May 13, 2019
At its core, our equity investment approach at Clifford Swan is to own businesses. On behalf of our clients, we purchase companies that make goods, provide services, or do a combination of the two. We do not buy an index of 500 or 3,000 stocks, which includes companies regardless of what those companies sell, their financial standing, or their business prospects. In contrast, we invest in companies we know well—those where we look “under the hood” to understand the investment value.
"At its core, our equity investment approach at Clifford Swan is to own businesses."
To decide whether to invest in a business, we conduct fundamental, bottom-up equity analysis. That is, we evaluate the “fundamentals” of a specific company, including the company’s business model, the industry it operates in and general growth prospects, and the company’s future revenue, profits, and cash flows.
There are two basic approaches to fundamental equity analysis: accounting valuation, which utilizes basic accounting-centric metrics, and economic valuation, in which a company’s value is determined based on the cash flow it generates. Each approach has its own toolkit. Accounting valuation uses tools like price/earnings ratios, return on equity, and price-to-book value, while economic valuation considers valuation models such as economic value added (EVA), cash-flow return on investment (CFROI), and economic margins (EM). While we utilize both accounting valuation and economic valuation when we evaluate a company, we rely more heavily on economic valuation, or wealth creation, in our stock analysis.
"While we utilize both accounting valuation and economic valuation when we evaluate a company, we rely more heavily on economic valuation, or wealth creation, in our stock analysis."
At the heart of evaluating wealth creation is a methodology called discounted cash flow (DCF). According to one major Wall Street firm’s primer,1 “the DCF approach values a business based on its future expected cash flows discounted at a rate that reflects the riskiness of the cash flow.” Variables to this analysis include revenue and margin estimates, present value determinations, cash flow modeling, and, importantly, the volatility or unpredictability of the company’s cash flows. Essentially, EVA, CFROI, and EM attempt to determine the value of a company by estimating 10 to 20 years of cash flows for that business, and then pricing that future cash in today’s dollars.
"At the heart of evaluating wealth creation is a methodology called discounted cash flow (DCF)."
Obviously, a lot goes into DCF. The building blocks of this methodology developed over many years, if not centuries, and incorporate statistics, probability theory, present value analysis, and modern portfolio theory.
The rise of statistics and probability can be traced to the seventeenth and eighteenth centuries, when the concepts of compound interest and probability theory rose to prominence (e.g., Pascal, de Fermat, Halley—yes, like the comet!). Much of this was driven by the needs of the life assurance business in England at that time. Similar to insurance, assurance typically refers to a policy that is for a long period of time or until death, and we saw the emergence of mortality tables in conjunction with this assurance work. In order to determine the profitability of insuring a person, an assurance company needed a way to incorporate the likelihood of the person dying (probability, statistics, and mortality tables) relative to the potential compounded earnings of the life assurance payments.
Moving ahead a couple hundred years to the late nineteenth and early twentieth centuries, the dominant railroads and telecommunication companies of that era utilized present value analysis extensively. These companies wanted to know whether an investment in a new locomotive (or locomotives) would provide attractive returns. The concept relied heavily on the time value of money. What is the time value of money? Consider a company that can invest its money in a savings account that earns 3% interest. If the company invests $0.97 today at 3%, then a year from now that $0.97 will be worth $1.00. That is the basic concept of the time value of money. A dollar today will be worth more next year, and that dollar next year will be worth less today.
"...the dominant railroads and telecommunication companies of that era utilized present value analysis extensively."
A few decades later, in the 1950s and early 1960s, a tremendous amount of financial research was published, especially out of the University of Chicago. These two decades following World War II saw the extensive development of modern portfolio theory and the basic investment frameworks that are taught today and were utilized in the development of many of our contemporary investment options, including mutual funds. These concepts include efficient market hypothesis (everybody knows everything); capital asset pricing model (CAPM is an elegant and sophisticated pricing theory for investments that is primarily embraced by academics), and initial discounted cash flow models. This work is credited to names such as Markowitz, Miller, French, Fama, Solomon, and Hirshleifer, all with ties to the University of Chicago and many with Nobel Prizes in Economics.
