I recently gave a presentation at the Sydney chapter of the Australian Shareholders Association (“ASA”). The theme was finding investments that are right for you. That means finding shares, ETFs and funds that are aligned with your goals and your investment strategy. It means finding investments that are intellectually aligned with your view of investing.

This sounds trite. Yet the biggest risk to a positive investing outcome is constantly trading and chasing over hyped investments. The minute we think we’ve figured out tricks and short-cuts for high returns is the minute we start failing. We succeed by being good at investing. Not by picking the “best” investments. It is the process and structure that matters.

At the end of my talk I shared our analyst’s fair value estimates of the three shares I was using as an example. One of my favourite parts of presenting is getting questions. And mentioning our fair values elicited a discussion about using price targets as the sole basis for making decisions. It is clear a lot of investors are doing this. I don’t think it is a great idea.

What is a price target?

You’ve probably heard professional investors talk about how much they think a share is worth. At Morningstar that is our fair value estimate. Some professional investors call this a price target.

Anytime someone tells you how much a share is worth it is a prediction about an uncertain future. That is not how it is portrayed. It is portrayed with a level of precision that is not real. It is a guess. If you are getting it from a reputable source it is an informed and honest guess. But still a guess.

How do professional investors estimate the fair value of a share

Most professional investors use a discounted cash flow model to estimate the value of a share. Step one in the process is opening excel. Step two is figuring out the revenue the company will earn in the future and all the costs associated with generating that revenue and running the business. That gives you an estimate of future earnings. Step three is figuring out the discount rate that will be used to calculate the present value of the future earnings. Too easy.

This is obviously tongue in cheek. Yet it is illustrative of a larger truth. This is hard. Figuring out the revenue earned in an uncertain future is hard. Figuring out the costs associated with that future revenue is hard. Figuring out an appropriate discount rate is hard. Opening excel is easy. We can all aspire to perfecting that step.

But this is not how it is portrayed. There is Warren Buffett for example. He wakes up in the house he bought in 1958 and is worth a rounding error in his net worth. He stops at McDonalds for an Egg McMuffin. He sits in an office without a computer and reads annual reports to collect his $100,000 salary. Next thing you know he is worth $130 billion and his folksy demeaner becomes charming instead of annoying.

How to use a fair value estimate or price target

Any estimate of how much a share is worth is an input into your decision-making process. It is not a substitute for the decision-making process. Like anything in life, the context is important. I don’t know Warren Buffett. But I bet he doesn’t just spend his day driving to McDonalds. In fact, he has said that he eats the same thing for breakfast every day because it saves him the mental energy of deciding what to eat. He spends that mental energy thinking about investing. Thinking about companies and what factors will impact their results. And thinking about a fair price to pay.  

It is easy to fixate on the output of the process of estimating the fair value of a share. Yet it is far more valuable to understand the inputs that went into the process. That allows an investor who is unwilling or unable to put the work in to building their own discounted cash flow model a way to come up with a thesis for investing in an individual share. And lets be realistic – very few individual investors are building their own models.

When investors ask me about Morningstar analyst reports I always point out the most valuable part is reading why the analyst has come to their conclusion. That is what I do when I’m looking at investment opportunities. Understanding the rationale behind a conclusion allows me to do what Buffett does with the mental energy of eating the same breakfast – to think. I can agree with the analyst. I can disagree. I can do some more research into a certain facet of a company. I can assess if the investment opportunity is right for my strategy and my goals.

Here is a checklist to consider when investing in a company:

  1. Is revenue going to grow in the future and by how much?
  2. How much revenue will the company get to keep as profits
  3. What is the competitive environment a company operates within
  4. What are the risks to future results for a company?

Is revenue going to grow in the future and by how much?

Revenue is where we want to start our assessment. Revenue can grow for several reasons. Price increases can grow revenue even if the volume of goods and services sold stays the same. The overall market for a certain set of goods and services can increase if the company is operating in a growing industry. There could be changes in market share if a company is able to win a bigger share of overall revenue for the industry. It is the interplay of all these factors that will ultimately drive revenue growth. And revenue can shrink if these factors go against a company.

The Morningstar analyst report on investor darling Pro Medicus (ASX: PME) can be used as an example. Morningstar Equity Analyst Shane Ponraj writes:

“We forecast a five-year group revenue compound annual growth rate of 17% that is largely driven by our revenue assumptions for Visage 7 in the U.S., which contributed 84% of fiscal 2023 group revenue. We assume Pro Medicus can win four major contracts per year on average versus its typical historical average of three major contract wins per year. We expect this is likely, as it aims to extend the product set to other specialty departments outside of radiology such as cardiology and ophthalmology.”    

