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Company valuations: Why first principles matter most

‘The more variables going into a valuation, the more chance there is that that the outcome is actually rubbish’: Keith McLachlan, Integral Asset Management.

SIMON BROWN: I’m chatting with Keith McLachlan. He’s an investment officer at Integral Asset Management. Keith, I appreciate the early morning. You wrote a piece for Moneyweb on Purple Capital last week; it came out maybe early this week. One of the comments in the chat was from someone saying you’d referred to it as ‘a matchbox calculation’, not an in-depth discounted cashflow or anything. The comment was that matchbox calculations often beat in-depth, simply because fewer inputs mean fewer things can go wrong. 

That got me thinking that there’s a lot to be said for discount cash flows for that complexity. Your take on it [is] the more we add to it, the more scope for error. How do you, as someone who does this for a living, balance that simplicity versus complexity?

KEITH McLACHLAN: Good morning, Simon. The analogy I like to use is one of a game of pool or billiards where, if you’re playing a shot and you’re hitting the white ball into one ball, into one pocket, it is a much easier shot to play than if you’re hitting the white ball into multiple balls, bouncing off the sides and trying to get them into different pockets and so on. 

For those listeners who don’t necessarily know these games, what I’m really saying is that assumptions and variables compound and one can’t assume a mistake on one is offset by a mistake on another one. In the worst-case scenario, the more variables going into the valuation, the more chance there is that the outcome is actually rubbish. 

In fact, you want to strip it down to its basics. This is a concept called ‘first principles’, where you are trying to really understand what drives the business and the valuation – and that’s it. Those become the key variables that you’re looking at. 

Referencing that article about EasyEquities, what are the key variables that I build my matchbox calculation on here? These are the things that drive the business and the valuation. So the things that drive the business EasyEquities are the number of accounts and the monetisation of those accounts. Then the key variable that drives that valuation is that offshore there’s Robinhood; so we have a relative valuation as a peg in the sand. That as a relative valuation allows me to relatively value this one. And that’s it. These become the key variables that you start to watch, not just as a business but as a valuation.

SIMON BROWN: I like that. So in a sense your first port of call when coming to a company for the first time is to do that dig, is to actually decide what matters here. What are the important components, what are going to drive profitability and ultimately the share price? In some cases that’s going to be relatively simple. I’m thinking of a mining company – you mentioned a Purple Capital and accounts; at other times it’s more complex. But it helps you know what to focus on and where to put your time and effort.

KEITH McLACHLAN: Those are the things that generate upside. The first principles, the key assumptions, are that these are the things to watch that would generate the upside because they drive the business. They drive the growth, they drive revenue, profitability, cash flows, and so forth. It doesn’t mean you shouldn’t look at everything else, but typically everything else, if there’s something wrong with it, can create downside. What I mean by that is EasyEquities, once again as a yardstick. Actually, you touched on a mine – what is a mine? The first principles of a mine are that it’s a resource in the ground, it’s a production profile coming out of the ground, and it’s a spot price. Everything else is basically noise, except if there’s a problem with it, because you can have the best resource in the world, a great production profile, and a rallying spot, but your balance sheet has too much debt and it sinks you. Do you see how everything else is important but it doesn’t add to the valuation? That can create downside. 

So look at everything else to manage risk, but in fact understand the first principles to manage and pick attractive valuations. Understand the business, what you’re buying.

SIMON BROWN: And once you’ve got those first principles – and I take your point that there are other moving parts there – you’ve got those key components you’re looking at. You’re obviously going to make an assumption and, whether it be in the case of Purple in terms of user growth, profitability per account, or a mine in terms of production versus spot prices, you make that call. You come back in six months, 12 months, when a new set of data comes out, and you can fairly quickly see where you’re getting it wrong, where you’re perhaps under- or overestimating the business and its profitability going forward. So it kind of gives you a nice, easy checklist for when you’re reviewing your process.

KEITH McLACHLAN: Absolutely. There’s a concept called ‘dashboard management’, and one can oversimplify the world. That’s why this is a balancing act between sufficient complexity to capture these businesses accurately, but not too much so that you just get lost in the noise and there are too many moving variables. 

But you now know what to watch – and watch that very closely, watch that like a hawk. Be aware of the rest, but watch those key variables. And this is how you track not just one stock, but thousands across multiple markets, just knowing what to look for and  knowing what the key variables are. 

Let me phrase it this way. It is always easier intuitively to call one or two things than to call the thousands. So if you’ve broken down the business correctly and you know what the key drivers are, that’s what you’re actually buying. Everything else starts to become just the circumstances in which you are buying it.

SIMON BROWN: A quick last point. And then to know, I mean, different industries, different things. In mining it’s spot price and production; in  banking it’s cost-to-income and impairments; in retail it’s operating margins. The different industries are going to have their own little first principles broadly to keep an eye on.

KEITH McLACHLAN: Definitely. So it’s a concept I call ‘intuitive valuations’ behind money. It’s just how we keep track of the score. In fact, behind money is inputs and outputs and they ultimately generate utilities. So there’s a real-world thing driving this business. Work on what the real-world thing is. Property is space – is the space being rental going up, going down? Is there more, is there less of it? There’s a real-world tangible something in the background, and then understand that; that’s what you’re watching, that’s what you are buying.

SIMON BROWN: No rocket science required. Keith McLachlan investment officer at Integral Asset Management, I appreciate the early morning.

Listen to Friday’s full MoneywebNOW podcast here.

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For a greenfield business, I like looking at how many months/years from peak invested equity point until that peak capital is regenerated (whether or not actually returned to equity). Cashflow measured, not IFRS nonsense. If that period is long and attractiveness relies on assuming what predictions about prices and growth and competition 5years out will generate, run. It is not different for long run businesses. You can use the same for a 30y wind farm as a panel beater.

Most of the DCF models have holes you can drive a truck through. If you did a Montecarlo on the model the valuation range could be anything from ⅓ to 5X the Valuation.

End of comments.

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