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When it comes to stock strategies, I know you hear all about different metrics and strategies that don’t seem to be about earnings. I want to explain how as professional investors we connected some of the most often quoted strategies and metrics you hear about to the real root of all good stock pricing work: ultimate potential earnings.
Let’s start with the simplest scenario. Pretend the stock market doesn’t exist. Someone approaches you privately and asks you if you want to buy their business – that is, 100% of the stock of the business. The business sells paperclips. Every year, it makes $3 in revenue and $1 in profit. Let’s assume that the odds look good that it can continue to make exactly $3 in revenue and $1 profit in perpetuity.
You’re now asked how much you would may to own this asset. A profit stream of $1 forever and forever is pretty cool. You definitely would buy it at some price. Maybe you’re willing to pay $10 for the business. That means the business will take 10 years to pay you back your initial investment, but after that you’ll own this stream for the rest of time.
In the simplest scenario of 100% ownership trading hands from one party to another, the only economic framework that makes sense to value the business is based on how much profit you think it’ll make during your hold of the investment. That is why you hear such a focus on earnings when you read about stocks.
Now let’s add some complexity.
Under Optimized Businesses
Let’s go back to the paperclip company. The guy comes to you and he says here’s my paperclip company, it generates a revenue of $3 and a profit of $1 a year. BUT, savvy investor, I should tell you this has been a family run business for 40 years. We haven’t put that much effort into it and the profits are under optimized. Look at other paperclip companies. They have a 50% profit margin on revenue. I’ll bet you could come in here and get profits up to that 50% number, too. That means you can expect $1.50 of profit a year.
Well, with a growing profit line presumably the business is worth more to you than it was before. Depending on how much credit you give the guy’s story after doing your own research on the industry, you may still be willing to pay him 10x profit and make your money back in 10 years. Or since you have to do a lot of that optimizing work yourself, maybe he doesn’t get the full credit of that theoretically higher profit. Maybe you give him 1.5×9=$13 for the business; more than you did in the first scenario, and yet a price which you think is ultimately a more exciting story for you, too, because you will be paid back in 9 years instead of 10.
Note that in this scenario, you are still focused on what profit stream you will ultimately see from buying the business. Profits are how you ultimately recoup your investment.
High Growth Businesses
High growth businesses are another iteration, and they come in two main flavors.
Fast-Growing, Highly Profitable Company
The guy with the paperclip company points out to you that in fact, his revenue is $3 and his profit is $1 this year, but he has been growing 50% every year. Surely if you can count on your profit growing 50% every year during your ownership, you should pay him more than 10 times this year’s profit, which is what you’d pay for a stable business with no growth. After all, if you do the math and assume 50% growth in profits each year, paying him $10 for the business you will be repaid in less than four years.
Surely he can find a buyer to pay him more than that if you won’t step up your price. Of course, you’re no fool; you know that the business can’t grow at 50% forever. It’s much harder to grow at 50% when you are doing $1,000 in revenue than when you’re doing $1 in revenue. So maybe you build a model that doesn’t have earning grow 50% a year forever, but maybe it grows 50% for the next two years and slowly drops down to 0% growth. Then you look at how much you can pay in order to be fully paid back in 10 years, and that’s your price.
Since a growing company implies growing profit streams, it is inherently worth more than an equivalent company with no growth. This is one reason you may see a company trading for 30 times earnings and one trading at 7 times earnings in the same industry.
Fast-Growing, Highly Unprofitable Company
There’s a second common scenario when it comes to high growth businesses. That of the high growth business with little to no profits.
Paperclip guy is back. His company is doing $3 in revenue but has no profits. But it has grown 200% in a year, up from $1 last year. Demand is booming, his company is on the front page of every office supply magazine out there. Why isn’t his company profitable yet? Well, since he’s tripling sales year on year, he has to invest ahead of the curve. He has to hire extra warehouse guys who aren’t fully utilized because orders are growing so quickly. He has to add sales people who take six or twelve months to fully ramp up. Many business investments take at least several months to make back their worth, it’s a true fact. So how do you value his business?
Here is where you start to hear about revenue multiples. You’ll hear this alot with sexy internet and software stocks. Company X is trading at 8x revenue!
Is this a total break with fundamental traditions to buy for future profit streams?
It’s not intended to be.
