GWV 014: Flight Centre Analysis

Download PDF Analysis of Flight Centre Travel Group (FLT) HERE.

Download PDF Analysis of Lovisa (LOV) HERE.

Download PDF Analysis of Nick Scali (NCK) HERE.

Over the last nine episodes we covered a number of different topics which together form the basis of valuing a business’ intrinsic value. I began the Investor Education Series in Episode 2 with a brief Overview of my Investment Process. My basic investing concept is to find the best businesses out there and increase my understanding of these businesses so I am ready to invest with conviction if or when the time comes that they trade at or below their respective intrinsic values. I outlined the process I undertake to find these wonderful businesses over the next eight episodes, where in Episode 3 I explained how I use a stock filter to find the companies that meet my criteria, then in Episode 4 I ran through how to utilise an investment checklist. Episodes 5-9 covered the fundamentals of valuing a business and Episode 10 we looked at the importance of applying a Margin of Safety to your investments. Thanks very much for listening to my short Investor Education Series and I hope I have been able to help you to better understand a few key fundamental points behind valuing a business. From here you can continue to build your knowledge, which is a never ending process, and begin to make intelligent, fundamentally based,  investment decisions.

Today we will talk about the Margin of Safety. Basically, the Margin of Safety is the difference between the value of a business, its Intrinsic Value, and the price which you pay for that business, its market price. It is different from the Discount Rate and can vary, depending on the perceived risk of the investment. The Margin of Safety is there to; absorb the impact of any unforeseen events that may adversely affect the business or the market in general, minimise the impact of any miscalculations made during the valuation process, allow for small declines in the company’s future earnings power, as well as taking into account your own risk tolerance. It is imperative not to use the Margin of Safety to justify the purchase of undervalued stocks if their fundamentals aren’t sound. As a general observation of the market, investors are happy to buy when prices are high, and they see less perceived risk in the market. Then in turn, when the market crashes and prices plummet, they perceive this situation as high risk and sell. Logically, the margin of risk has now greatly reduced as prices are much lower than they were. If you were to purchase quality businesses at this time, your Margin of Safety has greatly increased. To further increase your Margin of Safety (but not just by purchasing at a lower price) you should stick to businesses that you know and understand. By doing this your evaluations and future earnings predictions will have more meaning and certainty behind them. To know what Margin of Safety to apply can be difficult. Generally, the riskier the investment the higher the Margin of Safety required. I like to set my desired Margin of Safety after first completing my checklist. I will give each checklist item a rating from 0 to 5, with 5 being excellent, 3 being average, 1 substandard and 0 being non-existent. From here I sum my checklist results to give me an overall rating and then divide that rating by the sum of the total points available. For example, say we have 30 checklist items; each item can achieve a maximum score of 5 points, which would give a total of 150 points (30 checklist items x 5 points for each item). If, after conducting my analysis of the business and giving each checklist item a rating, I arrive at a total of 125 points, I would divide my score of 125 by 150, which equates to 83.3% and by inverting that number I get a Margin of Safety of 16.7%, or 100% - my 83.3% checklist score which equals 16.7%. I will then discount my calculated Intrinsic Value of a company by 16.7% which will equate to my preferred purchase price for that company. For example, if I have calculated the Intrinsic Value of a company to be about $10 per share, I will then discount this price by 16.7% to give me my purchase price for that company, which is now $8.33. As a side note, my minimum required Margin of Safety is set to 20%, so in this circumstance I would use the greater of the two and apply a 20% Margin of Safety, resulting in a lower purchase price of $8.00 instead of the previously stated $8.33. I believe this approach is a simple and relatively accurate way to assess a company’s risk and thus allowing me to incorporate a Margin of Safety into my Intrinsic Value calculation.

Welcome to Part B of the two part episode on Valuation Methods. In part A we ran through how to value a business using the Discounted Cash Flow model. This method can be used to value the majority of businesses, especially those that are expected to continue operating well into the future. Today we will take a look at the Liquidation Value of a business. Liquidation Value can be used to estimate the potential investment risk of holding a company, as it provides you with an estimated value you, as an investor, can expect to receive if the company was to go out of business and its assets liquidated. Given shareholders are the last to be paid in the event of a liquidation, it is often the case that they will not receive any compensation for their investment in the business, resulting in a 100% loss. If however the Liquidation Value of the business is say $100 for example and you paid $200 for the business, then you can at least hope to get back $0.50 on each dollar you invested, or in other words a 50% loss total, which is obviously much better than a 100% loss. The Liquidation Value is a method Benjamin Graham developed to estimate a value for the assets of a business if it was to be liquidated. It is basically the Tangible Book Value of a business but adjusted to better represent the liquidation value of its assets. When a business is trading near its Liquidation Value, it obviously has some problems. It would be amiss of someone to expect a struggling business to be able to sell its assets and inventory at Book Value, or the value quoted on the company’s Balance Sheet. This inability for a company to sell its assets at Book Value could be due to the company’s products not being as desirable or in such high demand as it used to, or the industry in which the business operates becoming obsolete. Unless you have the ability to analyse each asset and individually estimate the current market value of the assets, you can instead refer to estimates of the recovery rates for each asset class as determined by Benjamin Graham in his extensive research. 

