I remember working at my Uncle Lou's garage when I was still in high school. He was teaching me how to paint cars. There is one chunk of Uncle Lou's garage wisdom which I think is worth sharing as it applies to business and investing. He would tell me to treat the garage as if it were my business. He wanted me thinking this way mainly because he didn't want me wasting sandpaper but it had a bigger impact on me. Uncle Lou passed away late Thanksgiving night but his teaching's live on.
How does this apply to investing?
When you invest in a company, you become a shareholder. What does it mean when you become a shareholder? It means that however small, you own a piece of the business. When you buy a stock, you are essentially becoming a partner in the business. You are buying the assets of the business as well as the potential for future revenues and income. Whether buying one outstanding share or every outstanding share, you should employ the same style of investing. My articles are not intended for those who trade stocks. My articles are intended for those who wish to own businesses. While it would be great to own a hundred percent of a company, for now we must pretend that our small stake represents the entire business. So then, how does it make sense to trade your company based on price movements? That would make as much sense as selling your house every time real estate prices jump 5%. In my opinion, if you aren't interested in becoming a business owner then you are better off investing in mutual funds.
I am a shareholder of Dolby Laboratories (DLB) and this is why I've decided to become a partner in this business:
Thinking as a business owner, I am concerned about two things, cash and margins. DLB is a company that has continually grown both.
This graph depicts DLB's margins over the last ten years:
As the sole owner, net income according to GAAP has no impact on my business other than for paying taxes. However, what does impact my business is the cash that the daily operations of the company generates. To figure this out, I have to convert GAAP accounting to cash accounting. This is done by taking Net Income and then adding back depreciation, amortization, extraordinary gains and any other non-cash expenses. I then subtract out all net capital expenditures for the year.
For comparison purposes, here is the Net Income of DLB for the last ten years according to GAAP.
|Net Income (in $M)||$31.0||$39.8||$52.3||$89.5||$142.8||$199.5||$243.0||$283.4||$309.3||$264.3|
And here are the earnings as if I were the sole owner.
This graph depicts DLB's equity & Owner Earnings:
In some years the GAAP Net Income came close to actual cash being generated. Yet, over the past ten years I know that DLB made an additional $35M than what was reported to the public.
Of course, the value lies in the future cash flows, not the historic. To determine the growth rate of my future cash flows, I like to use the median of the Cash Returned on Invested Capital (CROIC).
|CROIC (Perf from various periods)||38.5%||38.5%||38.5%||38.4%||49.2%||51.0%||38.5%||38.5%||38.5%||38.5%|
The issue forecasting cash growth is that DLB has had a high CROIC over the last ten years. I cannot reasonably expect DLB to continue to grow cash at a rate of 38.5% every year. However, I think it is fair to expect DLB to grow cash by 30% next year and then gradually decrease over the next ten years. By the year 2022, I forecast DLB to have slowed the cash growth to about 14.9% (which is still good compared to other publicly traded companies).
|Forecasted Owner Earnings||$349.6||$447.4||$568.3||$716.0||$880.7||$1,065.6||$1,278.8||$1,540.6||$1,824.5||$2,127.1|
I require a discount rate of 15% because at this rate, the investment would double every five years. When I discount all of the forecasted cash to today's value, I can then calculate that Dolby Laboratories should be worth right around $4.352B or roughly $40.50 per share.
If I extend my terminal value another ten years and assume very conservative cash growth of 5% in the year 2023 and bring it down to 2% by 2032, I am able to forecast the following:
|Forecasted Owner Earnings||$2,233.5||$2,322.8||$2,415.7||$2,512.4||$2,612.9||$2,717.4||$2,798.9||$2,882.9||$2,969.4||$3,028.7|
Again, requiring the discount rate of 15%, I value Dolby Laboratories at about $7.512B or roughly $70 per share compared to the current share price of $33 (roughly a 53% discount).
This doesn't mean that I expect the market to push DLB's share price up to $70 or even $40.50 any time soon. It might be one, two, five or even ten years (or longer) before the market catches up to DLB's cash value. But I don't plan on ever selling this company for any price so the time table is no worry to me. If anything, the market may push the price down before it pushes the price up which would allow for an even better buying opportunity. The point is that price is what you pay and value is what you get. The other point is there is a lot of value in DLB and that it is a company that will continue to do very well for its owners.