When you walk into the team offices at major institutional investment firms, you will see that what they are trying to do is build a map between the financials of the growing firm to an ultimately expectation of profit stream. I used to invest in high growth companies burning lots of money, and the goal was to map revenue to typical, expected profit margins once the company reached a stable state. There’s a lot of detail that goes into this, for example understanding the company’s gross margin (it’s variable costs on each sale) and whether it’s trending up or down, what its unit economics are, which means if you look at how much it costs to acquire a customer and service them each year, what year they actually break even for the business. But ultimately even though people talk in revenue multiples as shorthand, it is meant to map ultimately to what the company’s stable state profit streams can be.
Why? Because we knew, and everybody else knows, that they have to buy this way because when they turn around to sell the business that the ultimate bag holder will be paying based on profit stream.
The above cover about 85% of companies you see on the stock market. It does not cover the high profile, eye-popping stories we see in the news about tech’s biggest darlings. How do we explain Instagram being acquired for over a billion dollars by Facebook with little to no revenue? Or Walmart buying Jet.com for $3 billion?
Having worked with M&A teams in these types of companies, I can say that the acquisition teams underpin their purchase of these high-flying acquisitions with a financial plan for how the acquisition saves or creates revenue in existing product lines and ultimately pays for itself. The thing about strategic acquisitions is they can be incredibly lucrative or dead wrong because there is a lot of emotion around staying relevant in a market that comes with buying hot high-flying startups. In addition, there are also way more steps between what the company looks like today and what it takes to transform the company into the acquirer’s vision – you have growth of the company, their ability to optimize their own expenses, and then the whole integration and how successful it is in boosting the revenue and cutting costs of other existing units. Still, the underlying premise is still grounded in a projection of ultimate profit streams in stable state coming from the acquisition.
Corner Cases: Non Earnings-Based Strategies
Each company you see on the stock market has sliced up ownership of the company into tiny slivers of ownership, called shares. Buying a share of stock means you by a small sliver of the business and a share of any dividends it distributes. You purchase these shares on major US exchanges like the NASDAQ or the NYSE. In the background, what these exchanges do is take orders to buy and orders to sell a stock, and they create a giant order book sorted by price. When they see a match between what someone is willing to sell the stock for and what someone is willing to pay for it, it connects the two parties, a trade happens, and everyone goes on their merry way.
Should this change the way you invest in companies? Not really. The creation of exchanges has made the market for stocks much more liquid than it used to be – that means that it is easier and faster to buy and sell stocks than it was before. These digital exchanges also create lots of capturable data about what orders executed and in what amounts throughout the day. The combination of increased liquidity and increased data transparency means that some folks have entered the market with different approaches to investment than the fundamental focus on ultimate profit streams but which will unlikely be a fit for you.
High Frequency Trading
You may have heard of high frequency traders. These guys use algorithms to track minute movements in a stock price and use software that enables them to send their orders faster than you or I can so they can get to the top of an exchange’s order book and get the trade before you or me. They then turn around and do the same thing on the sell side, trying to eke out a few fractions of a penny each time. They often have no idea what the stock does or what its long-term outlook is; they are trading on technical data patterns and hoping to turn a profit. This is unlikely to be a strategy for you.
Momentum-Based Investment – Buy High, Sell Higher
This liquidity also has led to a group of speculators who get excited about buzz and momentum and buy high, hoping to sell higher. Unfortunately, this happens to include a lot of retail investors. They hear on the news that AOL is a hot stock. They don’t the market. They pick up some shares hoping to win big, and cross their fingers hoping for the best. If the coin flip lands their way, they win big. If not, they probably dump the stock as it slides, panicking because they don’t have a view on why they’re in the stock in the first place. This is also probably not your strategy.
Ignoring Non-Earnings Based Strategies
The increase in liquidity and data does lead to new classes of investors but they are unlikely to be good approaches for you. The end result is that you can think of these groups as adding noise and volatility to the market with their noise, but not changing their overall long-term direction and outcome of any investments you make.
While there may be intermediate metrics to track in between, most investor strategies ultimately lead to trying to understand earnings potential, as that is what an end-buyer planning to hold onto the business will be paying for. When you engage in a discussion with others about the next high-flying stock, you can use this framework for yourself to come to an opinion on its prospects.
This is a companion piece to How to Forecast Stock Prices in 2017 and Beyond. If you’re finished here, check out that piece next.