Pro Medicus sells imaging software to radiology departments in hospitals. The company focuses on a single product called Visage 7 which makes an estimate of future revenue relatively straightforward. This is a case where the predicted driver of revenue growth is an increase in market share as the company has introduced a superior product. It also involves selling to different departments within hospitals. In this case Ponraj assumes that sales will accelerate over historic levels based on extending the use cases of Visage 7.

This gives me a jumping off point to do some more research. To consider if his thesis is correct I can see why he believes that other hospital departments will use the product and if more radiology departments will use it. Elsewhere in the analyst report Ponraj outlines the advantages of Visage 7 which will be key to winning new clients and extending the use of the product. He writes:

“Many of Visage 7’s current advantages in speed, scalability, and reliability stem from it being developed in more-modern cloud native architecture. Cloud native applications also ensure software engineers can make high-impact changes predictably and scale services as needed with minimal toil.

Visage 7 is currently the only desktop application that supports 2D, 3D, and 4D visualizations in one viewer and as a result, saves hospitals on IT infrastructure such as specialized workstations, as well as servers if opting for cloud storage. Many radiologists are currently still only able to view and manipulate images on specialized workstations after waiting up to 30 minutes in some cases to download large files off a local network. Helping radiologists be more efficient by reducing access time to images is a key advantage for hospitals.

Another major advantage of Visage 7 is its ability to be implemented at a hospital in a fraction of the time compared with competing products. Competitors can often take over a year to migrate data and deploy software versus roughly three months for Pro Medicus if the client requires local servers, or potentially within two days if using cloud-based storage. Lowering disruption and the barrier to change providers is a key factor in Pro Medicus currently winning tenders, with the firm also able to demonstrate and set up cloud-clients remotely.”

I can devote additional time to check this rationale from other sources. That will allow me to form an opinion on Ponraj’s view of revenue growth. I am not a doctor so it could be challenging to come up with an informed view. It is much easier to do research on products and services that I use. That follows famous fund manager Peter Lynch’s call to invest in things we know. Perhaps this is a case where I will follow Buffett’s approach and decide Pro Medicus is outside of my circle competence.

How much revenue will the company get to keep as profits

Revenue growth is great but what matters over the long-term is how much flows to the bottom line as profits. It is important to understand the costs incurred by any business. Those could be costs directly related to creating a product and service and selling it or just general business expenses. This is where we consider the margin which represents the amount of earnings generated from a given amount of revenue.

In this case we can use Woolworths (ASX: WOW) as an example. The amount earned by the supermarkets has been in the news lately due to political pressure. Morningstar Director of Equity Research Johannes Faul had the following to say about Woolies’ margin:

“We do not expect Woolworths to widen its margins toward similar levels it had enjoyed before 2016, as the Australian supermarket sector has structurally changed with the reintroduction of the discount channel. Aldi is taking market share from the established supermarkets, intensifying competition among them for the remaining market. We expect supermarkets to compete by passing on efficiency gains or cost savings to consumers through price cuts, instead of expanding operating margins and potentially losing share. We forecast group earnings before interest and taxes (“EBIT”) margins to remain relatively stable from fiscal 2026.”

This is an easier business for me to understand than a speciality healthcare IT provider. I buy food like everyone else. I understand how price is a driver of where I choose to buy food. The competitive pressures in the industry make it difficult to increase margin by either raising prices above increases in the cost to source products or by keeping any efficiency gains.

If I agree with Faul’s conclusion that margins will the stay the same I can focus instead on how much revenue is being increased as that would be the only remaining source of growth. I may want to explore what factors would cause me to make a different conclusion. Perhaps the competition will get so intense that margins will have to be cut to maintain market share. Perhaps the political pressure will cause margins to fall to prevent action by the government.

This is where it is important to understand the competitive environment of any industry you are considering investing in. In a Morningstar analyst report the moat section contains a detailed discussion about the competitive environment. I can sense check those conclusions with my own research. That is the next area to consider as an investor.

What is the competitive environment a company operates within

I’ve written a detailed article exploring how to find a great company that has a sustainable competitive advantages or moat. For the purposes of this article it is worth looking at the competitive environment and how it impacts the conclusions around future revenue and earnings.

In a highly competitive environment where a company lacks a sustainable competitive advantage the impact of competition doesn’t lead to great outcomes. The company could do nothing and lose market share to competitors. Or a company competes on price which will lower revenue and erode margins. A company might also have to constantly improve their products and services by investing in making them better which will also erode margins.

