Part 3 – Lesson 10

Overview


If you’ve read through the previous lessons in Part 3, you should now know where to source investment ideas, where to go to research them, how to get up to speed on those companies, and how to formulate an investment thesis around it.  The next step is to finalize your “target price.”  The target price for a company’s stock is what you believe the stock price is worth, which will give you an idea of how much upside there is vs. the current stock price.  It is important to remain intellectually honest when valuing a company’s equity.  Having a good investment thesis is not enough to buy a stock.  The valuation also needs to make sense.

You can perform a valuation of the company by using a discounted cash flow (DCF) valuation or using a relative value multiple.  For a refresher on valuation methodologies including DCF and relative value multiples, please refer to Part 2, Lesson 5 / Lesson 6 / Lesson 7 / Lesson 8 / Lesson 9.  Once you’ve valued the company, you’ll pick a target price based on where you think the company’s stock can trade (typically in the next 12-24 months).

For speed and simplicity, we favor using relative value multiples when conducting a valuation of a company.  Our favorite multiple is Price / Free Cash Flow (P/FCF) since we ultimately want to know how much cash a business generates.  We also use Enterprise Value / EBITDA (EV/EBITDA) and Price / Earnings (P/E) ratios in many of our valuation analyses.

When picking a target price for a company, an investor should consider the following factors:

  1. The investor’s forecast of cash flow and earnings relative to consensus expectations

  2. The investor’s belief of a fair valuation multiple for that business

Let’s look at each of these factors individually.

Forecasted cash flow (or earnings or EBITDA) vs. consensus


In Part 3, Lesson 9, we discussed how an investor’s research may lead the investor to formulate a different view on a company vs. consensus expectations, referred to as having a divergent view or variant view.  If the investor believes Company A will grow revenue at 10% vs. sell-side consensus estimate of 5%, this will lead to a higher forecast for cash flow vs. consensus expectations.

The investor should then complete their financial model to calculate their estimate of cash flow and compare this to sell-side consensus (refer to Part 3, Lesson 6 and Lesson 7 for an explanation of sell-side consensus).  Let’s look at an example (download the Part 3 Excel here Part 3 Download):

Note the following in the above example:

  1. The investor researching Company A is more positive than consensus, and his/her divergent view is expressed through a higher revenue growth rate (10% vs. 5% consensus) and the belief that Company A will use 100% of their free cash flow to buyback their shares, which should result in further accretion to Company A’s free cash flow/share.

  2. The 10% revenue growth for 2019 leads to $3.70 FCF/share for 2019 vs. $3.40 consensus, and by 2021, the investor is forecasting $5.35 FCF/share vs. $4.26 consensus. When layering in the buyback, the upside to FCF/share becomes even greater with 2021 FCF/share hitting $6.55 vs. $4.26 consensus.  This estimate of FCF is 54% higher than consensus.

  3. With an FCF estimate that is 54% higher than consensus by 2021, this should provide the investor with confidence that the stock price can trade higher if his/her FCF estimate proves to be correct. Over-time, sell-side analysts will have to revise their forecasts higher as the investor’s research is proven out.

But what if we don’t have confidence in forecasting a higher revenue growth rate or if we are not certain that Company A will repurchase their stock?  Does that make it not worth investing in?  Not necessarily.  If the investor’s research into Company A revealed a fundamentally strong business, the investor will have to make a judgement solely on the consensus growth rates and implied valuation to see if it is attractive.

Just looking at consensus estimates, the FCF/share is forecasted to grow at 12% in 2020 and 2021, and the investor will have to pay 14.7x FCF for that growth.  Based on our experience, this is a reasonable valuation multiple.  Even without a strong divergent view, this could still prove to be a good investment if Company A simply achieves consensus estimates.

In the next section, we will assign a target price using both the investor’s view on free cash flow and the consensus view on free cash flow.

Applying a fair valuation multiple for the business: constant multiple vs. multiple expansion


Whether an investor is using their own cash flow estimate or simply using consensus estimates, the next step is to apply a fair valuation multiple to the estimated cash flow (or earnings) to calculate the target price.

Target Price = Estimated Cash Flow (or earnings) * Assumed Valuation Multiple

When applying a valuation multiple, many investment analysts will simply take their estimated cash flow and apply a “constant multiple” to that estimate.  For example, in the previous example, we showed that Company A trades at 14.7x FCF on 2019 consensus FCF estimate of $3.40.  If we take the forecasted 2019 free cash flow of $3.83 and apply the current multiple (constant multiple) of 14.7x, this would result in a $56.38 target price vs. the $50 current stock price.

Alternatively, if the investor believes that 14.7x is too low of a multiple for this type of business and growth, he or she may assume that the valuation multiple could expand.  Particularly, if comparable companies are trading at 18-20x, the investor could make a good argument that the valuation multiple will expand to at least 18x once the higher growth materializes.  Applying 18x P/FCF multiple to the forecasted $3.83 FCF results in a $69.01 target price.

