Other things being equal, good quality investing will work
because the combination of free cash flow and future growth will
lead to higher returns than suggested by the P/E you bought the
stock at. This is because of the ability of the company to
convert high amounts of earnings into free cash flow and still
grow. A good current example of this is
John Wiley (
. The book business (which is still a substantial part of their
business) has poor future prospects. However, I think the Journal
Publishing business (which in my view, now makes up the majority
of the company's value) can grow by anywhere from 2% to almost 5%
a year without much, if any reinvestment in the business. In
fact, it didn't really shrink even with tight budgets in the U.S.
and especially Europe this year. It seems to have pricing power
specifically and bargaining power generally. For this reason, I
think that when JW.A trades at about 11 times earnings - which
we'll call a 9% earnings yield, it is actually (the journal
business at least) priced at a level that may deliver returns
that meet my expectations (11% to 14%).
This is interesting because my estimate of 2% to 5% potential
growth in that business is a pure quality approach. I do not
assume the academic publishing business becomes any bigger
relative to nominal GDP of U.S., EU, etc. I just assume the
company can increase cash profits at least as fast as it
increases the top line and it can increase sales anywhere from
the rate of inflation to the rate of nominal GDP growth (but no
faster). In no sense is that a growth company, but in my view, it
is still likely to beat the market when it trades under 12 times
earnings. In fact, I think JW.A's academic publishing business
would be "fairly priced" in the sense it would offer market
matching returns at the "normal" P/E of 15 to 16. Again, this is
interesting, because JW.A is clearly a slow to no grower. It can
not be seen as a growth company. And yet I think - purely because
its business quality allows high free cash flow and pricing power
- it is able to be worth as much as businesses of lower quality
but better growth prospects. In this sense - and this is a very
approach - quality can, if it leads to higher FCF/Net Income and
lower Reinvestment/Growth - basically be a substitute for growth.
I believe this is what happened at See's Candies. It is most
obvious in situations where companies with 0% volume growth over
a decade raise prices by 3% a year and use all free cash flow to
buy back stock. In such situations, EPS can grow almost 10% a
year (depending on what P/E the buybacks were done at and whether
margins expanded with price increases) even while volume did not
increase at all. Other than unregulated intangibles based
monopolies - IMS Health,
Dun & Bradstreet (
, etc. - this is a situation most people will never see. Logic
suggests that if the market now trades around 16 times last
year's earnings and I do not expect the S&P 500 to grow its
earnings by more than 10% a year, that such a company - despite
being no growth - will actually beat the market if it trades at
the same (16) P/E.
In this sense, we can say that at the extremes - where free cash
flow always exceeds net income, returns on capital are nearly
infinite, and pricing power allows increases equal to or above
inflation even at 0% demand growth and the reverse (where free
cash flow is always below net income, returns on capital are
value destroying, and prices are deflationary at 0% volume
growth) the P/Es should be very different. In this sense -
although many value investors may disagree - a "bad" quality
business may truly be worth a P/E of 8 and a "good" quality
business may be worth a P/E of 24. I am not saying you should
ever pay 24 times earnings for a great "no-growth" business
anymore than I am saying you should buy a random established
company at 16 times earnings. But I am saying that if you take
the stereotype of the worst profitable business you can imagine,
the stereotype of the most average profitable business you can
imagine, and the stereotype of the best business you can imagine
that at P/Es of 8, 16, and 24 respectively - they may be priced
today to end up giving you roughly the same returns over the next
15 years. This does not require a true "growth" explanation. A
pure quality explanation is sufficient. Volume growth is not
needed to create that kind of pricing difference if it is pure
price growth in the best business and it is actually value
destroying in the worst business.
