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Mistake #3 Growing fixed assets slower than revenue | 9 Valuation mistakes - YouTube
Channel: Andrew Stotz
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This is Andrew Stotz of A. Stotz Investment
Research to talking to you about the top nine
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valuation mistakes and how to avoid them.
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This is Mistake #3: Growing fixed assets slower
than revenue
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Before we get into it, let's review the top
nine:
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#1 Overly optimistic revenue forecasts
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#2 Underestimating expenses causing an unrealistic
profit number
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#3 Growing fixed assets slower than revenue
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#4 Confusing growth Capex with maintenance Capex
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#5 Forecasting drastic changes in the cash conversion
cycle
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#6 Underestimating working capital investment.
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#7 Valuing a stock using the calculated Beta
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#8 Choosing an unreasonable cost of equity
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#9 Not properly fading the return on invested
capital
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Let's talk about #3: Growing fixed assets
slower than revenue.
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Sit down around the campfire and I'm going
to tell you a campfire story.
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This is a true story though I've changed the
facts to make it a little bit easier to understand.
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But this is a story about what an analyst
came to me with when they were getting ready
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to publish a report and I was the head of
research.
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So let's take a look.
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The analyst first presented me with their
cash flow data.
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And what I could see is what I call “basic
cash flow.”
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It's just net operating profit plus depreciation
and amortization.
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What we can see is a slightly double-digit
growth and slightly high in 2021 at 16.
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We could discuss that; maybe it needs to come
down.
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Of course, you need to think about assumptions
in the final years because if they're really
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high, then we're going to carry on those high
profitability or free cash flow valuations
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to infinity, and that could cause us to inflate
the terminal value.
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Let's look at the next thing.
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This is the next part that he presented.
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What he showed me was the Capex: the Capex
in the first forecasted year, 2017, was 29;
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in the second forecasted year of 2018, it
was 32; in the third forecasted year of 2019,
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it was 35.
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When we got to the fourth and the fifth years,
what he showed me was that it went to five.
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Wow!
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So the investment amount of the overall company
dropped dramatically in those periods 4 and 5.
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And what does this cause?
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In the first year, in particular, it caused
a massive jump in the free cash flow to the
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firm.
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The free cash flow to the firm went from 54
to 95, a 77% jump.
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What's the problem with that?
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The problem is that you're overstating the
free cash flow to the firm; and when you're
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overstating in one year ─ let's say, a discrete
year ─ it's not a big deal.
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But when you're overstating towards the end
of the discrete period that you're forecasting,
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what ends up happening is that you're carrying
on that very high number to infinity ─ to
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the terminal value ─ and, therefore, you
may find a situation where you're overvaluing
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the stock based upon this assumption.
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Now, another way of looking at it is to look
at the basic cash flow versus free cash flow
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to the firm.
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We could see that it was 2020 that that cut
came in the Capex.
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Here's the further information on the story.
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I asked the analyst, “Wait a minute, if
we go back to this number, why did you choose
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five in 2020?”
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He said, “I didn't choose five.”
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“Why did you get five?”
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He said, “Actually, the company gave me
the numbers for 2017.
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They gave Capex guidance: 29 in 2017, 32 in
2018, and 35 in 2019.
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I just plugged in 5 because I didn't want
to show you zero for 2020 in 2021.
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But the company gave no guidance.”
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So what do you do in a situation where a company
gives no guidance on something like that?
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I discussed with the analyst that, basically,
the job of an analyst is to think about the
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perpetuity or that this company is going to
exist for many years going forward; and the
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CEOs and the management of the company are
going to find new investments to spend on.
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And, therefore, though you don't have specific
guidance from the company, you need to make
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a Capex assumption in those later periods.
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If you don't do that, you're going to have
the problem that I highlight which is overinflating
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the free cash flow to the firm.
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So what you're seeing is a case of an analyst
not growing the Capex or the fixed assets
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as fast as they're growing the revenue.
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Let's take a look at that now.
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Let's look at a company here that I've taken
and made it simple: sales, assets, and the
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sales-to-asset ratio.
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This company is growing assets from 100 to
115 ─ a small growth in assets of 15%.
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But what we can also see is that the sales
are going from 140 to 168.
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So what does that do to the sales-to-asset
ratio?
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It increases from 140 to 146.
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That's pretty good.
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That means the company is generating 146 in
revenue for every 100 in assets it has in
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place.
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But if we go forward and we look at this number,
what we're going to see is that if we take
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the data from the prior company, we're going
to see that the amount of sales relative to
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assets is going to be rising and rising.
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So we take a company that had sales-to-assets
of a 140 and by the time 2021 is seen, it's
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at 248 in sales for every 100 in assets.
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We can look at that sales-to-asset ratio here
in a simple chart.
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And what does this tell us?
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This tells us that the analyst has probably
been overly optimistic on sales growth but
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it's probably more likely that the analyst
has not forecasted enough fixed asset growth.
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So let's look at this Error #3: Forecasting
fixed asset growth lower than sales.
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Analysts often underestimate fixed asset growth.
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It actually happens in almost every analyst
that I've worked with in the Valuation Master
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Class in the beginning.
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They put in a little bit of fixed asset growth.
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And it takes investment to grow revenue.
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You can't grow the revenue of a company without
this fixed asset growth.
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And that's why it's got to be in there.
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It's also unrealistic to forecast a company
to grow revenue without growing its assets.
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So we always want to be thinking about the
assets that the company has and how they're
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growing it.
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How do we avoid this common mistake?
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A rule of thumb is that fixed asset growth
should roughly match revenue.
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We know that investment and fixed asset is
generally lumpy in that we build a new factory
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or something like that.
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And when we do, it may not get the revenue
yet but, eventually, it comes back.
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Taking into consideration that the fixed asset
growth is lumpy, we want to think that it's
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going to grow generally the same as revenue.
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Use the asset turnover ratio to prevent this
error.
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It can help you to see when you're getting
unrealistic as we saw in that one chart.
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Large deviations in the future should be revised
or explained.
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As I always say, “Revise or explain that.”
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Either you made a mistake and you need to
revise it or you feel comfortable and confident
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about what that is.
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Now, you need to explain because if you told
me, “I'm confident about that 5 in Capex,”
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great!
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Wow!
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That's a big, big number that you've got to
think as to how that impacts the free cash
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flow, and that could cause us to be very bullish
on the stock.
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But if it's just that you don't know what
the Capex is, then that's not acceptable.
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So in the value model, this is an example
of what you would see revenue growth of, let's
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say, roughly 10% but then the error is when
an analyst would grow the fixed assets or
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net fixed assets, ultimately, by only one
percent.
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So what have you learned?
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Over the long run, companies should grow fixed
assets about as fast as revenue.
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Also, if that's not the case in your forecast,
then this is an excellent point of discussion
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about your forecast.
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Finally, prevent this error by using the asset
turnover ratio.
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I hope that helps you.
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And that gives us a little background on Mistake
#3.
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Next time, let's look at Mistake #4: Confusing
growth Capex with maintenance Capex.
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I'll see you there.
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