Category Archives: Investing

Grounding Software Multiples

Software companies are generally valued for their high growth while profitability measures are often overlooked. Twilio, a recent software IPO, is currently trading at 17x it’s next twelve months estimated revenue. In an effort to “ground” software valuations, I backsolved fundamental indicators which enable us to observe a company’s fall from the sky towards a valuation closer rooted to traditional fundamentals.

The model works as follows:

  • Share price x basic shares outstanding
  • Adjust for capital structure (add cash, subtract debt) to arrive at enterprise value
  • Input a required rate of return (we’ll use 15%, for our example)

[iframe src= “http://kfguiang.co/xls/Software/Theorems/RequiredIRR.htm” width=”100%” height=”400″]

Here, we observe Twilio’s financial profile. We analyze its current growth rate, and its current cost structure. There are two possible drivers of returns:

  • High growth, low margins
  • Low growth, higher margins

As we see here, companies with a higher rate of growth typically have lower margins
[iframe src= “http://kfguiang.co/d3/scatter/index.html” width=”100%” height=”420″]

Furthermore, our analysis reveals that at below $1.0bn in annual revenue, growth is typically expected in the range of 15 – 20%
[iframe src= “http://kfguiang.co/d3/growth/index.html” width=”100%” height=”420″]

At this point, we can start rationalizing our target’s growth rate: for how long can it sustain its current growth? Once we determine this, we can observe how aggressively our target is currently investing in growth:
[iframe src= “http://kfguiang.co/d3/barchart/index.html” width=”100%” height=”420″]

We can further refine our analysis by observing cost structures across all companies within the software universe to ground expectations in where costs can be optimized or whether certain cost structures are sustainable:
[iframe src= “http://kfguiang.co/d3/boxplot/index.html” width=”100%” height=”420″]

Here, we can “sanity check” where we believe growth will come from. The following table sensitizes margin achieved versus implied revenue:

[iframe src= “http://kfguiang.co/xls/Software/Theorems/GrowthImplied.htm” width=”100%” height=”420″]

 

 

 

Investment Models

Macroeconomic Model for Growth

Simple Diagram which outlines the relationship between growth and inflation.

drawit-diagram-13

Risk Return Profiles for Various Asset Classes

Once we develop an understanding for trends in macroeconomic environments, we can begin to select which asset classes to diversify in to. In general, investors should be compensated marginal returns for marginal risk assumed.

[pdf-embedder url=”/xls/Theorems/Risk%20Return%20Profiles.pdf”]

 

Assessing Risk

Risk compensation is determined by our degrees of understanding with an important emphasis on truth versus belief. The more we cannot assess, the higher degree of risk we take on (and theoretically, higher degrees of return). As such, contemplate the returns of the following asset classes:

  • US Treasuries: guaranteed return (based on ability of the US to raise interest rates)
  • SP500 Stocks: returns affected by industry competition and ability to execute
  • High Yield Bonds: returns predicated on cash flows aligning with liabilities
  • Leveraged Buyouts: can the business be turned around?
  • Venture Capital: can the company capture market opportunity?

drawit-diagram-14

Assessing Market Opportunity

drawit-diagram-15

Resource Market

drawit-diagram-16

 

Restaurant Model

Theoretical P&L for restaurant startup. Buildup on left, income sensitization on right. FIgures in blue box represent considerations to model in the future.

Primary model will include breakeven analysis resulting from 1. initial investment (furniture, equipment, licenses); 2. cash flow over time 3. potential liquidation opportunities (sale) in order to arrive at theoretical IRR.

My assertion was that IRR for a restaurant should exceed 25% (roughly equivalent to that of a venture capital investment) given the high degree of effort required to operate the business.

[pdf-embedder url=”/xls/Restaurant/Restaurant%20Model.pdf”]

 

Capital Deployment Decision Making

Secular Shifts
per Credit Suisse

  • Increased R&D spending, opposed to Capex

Capital Deployment

  • Organic (Capex, R&D) – Increased output, increase market size, new products
  • Inorganic (M&A)
  • Shareholder Returns (Dividends, Buybacks)

Corporate Life Cycle

  • Increasing returns & reinvestment (growth)
  • Diminishing returns (fading)
  • Average returns (mature)
  • Below average returns (restructure)

Deployment Considerations
per Credit Suisse

Building A Framework for Future Earnings Considerations

To demonstrate “fair” values for equity issues, I’ll elaborate on techniques in credit analysis to identify illustrate the relationships between bond yields and equity yields.

Components

  • Credit Analysis: franchise power (reputation), capital (leverage), earnings power
  • Yield to Maturity: market price, coupon, term to maturity (and here, sketch relative yields for different credit classes & characteristics of each class)

Financial Risk Profile Assessment
(per Standard and Poor’s)

Default Probability
(per HomeProtect.uk)

Switching Costs

  • Financial switching costs (e.g., fees to break contract, lost reward points)
  • Procedural switching costs (time, effort, and uncertainty in locating, adopting, and using a new brand/provider)
  • Relational switching costs (personal relationships and identification with brand and employees)

Per Wikipedia