Graham's use of an 8.5 P/E is interesting. It is roughly
equivalent to a 12% earnings yield. If you look at historical
returns in stocks, etc. I think Graham got it about right. If a
company has literally no opportunity to grow it should still be
an acceptable investment at a 12% earnings yield. Today, you
could argue the number is closer to 8% or so (but this is purely
because of low interest rates that will not last forever). If we
look before and after Graham's death we see this 12% yield as a
pretty good estimate of what no growth should be valued at. It
also works pretty well if we imagine a growth business trades
around 16 times earnings. We can think of a true growth business
(not a fast grower, but certainly an economy speed type grower)
trading at around 16 times earnings and a no grower trading
around 8 times earnings. In this situation, it is unclear to me
which will win a 15 year investment race. A true no grower at 8
times earnings could beat a true grower at 16 times earnings. But
the grower could win too. If the race is between a traditional
value stock at 8 times earnings (with absolutely nothing else to
recommend it) and the S&P 500 at a Shiller P/E of 16 - I
think it is a fair race. In fact, I think the only reason that -
over holding periods as long as 15 years - the "value" stock
still tends to win the race is that investors aren't great
handicappers. It is very easy for investors to think a 3% to 6%
grower is a 0% grower. If they price a 6% grower at a P/E of 8,
the race will not even be close. A 6% grower at a P/E of 8 will -
over a holding period of 15 years - absolutely crush the S&P
500. In fact, a 6% grower trading at a P/E of 8 would make a good
Your last point about "solving for growth" is a great way of
inverting. In fact, although people frequently cite Graham's
growth formula, they forget this is what he was doing. What
Graham was saying is that if you see a stock with a P/E of 28.5 -
you can view that stock as having an expected return over the
medium term future (he used 7 years as I remember) of 10% a year.
That's because 10 times 2 equals 20; 20 + 8.5 = 28.5. Therefore,
the market is assuming 10% growth for the company over the next 7
years or so.
I think that would be about right in Graham's days. Today's stock
prices are a little different. The Shiller P/E is higher than at
all points during Graham's career. Interest rates are lower than
at most - but not all - of the time Graham was investing. The big
difference is that when interest rates were low in Graham's day
stock prices were not high. Graham did not have quite the
experience we are having now of simultaneously low interest rates
and earnings yield. And Graham was both a stock and bond
investor. So, he didn't face quite as hostile an investing
environment as we do in searching for any high returning
There's another way we can tackle the situation. Assume you knew
what the market P/E was. I think it is usually best to use the
Shiller P/E for the entire market. Especially since I've seen no
evidence that single year backwards looking P/Es of the vanilla
flavor - and certainly not forward P/Es - have any real
predictive value for future returns. People talk about whether
the Shiller P/E adds anything over the traditional P/E. To me,
the problem is that it's unclear the traditional P/E ever had
much power as a value indicator on its own.
But, for now, let's say we know the P/E is 16 on the S&P 500.
Or, better yet, let's just stick to yield numbers. So, let's say
the P/E is 16.67x. That's an earnings yield of 6%. The historical
growth rate in stocks' earnings per share has been about 6% in
the U.S. There are reasons to think it will be a bit lower in the
future (mostly because population growth in the U.S. and markets
where U.S. companies export are all expected to be lower in the
future than they were in the distant past - this might chop 1%
off growth, not much more than that). We are left with a
situation where we assume the usual 5% to 6% growth. Now, if we
take a hardline reversion to the mean approach we would say that
if you bought the S&P 500 today and held it for 15 years you
would earn only the 5% to 6% a year plus dividends (Value Line
tells me the median dividend yield on the 1,700 stocks they cover
is now 2.3%). In other words, if today's P/E ratio is truly
normal - and your portfolio really is getting a 2.3% dividend
yield - you can earn 7.3% to 8.3% over the next 15 years in big
I think this is the middle of the road - moderate center -
consensus view right now in investing. I do not entirely agree
with it. I think it is a possible scenario. But I think it is on
the very sunniest edge of the possible. As I see it, there is no
reason to believe today's earnings are at a cyclical low of any
sort. Wages are not high. Taxes are not high (relative to what
the government is spending). And interest rates are not high.
Companies profit from low wages, low taxes, and cheap loans. At
the moment - with plenty of unemployment, a government interested
in increasing demand, and banks who have more deposits than they
need to fund their loans - there are offsetting factors for
corporate profits that mean economic recovery may not have to
fall straight to the bottom line. This is why I tend to favor the
Shiller P/E. Because, without it, investors may say they expect
GDP to grow 6% a year over the next 15 years and they expect
corporate earnings to follow in lockstep. They may not ask - what
about taxes, interest, etc.? - they may just assume an increase
in sales is an increase in operating income is an increase in
I am not smart enough - even
's article on ROE recently republished in Tap Dancing to Work
turned out to be totally wrong - to consider each of these
factors carefully. I can, however, notice when they seem unusual
favorable or unfavorable. I think wages, interest, and taxes are
on the favorable side of things right now for U.S. companies.
