's probably one that a lot of people do invest in. How are you doing that? Well, this.
Owen: [00:12:02] Is kind of a bit of a black box globally. So ETFs, if you think about what an ETF is designed to do for most people in a traditional ETF. So I'm not talking about this crazy thematic or inverse leverage ETFs, that type of stuff. For those, you can go to the website and you can look at it and say like average PE ratio, or it will say like average price to sales, average size of the companies inside it or whatever. Now you can actually use that. I don't do this as much in practice, but you can actually use that to determine a valuation because if you think about any investment, you put money into it, you get some money back, hopefully, you know, hopefully more than you put in. And if you think about that, you can take the price of the ETF as a whole and think, what dividends am I going to get from this thing? And so you can use those dividends as a cash flow stream and you can value that. And that's just how we use that. We call that the dividend discount model or DDM. It's very simple. It's basically what's the value of those dividends and what risk rating in my opinion. It's actually quite simple and we cover that in the course. We don't cover ETFs in general because for the most part, what we're talking about today, I just want to be clear, maybe we should have said this at the outset, is that most investing and most people who listen to this never need to become value investors. The simple fact is you don't need to. This is for the people that are truly curious about how businesses and how industries operate. But if you just want to invest in a passive ETF, don't even worry about it. Like you can use different rules, like.
Alec: [00:13:32] You should be able to cope.
Owen: [00:13:33] Yeah, and you can do those types of things where you get like a PE of the whole sector. In the whole industry. We see that with us as a consultants, but for the most part you don't need to worry.
Alec: [00:13:42] All right. And let's pause there and take a quick break to hear from our sponsors. So let's turn to individual stocks. The most common is a discounted cash flow. Yep. Now, a lot of people will probably be familiar with the term, but for people who aren't, give us the 25 words or less. What is.
Owen: [00:13:59] It? Yeah, sure. So it's the future value that is of cash that's created in today's dollar. So you have a cash flow stream that's expected in the future. You just put that in today's dollars. So you know that whole thing with the kid in the ice cream, if you if you promise them one ice cream today or two tomorrow, they'll take the one today that emphasises that the value of something today is worth more than it is tomorrow. And that's basically what we do with cash flows, is we try and take what's expected in the future and we get that today and there are multiple different ways to do it. It sounds really complicated, but there are many ways you can do it with even just like a few lines in a spreadsheet or even just on a piece of paper. [00:14:38][39.2]
Bryce: [00:14:39] Without going into specifics, because I'm sure we will do it in a bit of detail when we do Xero and Apple. But what are some of the positives about a DCF and perhaps some of the negatives or weaknesses as to why you might not use that as a valuation method?
Owen: [00:14:53] Yeah, sure. So the first thing is you obviously need to determine what is the cash flow of the business. And so that's often different to profit. So with zero, which we can talk to a little bit, you know, in the next episode, but with that you have to kind of assume some things have to guess basically. So a lot of valuation when it comes to the future is just educated guesswork. But there's other things, and I think the best analogy is that when you're in a spreadsheet and you're valuing companies, if you make one wrong move, it's kind of like programming. If you like to miss a comma or something, the whole thing can just break. And so what happens is the best analogy is it's like the Hubble telescope. If you might move one thing one millimetre, you're looking at a different galaxy, right? And so when it comes to valuation, it's much the same in that if you change like the discount, call the discount rate or like the risk rating, if you change that by like 1%, you could be looking at overvalued versus undervalued. And so it's very sensitive. So we have to build tools into it to make sure it's not as sensitive.
Bryce: [00:15:51] So that reminds me, we were speaking to an expert late last year, Ricki Sandler from the States, and he said a quote that was valuation is an opinion. So I wanted to get your thoughts because, you know, a lot of this is theory and spreadsheets. And it feels like that if you do it, you get to the right answer. But is there such a thing? A thing in valuation, in your opinion?
Owen: [00:16:16] I would say that's probably the most exciting thing I've heard, To be honest about value investing is that there's no one right answer and we all three of us could have the same set of information in front of us and come up with completely different answers. And that's because, you know, we all come. You guys spend a lot of time talking about this on the show is like people's investment philosophy and how they approach things. And that's actually built on people's education and experience. So if you have a different set of, I guess, experiences and you come at it in a different way, we might both be looking at the same company or industry. So we might look at, say, Seek, which is the high job website, and you guys might have had a really good experience with that in the past. We think it's a great service and I might have had a really bad experience with that and think, Oh, there's going to be someone that disrupts this for sure. We have the same set of information, but we have different opinions about the quality of that franchise or that business. And so, absolutely, you know, what we're doing in a spreadsheet is basically just wrapping maths around an opinion and that's it.
Alec: [00:17:12] And I think that's the key thing. People often think the hard thing about discounted cash flows is what's in the spreadsheet, but that is the easy part of the job. The hard part is predicting the future outcomes for a business, figuring out the range of outcomes and then figuring out the probability of each outcome coming through. And so, you know, to go back to what you were saying earlier about Jamaica, it's like you need to understand the business and where it's going. And predicting the future is hard. Doing the maths, once you understand it, is actually quite straightforward.
Owen: [00:17:44] Yeah, absolutely. So you know how I said before about valuing an ETF you can use a dividend discount model that only takes three inputs. It just takes the dividend how far you expect the dividend to go and your expected return. So what you want from the investment there are the three things, and that's a really simple illustration of, you know, the tool.
Alec: [00:18:02] Now, if you're worried that this all sounds too complicated and you're not going to be able to get it, I have no fear. A lot of experts don't get it. And this introduces prices Man of the Year in 2022. That Carvana analyst over in the US car. Yes.
