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While we perpetually try to improve our investment process – continually seeking to incorporate new learnings and fresh perspectives – one thing will always remain axiomatic: the worth of any financial asset is the present value of its future cash flows.
As such, our investment effort can be summarised as an ongoing attempt to value equities and try to buy them at a discount. Because we regard stocks as shares of businesses, not numbers that bounce around on a screen, our approach to fractional ownership is no different to private equity and industrial buyers purchasing whole businesses based on the expected cash flows they can extract.
Investment is most intelligent when it is most business-like
Our focus is the future free cash flow produced by a firm, while investing sufficiently to sustain its long-term competitive position, discounted to today’s value at an appropriate rate. We make various adjustments to the historical statements, including normalising cyclical margins, smoothing investment programmes, treating ‘non-cash’ stock-based compensation as an economic expense, and adding-back recurring ‘one-off’ costs. The numbers we arrive at are subjective, and would never be recognised by any accountant; yet the crucial importance of intrinsic value is not diminished by our inability to calculate it precisely.
Here, we part ways with most of the active fund management world. Building a discounted cash flow (DCF) forecast is rigorous. It involves making predictions about an inherently uncertain future based on incomplete evidence while maintaining coherent assumptions about growth and returns. Faced with this complexity, many fund managers fall back on the deceptive certainty of third-party earnings forecasts and relative profit multiples.
Corporate results press releases typically display an adjusted earnings-per-share figure prominently but leave the cashflow statement to the final page, if it gets mentioned at all. Sell-side analysts working for investment banks tend to take these earnings, extrapolate them out two years, and divide through the current share price to arrive at a price-earnings (P/E) ratio. Thus, company A might be on 16 times earnings, making it apparently cheap against peer company B on 20 times because it usually trades on the same multiple, and therefore becomes a recommended purchase with 25 percent upside. However, all a P/E ratio achieves is to collapse the assumptions a DCF makes explicit. Hiding from the investment conundrum cannot substitute for addressing the propensity of earnings to convert to cash, future business trajectory, and what prospective return might accrue to long-term equity holders.