Now, maybe demand isn't, maybe energy costs aren't, maybe
currency isn't. I don't know enough to know that. But I think I
know enough to be extra cautious. And so I think I'd like to use
the Shiller P/E.
GuruFocus tells me the Shiller P/E is 23 and the historical mean
is 17. In that case, we would assume that your return over the
next 15 years in the S&P 500 will be determined by today's
Shiller P/E (the one you buy at), the growth rate of EPS in the
S&P 500, and the 2028 Shiller P/E (the one you sell at).
In this scenario, the 15-year price appreciation would be 4% a
year if we assume 6% a year earnings per share growth. That's
because the other 2% a year is needed to eat the multiple
contraction from 23 to 17 over a 15 year adjustment period. Of
course, we still get the dividend yield. I'll assume it's the
2.3% a year Value Line gives as the median. So, assuming 5% to 6%
growth in earnings per share over the next 15 years we get
expected returns ranging from a low of 5.2% on the low end (2.3%
dividend yield plus 2.9% price appreciation under 5% EPS growth
and Shiller P/E reversion over 15 years) to a high end estimate
of 8.3% a year.
That, to me, sounds about right. Truly long-term returns (like 15
years or more) in big American stocks are probably in the 5% to
Can investors like
, etc. do better?
I think they can. I think durability, quality, value, capital
allocation, and growth are all sometimes mispriced in the market.
Right now, a particularly interesting situation is the
compression (or is it confusion) of companies with above average
durability and quality and companies with below average quality
and durability. Many seem to be trading at close to the same P/E.
If we look at banks, we can understand why Warren Buffett keeps
Wells Fargo (
. Is it that Wells Fargo is cheap relative to other banks, that
all banks are cheap, or that Wells Fargo's quality and durability
is higher than banks with the same P/E?
I think it is that he believes banks are probably on the cheap
side. And that Wells Fargo is certainly high in terms of the
durability and quality of its business. So, if over the next 15
years, he gets above average growth for a bank in terms of EPS
and then he gets a 50% higher P/E ratio at the end of these 15
years - he's looking really good.
I do not see a lot of value opportunities in today's market. I
have a screen where I look at all the companies in the U.S. that
have been profitable for 10 straight years and now trade at less
than 8 times EBITDA. It's still a pretty long list (about 200
stocks right now). But it is all scrunched up at the top of the
list. There are some for profit education stocks, etc. down in
the low single digit multiples of EBITDA. But a large number of
stocks of varying quality are in the 6 to 8 times EBITDA zone.
This is not an especially great price. It's an okay price for an
okay business. It's only a really good price for a really good
business. This is where I think the opportunity is in American
stocks right now. It's in fairly priced quality companies.
I like to look at five return possibilities when considering
1. The return you could get - right now - if the company sold to
a control buyer
2. The return you could get if - over 3 years and in a normal
business climate - the company's price rose to match its "peers"
3. The return you could get if you held the stock for 5 years and
sold it in a normal business climate
4. The return you could get if you held the stock for 15 years
and sold it in a normal business climate
5. The return you could get if you held the stock forever
?Sometimes, there is a #0 which is a floor. I like those best.
But buying below hard floors - made up of cash, net current
assets, real estate, etc. - is rare at most stocks. It is very,
very rare at companies I would be willing to buy and hold for the
I've adopted a several "point-to-point" return calculation
approach over time. Mostly this is based on practical experience.
I realized over time that when selecting for asset quality it was
best to focus on forever return potential. Basically, to buy like
Warren Buffett. However, I found that because a significant
amount of my returns over time came from just two sources -
corporate takeovers and price-to-something mean reversion - it
also made sense to look at the immediate upside (what can this
company be sold for now) and short-term reversion to sanity by
the industry, economy, stock market, etc. That is what the 3-year
return number is for.
I think it is possible to earn a good return (10% to 15% a year)
thinking only of returns beyond a 5 year holding period. You can
be a truly long-term investor like the modern day Warren Buffett,
Phil Fisher, etc.
However, I think all returns of the 20% to 30% a year varieties
tend to come from the potential in #1 and #2 considerations. You
are either buying "deep value" or "being greedy when others are
fearful" or getting "a private owner value" in these situations.
You are not buying and holding Coca-Cola etc. Donald Yacktman's
approach is purely based on #3 through #5 type consideration.
