The Joys of Compounding by Gautam Baid

# Avoid Physics Envy

### Always Think About the Math, but Avoid Physics Envy

Munger teaches us how to think about arriving at a potential future value, which we can then compare to the current market value of the business to calculate expected return.

In this instance when calculating potential future value, we are forced to think in terms of the math implicit in our assumptions. This method is commonly referred to in finance as performing a "reverse discounted cash flow" operation.

Let's use a simple hypothetical example to explain:

Assume that, we want to buy stock in Company X, which has a market capitalization of \$1 billion. We assume that there are no dividends, stock options, debt, or off-balance-sheet obligations for the sake of simplicity.

The company has \$40 million in owner earnings and a ten-year average annual growth rate of 10%. (the explicit forecasting period in this example). This equates to \$104 million in owner earnings in year ten.

Assume that the market pays an average multiple of 15 on owner earnings for this type of business and that no valuation rerating or de-rating occurs during the interim period. In year 10, this equates to a market value of \$1.56 billion. In comparison to the current market value of \$1 billion, this implies a 4.5 percent annual return. Simply compare this to the expected returns on the other investment options available to you. If the expected return over the next ten years is not even equal to the yield on the top-rated sovereign bond, then owning this stock at the current price would be irrational.

A business may have great economic characteristics, but if the expected returns are greatly inferior when compared with existing alternatives, investors should avoid it. Suppose we want to know under what scenario we could earn a 15 percent annual return from this stock.

What assumptions would be required to hold true to achieve this—and, more important, are they reasonable?

A present market value of \$1 billion and an annual return of 15 percent leads to \$4 billion in market value in year 10. An exit multiple of 15× suggests owner earnings of \$270 million in year 10. This implies an average annual growth rate of 21 percent in owner earnings (on the initial starting point of \$40 million). A hypothetical profit margin of 15 percent suggests sales of \$1.8 billion in year 10. This implies a 21 percent annual growth rate in sales for ten years.

Now we can work with the various assumptions regarding required sales volume growth, trends in sales realization per unit, market share, and so on, and we can assess whether these are reasonable, given the past trends and track record of volume growth, pricing power, profit margins, market size, market share, and competitive advantage.

We also can find out which factor has the greatest impact on future owner earnings and under what circumstances it could change. We then could engage accordingly in a constructive “pre mortem” exercise.

To build in multiple redundancies to act as sources of margin of safety, we should always use conservative assumptions.

We should avoid assuming future growth rates significantly in excess of historical growth rates (both long term and short term), use a reasonable exit multiple at the end of the explicit forecasting period, and apply the method only on stable business models.

The benefits of thinking in terms of long-term expected return rather than a precise current intrinsic value are numerous. This method forces the mind to consider future value drivers. It assists us in determining the appropriate position sizing by comparing the competing investment alternatives available within our circle of competence objectively. It enables us to select only simple businesses with relatively predictable futures. This model cannot be applied to fast-moving technology businesses, but it can be applied to moated businesses that meet basic human needs and aspirations in a relatively unsaturated market with a long growth runway. The rate of change in these businesses' business models is typically slower.

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