Generic Company A
I have a mental framework that I use when I look at a new company. I’ve never really had a name for it before, but now that I am writing about it, I call it “Generic Company A.” Pretty sexy, right? It is a loose framework for a company and its valuation. The first step is just thinking about a (generic) company. What is a company? I consider a company to be the total of the capital invested into an enterprise to date. That capital usually comes in as cash: equity, debt, or cash earnings. The company deploys it into its enterprise - creating goods or services - in the form of human resources, physical resources (plant and equipment), or intellectual resources (R&D, brand names, customer relationships, etc.). The company as it stands today is just a snapshot of how the capital was deployed into various resources to date.
Again, this is a fairly generic company, so I think about some basic assumptions. I spent my corporate career working for a large retailer, so I often have a retail company in my head as I think about it. But it could be a manufacturer, software company, or service business. Again, this is an average company with typical characteristics. In my mind, it might look something like this:
Revenue growth at GDP + 1-2%: around 5-6% annually
Modest leverage: debt-to-equity around <50%
COGS at 50% of revenue
Operating margins of 10-20%
Net margins of 5%
A going concern with normal existential risk
In the middle of its life cycle
OK, that’s great, but what is this company worth? Let’s say the revenue is 100. The net income is 5 then. A reasonable price for this normal business growing at normal rates might be 20X net income. This gives the company a PE of 20 and a PS of 1. This sounds pretty reasonable for a decent but not great company. You might argue about some specifics, and we could disagree on what represents an average company, but hey, it’s my framework!
What I like to do with this hypothetical “average” company is compare it to a real company that I’m looking at. It helps me stay grounded when I start to look at things that are usually quite different from average. This is probably just a riff off of Michael Mauboussin’s Expectations Investing. I find it a helpful way to think things through. For example, here are some common scenarios:
Fast Grower: What if a company is a fast grower? Instead of 5% per year, what if you think the company could grow at 10% or 15% per year? Maybe then it’s worth 25-30X net income. What if it is growing but not profitable? Maybe it is worth 2X sales. Or 3X sales.
High Margins: What if you find a highly profitable company? It has 80-90% gross margins. Does this imply that the net margins should be higher in the future? Again, maybe this deserves a higher PE, maybe 30X? Maybe 40X?
Turnaround: What if your company is shrinking or not growing? What if the margins are challenged in the short term? If it is a break-even vs. profitable, what should you pay? PS of .5-.75?
Low Margins: Some industries, like grocery, have structurally lower margins. Maybe net margins are 2-3% on a steady-state basis. Should it have a lower PE? Maybe. Lower PS? Probably.
I developed this Generic Company A framework almost unconsciously. After looking at a number of companies, it became apparent that I was holding each one up to a mental yardstick I developed through experience. This makes it a bit more concrete. It doesn’t eliminate the work required to think deeply about a company and its strategy. Our success as investors does not relate to how the capital has been deployed in the past but how it will be deployed in the future. The company’s life cycle, unit economics, growth, etc., will be more important going forward than the snapshot of today. However, it does give a quick yardstick to discard companies not worth exploring. For example, using Generic Company A, if I am looking at a higher margin company trading at 2-4X sales, that may be interesting. But if it sells at 15X or 20X sales, I will probably not spend much time analyzing it. Or if I do, it will be to wait for a lower price to buy at - or it must be an exceptional company!
Let me know if you have any thoughts on my generic company framework. Or if you have any other useful ways of analyzing a company!