Over time, I have learned a tough lesson. In moments of fear,
panic, contempt, etc. - at companies, in industries, in
countries, in markets, etc. - it is considerations #1 and #2
(what would a control buyer pay for this today and what - when
the dust settles in 3 years - will the average investor pay for
this stock) that makes you all your money. In "normal" times it
is considerations #4 and #5 that will make you all your money. In
other words, if you have to invest equal amounts of money across
time, you never need to focus on a return expectation for a
holding period of less than 15 years. However, if you have the
opportunity, the stomach, etc. to dive into a situation where
there is true psychological distress on the part of buyers,
sellers, etc. you can make as much money in 1 to 3 years as it
will take some people to make in a decade.
The problem is that these moments of panic rarely coincide with
your circle of competence. So, you often have to learn about new
industries, new countries, etc. while they are already making
The tough lesson I learned is what to do the rest of the time. It
is fairly easy to know how to figure out returns are "good
enough" in a stock if you buy it when stocks generally, the
country you are investing in, the industry you are investing in,
and the specific stock you are investing in are out of favor but
otherwise sound places to put money. The hard part is knowing
what to do if you - say - know the most about American stocks and
expect they will only return 5% to 8.5% a year over the next 15
years. What do you do then? What do you do when stock prices are
Most value investors do the wrong thing. They look for the last
cheap dregs. They see that the bargain bin has been emptied of
900 of the original 1,000 pieces in there - and they decide they
will sort through the remaining 100 trinkets looking for that one
good deal that's left.
When future potential returns are low this is probably a bad
idea. You are likely to end up trading a lower price (value) for
a lower quality company (quality). These two factors offset.
Value investing is like "value" in shopping. It doesn't just mean
a low price. It should mean a higher quality of merchandise than
seems reasonable to be sold at that price.
Over time, I have realized it is much better to slide toward
considerations #4 and #5 when prices are high. It is better -
when the market is high - to think of buying and holding the best
companies you can find at acceptable prices than to try to find
the last bargains left. The biggest reason for this is that - as
long as you don't confuse insanely high prices with acceptable
prices - you will tend to lose only time in high quality
companies where you are paying a price value investors might not
like. When you buy lower quality merchandise - especially
cyclically, operationally, and financially leveraged low quality
merchandise at a seeming bargain price - you actually run the
risk of losing more than time. You risk losing money. You risk a
permanent impairment of capital. That risk is always highest when
investors are jolliest.
Even Ben Graham knew this. And he said as much. But I have been
slow to recognize this fact. Even after I understood the upside
of quality merchandise, I didn't pay enough attention to the
special risk of compromising on quality because stock prices
generally are just too high. And yet that has been the ruin of
many otherwise intelligent value investors.
I think it's hard to solve for growth and price quantitatively in
a way that makes practical sense. It is very easy at the
extremes. In other words, if we avoid using a spectrum of values
to deal with and instead focus on a few static points useful as
thought experiments - especially pricing increases only, value
neutral growth, etc. - I think we can understand growth and price
better. I still have trouble with the inbetween situations.
Practically, how do you deal with a company retaining 50% of
earnings and paying out a stable and slightly rising dividend
plus buying back stock in fits and starts over time while growing
in a way that growth probably creates some value?
That's a pretty common scenario. I know it is certainly a
difficult to deal with scenario in terms of finding a practical
solution to the problem. It's not easy to value that growth. The
company is growing, but is the return on marginal capital
employed stable. How likely is it that stock repurchases and
growth in the future are likely to actually add value? It's very
easy in such situations to see that a little growth right now
will encourage both more stock repurchases and more expansion and
yet both of these may therefore be ill-timed because they lean
into a boom. Looking backwards, we can value what the company did
in terms of creating or destroying value through share
repurchases and through organic growth. But we invest looking
My biggest problem is that return on the next dollar of retained
earnings is hard to know at most companies. I believe it becomes
harder to know as a company grows faster than GDP. I know
investors love industries that grow faster than GDP. I know they
love sectors that grow faster than GDP. I know they love
locations in cities and states that grow faster than GDP. I know
they love a business with customers who are growing faster than
the overall population.
I have never been able to translate that into a situation where I
was confident that a business catering to fat, old, diabetics in
Texas will actually grow faster than a business catering to 30
year olds in New Jersey. That would only be true if some
government were issuing a monopoly on serving fat, old, diabetic
Texans. In my experience, the reverse tends to be true. While no
one has a monopoly on a static populations they do - once they
are well established - have less to fear from hot growth hunters.
