Video Under Production
Section Summary - Four
Course Section 4 - Lesson 6
When all of the cash flows from an investment are known in advance, valuation is straightforward. It's a simple math problem. As stock investors, we will never encounter a situation where cash flows are known with certainty before an investment is made.
We can do our best to estimate what dividends we are likely to receive in the future. But the sensitivity of valuation equations to slight changes in cash flows and risk makes mathematical valuation techniques unreliable and difficult to use in practice.
Instead, we rely on comparable asset analysis. By defining closely related assets, in our case, competitors' stock, we can assess how expensive our target company is relative to other potential investments.
This valuation methodology removes many of the stickiest issues that plague computational techniques like discounted cash flow analysis. By comparing our target company to peers, we only have to estimate the future strength of the target vs. its competitors to evaluate an appropriate valuation level for the company.
Once we have estimated an appropriate valuation range, using multiples such as EV/Revenue, EV/EBITDA, or EV/EBIT, we can then convert those valuation ranges into explicit price targets that guide our buy/sell decisions.
Never Start with Valuation
It's important to remember that the investment process never begins with valuation. If we are to select companies that generate long-term value for their customers (and investors), then we must start with businesses that we understand, believe in, and stand up to scrutiny. Only after we have found a company that checks these boxes should we move on to valuation.
If we instead start the process with valuation, we run the risk of identifying what appear to be attractively priced stocks that seem so because they are terrible companies.
Characteristics of Great Companies
All great companies have two things in common: they grow sales and sell their products and services profitably. Growth and profits happen because of an attractive offer and effective management.
Great companies that do both of these things deserve to trade at a valuation premium compared to weak companies. The degree of the premium they deserve depends on the strength of their growth relative to the industry and their ability to expand profit margins.
As we've seen throughout our work in the course, Texas Roadhouse is a great company. They've been consistent, profitable, and growing faster than the industry. They've done this while delivering a service that their customers love.
If nothing changes about its business, then it's reasonable to expect growth and profits to continue into the future. Because the company is growing faster than the industry, then, of course, its dividends will grow faster than the industry. Finally, because its dividends are growing faster than the industry, the company should trade at a valuation premium relative to other casual dining companies.
When, as we did in section four, you look at valuations for casual dining restaurants, and you see that a company like Texas Roadhouse is valued the same as peers that don't offer the same growth and profit potential. Then you know you have found a valuable investment opportunity.