Use Owner Earnings and Opportunity Cost to Drive Valuation Decisions

During their recent episode, Taylor, Carlisle, Ben Beneche discussed Use Owner Earnings and Opportunity Cost to Drive Valuation Decisions. Here’s an excerpt from the episode:

Tobias: When you construct a portfolio, what is the sizing at initiation? How big would you let something get? What’s the criteria for buying, and selling and so on?

Ben: Yes, I mentioned 15 to 25 investments total. That’s pretty top end skewed, so 80% of the assets are in the top 10 investments. Then, we think there’s some value to having a tale of smaller investments where reduce the mental friction associated to being able to increase or decrease the size somewhat quickly as a behavioral element as opposed to a purely rational type of thing.

But the sizing beyond that is driven by, A, our approach to valuation. We like to see cash flows upfront as opposed to somewhere in the ether. So, we just think about basically normalized free cash flow yield this year or next at the very latest. We call that owner earnings, but it’s pretty much synonymous.

We’re looking to buy things that are owner earnings yield somewhat better than effectively what our opportunity cost is. For us today, that’s around 6.5% things that we understand and pass our criteria, but it definitely has to better than long-term cost of money. So, call it 4% today in the US, 5% very, very long-term. So, we’re trying to buy a lot better than that and sell when you’re getting down to the 3% type of range. So, sizing is a function of that valuation.

And then, we also implement a checklist. So, borrowing from Daniel Kahneman System 1, System 2 type of thinking, we’re trying to bring some of these things account, but can’t be counted into the realm of something, and make sense of and actually quantify or at least form a discussion around. That checklist is married with evaluation to bring us an idea of where we should be sizing or at least what we should be thinking about when it comes to sizing decisions.

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