They tend to be left alone. And if they tend to their niche very
carefully they tend to do as well over the truly long term - like
my 15 year look into the future - than the company that should
have all the tailwinds.
Of course, like any Warren Buffett wannabe I dream of finding
that business with sticky customers, a great brand name, etc. and
all the demographics going for it.
Unfortunately, in those situations where I think I understand
both that growth is likely and that there is some sort of durable
competitive advantage, the market more than agrees with me.
Boston Beer (
Under Armour (
for details. I wouldn't call those fair prices.
John Wiley (
Weight Watchers (
Dun & Bradstreet (
I wouldn't call those growth business. One (Weight Watchers) is
Even in cases where I think there is potential for future growth
- but it hasn't even shown up at all in the financial results yet
- the market is pricing the stock too high for me. See
At $13 a share, you'd be getting in under book value. Nothing in
their 5-year GAAP ROE results: 14% in 2008, 14% in 2009, 14% in
2010, 7% in 2011, LOSS in 2012 suggest this is a company
investors would be eager to pay a big premium to book value for.
But the stock - which I'd be eager to buy at $13 - is now trading
around $19. The stock is trading around a 16 P/E of normalized
earnings if earnings since it went public are basically normal. I
think it has real growth opportunities.
If I was sure of that growth, maybe today's price would be a fine
price to pay. That is usually the problem with trying to apply a
quantitative approach to the right price and right growth rate
problem. A good model is one that is theoretically correct, that
you can understand and feel comfortable using, and that gets good
The problem with an investing model is that for investors -
unlike economists - it has to be a model that tells you something
different from the market. It is only in being right in a way
that others are not right that you win in investing.
Bill Miller is the person I associate most with the idea that
complete DCF type approaches and value investing can work well
together. Basically, you can use a DCF to get an intrinsic value
and then you can buy at a steep discount to that intrinsic value
to get your margin of safety. I've never been able to use that
approach. And I'm not sure it's a good one.
I think some sort of comparative approach makes more sense. An
approach based on what P/E ratios, Shiller P/Es,
Price-to-free-cash flow, EV/EBITDA, etc. the market and peers now
trade at and what they are expected to grow the bottom line by
over the next 7 years or 15 years or whatever makes sense to me.
Likewise, a historical approached based on what P/E, Shiller P/E,
Price-to-free-cash flow, EV/EBITDA the company, peers, the
market, etc. has traded for in the past makes sense to me.
Always using both a "normal" P/E and a "normal" growth rate based
on comparative and historical data as reference points seems
logical. It seems like you should be able to look for companies
where you are sure they will grow closer to 10% than 5% and then
try to always buy them at 5% growth type prices and you should be
able to find 5% growers at no-growth prices and buy those too. In
other words, there should be a good way to know you can pay 8
times earnings for a stock because its future growth is really
just as good as the market and the market often trades at 16
times earnings. And you should be able to pay 16 times earnings
for a business you think will grow 10% a year rather than 5% a
year like many 16 times earnings stocks.
But here is the real question: Can I buy Copart at a 24 P/E?
On a trailing 5-year average basis, there is no year in the last
10 - and the last 10 for cars on the road growth in the U.S. were
as bad as ever - where Copart grew EPS by less than 10% annually.
Let's assume I think they can grow EPS by 10% a year. A P/E of 24
is higher than an earnings yield of 4%. And a 4% earnings yield
growth plus 10% is 14%. That's definitely an acceptable return
for me personally given today's stock prices. At any point in
time, I'll take 15%. I'd like 10% at a minimum. And, as we
discussed, I think the next 15 years won't see much better than
5% to 8.5% returns in U.S. stocks. Personally, I've often given
7% a year returns as the high end of future returns expectations
for the S&P 500. So, 14% a year certainly clears those
You mentioned the retention rate approach. Copart - I'm using
their Value Line page here - has essentially retained all
earnings all the time since going public. Return on total capital
has ranged from 11% to 19%. Return on equity has ranged from 11%
to 33%. The two only decoupled when Copart bought back stock very
recently. I believe they are likely to have more free cash flow
than they can use in the future and therefore must decide on
buybacks, dividends, etc. going forward. Previously, they could
always buy enough small competitors out in the U.S. as a roll up.
