Monthly Archives: June 2011

10 Essential Questions to Ask When Deciding What Multiple to Pay For a Stock

Buffett has correctly pointed out that the correct way to value a business is to calculate the discounted value of all its future cash flows. The concept is simple. The application is not.

For many businesses, it is difficult to calculate this with a level of precision that has much utility.

Some businesses are sufficiently predictable that a careful business analyst can make a reasonable and useful calculation of its DCF, or what Buffett calls its intrinsic value.

Also, sometimes in periods of extreme dislocation, a business will sell at such a depressed price that you can reasonably conclude that the market price is below intrinsic value, even if the range of possible DCFs is large.

The multiple at which a stock trades is nothing more than a shorthand proxy for its DCF.

In Buffett’s 1991 letter to shareholders, he concluded that, assuming a discount rate of 10%, a business earning $1 million of free-cash and with long-term growth prospects of 6% would be worth $25 million or 25 times earnings.

A no-growth business also earning $1 million would be worth about 10 times earnings.

Business 1: $1 million / (10%-6%) = $25 million

Business 2: $ 1 million / (10%) = $10 million

As a practical matter, what types of things should you be thinking about when deciding if you are dealing with a company that deserves a multiple of 25 times earnings versus one that only deserves a multiple of ten times earnings. There are many factors to consider.

Venture capitalist Bill Gurley has written an excellent list of characteristics to consider when evaluating a company and determining what multiple to use when valuing its earnings.

You should carefully think about each of these and add them to your checklists for evaluating a business.

I’ve put Gurley’s characteristics in the form of a question.

1. Does the business have a sustainable competitive advantage (Buffett’s moat)?

2. Does the business benefit from any network effects?

3. Are the business’s revenue and earnings visible and predictable?

4. Are customers locked in? Are there high switching costs?

5. Are gross margins high?

6. Is marginal profitability expected to increase or decline?

7. Is a material part of sales concentrated in a few powerful customers?

8. Is the business dependent on one or more major partners?

9. Is the business growing organically or is heavy marketing spending required for growth?

10. How fast and how much is the business expected to grow?

Gurley’s post: All Revenue Is Not Created Equal: The Keys To The 10X Revenue Club.

Links of Interest – June 3, 2011

Transcript of David Einhorn’s Speech at the Ira Sohn Conference – Insider Monkey – Einhorn gives a detailed explanation of Greenlight’s investment in Microsoft.  Valuable on two levels: 1) the analysis itself and 2) to see the way Einhorn thinks about an investment.

Yacktman Funds 2011 Q1 Conference Call – (Audio) – Good high level discussion of the fund’s current holdings. Yacktman is bullish on large-cap global consumer products, media and “old tech” such as MSFT, HP, and CSCO.

Longleaf Partners Annual Presentation – (Audio) – Mason Hawkins and his team are great value investors. Listening to their perspective and insights is always a good investment.

Google, the new master of network effects – The New York Times – Understanding the various forms of durable competitive advantage is critical to investing success.

U.S. Could Face Debt Crisis Without Policy Changes –

Transitions: Michael Reinvents Dell – – Insight on how Michael Dell has repositioned the company.   This is one of Southeastern Asset Management’s (Longleaf) largest positions.

Warren Buffett on castles and moats – (37signals) – Good review of some investing fundamentals.

HEARD ON THE STREET: Big Defense Girds for Battle – – Some big defense stocks look cheap. Maybe there is a good reason why.

Diageo’s deals: Replenishing the drinks cabinet | The Economist – A great long-term holding at the right price. Tom Russo, who counts global beverage companies in his very focused cicle of competence, initiated a position in the first quarter.

Yacktman Value Investor Insight Interview – November, 2009



“The Freight Train That Is Android”; more on Google’s moat…

A couple days ago, I posted a blog on Google’s moat. Today, I am posting a blog post written by venture capitalist Bill Gurley. Gurley explains how Android, Chrome and Chrome OS are being used by Google to strengthen its moat. According to Gurley, “They are not just building a moat; Google is also scorching the earth for 250 miles around the outside of the castle to ensure no one can approach it. And best I can tell, they are doing a damn good job of it.”

Google realizes that a major factor is which search engine you use is what’s available to you in the application you’re using.  If you were to use Firefox and the default search engine was Bing (Firefox comes with Google as its default search engine), there is a reasonable chance you would stay with it. That is why Microsoft has worked hard to make Bing available in different channels.

With Andriod, Chrome and Chrome OS, the endgame is to aggressively frustrate any attempt to put a layer between Google and its users. This would be like Coke aggressively expanding into retail to insure that the its products were available. The conundrum for Google’s rivals is that Google does not expect to profit directly from this effort. It simply wants to keep the Huns at bay from its search castle.

Read on…

Yesterday, after the market closed, Research in Motion, the makers of the Blackberry device, announced that they would be lowering their current quarter earnings due to lower average sales prices. In a separate announcement, the company proffered that their new tablet will support Android apps, yet the CEO also made it clear that he believes the world is overly focused on the criticality of having a large numbers of applications on your platform. They also suggested that the guidance issue is temporary, and relates mainly to a product cycle not a systematic change in the industry.

Despite all that has been written about Android, as well as its unquestionable early success, the world at large still doesn’t fully appreciate the raw power of this juggernaut. I have written about this in the past in Android or iPhone? Wrong Question, and Google Redefines Disruption: The “Less Than Free” Business Model. But even so, the more I see, the more I wonder if I too may have underestimated the unprecedented market disruption that is Android.

One of Warren Buffet’s most famous quotes is that “In business, I look for economic castles protected by unbreachable ‘moats’.” An “economic castle” is a great business, and the “unbreachable moat” is the strategy or market dynamic that heightens the barriers-to-entry and makes it difficult or ideally impossible to compete with, or gain access to, the economic castle. Here is a great post from the 37signals blog a few years back that walks through several different examples of potential moats.

For Google, the economic castle is clearly the search business, augmented by its amazing AdWords monetization framework. Because of its clear network effect, and amazing price optimization (though the customer bidding process), this machine is a monster. Also, because of its far-reaching usage both on and off of Google,AdWords has a volume advantage as well. Perhaps the most telling map with regards to the location of the castle can be found in Jonathan Rosenberg’s “Meaning of Open” blog post. In this open manifesto, Jonathan opines over and over again that open systems unquestionably result in the very best solutions for end customers. That is with one exception. “In many cases, most notably our search and ads products, opening up the code would not contribute to these goals and would actually hurt users.” As Rodney Dangerfield said in Caddyshack, “It looks good on you, though.”

(continue reading)

New Audio: Ten Ways to Improve Your Investment Process – #3. Don’t Focus on the Outcome

If you want to be a successful investor, you need a great investing process. Ironically, focusing on the outcome can lead to poor results.

This is part three of an eleven-part audio series on improving your investment process. It is based on a presentation I gave to the CFA Society of Columbus on May 19, 2011 at The Ohio State University.

#3. Don’t Focus on the Outcome (audio)

PDF of presentation slides


Previous audio recordings in this series:

Ten Ways to Improve Your Investment Process – Introduction

#1. Know Your Outcome

#2. Define Your Investment Process