Bryce: [00:18:22] The guy who I worked for at Morgan Stanley was at Morgan Stanley. Yeah. Wanted to be, you know, it was a JP and I've forgotten his name. One someone who, in a matter of 12 months or so, said that his valuation on Carvana was $420 a share. Then a year later, when it plummeted, he said there is a very high probability that this is valued at a dollar.
Alec: [00:18:52] So valuation is an opinion.
Bryce: [00:18:54] Tell me how that works. Tell me how that works. Yeah, well, I guess.
Owen: [00:18:58] I can tell you how it works. And that's basically recency bias, right? So that's someone that's taken some information from right now and they've gone this thing is going to go to the moon and then reality sets in. And this thing is obviously very fickle. The business itself is very sensitive to changes in the economy and whatever and recency bias turns it around and says what happened in the immediate past is actually not a fair representation of the future and that you see that all the time.
Alec: [00:19:21] Yeah, and the maths wasn't the challenge for this guy. He might have got his spreadsheets wrong, but it was, it was accurately forecasting what carvana his future was. So this isn't so much a maths problem and we'll get to that when we talk about Zero and Apple in the next two episodes. What price and I will be stress testing in on is his assumptions about zero, his future and you will be stressed.
Bryce: [00:19:44] So we've spoken about DCF, which is probably one of the most common methods of valuation across time, across most companies, but you also hear ratio ratio ratio time and time again.
Alec: [00:19:58] Yep, yep.
Bryce: [00:20:00] Yeah, yeah. So where, where does that come in to valuing companies and potentially the difference between using that versus a DCF?
Owen: [00:20:08] There are many great investors that use these what we call multiples, like it's just a multiple of this or multiple of that. And at the end of the day you can use these two in one or two ways. The most common way is just to take the the ratio or the multiple and say, oh, well this companies at a PE of ten price earnings ratio or price to profit, just that's the comparison. And you say I think it could be worth 15. So if it goes from 10 to 15, what you're getting is you're getting an increase in the valuation. So that's not necessarily the E or the earnings growing. It's just saying I think it's worth more. And so people use that as a genuine methodology, which is a great example of this in Australia. John Garrett He's a fantastic investor. He basically takes this approach that you get the and I'm simplifying it down, but you basically get say a sector. So you want like automotive companies in Australia and you take a job which creates the blue bars and has that red and black logo you see around four wheel drives and you say, okay, this is trading ordinary hypothetically at 20 times its profit or earnings. Now you compare that to the. The automobile companies and you go there all at 25. Now, does that say that IAB is lesser quality because it's probably the other way around? So you would maybe then say, no, I think it's worth more because it's a better quality company and you can compare that. You can use another example. You could say that you could have a multiple day of, I don't know, like MYOB versus Xero, and you could do a direct comparison. And the final thing you could do is and this is what a lot of investors do, is they basically take the multiple and then they compare it to the market and they say, is this an above average quality business or is it a below average quality business? And so what I mean by that is like you can go into like market index or anyone like Google Finance or one of these websites. You've got to find what's the average PE ratio of every company in the country. Do I think this is better than average? Yes. So if it's below the PE ratio, it's below, you can buy it. And that's why I wouldn't place a lot of stock in that. But that's a genuine way to do it. The way I use them typically is when you have a discounted cash flow analysis, you use it as a sense check on your model.
Alec: [00:22:16] Yeah, right. So I only want to close with how to learn about valuation because I think some people will be overwhelmed by the amount of jargon and stuff we've used. First things first, there is a free Rask Australia Times Equity Mates course to get started investing and then there is a paid one, this value investor program. So the first port of call is the courses. Yeah, but there are some other things that you think are valuable when it comes to how to learn about valuation. So where else can we go?
Owen: [00:22:46] Yeah, I mean, you guys have done these in the past where you talk about like checklists and these are great things and you can, you can find these online, like there'll be links, I'm sure, in the show notes to the course. And you can see you can get a general outline. I think you can get started investing. There's a checklist as well. So what I would say is like using a checklist or just some sort of repeatable process makes a lot of sense. So the earlier you can do this, the better. It's not because it's going to give you the answer. It's just because it will just help you in the sense of giving you a framework to work with that you can then tinker with and improve. So I mean, there's heaps of these resources on the Rask education website and in the course, like in the course itself, in the Value Investor program, we go through, I think it's 43 different points on a checklist. And that might sound overwhelming, but it's literally like, does the company have an aligned management team or a founder as the boss? And that's a good thing. So you give it a tick that's positive. So that might add two plus one for this company. And you can use checklists like this and eventually what you do is you get the you make the checklist in the first instance, it's like comfortable for you. And we've talked about circle of competence before, which is like the idea that you invest in things. You know, there's a great picture in the book, Get started Investing book. It's just investing in the things that you know, and you can design your checklist around that. And that's like it could be things like I, you know, is this company in technology because I'm a software engineer or is this company in health care because I'm a nurse, you know, And you can use that to create your own very simple checklist and just iterate over time. And there's heaps of those free resources online as well as in the course.
Bryce: [00:24:18] Yeah. So you can check out the course. The link will be in the show notes or head to equitymates.com But I think one of the key takeaways for me for those that may be listening just joined us is that you don't need to understand valuation, as you said, to be invested or to get investing. This is for those that really want to understand how businesses operate and get under the hood, but definitely stick around for the next two episodes because we're going to be putting a lot of this into action. I'm super keen and I know Ren's got some hot questions for you to really stress test starting. So next episode we're going to be doing a valuation of zero Australian listed companies and then the world's largest company, and that is Apple in the third episode. So Owen, thank you very much and then we'll pick it up next week.
Alec: [00:25:00] Sounds good.
Owen: [00:25:01] Thanks, guys.
