Deciphering the External: The Third Step in Value Investing

Welcome back, dear readers, to the third installment of our journey through the intricate world of value investing. Having thoroughly analyzed a company's financial health and performance, we now venture into the realm of external factors and their significant impact on valuation. This step is crucial in shaping our understanding of a company's future earnings potential and the various risks that might affect its growth trajectory.

Step Three: Estimating Future Earnings

The Valuation Model

In this phase, I adopt a forward-looking approach, focusing on a five-year horizon. My method involves applying a series of Price-to-Earnings (P/E) ratios, which helps me estimate the value generated by five years of dividends, plus the potential selling price of the stock after this period. This approach, while simple, allows for flexibility and ease of adjustment based on varying inputs.

The Three Pillars of External Analysis

Credit Risks: This involves assessing the company's solvency and financial solidity. I use specific metrics (see table below for further detail, the first raw below the rating is the interest rate), and apply them to the interest rates used by rating agencies like Moody's. This assessment culminates in a number that I use to adjust the expected earnings in the fifth year. The more financially solid the company, the lower this adjustment factor.

Macro Risks: Starting with the equity risk premium calculated by Aswath Damodaran (available here on his website), I further refine this number using a coefficient based on five parameters: GDP per capita, the level of “rule of law” according to the GDI index, “economic freedom” as per the Heritage index, and “political stability and absence of violence” from the GDI index. This analysis goes beyond the company's headquarters, focusing instead on where it primarily generates revenue and conducts its operations. The resulting number is used to adjust the expected future earnings, reflecting the risks associated with operating in various geopolitical and economic environments.

Industry and Company Risks & Opportunities: This is the only factor that can potentially increase, as well as decrease, the expected earnings. It encompasses a range of parameters including industry growth prospects, the company's potential for expansion, customer price sensitivity, competitive dynamics, barriers to entry, ways to achieve competitive advantage, customer perceived value, main risks, and resource requirements. This nuanced analysis ensures that we don't oversimplify by treating all companies within an industry equally, recognizing the unique position and potential of each.

Applying P/E Ratios

The modified earnings, influenced by these three parameters, are then translated into a stock price using various P/E ratios. I consider multiple market scenarios, including the company's current P/E, its minimum P/E over the last five years, and the industry's trailing P/E, among others. This approach allows for a comprehensive view of potential outcomes.

Beyond Numbers: The Art of Valuation

This step in the valuation process underscores the importance of looking beyond mere numbers. It's about understanding the broader context in which a company operates - its risks, opportunities, and the unique dynamics of its industry. Such an approach ensures that we're not just investing in a company but also in its potential to navigate and thrive amidst external challenges and opportunities.

A Word of Caution

As always, I remind my readers that I am not a professional investor. This blog is a platform for sharing my personal experiences and insights into value investing, born out of a deep passion for this field. This article is not an investment recommendation but a reflection of my approach and philosophy. It's a hobby, shared with no economic interest or business ties.

Investing involves risks, and it's essential to conduct your own research and consult with a financial advisor before making any investment decisions. Thank you for joining me in this third step of our value investing series. Stay tuned for the next article, where we will continue to explore the multifaceted world of stock valuation.