Motley Fool Money - The Two Most Important Questions in Investing

Episode Date: June 29, 2024

What is it worth? Why?  Ricky Mulvey caught up with Motley Fool Canada’s Jim Gillies for a conversation about how retail investors can value stocks and why they have an advantage over institutional traders. They discuss: - The difference between price and value. - What financial metrics can and can’t tell investors. - The valuation case for a sporting goods retailer. Companies mentioned: AAPL, OTC: WIPKF, MEDP, ASO, DKS, ADDYY, SFM Host: Ricky Mulvey Guest: Jim Gillies Engineer: Tim Sparks  Learn more about your ad choices. Visit megaphone.fm/adchoices

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And as an outside individual, and I still consider myself, in spite of what I do for a living, I still consider myself retail investor, I can hold things forever. I don't need to worry about companies meeting guidance. I'm like, you know what? I'm good. The market's pretty wild right now. So I thought it was a good time to take a step back and look at the fundamentals of valuation. I caught up with Motleyful Canada's Jim Gillies to talk about how regular investors can value companies

before buying a stock, why a price to sales multiple can steer you wrong in one advantage that retail investors have over the institutional ones. Jim, I think now's an interesting time to talk about valuation in the market. If you look at the way that equal weighted standard and poor's 500 indexes have been doing compared to market cap weighted, you can see that the big dogs are really pulling things forward. So I think it's good to take a step back and give a little primer on valuation and investing, and you are, you're a big valuation guy. So to set the table, what's the difference between price and valuation for investors looking at any stock?

Sure, I have been accused of being a valuation guy from time to time. There is a cliche that price is what you pay and value is what you get. And that's actually not bad. All a stock price tells you is what other investors or prospective investors are soon to be former investors are willing to transact at the moment. It doesn't really tell you, doesn't tell you much about, doesn't tell you about the underlying business, doesn't really tell you anything about what's going on. And one of the things I like to do when I, when I used to teach this stuff and with some of the other analysts that I deal with, the young analysts that I

mentor is, I always say, you know, the two most important questions in the valuation process, because you found a stock, you're really, really excited about it. And look, you might be fine buying it today, you know, after you're really excited about reading about their opportunities or whatever. But the two most important questions that come to investing are, what is it worth and why? And there's multiple ways to answer, certainly that first question. But the stock price is just, again, it's the stock market. What the stock market is charging for the opportunity here. It may be right. It may be wrong. It's always up for debate. Everyone, every investor is playing a different game because everybody's at a different course in

their life, has a different amount of money. Maybe you're a short-term holder. Maybe you're hoping to be a long-term investor. And things are always in flux. A very obvious example would be go look at stocks in the so-called growth and tech stocks, software stocks, SaaS, software as a service, and SPACs in 2021. Go look and see what those prices were doing. And then you can go and look at what the valuation implications of all of those prices were, and then flip them a year later and look at those same stocks and the same implications that were tied in in 2022. And they're radically different, even though they're the same stocks, the same companies. So if I'm thinking about valuation, do I have to build models of future cash flows? I know there's not just top line growth. Do I have to guess the effective tax rate for

the companies I'm looking at five years from now? Are there ways to do this without getting the Excel spreadsheet out? Oh, don't fear. the Excel spreadsheet, Ricky. I like to say that every model is precisely wrong, but you do have the opportunity to be roughly right. And frankly, roughly right is going to be good enough. Warren Buffett and before, well, Ben Graham, Warren Buffett popularized the topic, but it comes from Ben Graham, the father of value investing, the concept of margin of safety. So you do the best you can. And you can make it as complicated or as uncomplicated as you want. You may observe say that a company, does any particular company, translates about five or six percent of their

top line revenue into free cash flow. That is the cash that is left over after the company has paid all of its build, made all of its capital investments, made all of its investments in working capital. Let's say, you know, for every $1,000 in revenue they do, they end up with 50 bucks at the end, with 5%. And, you know, you can look back and you do kind of a time series, a historical analysis. You might see, you know, they've averaged between four and a half and five, percent for the past decade, you can build a really complicated model where you can use the capital asset pricing model to fine tune your weighted average cost of capital down to 14 decimal points. And you can make an estimate for tax rates.

