Portfolio management
Hunting in woebegone regions
The issue I discuss today is how you make sure the price you pay for a stock is a bargain price. To make the discussion practical rather than theoretical, I offer a case study of a recent purchase I made.
Many readers will know that I only invest in superb companies and then only if I can buy at bargain prices. This post will focus on identifying the bargain price.
Many investors figure the market is pretty efficient and are basically prepared to go with the current market price. They may follow a strategy like GARP (growth at a reasonable price). They are wrong.
Superb companies do trade at bargain prices from time to time. Let’s first look at how that happens and then look at how we can work with the available tools to buy at very attractive prices.
Woebegone regions
John Neff managed the Windsor Fund for more than 30 years. Over the period when he was at the helm, the average annual total return of the Windsor Fund beat the S&P 500 by 3.15% per annum. John Neff on Investing is a book he wrote describing how he came to investing, how he achieved those results and his experiences as a fund manager. (Neff, Neff on Investing, 1999)
Neff writes: “Woebegone regions have always lured me, for one very compelling reason: Swept up by flavors of the moment, prevailing wisdom frequently undervalues good companies. Many – but not all – that languish out of favor deserve better treatment. Despite their solid earnings, they are rejected and ignored by investors caught in the clutch of groupthink.” (Neff, 1999) p63
Joel Greenblatt is an American academic, hedge fund manager, investor, and writer with an outstanding 30 plus year track record. He is an adjunct professor at the Columbia University Graduate School of Business he puts it this way in describing opportunities to buy at bargain prices: “In many cases, the outlook for the next year or two is downright ugly.” (Greenblatt, The Little Book That Beats the Market. 2006) p101
My post The joy of higher return with no more risk lists over 20 reasons why the outlook for shares of a superb company might be downright ugly.
Two ways to value shares
There are two basic approaches to valuing shares. The first is the use of multiples or ratios based on next year’s estimated earnings or cash flow. It is used by sell side analysts and the reports almost always have a target price. The target does not purport to be an estimate of fair value today. Because they are based on next year’s estimate, it is suggested the market price will move to the target in the next twelve months or so.
The second approach is the use of discounted cash flows (DCF). The analyst predicts the expected cash flows a company will produce a few years into the future and then discounts those cash flows back to the present to arrive at a fair value today.
There are pros and cons to each approach. The main thing to understand is that the two approaches come up with two very different things. Sell side targets are where the analyst thinks the price will move at some point down the road. The DCF output is an estimate of what the fair value of the stock is today.
Two companies
To illustrate this let’s look at both sell side and DCF reports on one stock I have owned for some time and another stock I recently purchased. The text below in “quotes” is taken from recent reports and is the language used by the respective analysts.
Salesforce Inc. NYSE: CRM
I have owned this stock for several years.
RBC Sell side target
“Valuation We calculate our base-case price target of $350 by applying a 29x EV/FCF multiple to our CY24 FCF estimate of $11,758M. Our target multiple is slightly above peers, supported by the company’s market leadership in several key software categories and improving margin profile. Our price target supports our Outperform rating.” (Emphasis added)
Morningstar fair value
“Our fair value estimate for Salesforce.com is $300 per share, which implies a fiscal 2025 enterprise value/sales, or EV/S, multiple of 7 times, adjusted price/earnings, or P/E, multiple of 32 times, and a 3% free cash flow yield. We model a five-year compound annual growth rate, or CAGR, for total revenue of 10% through fiscal 2029, which we think will be driven by solid growth in all clouds, with most notable strength coming from the data cloud. Our revenue forecast assumes modest revenue acceleration after depressed growth in both fiscal 2023 and 2024. We forecast non-GAAP operating margin expanding from 31% in fiscal 2024 (actual) to the mid-30% area in fiscal 2029, which we think is consistent with management’s new profitability focus.” (Emphasis added)
These two reports are consistent. The price target of $350 is a look ahead of a year or so based on a year ahead forward estimate of free cash flow. Sell side analysts generally use cash flow, sometimes use free cash flow (FCF) and ideally would use Warren Buffett’s owner earnings for their calculations. Cash flow, free cash flow and owner earnings are better than net income for any analysis today because earnings for today’s intangible heavy/tangible light companys’ are misleading because company investment in intangibles of lasting value is expensed against earnings.
While we own shares in Salesforce CRM, I would not be a buyer at current prices of around $275 because the stock is not available at a real bargain price. The estimate of fair value is $300. This is a misleadingly precise figure. There are a whole lot of subjective predictions built into the estimate. As well, the discount rate used is also very subjective. The reality is that the $300 figure is a boxcar number that could be high or low by quite a margin. Just to pick a range, I would say fair value might be anywhere between $250 and $350.