"These two decades following World War II saw the extensive development of modern portfolio theory and the basic investment frameworks that are taught today..."
In the early 1960s, Joel Stern, who earned his MBA from the University of Chicago, developed economic value added (EVA). This preliminary discounted cash flow model structure relied on probability, statistics, interest rates, the time value of money, and estimates of revenues and profits to determine a company’s value in today’s dollars.
This initial EVA approach was refined during the 1980s and 1990s—again led by MBA students at the University of Chicago—into the concept of the cash-flow return on investment (CFROI). CRFOI looks at projected cash flow returns relative to a company’s assets and the investments a company has made. Since the 2000s, CFROI was refined to include the use of economic margins, which consider CFROI-like returns, but net of a capital charge. That is, if it costs 8% to obtain the funds to run a company (through a combination of equity and debt), in order to create wealth, the company’s returns need to exceed the 8% cost of capital (the capital charge). The key to economic margins is to look at the difference between a company’s returns and the cost of capital to determine whether wealth is being created or destroyed.
This multilayered history puts our valuation methodology at Clifford Swan into context. We use proprietary software that considers economic margins to conduct DCF analysis, and internally develop the assumptions (variables) the software requires. We project revenue and margin trends, as well as estimate potential financial structures and real interest costs, among other key data points. A new car provides a good analogy. DCF is the car and we have all the fancy accessories (DCF software), but unless we put gas in the car and set a destination in the navigation system, the car will not go anywhere. As the environment/circumstances changes, so too should our inputs/route (valuation is a fluid concept). Our DCF estimates and assumptions are the gas and navigation inputs in our car analogy. In the final analysis, our intent is to produce a valuation estimate that we can compare to today’s market value. Is the market price lower than the value we calculate? Or, is the market value above our estimated value? We would buy one, and not necessarily buy the other.
"This multilayered history puts our valuation methodology at Clifford Swan into context."
The methodology behind our equity analysis is similar to our evaluation work for bonds. In many ways, the analyses of bonds and equities are similar (sounds strange, right?). Both involve number crunching and analysis, and rely on fundamental cash flow and present value analysis. With a bond, we know the interest rate, the coupon payment dates, and that the principal will be returned at a set future date. Assuming a particular interest rate today, we could calculate the value in today’s dollars of that specific cash flow with significant precision. For example, a $1,000 five-year maturity bond with a 5% coupon interest rate, with annual interest payments and a market investment rate (i.e., the going interest rate today) of 5%, would be worth $1,000 today. If the market interest rate was less than 5%, then the bond is worth more than $1,000; there is wealth creation, if you will.
"In many ways, the analyses of bonds and equities are similar..."
In contrast, with a stock, there are a lot more moving parts, with unknown and inconsistent flows of earnings, cash flows, and dividends. However, while the “coupon” and “earnings” of a company are volatile, we can make a reasonable estimate of the value of the company. In a very crude way, stocks are bonds, but with unpredictable cash flows and coupon interest.
At Clifford Swan, we buy businesses for our clients. We know what they do, how they operate, their management teams, what their prospects appear to be, and have reasonable estimates of their key revenue and cash flow metrics. As the old saying goes, portfolio management is part science and part art. This is the science part. What is the art part? Ask your investment counselor for an in-depth answer to that question.
Corporate Finance Institute. “DCF Model Training Free Guide.” www.corporatefinanceinstitute.com/resources.
Madden, Bartley J. CFROI Valuation: A Total System Approach to Valuing the Firm. Butterworth-Heinemann, 1999.
Obrycki, Daniel and Rafael Refendes. “Economic Margin: The Link between EVA and CFROI.” Value-Based Metrics: Foundations and Practice, edited by Frank J. Fabozzi and James L. Grant, John Wiley & Sons, 2000, pp. 157-178.
Parker, R.H. “Discounted Cash Flow in Historical Perspectives.” Journal of Accounting Research 6.1 (1968).
1. Bear Sterns. Discounted Cash Flow Methodology. Internal, circa 2001.
Download Article: Fundamental Equity Analysis: What Do the Numbers Say?
The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.