For this episode we will be discussing two different valuation methods. We will break up the episode into two parts, in part A we will look at the Discounted Cash Flow Model and in part B we will look at how to calculate the Liquidation Value of a business. In this episode we will look at the Discounted Cash Flow method, we will be applying many of the topics we have discussed in previous episodes such as; Discount Rates, Cash Flow and Growth, so if you have not already listened to those episodes I would recommend you go back now and have a listen. The Discounted Cash-Flow Method is one of the most popular and widely used valuation techniques. It is basically the addition of all future free cash flows which have been discounted annually by the Discount Rate, which we discussed in episode 5 of the podcast. This will give us the present value of all the future free cash flows generated by the business. The sum of these free cash flow figures is the company’s Intrinsic Value. We discussed Free Cash Flow in further detail in episode 7 of the podcast. The Discounted Cash Flow formula comprises two parts; the first part is used to calculate the Intrinsic Value of a business during what is generally referred to as the High Growth Period, where the company may have higher but potentially inconsistent free cash flow growth rates. This period is usually calculated to no more than 10 years. The second part is used for the Terminal or Stable Growth Period of the company. This is generally a more conservative estimate of a consistent rate of growth that can be expected for the remaining life of the company. A stable growth rate at or just above inflation is usually acceptable, between 2% - 5%. We discuss growth and how to calculate it in more detail in episode 8 of the podcast.

Today we will be looking at a company’s growth and how we can forecast its expected future growth rate. We will be using the compound annual growth rate formula to calculate the growth rate. I also have a few additional tools we can use to calculate the expected growth of a business in the value investing spreadsheet I created to help me value a business. It is free to download from my website at www.growthwithvalue.com/tools, I have provided a link in the show notes. The Compound Annual Growth Rate formula is as follows: CAGR = ((Ending Value)/(Beginning Value))^((1/(Number of Years)) )-1 Where: Ending Value  = Last published EPS, Dividend or Free Cash Flow figure Beginning Value = First EPS, Dividend or Free Cash Flow for the chosen period Number of years  = Number of years between the Beginning Value and the Ending Value. In summary, we have established that it is important to properly understand the business and its operations to help guide our decision on applying an appropriate rate of growth for the business into the future. We use the Compound Annual Growth Rate formula to calculate the historical growth rate of the business, using either Earnings per Share, Free Cash Flow or dividends, or a mixture of all three, with the result being a good basis to use as the future growth rate of a company. We also understand that the past performance of a business does not always equate to the expected future growth of that business. Again, this is why we need to properly understand the business and the economic environment in which it operates. We also discussed the importance of organic versus inorganic growth and how inorganic growth through acquisitions will provide an unsustainable boost to a company’s earnings. Finally, we discussed two separate growth periods, a high growth period and a terminal or stable growth period. The high growth period is used to apply a higher rate of growth to project the earnings of the business over a given period of time, usually less than 10 years. Terminal growth is a rate of growth usually inline with inflation and is used to calculate the projected earnings of a business into perpetuity, after first accounting for a period of higher growth.

Today we will be talking about a company’s Cash Flow and how to calculate it by using the Cash Flow Statement. We will also look at earnings as reported on the Income Statement. We will compare the two figures to understand the difference between Cash Flow and Earnings. I will also provide a run down on the difference between the Income Statement and Cash Flow Statement. A final point we will be covering is Owner Earnings, this is another earnings figure used by Warren Buffett when he calculates the Intrinsic Value of a business. You will find I have a checklist in my Value Investing Spreadsheet that will help investors look for any manipulation in relation to falsely recording Earnings and Cash Flow that may be attempted by management. I have a link to download this spreadsheet and checklist:  https://growthwithvalue.com/tools/  GuruFocus is a site which provides vast amounts of data and 30 years worth of financial reports, they also include many of the great Value Investors’ formulae within their historical financial data. Here is a link to the website.  https://www.gurufocus.com 

Today I will provide a brief overview of valuation and why we need to calculate a business's intrinsic value. In later episodes I will delve further into some of the different valuation techniques such as the discounted cash flow model, providing you with more detail on how to value a business. In this episode we will primarily focus on the difference between price and value. Intrinsic Value is the calculated value of a business based on its fundamentals such as its level of risk. For example, if the business is carrying too much debt or if the industry under which it operates does not have a foreseeable future, this would greatly increase the risk of the business. Another fundamental item is how much cash flow the business is currently producing or can be expected to produce into the future and also is the business expected to grow and by how much. Intrinsic business value and market price are not always the same. Market price is the quoted stock price you see on exchanges such as the ASX. This difference in price can be due to many reasons, such as; market hype from investors overreacting to news, a difference in valuations and business expectations between investors and also a lack of volume.