Podcast Summary
Valuing businesses with DCF and IRR frameworks: To accurately value a business, use both a discounted cash flow (DCF) model and an internal rate of return (IRR) framework. The DCF model provides insights into the cash economics, while the IRR ensures a minimum 15% return.
Successful investing involves identifying companies with sustainable competitive advantages, run by good capital allocators. However, even with these two factors, it's crucial to consider the valuation of the business. Pat Dorsey, a guest on the Invest Like the Best podcast, shares his framework for valuing a business using both a discounted cash flow (DCF) model and an internal rate of return (IRR) framework. The DCF model helps understand the cash economics of the business, while the IRR framework ensures the investment generates a minimum 15% return. These methods should be used in conjunction to triangulate the value of the business. This dynamic approach to valuation is particularly important for businesses that are growing and producing cash through various projects.
Understanding business fundamentals is key to accurate valuation: Spend more time on inputs like growth rate, margins, and discount rate than on valuation output. Markets price quantitative info well, but qualitative insights often create value opportunities.
Accurate and meaningful valuation of a business depends heavily on the quality of inputs used in the analysis, rather than the output itself. The speaker emphasized the importance of spending more time on understanding the business fundamentals and arguing about the inputs, such as growth rate, margins, and discount rate, than on the valuation output. He also mentioned that markets are generally good at pricing quantitative information, but qualitative insights are often mispriced and provide opportunities for value creation. The speaker's firm doesn't find the growth vs. value classification useful for their investment approach, but it can be valuable for investors who use the right tool for the job and consider the specific context of the business they're analyzing. The idea that quantitative information is fairly priced in the market and qualitative insights are likely mispriced is a core belief of the speaker's investment philosophy. This belief stems from the increasing availability and reliability of data over time, and the recognition that historical data may not always accurately project future performance.
Leveraging Zero Marginal Cost Business Models for Growth: Companies with strong brands and distribution channels can shift to zero marginal cost business models, generating significant revenue through high incremental margins and user-generated content.
Companies with strong brands and distribution channels can leverage zero marginal cost business models to generate significant revenue and value for customers. The case of Chegg illustrates this concept well. Originally a textbook rental company, Chegg was disrupted by competitors like Amazon and Barnes & Noble. However, the new CEO recognized the value of the company's brand and shifted focus to creating a digital library of step-by-step answers to textbook questions. This asset-light business, Chegg Study, has high incremental margins and attracts users organically through search engines. Despite being a zero marginal cost distribution model, Chegg monetizes the content and maintains relationships with publishers, who struggle to compete in this space. While there are crowdsourced competitors, the value of accurate and reliable answers for students justifies the cost of a Chegg subscription. Facebook is another example of a successful zero marginal cost business, monetizing user-generated content and maintaining a strong distribution channel. However, the unique value proposition and brand recognition of each company are crucial factors in their success.
Maintaining network effects requires constant care and innovation: Companies with strong network effects, like Facebook, can maintain their market dominance through continuous improvement and innovation.
Network effects, which can create sustainable competitive advantages and massive value, require constant care and innovation to maintain. The example of OpenTable's decline illustrates this point. Network effects make products or services fungible, meaning users can easily switch to alternatives if they're unsatisfied or if a competitor offers a better experience. However, this isn't the case for all companies, especially those with strong network effects like Facebook. Valuing companies with network effects can be challenging, but primary research, such as attending digital ad conferences and gathering feedback from users, can provide valuable insights into the unique value proposition these companies offer. In Facebook's case, their ability to target ads based on user-provided information sets them apart from competitors like Google. This information advantage, coupled with their massive user base, has contributed to their continued growth and market dominance.
Understanding a business's unique model is crucial for evaluating scalability: Focus on unique aspects of business model, prioritize customer satisfaction, continuously innovate, and invest wisely to maintain growth.
While a business's financial metrics may not appear scalable at first glance, it's important to consider the unique aspects of the business model. For instance, in the case of Facebook, the high R&D spending as a percentage of revenue can be misleading due to the minimal cost of adding users. However, potential risks such as declining user engagement, capital misallocation, and lack of innovation could impact the business's future growth. Another important lesson for smaller businesses is to prioritize customer satisfaction over Wall Street expectations. Companies like Facebook, Google, and Amazon have thrived by focusing on their customers and ignoring short-term market pressures. By doing what's best for the customer, businesses can build long-term success. Additionally, it's crucial for businesses to continuously innovate and invest in their platforms to maintain user engagement and attract new users. This is especially important for network effect businesses like Facebook, where user engagement is the key driver of growth. Lastly, businesses should be cautious about large capital expenditures and ensure they are being invested wisely. In the case of Facebook, the sudden increase in capital expenditures raised questions about how the funds would be used and whether it was politically motivated. Overall, the discussion highlights the importance of understanding a business's unique model, prioritizing the customer, and continuously innovating to maintain growth.
Leveraging primary research for deeper insights: Primary research provides valuable insights often mispriced in the market. It can help fundamental investors gain an edge over quantitative ones by directly engaging with industry experts and customers.