In this case we can look at former investor darling ZIP (ASX: ZIP) as an example. The company is growing revenue but having a hard time translating that revenue into profits. ZIP still hasn’t been able to earn a profit for a full year although they did manage to make money over the first half of fiscal 2024.

A clue into these troubles can be found in Morningstar Analyst Shaun Ler’s view of the competitive environment in the buy-now-pay-later (“BNPL”) space. Ler writes:

“No-moat Zip faces several challenges in establishing a maintainable competitive advantage. The commoditised nature of payment financing and low barriers to entry contribute to intensifying competition and hinder the development of a durable moat source.

It is challenging for Zip to develop a network effect. The buy now, pay later industry has evolved beyond its infancy, leading to the emergence of more direct competition. Customers have the freedom to hold multiple BNPL accounts, and merchants are not limited in partnering with multiple providers, reducing the exclusivity of Zip's offerings.”

This is a challenging operating environment that Ler describes. A commoditised product and low barriers to entry make it very hard to keep growing revenue while earning profits. This is once again a jumping off point to think about the industry and do some more research. Is there a pathway to a sustainable competitive advantage if they grow large enough? Will the industry change with an evolution in the regulatory environment? Can they outlast competitors until there is a more rational operating environment? All questions to consider as I assess Zip’s prospects.

What are the risks to future results for a company?

Assessing how much a share is worth involves predictions about the future. Different companies face different risks that can impact their future results. I’ve written more about this topic in this article. Assessing the prospects for revenue and earnings in the face of the competitive environment is a starting point but an investor should also consider what might go wrong.

This doesn’t directly impact a valuation model. However, it does impact how an investor should interpret the output of the model. The higher the level of risk the higher the chance that the future predicted within the model won’t happen.

A model can be adjusted in two ways based on the business risk of a company. The first is to increase the discount rate that is used to calculate the present value of future earnings. A larger discount rate will make those future profits less valuable. That can account for the increased risk that outcomes will differ from predictions.

The other way is to build in a larger margin of safety. Estimating a fair value doesn’t mean that is the price an investor should pay. The future is unknowable and the implied precision in a fair value estimate needs to be adjusted. A margin of safety or difference between what an investor thinks something is worth and an investor will pay for a share should be larger if projected outcomes are riskier.

Morningstar Equity Analyst Adrian Atkins outlines the risk to Transurban Group (ASX: TCL) in his analyst report. He writes:  

“While the underlying toll roads are relatively defensive, Transurban has several key risks to consider. Toll roads are capital-intensive and typically require ongoing access to debt markets. This makes them more vulnerable to potential credit crises and economic downturns. Potential deterioration of credit markets could make it more expensive and difficult to borrow, particularly longer-dated debt. There is also the risk of weak economic conditions and pandemic lockdowns depressing toll increases and traffic volumes. Additionally, Transurban has expanded aggressively, which introduces construction and traffic-forecasting risk.”

In this case the underlying business is fairly defensive and results are relatively easy to predict unless less people are driving because of a poor economic environment or return to lockdowns. However, Transurban can’t internally fund all the costs associated with maintaining their network of roads and needs to keep accessing debt markets. This is not unusual and constricted debt markets would have adverse effects on many companies. However, it is a risk that needs to be considered.

Transurban receives a Medium Uncertainty Rating which is our second lowest level of business risk. I can use Adrian’s analysis of the risks faced by the company as a jumping off point to think about all the different factors that will impact the assumptions that drive Transurban’s fair value. If I agree with Adrian, Transurban doesn’t warrant a large margin of safety as a potential investment.

Final thoughts

Some investors may think this process makes intuitive sense and is a good basis to evaluate potential investments. Some may think this is too much effort and requires too much time. If you come to the same conclusion as the professional investor that is not a bad outcome. The process matters. Having a thesis that you believe in matters because that will provide ballast when share prices fluctuate.

if you don’t want to spend your time thinking about individual shares that is not a bad thing. Taking a passive investment approach is more than fine. It is a proven way to build wealth over the long run. Chances are you will do better than most of your stock-picking peers. Chances are you will do better than highly educated professional investors who are paid high salaries to think about investing all day.

My colleague Shani has an investment approach that makes a lot of sense. She focuses on asset allocation because she knows that is the biggest driver of long-term returns. She focuses on minimising the taxes and fees she pays because that is 100% in her control. She lives Buffett’s adage that investing is simple but not easy by not trying to overthink her approach.

Successful investing isn’t about building your own discounted cash flow model. It is about being thoughtful about what actions you can take to achieve your goals. For investors that want to pick individual shares understanding why a professional investor comes to a particular conclusion is far more valuable than the conclusion. More thinking and less blindly following professional investors is an approach that all of us can benefit from.  

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