And you can read the T leaves to see what the, well, if the next president is this person, the tax rates for corporations are going to go to here. Or you can just say, you know what, I'm going to be wrong on those things. but they've largely been between four and a half and five percent free cash flow margin for the past decade. So I'm going to forecast my growth and then I'm going to hit it with five percent. I'm going to call it a day at that point. It's far simpler to do that. And you're going to be roughly right. And then the concept of margin of safety is if I figure out that a stock, any particular company is worth, say, $100 a share, well, if the stock is trading at $100 a share, that's not a great deal.

maybe I buy a few shares just to get my head in the game. But if that stock is trading at 80, it's a 20% margin of safety. And that is, that's going to allow you, that's going to allow you to have made a significant number of errors during your valuation process. You know, maybe the next couple of years, they only do four and a half percent free cash flow. They underperform what you're expecting. But it's not going to matter if you bought a discount to free cash flow. Similarly, if the company, and this is always wonderful when it happens, when a company outperforms your expectations and you've bought it in a margin of safety, it becomes magical because you get both, you know, the company outperforms what you were expecting and you bought it a discount.

Does a regular investor, though, have any hope of playing this game better than a, you know, Wall Street analysts who do this for 12 hours a day and have fancier software access to better data on Bloomberg Terminal? that kind of thing. It seems like if you're playing this game, you might be its significant disadvantages to a lot of professionals. The professionals are at the disadvantage. Yeah. Yep. Because the professionals being graded quarterly.

They're running a fund and they tossed up a couple of garbage picks during the quarter. They're probably having an uncomfortable conversation with their portfolio manager at the end of the quarter. Do it several quarters in a row and you're probably having an uncomfortable conversation with your HR department. is you can negotiate your exit. It is constant. What have you done from me lately? It's almost, except for the rare shops, which can do their own thing and go their own way, it's inherently short-term minded. And as an outside individual, and I still consider myself, in spite of what I do for a living, I still consider myself retail investor. I can hold things forever. I don't need to worry about, you know, companies meeting guidance. I'm like, you know what? I'm good. And so you can take

the time. Like, I've sat on a couple of stocks that have, you know, done nothing for years, you know, which would probably get me a talking to, you know, working for that large fund company on Wall Street. And they do nothing for three, four, and five years. And then they quadruple in three months. Those are fun. Sounds like fun. Is this exercise, if you're doing this, are you better off spending your time? It seems like you'd be better off spending your time with smaller cap companies, not the companies with all eyes with the eye of Saron upon them. Right. Well, yes and no. It's an interesting exercise. Usually, if you are one of the few who is, yeah, if you are playing in the small cap world, which is where I usually play, you can have an advantage. I mean, big, big funds can't come in and own it in any size to matter. Right. Like, you know, if you're dealing with a billion dollar company and a fund can only buy up to 5% of a company, $50 million. And that fund is a $10 billion fund. They're not going to look for it. Look at him. Where I think you have, again, this kind of ties into the short-termerism. And my favorite

example of the species is Q4 of 2018. Now, people don't remember because we have short-term memory most of the time. 2018 was kind of a dismal year for the market. I wrote a column back then called the year no one made money. And I went through all the major asset classes and just like, you know, bonds were down, stocks were down. The marijuana stock sector, which was big in Canada in 2018, it was down. Bitcoin was down. Housing prices were down. I know what that never happens, right? But like every major asset class, like nothing made money in 2018. And you got to the end of 2018 and going into early 2019, there's this small fruit company at a Cupertino, California. Apple or something? They were doing, we're doing the if you haven't heard of Apple game. Exactly. In 2018, I. Yeah, okay. That's exactly. So,

okay. So, so Apple at the time was the largest company by market cap in the world. And Apple was trading at 10 times free cash flow, 10 times operating profit as well. Ballpark. I don't have my spreadsheet open, so it's a ballpark. And all of the stories at the time, all of the words of the wise, everything coming out was that Apple's growth was gone. Apple was going to struggle to respark growth. They hadn't had any really new innovative products for a few years. Steve Jobs had been gone for seven years at that point and really, seven, eight years by that point. And that Tim Cook guy, you know, well, you know, he's a good operator, but he's no, he's no Steve Jobs, and on and on and on. And you don't, you didn't need a detailed spreadsheet analyzing every product line and the rise of services.

And you didn't need that to go, okay, here is Apple, the largest company in the world by Market Cap. The biggest cash generation story that I've seen in my career, and I've been doing this for a while, that had a really interesting habit of returning all of the cash and then sum to shareholders in the form of a small dividend and very, very large stock buybacks. When you tell people that Apple's bought back over the last decade, about 40% of their stock, they don't, you know, they generally comes as a shock to them. But they have. Now, and they say, oh, well, they give lots of equity, cookie insiders.

