The three boxes to check for the perfect case

What to look for in a case which will produce returns

This post is reposted from Investacus.com, my old blog.

If we condense where the total return comes from in a case, it comes down to EPS growth + P/E valuation + Dividend.

So if we consider these three drivers for returns in the topic below, what drives them to increase?

Increasing Net Sales

Increasing Margins

Low valuation

The first two affect the third one in a way where a higher valuation is granted with higher growth and margins. Then, of course, you need to consider many external factors, but we leave them out of the discussion for now.

To illustrate this, I have made the below example with three different scenarios.

Scenario 1: Revenue grows by 10% per year.

Scenario 2: Revenue grows by 10% per year, and the profit margin increases by 10% per year.

Scenario 3: Revenue grows by 10% per year, profit margin grows by 10% per year, and 10% increase in valuation.

As illustrated, the trifecta effect is potent for investors in producing returns.

Essentially over time, these are the metrics we as investors look at to earn a return on investments. The two before are mostly internally driven with some external components, while the low valuation is almost exclusively an external factor.

Let’s look into these three factors and what an investor should look after to estimate higher net sales and margins and conclude the valuation is low.

Increasing Net Sales

There are many ways to increase net sales, either through suitable internal investments in assets or externally acquiring assets through acquisitions. Historically, the achieved growth has not yielded any high valuations. Still, recent times have changed (at least on the Swedish stock market, and a company that promises to acquire can earn a premium for the anticipated acquisition). But they both boil down to return on invested capital (ROIC) and reinvestment rate. Here, can we discuss in ages dividend is a good thing? Doesn’t that signal that the company has limited projects to invest in to earn a return on capital? Or does it signal that the company is overcapitalized and that it is better to let the investors invest it elsewhere? So, in the end, is management good at capital allocation to earn a high ROIC?

One aspect we haven’t yet mentioned is the market the company operates in and has options to evolve into. Are they active in a need that grows significantly and gives the company's assets optionality to develop in other markets? With a market that grows and management that doesn’t entirely fail to allocate the capital, the company, with an almost certain probability, will have higher Net Sales in the future. Adding optionality to their business will also be the runway for increased Net Sales longer than many anticipate.

Increasing Margins

The cause of increasing margins differs from the company's current stage. So the reason can be several things. From a company reaching the infliction point of scalability in their business, a change in their a companies business model, the product and service mix change, shifts in the market goes towards a higher-margin way of distributing their products, price increases without any loss of customers, the price of essential inputs decreases, and many other reasons that are primarily internal but also can be of external causes.

To group it, I would say two internal causes and one external cause. The two internal causes can be divided into a one-time change, and the other is continuous but can be mixed as the past changes, not by a snap of a finger but happens over a long period. I would label the one of continuous nature as ”Moats” and the other I would mark as ”operational development” I hope you see the distinction between the two.

The external cause is problematic as you need to evaluate if the reason is sustainable and will continue or if it will reverse and negatively affect it.

Let’s take an example to illustrate this better. In gaming, we converted from CDs to downloading games digitally. This is an example of a sustainable cause and will continue as it is a better experience for most gaming consumers. It is faster, and you can’t lose your game, but the most harmful side is that you can’t lend it to a friend or resell it. Both negative is positive effects for gaming companies. Meanwhile, the decrease of an input good such as oil volatile in price will most probably be net positive during one period and negative during another.

Low Valuations

Let’s start by asking: What is a low valuation?

Suppose we skip the TINA discussion and focus on what has happened in recent years with digital businesses compared to traditional analog ones. Everything from the product to the distribution and now integration is digital. This means the COGS are much lower as the second creation of the software is no additional cost, and distribution is also common as the logistics costs are essentially zero for software.

In a way, you can argue COGS has moved to Research and Development and Depreciation and Amortization of in-house developed assets. It is a product sold to customers but not consumable as a physical product. So the service will be used again and again. This is shown very clearly by the Visual Capitalist post, which I recommend reading.

This leaves the OPEX costs for admin, marketing, sales, and other operating costs. These are not so different from industry to industry; everybody needs a marketing department, finance, sales, and general costs. They could even argue that there is a need for fewer finance departments and general costs with no factories producing anything.

Below we can see a difference between the traditional and the IT sectors in the average margins. This is quite telling as the IT sector is younger and more immature, hence would entail lower margins.

Source: Börsdata

Let’s also look at the growth side. Reaching 50 million users has never been done faster, and it´s going even more quickly—another excellent visualization from Visual Capitalist.

If we considered, wouldn’t digital companies focus on growing their user base and not being profitable for a few years?

Significantly since the competition can grow as fast, the only option is to grow as fast as possible to establish a user base that they can turn profitable later on. Given the high gross margin of digital companies, it can also be assumed the profit margins will be pretty high.

Also, given that most digital companies are building strong network effects and switching costs, it can be assumed that most users will stay for a long time. With software going from on-premise deployment to the cloud on a SaaS model, the revenue will be recurring and easily managed remotely to update the customer base.

Because of this, wouldn’t a high P/S valuation be valid?

It may sound a little like the arguments in the 99’s, but compared to those companies, at least companies today have revenues and are not valued on the number of eyeballs.

This argument for high valuations is not that high after all when this is a post of finding the three boxes to check for a perfect case where low valuation is one of these checkboxes. But I want to argue you would miss many cases if you look at a P/E valuation and say it is high, given the new possibilities digital products and services give companies unprecedented scalability and to reach more customers than ever before.

But let’s talk about low valuations instead of high ones. A low valuation can be due to being an undiscovered company, a shunned business by investors, a lack of trust in the management, an unfavorable market outlook, and many other reasons. The low valuations connect back to the two other check boxes; you must have a different view than consensus to see any upside in the valuation. Suppose the reason doesn’t connect with the two earlier boxes. In that case, the market may shun the sector, such as gaming companies with low valuations or companies under a particular market valuation. You can have an edge by not having to abide by ESG restrictions or other reasons for the broader institutions not to invest in the asset.

Another way to find low valuations is to look at companies doing their financial reporting according to GAAP in a specific country compared to IFRS. Especially in Sweden, there is a difference in handling depreciation on intangibles; in the acquisition, active companies do this to create visually low earnings; meanwhile, the cash flow is vital. I have taken up this case in two companies in my former podcast Game of Stocks, Awardit and Embracer Group, how these companies’ valuations looked shockingly high but low. All because of accounting differences between Swedish GAAP and IFRS, causing the depreciation is much higher than peers.

Valuation differs from the other two variables as it reflects the expectations of revenue growth and margins. Because of that, you can work both ways, from the valuation to the expected revenue and margin or from the predicted revenue and margin to the believed justified valuation. The same principle is made with DCFs, where you make one conventional DCF find the intrinsic value the asset is worth and a reverse DCF to see what the inherent value is expected.

If anything were to add, it would be a high ROIC as it would combine high margins with capital-light. You can argue that a high long-term ROIC is already taken care of by revenue growth and high margins, but it adds one variable of capital efficiency that the three other check boxes don’t handle. But this will only indirectly support a perfect case and are essential for a case in the long run.

Many of you would argue that there are more areas to consider in a perfect case, and I agree, especially on the qualitative side. I wanted to condense as much as possible, and I will argue that everything else matters for a case, both qualitative and quantitative. It trickles down to either one or two or all three of the checkboxes mentioned above.