They and their biggest competitor now account for too much of the
market (almost three-quarters) to make that approach a
possibility in the U.S. any longer. Obviously, free cash flow has
been rising while the number of potential competitors to buy out
has been shrinking. They plan to expand internationally. There
are hurdles to clear. But I expect U.S. companies will go from
the U.S. market to other countries in this business. I think the
reverse is unlikely. Someone is going to take the American
business model in this industry from country to country around
the globe over the next few decades. This is especially true
because already a meaningful amount of sales are cross border.
Before Copart and IAA rolled up competitors and went online there
were very few cross state border sales in the U.S. Now, there are
plenty of cross country sales. These are networks. So growth
seems likely to be foreign. But I think it's still possible. This
is on top of baseline growth equal to U.S. car population plus
car price inflation (basically I view annual percentage nominal
dollar growth in the salvage value of cars in the U.S. as a given
for CPRT because of their competitive position).
Let's be pessimistic and exclude the recent ROE boost. This is
due to leverage. For the record, Copart uses less leverage than
most companies in a similar position would. They own a lot of
their land. Because the core business is good and uses the land
for its operations, this land should not be assigned its own
value. However, it is worth noting that Copart operates with a
ton less borrowed money relative to the collateral and stable
cash flow they have then most of the retailers, restaurants, etc.
value investors look at everyday. For these reasons, I think it
shouldn't be hard for return on equity in the future to be as
good or better than return on total capital has been in the past.
This is also helped by goodwill. The likely leveraged return on
tangible equity someone would get out of this business is
certainly at least in the 11% to 20% range Copart has achieved on
its total capital.
Let's take 15% as the midpoint. Let's assume Copart can return
15% on its equity and grow its book value by 10% a year through
retained earnings. They will have to do something else with the
rest of that money.
Earnings are now $1.43 a share. They will grow earnings by 10% a
year. That means earnings will grow by 14 cents next year. If
they earn 15% on incremental equity, they will need another 93
cents of book value ($0.14/0.15 = $0.93). That would leave 50
cents of earnings they don't need to retain. Copart doesn't pay a
dividend. They can buyback stock. For simplicity here we'll
assume they pay out all earnings not retained as a dividend. We
would then have two series of cash flows over the next 15 years.
One would go back into the business to increase earnings. The
other would be paid out to shareholders. That would leave
earnings and dividends looking something like this:
The stock at the end of 2028 - if it sold at 16 times earnings as
a "normal" P/E for a stock - could then be sold for $95.52 a
Meanwhile, the dividend payments would look like this:
So, in 2028 we would own a stock earning $5.97 a share and paying
$2.09 a share in dividends. We assume this stock would be trading
at $95. This is equal to a P/E of 16 and a dividend yield of 2.2%
at the time of our hypothetical 2028 sale of the stock.
If you plug just the dividend portion - the non-retained earnings
- cash flow stream into a DCF using 10% growth over the next 15
years in the dividend, 6% terminal growth (basically nominal
GDP), and use our high end for the S&P 500 return of an 8.3%
as the discount rate you will get a value of $37.62 a share just
on the dividend portion of Copart's hypothetical future. As I'm
writing this, the stock is trading at $34.36 a share. So, we can
just (a tad conservatively) cancel those numbers out. Copart is -
under my 10% a year growth for the next 15 years, 15% ROE, 6%
terminal growth, 8.3% discount rate, etc. - assumptions trading
at the value of its future dividends alone. The stock is worth
more than its future dividends. This is because the company
retains earnings and the retained earnings add value because they
are assumed to earn a higher return than we could earn on our
dividends. Our estimate of a $95 market price for a stock earning
$5.97 a share in 2028 supports this.
For the record, the DCF thinks the retained earnings stream is
worth $107.60. That's higher than our 16 P/E in 2028 so I'll
ignore the DCF just like I canceled out the dividend and the
share price. In both cases, the DCF wants me to be a bit more
aggressive. It's safe to ignore that.
So, the only question becomes how much profit is there in Copart?
How willing should I be to trade $34.36 today for $95 in 2028?
On a CAGR basis this is 7% a year of pure profit. Simply put, the
DCF thinks Copart will run 7% a year ahead of the market over the
next 15 years.
I have to say that when we use my carefully cherry picked, oddly
idiosyncratic estimates for Copart, the S&P 500, etc. I think
the DCF looks pretty smart. Or at least it sounds a lot like me.