Primary research, or directly talking to industry experts and customers, can provide valuable insights that are often mispriced in the market. This was emphasized during a discussion about Amazon Web Services (AWS), where the speaker mentioned attending a conference and conducting surveys to better understand customer needs. In the case of AWS, despite its significant value proposition, the speaker couldn't provide a satisfactory answer as to why their firm hadn't invested in it. They suggested that the value of primary research could potentially give fundamental investors an edge over quantitative ones. The speaker also shared an example of their experience with the aerospace aftermarket, where they couldn't understand why parts sales weren't growing linearly despite increasing global revenue passenger miles. Through primary research, they discovered that cheap capital and an increase in old planes being parted out were the reasons for the surplus of spare parts on the market. This demonstrates the importance of directly engaging with industry experts and customers to gain a deeper understanding of businesses and markets.
Discovering new markets and cultures leads to investment opportunities: Exploring new markets and cultures can uncover valuable investment opportunities and expand investment horizons.
Exploring new markets and cultures can lead to valuable investment opportunities that were previously unknown. This was highlighted during a research trip to India, where the team discovered the growing market for buying used aircraft parts and learned that they would focus on export businesses instead of consumer-tied businesses due to their expertise. The team also visited Japan, an opportunity that arose through a friend in the industry, and found promising global businesses with improving corporate governance and capital allocation. These trips allowed the team to expand their investment horizons and gain valuable knowledge that could pay off in the future. Overall, being open to new experiences and investing in long-term knowledge can lead to significant discoveries and opportunities.
Considerations for Investing in Japanese Equities: Understand cultural differences, currency risks, and unique corporate structures when investing in Japanese equities.
Investing in Japanese equities involves unique challenges and considerations compared to domestic US investments. Japanese companies typically prefer in-person visits for business interactions, and the risk of currency volatility is a significant concern. Additionally, cultural differences and objective functions in corporate governance and shareholder value can impact investment decisions. Market share is not always indicative of competitive advantage, and high barriers to entry do not necessarily equate to great returns on capital. It's crucial to be aware of these factors and the potential risks when considering investing in Japanese equities.
Scaling businesses with SaaS models and fragmented markets: SaaS businesses in fragmented markets can achieve significant growth by consolidating market share. Workiva, a SaaS portfolio company, grew rapidly by securing over 80% of Fortune 500, due to its complex product and large internal reporting opportunity.
In business, the ability to achieve scale and consolidate a fragmented market can significantly accelerate growth. This was discussed in relation to companies in industries with small market shares, where the next largest competitor is far behind. A relevant business model to this concept is Software as a Service (SaaS), which offers the potential for increased lifetime value of customers due to recurring revenue. Workiva, a SaaS portfolio company, was highlighted as an example. With a focus on efficient SEC filings, Workiva grew rapidly, securing over 80% share of the Fortune 500. Its defensibility lies in the complexity of replicating its product, which involves replicating Excel in the cloud and enabling it for multiple users with linked data points. The larger opportunity for Workiva lies in internal reporting, where data is rolled up across the entire enterprise, making disruption more challenging. The key metric for investing in such businesses is the ratio of lifetime value of the customer to customer acquisition cost, aiming for a significant delta. Despite initial market hesitation during the transition to subscription models, the long-term value of these businesses can prove worthwhile.
SaaS businesses with high switching costs and strong pricing power can create profitable business models: High switching costs and strong pricing power lead to profitable SaaS businesses, aim for LTV:CAC ratio > 1 for long-term profitability, factors affecting LTV include retention, pricing power, and cross-selling, CAC influenced by marketing spend and sales difficulty.
SaaS businesses with high switching costs and strong pricing power can create a profitable business model due to their stickiness. These businesses often have no real substitutes, leaving users with no choice but to continue using the software despite potential abusive pricing. The Lifetime Value to Customer Acquisition Cost (LTV:CAC) ratio is a crucial metric for evaluating a SaaS business. A ratio of 1 indicates breaking even on the customer, but a business should aim for a ratio greater than 1 to ensure long-term profitability. Factors affecting LTV include customer retention, pricing power, and cross-selling opportunities, while CAC is influenced by marketing spend and the difficulty of the sales process. Workiva's experience illustrates the importance of understanding these factors, as their failed attempt to target the SOX reporting market led to a significant increase in customer acquisition costs. Ultimately, a successful SaaS business must balance customer acquisition costs with long-term revenue growth.
Maintaining a healthy CAC to LTV ratio and exploring demand aggregation opportunities: Focusing on customer acquisition while considering demand aggregation for increased efficiency and profitability is vital for a growing business.
A healthy customer acquisition cost (CAC) to lifetime value (LTV) ratio is essential for a company's growth. If the ratio becomes too large, it may indicate that the company is focusing more on retaining current clients than acquiring new ones. This discussion also touched upon the concept of demand aggregation as a valuable business model. Aggregating demand can lead to increased efficiency and profitability, as seen in distributors, content platforms, and other industries. The difference between aggregating attention and aggregating demand lies in the fact that attention is a finite resource, while demand can be seen more as a physical product or service. The creation of more attention through technology, such as mobile devices, has expanded the potential for ad time and revenue generation. Overall, maintaining a focus on customer acquisition and exploring demand aggregation opportunities are crucial elements for a growing business.