From this, you can see that applying a “constant multiple” to forecasted cash flow is more conservative than assuming “multiple expansion.”  Intuitively, this makes sense.  For a stock to go up based on higher cash flow numbers, all that really needs to happen is for the company to report higher numbers.  As long as the current valuation multiple holds, the stock should go up.  However, for a stock to go up based on multiple expansion, other investors need to collectively believe that the valuation multiple deserves to go up.

Since valuation multiples are highly correlated with long-term growth, to have conviction in multiple expansion, an investor needs to believe that the growth rates of the business will improve from current levels.

Putting this all together, there are two factors that cause stock prices to go higher: 1) higher cash flow (or earnings) or 2) higher valuation multiple.

Let’s take our previous example and forecast some target prices for Company A:

Note the following from this example:

  1. If we are to base our valuation solely on consensus estimates and solely on using the current 14.7x valuation multiple, the stock price should trade to $56.18 once investors start valuing Company A on 2020 cash flow numbers. Many investors refer to this as “calendar roll.”  If it is currently the middle of 2018 and investors are valuing Company A at 14.7x 2019 estimates, then, by the middle of 2019, investors are likely to value Company A at 14.7x 2020 estimates.  And by the middle of 2020, investors are likely to value Company A at 14.7x 2021 estimates.

  2. Assuming the stock price will accrete solely based on the calendar roll is a conservative way in which to pick a target price. If we have good reason to believe that positive news flow may cause investors to become more positive on the company or sector, then, we may be able to assume a bit of multiple expansion.  If Company A trades to 16x FCF, then, the stock could be worth $61.12 in 12 months.

  3. If we have confidence that higher revenue growth and the buyback will boost FCF estimates, we can take a more aggressive view on the target price to judge the real upside in the stock. Taking a constant multiple of 14.7x and applying it to our 2020 cash flow estimate implies a $73.67 stock price using our higher than consensus FCF/share of $5.01.  However, if we believe the valuation multiple will expand to be closer to peers, then, we could take the 16x valuation multiple and apply it to 2020 cash flow, resulting in a $80.15 stock price.

What should be clear from our calculation of target prices is that picking a target price is subject to variability and interpretation.  Often, investors may have a downside target price, a base case target price, and an upside target price.  This helps investors to judge how the stock may react under different scenarios.

In this case, an investor might decide that Company A stock could hit $80.15 in an upside scenario but should at least hit $73.67 if his/her forecasts prove correct.  The target price of your investments should constantly be monitored and adjusted as new information such as quarterly results and updated consensus estimates are released.

Charter (CHTR) – Picking a Target Stock Price


In Part 3, Lesson 9, we drafted an investment thesis for CHTR.  In this section, we will look at the FCF numbers for CHTR to see if we think the stock is worth more than where it is currently trading.

Below is a summary forecast of CHTR financials and accompanying valuation using P/FCF target multiples.  While some analysts may choose to build a detailed revenue model and income statement, we have relied on Wall Street forecasts for EBITDA, interest expense, taxes, and capex.  Built on top of the Wall Street forecasts, we have assumed that CHTR will repurchase stock aggressively over the next few years.

Please note the following:

  1. Our 2019 FCF estimate of $22.76 is slightly below the consensus forecast of $23.00, but the difference is small. Effectively, we are in-line with consensus on 2019 numbers.

  2. By 2022 and 2023, due to buyback estimates that are higher than consensus, our FCF/share estimates are higher than consensus. For example, one Wall Street bank is at $53 in FCF/share in 2023 vs. our $60 estimate.

  3. CHTR is trading at an attractive 13.1x multiple on 2019 FCF/share consensus estimate. Given growth that will exceed 20% for the foreseeable future, a 13x valuation multiple on this type of growth rate looks attractive to us.

  4. Target Price – By the end of 2019, we will assume that investors will value CHTR stock based on 2020 FCF/share. We believe the 13x multiple is too low, and as the investment thesis proves out, the multiple is likely to expand to at least 15x, which is still conservative considering these strong FCF growth rates.  Based on 15x 2020 FCF, we believe CHTR could trade at $448 by the end of 2019 (roughly in 12-18 months).

So why did we decide to choose 15x as opposed to 16x?  Much of this comes from experience and familiarity with how other investors are valuing the company.  For example, although it is technically not wrong to value CHTR on a P/E basis, most CHTR investors are not valuing the company on earnings.  Also, no one is valuing CHTR on EV/Revenue.  Instead, most investors evaluate CHTR based on FCF or EBITDA.  We chose 15x FCF to value CHTR because it is still a conservative valuation level when FCF is growing 20%+, and CHTR has historically traded higher than 13x as well.

And why did we decide to value CHTR off 2020 FCF/share?  When picking a price target, it is helpful to frame it in terms of where you think the stock will go at some point in the future.  Even if your valuation suggests that CHTR is worth $400 today, it is unlikely to get there overnight.  Instead, it is likely to reach that valuation over-time as specific catalysts occur.  We chose 2020 since investors typically value a company on the next year’s earnings or cash flow.  Therefore, by the end of 2019, investors will be looking forward to 2020 when valuing CHTR.