Yeah, about 12, 15% of the stock they buy back has gone back into the pool for employees. And that's just a cause of doing business. but they're still very much focused on returning that cash to investors and reducing their share count, which ratchets up the stock price. But the sentiment about Apple at that time was very negative just in the popular press. It's like I said, it got down about 10 times free cash flow. And all the eyes are on Apple, Ricky, at that point, right? Like, this is not an unknown stock at this point.

If I told you Apple's been a five plus bagger since then in barely over five years, would you believe me? I'd open another tab, but I don't want to do that. Well, I promise you, I'm correct on this. Because I was a very heavy buyer in late 2018, early 2019. And that's where you didn't need to come up with a giant spreadsheet to forecast all these things. You can do it. But, you know, again, there's the concept of declining utility. All you really needed to know was premier cash generating story of our generation and religious about returning that cash of shareholders. Fantastic relative valuation. Relative being I'm using, I didn't build a DCF discounted cash flow model. I'm using a relative valuation metric in this case, price to free cash flow, EV to free cash flow. Are there any price tag metrics that you use to help find those stories?

We got our price to sales. We got our price to earnings. You mentioned price to free cash flow, which is especially useful for a mature business. You're smirking and shaking your head just a little bit for the listeners who Can't see. Me? Okay. This is where I go off on. Number one, I hate the price to sales multiple. I hate anything multiple to sales. Hate it all. You didn't really see that a lot, frankly, until about five, six years ago. Okay. The previous time where I'd seen it even used it all was largely in the tech bubble in 2009-2000 era. And there's no faster way for me to throw out an investing thesis and to have an analyst tell me,

well, this is cheap, it's trading it only 20 times sales. I'm old enough to remember when 20 times earnings was considered starting to get into richly valued. That's because sales is at the top of the income statement and earnings is at the bottom of the income statement. Rearnings is after, in theory, at least on an accrual basis, after we've paid for all of the operating costs and the cost of sales of the business. So I loathe the price of sales multiple. And the only times I can actually remember using it, I used it to illustrate a problem with the formerly largest company in Canadian history, it would be Nortel Networks because I showed how, for those who don't know, Nortel Networks is the giant cautionary tale for most Canadian investors. It was the largest company

in Canada. It was largest company in Canadian history, frankly, by market cap. I think it hit about $350 billion in mid-2000. It's a zero today. So, largest company in Canadian history to zero in less than two decades. That's some good work. But at the time, this is going back a long time ago, but basically when Nortel started rolling over, and Nortel was a company that on a split-adjusted,

or I should say reverse split-adjusted basis, all-time high about $1,250 Canadian dollars per share. And it bottomed at $6.60, about two years, later, less than two years later. Okay, that's about a 99.5% drop for those playing along at home. And all the way down, I would have, I would have family members, I would have friends, that the acquaintances. As soon as they, you know, we talk investing, oh, I'm going to buy me some Nortel. It's come down so far. It's got to go back up. No, it doesn't. It's under no obligation to go back up just because it's come down so far and you think it's got to go back up.

And the exercise I was running was like, at the time, Nortel, they had turned cash flow negative. They had turned accounting negative, like accounting profit negative. So really, you had to move up. The only thing they had that was a positive number at that time was really their sales. And so I would use the price to sales multiple and say, here's a company that from 92 to 98 traded between one and a half and two times sales. But because sales went up six times over that period, the stock went up about six-bagger. Okay?

It followed the valuation. In 1999, it went from two-time sales to 10-time sales. So the multiple expanded by a factor of five and through a combination of a little bit of enthusiasm in the market and the markets they were serving as well as making a couple of really turned out boneheaded acquisitions. They doubled their sales in a year. So they doubled their sales and the multiple on sales went up 5x. So Nortel in 1999 was a 10 bagger.

But I showed, you know, like look, those six years went up six times in value. That's fine because on a relative basis, it actually never. got more expensive. That one year, 99, where, you know, the CEO at the time, John Roth was made, you know, he was fedded in every magazine and every newspaper as the CEO of the year. No, the dude just got on the right side of a momentum wave and caught it and was smart enough to bail out and take his $100 million home the next year. Like, I mean, you know, good for him. But the, so the price to sales ratio, I'm going to differ with some other people, some other fools who are not going to agree with me and that's fine. If all your hang, you got to hang your hat on is the price

to sales ratio, you're probably going to get hurt. We've not talked about price to earnings. It's the most quoted. Yeah. Yeah. It's fine. But you seem very tepid. You seem very tepid.

It's to give you a price tag. You know, you say price to sales doesn't give you any of the costs and expenses. A price to earnings. That'll give you some costs, costs and expenses to which you can compare that company against other companies in that category. Sure. Sure. Or against its own history.