I'm not sure that's the same thing. But, yes, I actually agree
with the DCF here. The earnings Copart won't be able to find a
place for inside the business are probably worth about what the
stock trades for. The really speculative component - beyond the
mere assumption of growth - is the issue of what growth and ROE
will look like together. This is always the tricky part.
I'm not sure I can guarantee 10% growth at Copart. I think if we
knocked the estimates down to 6% a year growth combined with 15%
a year ROE, I'd be real comfortable Copart is worth at least that
much. This is unusual in that I think there will be 6% growth, it
will return 15%, etc. and downside surprises will be much less
likely than with stocks generally. In other words, I see a wide
moat around a good and growing business. There are very few
companies aside from Copart where I could say that.
But can we quantify this? Can we then say 24 times earnings is a
fine - even good - price to pay for Copart? Even using my
confident estimates of 6% earnings growth forever and $6.65 of
added equity needed for every $1 increase to earnings (in other
words, a 15% marginal ROE), we'd get values for the stock using a
DCF that are close to double today's price. Bill Miller would be
fine with those. Would Warren Buffett?
What's interesting here - in a practical rather than theoretical
sense - is that I'm really quite confident in that 6% growth
number and 15% ROE number and I'm really quite confident in them
both being perpetual figures. This is not just a thought
experiment. I really think Copart can grow 6% a year and return
15% on equity literally forever.
What is a company like that worth?
I crunched the numbers separately on price appreciation and
dividends over the next 15 years. In other words, what would just
15 years of price appreciation be worth in Copart if it grows 6%
a year and ends up at 16 times earnings in 2028? You would have
to buy the stock at $16.60 a share for that to make sense.
(Again, we're using an 8.3% discount rate - my high end for the
S&P 500). Meanwhile, the dividend stream on a company that
pays 86 cents this year (that's what Copart would have left to
distribute in earnings if it grew only 6% next year and earned a
15% return on incremental equity) and growing by 6% forever would
be worth $39.63 a share.
In other words, the quality/growth part of the company - the
growing free cash flow that can't be put back in the business -
would be worth more than the stock trades for today ($39.63 vs.
$34.35). However, the value part of the equation actually takes
away value. On a valuation only basis - looking just for stock
price appreciation - Copart is extraordinarily overvalued if it
only grows 6% a year and you only hold the stock for 15 years.
The price appreciation potential of a 6% a year grower over 15
years that already trades at 24 times earnings today is exactly
what you'd expect - it's worse than the S&P 500.
This brings us to the Warren Buffett / Ben Graham paradox. Buying
and selling Copart is no way to make money. But holding Copart is
theoretically going to make you money. In fact, you could argue
that Berkshire Hathaway could afford to pay the very high looking
price of 24 times earnings and still make money in Copart. On the
other hand, if investor sentiment sours on Copart just enough so
the company is seen as an "average" stock it will have a 33% drop
ahead of it. The company is overvalued if the future for the
company is the same as for the average public company. It's only
undervalued if we count the extent to which Copart's future
creates more value than the future of other public companies.
I think it's a near certainty that will prove true. Copart's
future will be more valuable than the S&P 500's future. So
should we count it?
I'm not sure.
Warren Buffett can count quality to its fullest because Berkshire
is never going to sell what it buys. I have a hard time
recommending a stock you need to hold a long time to overcome the
fancy price you pay upfront.
Because I know anyone who acts on that recommendation is unlikely
to keep the stock forever.
It's hard to lose money holding a quality company forever. But
it's harder to find investors willing to hold a company forever.
The numbers on quality add up. Paying up for quality - in the
sense of a company that needs to retain less earnings to grow at
an equal rate to other companies - makes every bit as much sense
as paying up for growth.
The problem with both the growth approach and the quality
approach for most investors is that it has short-term risks and
long-term rewards. If you pay 24 times earnings for a stock - and
you are right to do it - that stock could easily drop 33% if
market sentiment on the stock becomes just "blah". Not "ick" but
Unless you are the kind of investor who will see the market say
"blah" and still believe in the business - which really requires
the same stomach as buying an "ick" stock does for the value
investor - than I'm afraid quality investors will enter a stock
with the best of intentions but exit it too soon.
I don't think there is an intellectual cure for this problem.
What you need is the right personality rather than the right
In that sense, sticking with a quality company for the long-term
is not really that different from buying a value stock. The
difficulty in value investing is often having the courage to make
the initial buy. The difficulty in quality investing is having
the patience not to sell.
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