In this article I want to outline a framework for assessing the future prospects of a company without the use of crystal balls or almanacs from the future. This controlled framework of thinking will maximise the chances of picking great investments.
Importantly, it will minimise the chances of getting carried away with overly optimistic or pessimistic opinions and potential misjudgement.
First, it’s essential to form an independent judgement rather than rely on the opinions of others – there are countless examples of why investing based on your neighbour’s stock tips is a bad idea. The goal of this thought process is to make sound, independent investment decisions.
First separate facts from predictions
Facts are proven pieces of information and should form a core component of determining value, whereas predictions are not guaranteed and come at a greater risk. The first step is to gather the facts and separate them from predictions / assumptions / opinions.
Mixing both fact and prediction taints factual information with subjectivity. For instance, Nike Inc is a world leader in sports shoes and clothing (fact). Given its market leading position, its sales should continue to grow at roughly eight per cent p.a (prediction). Whilst this growth may be realistic, it is not guaranteed and therefore still a prediction.
There is nothing wrong with making assumptions – all investors do so. The key is to distinguish between an assumption and a fact.
Start with the facts, not opinions
Any prediction of the future should first start with today’s facts. For a company, the current value can be determined with great certainty based on the facts presented in a company’s financial statements. Today’s facts should lay the foundation for the overall analysis of a company’s future prospects. At this point, make no assumptions yet, this is the next component of the company’s value.
For instance, Nike is a powerhouse brand, its low level of debt and its continuing pipeline of patented technologies is a genuine intangible asset that is a threat to any competitor contemplating entering the sports shoes market. It also has a strong culture through the everlasting spirit instilled by founder Phil Knight via his holding company Swoosh LLC.
To value Nike, we should start by focusing on existing facts and ignore any predictions for the time being. Assuming that EBIT remains constant at 2017 levels (we will deal with any growth assumptions separately), my estimate of value for each Nike share is USD $25-$28. This value is my estimate of what Nike is worth based on its most recently announced earnings – no blue-sky assumptions at this stage.
Forecasts – the possible, plausible and probable
Predicting the future is difficult because history doesn’t repeat itself. But for certain companies and industries, forecasts can be relatively stable. For example, Nike competes in markets that are more mature and stable than tech companies like Amazon. We should expect that the growth trend of Nike to be more stable than Amazon.
Leading New York University finance scholar Aswath Damodaran favours the use of three categories when evaluating a forecast: possible, plausible and probable. By evaluating a forecast as either possible, plausible or probable, it becomes clearer to an investor how much reliability should be placed in any forecast.
In the case of Nike, whilst it is possible that new competitors will take market share away from Nike, I think this is not a plausible scenario over the next 10 years.
The probable outcome is that Nike will remain ahead of its competitors Adidas and Under Armour. It will remain a strong brand through its innovative founder-led spirit and its product lines will continue to expand.
I think it is probable that Nike will continue to grow revenues at an average rate of eight per cent p.a over the long run and continue to generate it’s very high returns on invested capital (currently around 25-30 per cent p.a). By separately valuing the growth component of Nike, I estimate that Nike is worth around USD $60 to USD $65 per share (an additional USD $40 for growth).
The point of the framework is to distinguish between fact and prediction and to be conscious of how much weight we are placing in growth assumptions. Place more weight on plausible and probable forecasts, and less of possible. The art of investing is making a judgement call on how much you want to pay for the growth component.
A sensible approach to the unknown unknowns
But even if we correctly value the company and reduced the risk of misjudgement, there are still unforeseen risks which can change its growth trajectory over time.
Unknown unknowns such as wars, political crises, natural disasters may strike and disrupt the original forecasts that were made. These risks will always exist and shouldn’t prevent a sound investment from being made. If we haven’t overpaid for the growth component, the returns should still be attractive.
Unknown unknowns will always exist in the financial markets. Even the most sensible predictions are never guaranteed. One way to approach the unknown unknowns is to judge how likely the company is to survive any external shocks. Unknown unknowns will affect all companies, but those with low debt, strong market positioning and a founder’s spirit will survive these unforeseen shocks. These are the attributes I look for to buffer against the risk of unknown unknowns.
Applying the framework
The framework for predicting the future can be thought of like a tree. The current facts form the roots and trunk, forecasts form the branches and the unknown unknowns form the leaves. Sound predictions will be grounded in a solid foundation of facts. Forecasts should be used, but only if the likelihood is high.
Be wary of placing too much reliance on opinions and promises of performance rather than proven factual results, especially in volatile environments. Sound investment decisions are rarely made purely on blue sky predictions.
In the case of Nike, my valuation is based on a foundation of facts demonstrated by its impressive track record and dominant market position. I have estimated the value of the company based on its current financial performance. This forms the basis of the valuation. An additional portion of value is attached for probable growth which is distinct to the base value. It is clear how much reliance I have placed in fact versus prediction. Whilst there are no guarantees in the financial markets, for a company like Nike, I get added comfort that it should be able to withstand any unforeseen risks due to its low level of debt, strong brand and founder-led culture.
This framework doesn’t guarantee investment returns like the sports almanac, but it does provide any investor with a way of thinking about the future in a sensible manner.
At the time of writing, Lumen was an investor in Nike, but not any other stocks mentioned.
Lawrence Lam is Portfolio Manager & Founder of Lumen Investment Management