Effectively aggregating and engaging attention in the knowledge age: Businesses that can harness and monetize attention will be well-positioned for success in the knowledge age, where attention is a scarce resource
In today's world, attention is a valuable and scarce resource, and businesses that effectively aggregate and engage it can create significant value. This was discussed in relation to a quiz app that has raised significant venture capital to fund large cash prizes and has amassed a large user base. Monetization strategies for such a business could include allowing users to attempt additional questions in exchange for watching ads or other forms of engagement. This idea ties into the broader concept that in the knowledge age, attention has become a more scarce resource than financial or physical capital. As human capital becomes increasingly valuable, the output of that capital is often poorly reflected on financial statements. Businesses that can effectively harness and monetize attention will be well-positioned for success.
Understanding the value of human capital in business: Human capital's value goes beyond quantitative measures, evaluating it is crucial for creating a competitive advantage, and staying true to your unique strengths is key to success in asset management.
The value of a business goes beyond quantitative measures like engineering capabilities or the number of employees. Human capital, or the intelligence and creativity of a team, plays a crucial role in creating a competitive advantage through branding, network effects, and product differentiation. However, evaluating the value of human capital relative to peers or pricing can be challenging and often comes down to a competitive advantage analysis. Starting an asset management business requires thinking long-term and staying true to your unique strengths. One common mistake is focusing too much on short-term gains and being influenced by others instead of staying true to your investment style. For instance, trying to cook Chinese food when you're an Italian cook can lead to subpar results. It's essential to understand your competitive advantage and maintain it to provide value to clients in the long run.
Focusing on people and process in asset management: Success in asset management hinges on focusing on people and process, having humility, and iterating on strategies. Firms that prioritize these elements are more likely to succeed.
In the asset management business, focusing on people and process is crucial for success. Performance is an output, and getting these two elements right is essential before even starting to play the game. Firms that are thoughtful about process, iterate on it, and are willing to change things that don't work are good firms. On the people side, having humility and making all voices equal is important. The best insight can come from the least expected sources. Asset management has enormous operating leverage but can also be fragile, especially for single strategy firms with concentrated portfolios. A limited capacity strategy, like having a concentrated differentiated portfolio, is a deliberate choice for some firms. They don't have any ambitions beyond this approach, focusing on being good at one thing. Creating products to meet investor demand can lead to trouble, as people tend to make poor decisions about when to invest. Embedded options in companies like Facebook can get mispriced by the market, and it's essential to consider these factors when analyzing a business.
Understanding Risk and Return in Investing: Successful investing involves subjective judgments about risk and return based on a deep understanding of businesses and the ability to make informed decisions, which can be emotionally challenging but potentially rewarding.
The relationship between risk and return is subjective and depends on the investor's perspective and time horizon. For some, risk may mean volatility or a bad month, while for others, it may mean permanent capital impairment. In the case of options, such as those embedded in companies like Facebook, the value is uncertain and requires a judgment call. Risk can also bring uncertainty, which can have value. Ultimately, being a successful investor requires a deep understanding of the business and the ability to make informed, often subjective, decisions. The skills and structures required also depend on the size and nature of the investment firm. Personal experiences of taking on uncertainty and making bold decisions, like starting a business, can be emotionally challenging but potentially rewarding.
Starting a firm driven by belief in unconventional approach: Belief in unconventional investing led to starting own firm, seeking alignment with large endowments and foundations, influenced by Ray Dalio's 'Principles' emphasis on diverse opinions and open discussions.
Starting his own investment firm was a leap of faith driven by the belief that his unconventional investing approach would be best served by working with large endowments and foundations. This decision was influenced by his desire for concentration and alignment of interests with his clients. A key resource that helped shape his thinking was the book "Principles" by Ray Dalio, which emphasizes the value of diverse opinions and seeking the truth through open and honest discussions. This resonated with the speaker's belief in the power of teamwork and collaboration to make better investment decisions for clients. Overall, the conversation highlights the importance of staying true to one's investment philosophy and finding the right client base to align with that approach.
Engage with podcast community for valuable connections and discoveries: Engage with podcast hosts on social media, leave reviews, and join conversations to expand your network and learn from others in the podcast community
Engaging with the podcast community can lead to valuable connections and discoveries. Patrick encourages listeners to connect with him on Twitter @patrick_oshagos and leave a review on iTunes to help spread the word about the show. By doing so, more people will be introduced to the content and have the opportunity to learn and grow alongside the podcast community. This simple action can make a significant impact on the reach and impact of the podcast. Additionally, engaging with the podcast community can provide opportunities for meaningful conversations and the exchange of ideas. Overall, being an active participant in the podcast community can lead to personal growth, learning, and connection.