Veeva Systems Inc. NYSE: VEEV
Let’s turn to Veeva Systems VEEV. The sell side analyst’s target price is $250 which, as we would expect, is higher than the current price of $205. That doesn’t mean the sell side analyst thinks the stock is worth $250 today. He is suggesting the stock could move to that price in the next year or so.
Next, we look at the DCF estimate. Read the Morningstar fair value and I’ll comment below.
RBC Sell side target
“Valuation Our $250 price target is based on 34x EV/CY24E FCF, which we believe is warranted considering Veeva’s leading blend of growth and margins, runway for future growth, and competitive positioning. Our price target supports our Outperform rating.”(Emphasis added)
Morningstar fair value
“After adjusting our near-term assumptions and baking in the time value of money, we slightly raised our fair value estimate to $270 per share from $267.
In the near term, we expect Veeva to face headwinds in its services segment, caused by a difficult macroeconomic environment. Limited funding in the biotechology space, cost-cutting measures across major pharmaceutical firms, and dynamic geopolitical issues act together to pave a difficult few quarters for Veeva’s professional services business. But we think Veeva can more than offset this by continuing to gain market share and win new customers in Veeva Vault. Veeva also continues to win new customers in its CRM or Vault commercial solutions and further penetrates its existing userbase, shown by the consistently increasing number of average commercial products per user.”(Emphasis added)
The first thing that stands out is that the DCF estimate of fair value is higher than the sell side analyst’s target price. Clearly the DCF is looking further forward than the sell side twelve months.
What struck me was that the estimate of the current fair value was $270 compared to the current market price of around $205. This struck me as a potential bargain. But one has to dig deeper.
Digging deeper
Veeva Systems Inc. VEEV NYSE/US is a provider of cloud solutions for the global life sciences industry. It currently has a market cap of $32.8 billion. In the fiscal year ended January 31, 2024 it invested $26.2 million in tangible assets. It spent (invested) $ 629.0 million in Research and development. In other words, what it spent with potential to generate intangible assets of lasting value completely overshadowed what it spent on investment in tangible assets. On top of that, it may also have generated intangible assets from its spend on General and administrative expenses. It generated $488 million in net income. That’s what it has to pay tax on. But it generated $780 million in free cash flow. That’s cash left over after all expenses and investments. It sits with Short-term investments of $3,324 million on its balance sheet. That’s in addition to cash in the till of $703.5 million as against $32 million of accounts payable. In other words, its a cash machine with a big pot of money in the till.
The balance sheet shows $4,644 million of shareholders’ equity which includes roughly $500 million of reported intangible assets. Here’s the kicker. The market values the equity at $32.8 billion. The market suggests the company has over $30 billion of intangible assets not shown on the balance sheet.
This perked my interest. It led me to buy a moderate size position in VEEV. I will continue to follow the company closely. If it turns out the purchase was a mistake, I will sell immediately I come to that conclusion. If it turns out well, I will probably add to the position.
A note about Morningstar DCF Equity Analyst Reports
Morningstar uses two different approaches to their DCFs. The first is called an Equity Analyst Report and the second is called a Quantitative Equity Report. The latter is said to be generated by a statistical model that is based on Morningstar Inc.’s analyst-driven equity ratings and quantitative statistics. By contrast, the former is said to be based more on projections of a company’s future cash flows, industry and company assumptions to feed income statement, balance sheet, and capital investment assumptions, scenario analysis, in depth competitive advantage analysis, and a variety of other analytical tools.
I have used the Morningstar Equity Analyst Report for VEEV.
Disclaimer
I have discussed the valuation of the shares of two companies. I own shares in both. I’m not suggesting you invest in these companies. If you do, you are on your own. Don’t blame me if you lose your shirt.
Conclusion
This blog is only about how to invest. I make no recommendation about stocks and offer no comments on current conditions. Sometimes it helps to use concrete examples to explain the ideas. I’ve used my recent purchase of shares in VEEV to show how one can make good use of analysts’ reports to buy stocks in superb businesses at really good prices.
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Getting the most out of analyst’s reports requires a lot of thought. Here are some earlier posts that cover the subject in more detail. Every approach to value uses models in one way or another.
Remember that declining free cash flow may be a sign the company is investing for the future! Or it may be a very bad sign. Increasing free cash flow may be a good sign or a bad sign. It’s all in the interpretation of the financials.
Use models with caution.
Investment decision making in face of uncertainty
Fair value analysts’ reports
The dangers and benefits of using Discounted Cash Flow analysis reports
Heart of stock valuation: subtleties of free cash flow
Stock valuation in an age of intangible assets
Sell side analysts’ reports
Analysts’ reports and the estimate revision game
The problem with analysts’ target prices
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right hand side of this page to find references in both blog posts and also in the Motherlode.
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