Video Under Production
The Key Drivers of Value
Course Section 4 - Lesson 2
As we learned in the last lesson, making an accurate assessment of all of the necessary inputs to a Discounted Cash Flow model to calculate the "true" fair value of a stock is, for practical purposes, impossible. But that doesn't mean that we can't learn something about the drivers of stock value from these types of models.
Ultimately what matters in any valuation is:
What are the company's future cash flows?
How much risk is associated with those cash flows?
What Do We Mean by Cash Flows?
When we refer to cash flows, we are specifically referring to cash flows that accrue to investors. For stock investors, this consists primarily of dividend payments.
From the perspective of an investor, we care about the things that affect these cash flows. Generally, there are two levers that companies can pull to increase cash flow.
Sales growth - A faster-growing company is worth more than a slower-growing company, all else equal.
Profit Margins - A company growing its margins is worth more than a company with stable margins, all else equal.
Dividend Growth Levers
Two understand why these two levers matter, imagine a company's income statement.
Cost of Sales: $500,000
Gross Income / Gross Margin: $500,000 / 50%
Operating Expenses: $200,000
Operating Income / Operating Margin: $300,000 / 30%
Interest & Taxes: $200,000
Net Income / Net Margin: $100,000 / 10%
If this company pays out 50% of its net income as dividends, shareholders will receive $50,000 in dividend payments this year.
Think about what could change to cause investors to receive higher dividend payments.
First, the company could simply generate more sales. If the company sold $1.1 million worth of product instead of $1.0 million, assuming margins stayed the same, profits and dividend payments would immediately increase by 10% - making the company 10% more valuable.
Similarly, if the company only had to spend $400,000 producing its products instead of $500,000. Assuming operating expenses stayed the same at $200,000 and Interest and Taxes increase to 225,000 (more profit = more taxes), Net Income is now $175,000 instead of $100,000: Meaning dividends are now $87,500 instead of $50,000. This increases the payment to shareholders and the value of the business by 75%.
Always Look to the Future
While investors want to see sales growth and profit margin expansion, the only way for these two levers to affect the current valuation of a company is if they occur in the future.
A company that has experienced extraordinary growth in the past but is looking forward to mediocre growth has no reason to trade at a higher valuation than a competitor who has grown at a modest pace all along.
The same holds for margins. As an investor, it doesn't matter if a company has expanded its margins for the last five years straight. If margin expansion will be flat in the future, there is no reason to get excited about a company's ability to grow future dividends through efficiency gains.
But My Target Company Doesn't Pay Dividends.
Many publicly traded companies, especially smaller companies, don't currently pay dividends. But that doesn't mean that these two valuation levers don't still apply. Even if a company doesn't pay dividends today, you should expect it to pay them in the future.
Because the expectation is that dividends will come, even if checks aren't cut for many years in the future, how quickly a company grows and how efficiently it can deliver its products to customers matters when valuing its shares.
Applying Valuation Drivers to Texas Roadhouse
How might this knowledge on the key drivers of growth affect our current target company, Texas Roadhouse. Suppose we look back over the last five years (before the pandemic) at the casual dining industry.
Texas Roadhouse put up solid growth numbers. Over those five years, it has grown nearly 75%, putting the restaurant in the top 3 fastest growing restaurants.
As we talked about in section 3 - lesson 5, it's likely Texas Roadhouse won't continue to grow at such a breakneck speed. However, it should continue to grow faster than its peers.
Additionally, operating margins for Texas Roadhouse have been right in line, if not a hair better than average for casual dining companies. Moreover, because TXRH is aggressively opening restaurants right now, the company will likely see margin expansion in the future as new restaurants settle into stable operations.
These factors are both positive signals for where the company's stock should price relative to its peers. In the next lesson, we are going to at how we can compare the valuations of similar companies to find the most attractive stocks in the industry.