My main problem with priced earnings is, again, there's no leverage consideration. There's no leverage consideration. There is some non-operating expenses or income can skew the earnings line sometimes. If you're going to use an earnings multiple, number one, you want to be consistent. You want to look at the company over time. You want to be consistent and use your measures all the way along. We're also living in the grand age of adjusted numbers. I mean, now every number is adjusted 17 ways to Sunday.

And we've apparently forgotten that Ibada is a made-up number anyway. But, you know, like... There's too many problems with Gap. They have too many rules. Doesn't work for my company. I'm sorry, but keep going. Well, and actually, that's valid in a lot of cases. But, you know, my take on on price earnings is it could be fine.

Like anything, like any tool, hammer works great as a hammer. It might work okay as a lever. It's a terrible wheel. Right. And so use the tool, you know, you want to have multiple tools that you can bring to bear. And when those, all those different tools, maybe you're telling you similar stories, that's something to pay attention to and say, okay, you know, I think this is pretty decent. Counting earnings is fine, but, you know, it's not cash flow. My, if you're, if you're going to force me to use kind of a relative metric and a quick metric, I am going to, I am going to be a fan of a free cash flow multiple because, but then, So whether that's price or whether it's enterprise value, there's applications for each. But that's still only part of the story because then what does a company do with its free cash flow? There's a company in Winnipeg, Manitoba, Canada called Winpack, of all things. And has been a tremendous cash generator over the past, I'm going to say, decade or so.

For most of it, it's history. It's just a really, really well. It makes plastic cups. You know, if you like your little cup that your single serving Pringles come in or your single serving K cups or a little jams you get at the diner, congratulations. You're using a wind pack product. They made a tremendous amount of cash. They're really well managed. They respect their equity. By that, I mean, they're not like constantly diluting themselves. But the cash is just piled up on the balance sheet. Until very, very recently, they haven't done anything with it for almost a decade. So it's like, Okay, that's great. You're plying up with the balance sheet and I guess maybe, you know, its value is as, you know, it makes some interest income except until the last year and a half, the last two years, we've been in historically low interest rate environment. So who cares, right? As opposed to companies where company, I think we've talked about before in the past, Ricky, a company called MedPace Holdings, right? I know we've talked about them. Diagnostic testing. Yeah, yeah. It's a great company. Contract Research Organization run by a really great foolish founding CEO who continues to be the CEO and largest shareholder. And he founded the company 32, 33 years ago. They were piling up the cash, tremendously cash generative, debt-free. They were piling up cash on their balance sheet until 2020, late 2020, early 2021. And then the stock

got continually whacked. Every earnings report was down 15%, even though every earnings report like pretty good, actually. The market just wasn't believing that things could be that good there. And you saw MedPace Holdings, which I believe had about 425 million cash at its peak. They blew all of it buying their stock back. And they took on some debt and through that against it. Because they're like, no one else is going to respect their equity. And they were buying it, you know, between 130, 150, say. The stock's 400 and changed today. It was a tremendous, tremendous capital allocation move. But they were piling up that cash from their free cash flow generating ability. And then when opportunity presented itself, you might say when the valuation was attractive and they knew they were worth more than

the market was given. They said, fine, we will take advantage of this. And they did. Let's wrap up with this part of the conversation because Jim, I think we have more to talk about. I think there's another show in here. With using some of the multiple we've talked about that you have very, very tepid feelings about, to at least talk about one story. And that's one you've mentioned on the show. That's Academy Sports and Outdoors, especially in comparison to Dick's sporting goods. These are companies that are pretty easy to compare because they're sporting goods retailers, but the investment community is not just on a market cap basis, but also on a multiple basis, much more optimistic about the future of Dick's sporting goods.

We'll use the price to free cash flow multiple. Dick's sporting goods is about a 17 times free cash flow multiple. But Academy Sports and Outdoors is it in eight times free cash flow multiple, less than half, even though maybe it has more room to expand. Its store account, while Dix is a more mature business, why is the market so much more feeling the way you feel towards multiples about Academy sports and outdoors, you think? I am asking myself that same question because Academy sports and outdoor, it's probably one of my favorite stocks right now for buying new shares of today. I don't know why.

