In their recent episode of the VALUE: After Hours Podcast, Taylor, Brewster, and Carlisle discussed Francois Rochon – Flexible Valuations. Here’s an excerpt from the episode:
Tobias: Let me read it out. François Giverny, I love the name of that firm. “There’s not much difference between 20 and 25 times earnings. There is between 20 and 60 but between 20 and 25, I’m trying to be too prudent and miss the big picture. If you find a great company and it doubles its earnings every five years, valuation should be flexible.” That’s me paraphrasing, but that’s what he said.
Bill: Yeah, that makes sense to me, because 25 to 20, you’re giving up roughly like 20% in the valuation bleed. What, if you’re doubling your earnings, so you’re up 100, down 20, you are up 80 over what, five years? You’re still doing pretty well. I mean, you’re compounding north of 15%, but from 60 to 20, you’re fucked. That’s a technical term.
Tobias: Here’s the thing. I get no problem with mathematics of it. It’s the likelihood of something doubling every five years. In addition to that, we’re talking about earnings. We’re talking 20 or 25 times earnings. Out of that, you got some reinvestment and you’ve got some dividends, that’s not 20, 25 times free cash flow.
Bill: Yeah, I think he would probably say that he’s using earnings as a rough proxy. That dude knows his stuff. I’m not going to go at him for not knowing his stuff. I’m going to give him the benefit of doubt and think he’s maybe talking about free cash flow.
Tobias: I’m not disputing, I’m trying to understand.
Bill: Yeah, I’m not saying you are. I’m just saying I think he would probably agree with your comment.
Jake: Well, let me do a little inversion here. What you’re really trying to do is protect against compression by not overpaying. Not paying 60 means that if there is compression in the earnings, and even if it was to grow a lot, you get multiple fade like that, you’re going to get hurt. You don’t want to overpay, all right. Well, what’s the difference then between– why not 30 then instead of 25? Well, going back to 15 times, which is the long run normal for an average business, that’s a 50% fade. I don’t see a big difference between 25 and 30 on the fade, so going the other direction, what’s the difference between 30 and 25?
Bill: What do you mean? You’re saying why not take this–
Jake: Why not pay up to 30 then? If what you’re worried about is fade, then the difference between 25 and 30 fading back to 15, is not really that big a deal.
Bill: Well, I think that you can pay a lot if you’re that confident that the earnings are going to grow over time. I do think this is where some of the growth guys, on these smaller businesses– like small and rich, I still think can deliver you really good returns, but I do understand the base rates are not in your favor. But I think that these guys that are doing really, really deep work, would argue that you’re right, the base rates aren’t in your favor, and that’s what we get paid to figure out is the difference between the base rate and the outlier. That’s why we make our money.
Jake: Agreed 100% but the base rate of you thinking that you have some special talent might be less than what is currently self-assessed in today’s market.
Bill: Yeah, well, look, I think in anything, most people fail. I don’t care if it’s business, I don’t care if it’s most customer relationships, I don’t care what it is, almost everything that I’ve seen follows a power law, or I hate to be one of these winners win guys, but the average person that plays football sucks at football relative to the best. I do agree that if you’re the average investor, this is the case for indexing or using some computer-assisted tool or becoming a quant. I think that makes a ton of sense. But a guy like him, he’s made his career by proving that he’s pretty close to the outlier.
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