Now I’m going to share my own personal framework for valuation a mixture of the qualitative and quantitative methods which you are free to use and feel free to suggest improvements. I call it the DRRP (pronounced DRIP) which stands for – DURABILITY, RISK, REWARD, PERCEPTION. Here’s an explanation of each component:
Durability
Most investors are ignorant of the durability of a company’s moat simply because it’s very hard to accurately know in advance and there are no standardized methods of measurement. Companies will obviously boast about their prowess and offerings but we need to be watchful of claims (and try to figure out the underlying logic). If the moats can be easily copied or defeated when attacked, then there was no moat at all to begin with. A company might be the sole Indian producer in a niche industry but if the price is dictated by Chinese or European imports, then the moat is very shallow and vulnerable. One of the easiest ways to measure the durability of the moat is to understand:
- Where is the company positioned in the entire value chain?
- What is the % value added by it?
- What are the available substitutes/alternatives?
Some of these questions might need deep extensive research and the answers might not be obvious. This is where circle of competence comes into play and you’ll know you need to work harder if you don’t have all the answers. So if I were to put this on a spectrum to rank a company, here’s what it would look like:
Least Durable to Most Durable
Cyclical Shallow/Vulnerable Defensible Brand Monopoly
Risk
Risk is often underestimated or overestimated. Either investors are too conservative and risk averse or too bold and overconfident. It’s hard to stay level headed with the amount of noise and volatility growing exponentially. Smart investors understand risk both explicit and implicit. Accordingly, they make calculated bets where the margin of safety is sufficient. Even if there is a fall, they know when to hold, sell or buy more. When analysing a stock, it helps to be conscious of your own limitations which can be classified as:
Knowledge – Known Knowns
Awareness – Known Unknowns
Bias – Unknown Knowns
Ignorance – Unknown Unknowns
Known knowns refers to your knowledge about the company’s business.
Known unknowns refers to your awareness of the competitors and their range of responses to company’s actions. Another example of this is the company’s optionalities.
Unknown knowns refers to the inherent biases in our judgement and opinion of a company. We might subconsciously place the company on a pedestal simply because we love their products (remember this says nothing about their financials and others might not share our love).
Unknown Unknowns refers to events which we can’t fathom that could impact the company like a sudden change in regulations, invention of new technological substitute, natural disaster etc. If a company is financially strong it should be able to handle unknown unknowns better than its competitors.
So here’s how I would define the Risk spectrum:
Danger >> Risky >> Calculated Gamble >> Low Risk >> No Risk
Reward
As irrational human beings, we tend to be either overly optimistic or pessimistic about future returns. We are never satisfied with and don’t like to accept decent returns over a long time. However, if you buy a great business at a wonderful price, then the returns you get could be life changing. This is an underestimated fact, because compounding rewards are non-linear while our minds tend to calculate in a linear fashion. Our mind cannot naturally calculate the huge difference between 18% CAGR and 22% CAGR returns over a 25-year period. Do it and the 4% growth difference in results will astonish you!
Rewards are about having probabilities in your favor. While this sounds simple, it’s a little counterintuitive.
Amateurs don’t think in terms of expected value which is why the returns end up significantly deviating from their initial assessment. Another significant driver of great returns is position sizing, if a stock is just 2% of your portfolio, then if it doubles, the impact at a portfolio level will be much less than an 8% holding doubling in value. Your exact position size should correlate with your conviction in the stock, so highest conviction bets will have the highest % positions and vice versa. This is one way to go about it. There are other ways too which we’ll talk about later.
Another counterintuitive fact as mentioned by Charlie Munger is that even if you a pay an expensive price for a great business, over the long term, the returns delivered will be like the rate at which the company is able to deploy capital in its business. This is why, one should hold businesses who have high ROIIC.
Perception
Earnings growth is the key driver of returns in the stock market. However, another key driver which is underestimated and cannot be predicted is rerating by the market. If the company has a long runway, great history and consistency in sales and profit growth, then the market will put the company on a pedestal and rerate the company over its competitors. This means if the industry mean PE is 20, the market won’t mind paying 2-4x of this PE for the superstar company. PE is known as Price to Earnings but a lot of investors jokingly refer to it as Perception to earnings. Market perception of the quality of earnings determines how expensive a price it’s stock can fetch. This perception is often not logical and based on positive futuristic assumptions. It’s up to us to determine what is implied in the market’s perception of the company.
It helps to be a contrarian and go against the herd. A successful contrarian which is very very hard to make can bring you outsized returns because the market will not just reward the earnings growth but also potentially reward the company with an upward rerating.
If the market is uncertain, you are certain – outperformance
If the market is certain, you are certain – average performance
If the market is certain, you are uncertain – above average performance
If the market is uncertain, you are uncertain – below average performance
Do let me know your thoughts on this framework that I use. Of course, the qualitative judgement on these factors must be backed by hard data. While you can mimic my framework, feel free to customize it as per your own preferences (for eg. I know some investors who only invest in small and mid-caps). So based on the above factors, I determine if I’m comfortable with the valuation of the company or not.
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