I don't know why the market is valuing Dix more. I think it was 2019. I'm going to be precisely wrong here, but I'm going to try to make up for it. 2019, I believe this is before Academy even was even IPOed. At one point, they were voted, retailer most likely to go bankrupt by someone. I don't know. I remember who the period, but I thought that was funny. And they largely switched out. And they were greatly underperforming in terms of sales per square foot and, you know, same store sales and all the things that we look at for retail change. And they did a wholesale management change. Again, this is free IPO. They basically sent the present incumbent out and they brought in new folks and they came forward with a five-year financial plan. Here's what our sales

are going to be in five years. Here's our net income margin. Here's how many times we're going to turn our inventory. Here's our target return on invested capital. Here's our target sales per square foot. Here's our percentage of e-commerce sales. And spoiler, they hit all of their metrics that they laid out well before the five years had gone out. This new management team is excellent. About a year ago, Academy Sports and Outdoor actually brought out a second five-year plan that they're working on. And I've used that plan to inform my valuation model. And I'm not just using multiples here, Ricky. I do have an actual DCF built on this one. I'm not as optimistic as management is. I'll put it that way. Their five-year, this five-year plan, they want to be at over $10 billion

of sales by the time this five-year plan is done. I think in year five, I've got them just shy of 9 billion sales as I look at my spreadsheet here. And I've got slightly lower margins, free cash flow margin. Right now we're running about 8% on a trailing basis. My model, I don't have them any higher than 6.5% over the course of the next decade or so. I think I'm penalizing them appropriately for their cost of capital and for growth beyond the next decade or so. I've made sure I valued all of the outstanding stock options that are going to go to,

to insiders and make sure that I detract that from the business, make sure I take off their debt. It's real hard for me to get a stock value that's under $80 right now. And the stock's trading in 52, I think. And so where that comes back to the multiple, and again, I haven't done, I'm aware of the Dix thing because we have talked about Dicks before, but I've not done a similar amount of deep dive work into Dix sporting goods because it's a little larger than I want. I kind of like the smaller and the upstart. I, you know, I own several. US facing index tracking ETFs. I figure I've got enough exposure to exporting goods through those ETFs. But where it comes back is when you see peer groups, when you see two companies in

peer and it's on a, and you see one, it's such a sharp discount to the other in terms of evaluation metric that I do like, which as you've used is a free cash and multiple, that's a good place to start your research and go, okay, so what's going on here? Why do we have, maybe you find out that, you know, one store is just so much better well run the other and you start finding reasons for, you start finding reasons for the discrepancy. I will say this, the, you know, the setup for Academy is going to get me in trouble, I'm sure, in a year or two, but the setup for Academy Sports and Outdoor really reminds me of, are you familiar with Sprout's Farmers Market? Yes, I am. The organic grocery kind of poor man's whole foods. It reminds me of the setup for

for Sprouts' farmers markets about three and a half, four years ago. And that is, you know, the market just doesn't care about the prospects. And so Sprouts was hovering around 24, 25. I recommended it a couple times, like 25 and 30. And again, run the DCF. Hey, this is undervalued. Look at a multiples basis. It's actually cheaper than other grocery stores who have lower profit margins than they do. They have good management with, who had a very clear and, and stated plan going forward. I built a DCF that undercut the plan of the insiders, which is a conservative measure.

And I'm like, yeah, like, you know, I still can't get the stock price below. It's minimum 40% upside from here. And then stock basically tripled in a year and a half as the market caught up with it. And that's kind of the setup I'm looking at with Academy here. And then the last piece of the puzzle is, again, remember when I said earlier, what does the company do with its free cash flow? It's lovely to be cheap vis-a-vis its cash generation. But what are you doing with it?

And if you are utilizing it in the service of shareholders, and in the case of Sprout, what they were doing is they have very minimal leverage, they have more cash than debt. So they were aggressively shrinking their share count by buying shares back. When I first started looking at Sprouts a few years ago, they had 150 million shares, I think. I think they might be around 100 million today. And by the way, that's going on with Academy Sports as well. they are aggressively shrinking their share count, pay a tiny pittance of a dividend, whatever.

But when you get all of those things working together, the multiples say it's cheap. The DCF, discounted cash from multiple says it's cheap. You can see with your own eyes the cashierineer inability of the company. And they're using it in the service of shareholders at which you may or may not be one or you may not be a larger shareholder. It's on my watch list. Well, but what I'm saying is like, you know, like it's if you see that, happening, I think that's a really good solid place for you to enter, you know, to to enter hopefully, hopefully what will be a long-term relationship with a fantastic company, which is really all we're

looking for here. That's a good place to end it. Jim Gillies, let's do this again. I think we have more to talk about. Appreciate your time and your insight. Thanks for, thanks for being here. Thank you, sir. As always, people on the program may have interests in the stocks they talk about and the Motley Fool may have formal recommendations for or against. So, don't buy or sell anything based solely on what you hear. I'm Ricky Maldi. Thanks for listening. We'll be back tomorrow.