9 Valuation mistakes | Mistake #2 Underestimating expenses causing unrealistic profit

9 Valuation mistakes | Mistake #2 Underestimating expenses causing unrealistic profit

This is Andrew Stotz of A. Stotz Investment
Research to talk to you about the top nine valuation mistakes and how to avoid them. This is Mistake #2: Underestimating expenses
causing unrealistic profit So, let’s review the top nine valuation mistakes. #1 Overly optimistic revenue forecasts #2 Underestimating expenses causing unrealistic
profit #3 Growing fixed assets slower than revenue #4 Confusing growth Capex with maintenance Capex #5 Forecasting drastic changes in the cash conversion cycle #6 Underestimating working capital investment. In fact, by this point, you may have said,
“Hey, Andrew, are these valuation mistakes or are these forecasting mistakes?” They go hand in hand. You get your forecast wrong, your valuation
is wrong. #7 Valuing a stock using the calculated Beta #8 Choosing an unreasonable cost of equity #9 Not properly fading the return on invested
capital Let’s talk about #2: Underestimating expenses
causing unrealistic profit. What I’ve done in this particular tiny little
table is I’ve taken 17,000 companies from across the world and I’ve added all of them
up into one balance sheet, one income statement, and one cash flow statement; and I’ve done
that over a 15-year period rather than just looking at the most recent years or over some
portions of the economic cycle. Over 15 years, what I can say, definitively,
is that the net profit margin of companies globally is 5.5%. If the times are good, it’s going to be a
little bit above that; when times are bad, it’s going to be a little bit below them. So that’s a helpful number for us as we’re
forecasting. Of course, different companies and different
industries are going to have different levels. So this is really just a global concept. Let’s take the P&L and bring it down to the
next level of detail. We’re going to see that we’ve got the same
100 at the top and we’ve got the same 5.5 at the bottom. But the key thing is that the cost of goods
sold ─ in this case, I call it “cost of goods & services” because when we’re looking
at every company in the world, we could be talking about a service company or a manufacturing
company. But the point is that 70.4% of cost of goods
sold or COGS account for 70.4% of revenue. Now, if you look at SG&A, it’s pretty big
at 15.1. It’s the second biggest one but not by a large
margin. Cost of the goods sold is the critical item
to forecast. Now, let’s just look at this. First of all, don’t confuse gross profit which
is a dollar amount with gross profit margin which is a percentage amount. We can arrive at gross profit by looking at
revenue minus cost of goods sold or cost of goods and service; and then, we arrive at
gross profit margin by gross profit divided by the revenue. Analysts tend to be overly optimistic and
forecast a high or rising gross margin. So I want you to be careful when forecasting
because a small percentage change ─ even a 1% increase in gross margin ─ can have
a massive impact on the net profit. Let’s look into the value model that I use
for valuation and in the Valuation Master Class. Here, we can see that somebody has forecasted
30% gross profit margin when, in fact, it was 25% in the prior years. So the analyst forecasting it would have to
really justify why it’s going to jump from 25% to 30% and then to 32%. In this case, the analyst, the person forecasting,
didn’t really think about it; and they made a mistake ─ the second most common mistake. So let’s look at this: Analysts should realize
that it is very hard for a management team to sustainably increase the gross profit margin. I’ll tell you a story about my coffee business,
CoffeeWORKS. Basically, we have had a margin of about the
same for almost ten years. We’ve tried to hold it higher than the industry
average but we’re trying to hold that up and be as strong as possible. I can tell that, first of all, it’s easy to
fall on your gross margin if you’re not focused. But if we want to raise our gross profit margin
─ which is where analysts usually are overoptimistic and expecting it to rise ─ just by one percent,
it is damned hard. We’ve got to think about the cost of the raw
material coming into the business, mainly the beans. And that’s core thing. If we can reduce the cost of those beans,
we could potentially improve the gross profit margin. I do want to highlight a book. This book is just fantastic: Understanding
Michael Porter. For any authors out there, to get a 4.8 out
of a 5-star rating is just like “boom” off the charts. Joan Magretta has got this book and she has
been working with Michael Porter for years so she’s really distilled it down. And what I liked about this book was the idea
that to forecast changes in gross profit margin, an analyst should study the supply chain. Now, that’s my advice to you but part of that
comes from that book. You want to review the cost of raw materials
going into the process, how management action as well as industry factors may impact this. I think the message I got from this book was
that when Michael Porter talks about building a competitive advantage, a lot of that competitive
advantage comes from a different supply chain. The IKEA is an example where they decided
to do the supply chain as small flat boxes because that would make things easier to ship. And what Michael Porter talks about is that
building a competitive advantage is about building a different supply chain. Why is that important? If we can see that 70% of cost are cost of
goods sold, then that’s part of where you build your competitive advantage. If you build your competitive advantage by
having a little bit more efficient sales and general and administrative part of your business,
you’re only potentially impacting 15% of your revenue. That’s where I learned a lot from that book
and that’s what we’re talking about now. Let’s look at some common valuation mistakes. This is some academic-style research. I remember when I finished my PhD and my dissertation,
I walked away and I made this PowerPoint right here for my professor. I said, “I understand you academic types
and here it is. • First, when we want to do a research,
we ask a question. • The second is we summarize previous research
to see if that question has already been answered. • Then, we formulate a hypothesis to test
our question. • And we select a relevant data set and
we remove errors and outliers. Are we testing Asia or U.S. or the world? • We look at a method and formulate a methodology
to test the hypothesis. • And then, we get our results and we present
and we analyze these results. That is the academic framework but I added
on another action advice on how to apply to improve investment
decisions. Let’s go through this. If you see a poor rat getting a syringe into
it, it means I’m talking about some research. The question I’m going to ask is “How accurate
are analysts’ net profit and net profit margin forecasts in Asia?” I’ve looked at non-financial companies listed
in Asia including Japan but excluding India. To be included, the company must have 10 years
of actual data. There must be, at least, ten analysts covering
the company. The result is 540 of the largest companies
in Asia; and the point is that this is a study of large cap because that’s where analysts
are forecasting the most. We consider estimates made one year before
the actual results were released. Now, this is some of the academic work that
I’ve done on the forecast accuracy of analysts. Have you ever watched CNBC and they say, “Hey,
this company has beaten its forecast or the Street estimate by one cent”? How can that be? I was an analyst for 20 years forecasting
companies. I don’t think I ever got one cent close to
a forecast. Here’s the reason why: First, the companies
are feeding the analysts a huge amount of information compared to other places. But the second thing and, more importantly,
is that rarely are we talking about a forecast that’s over a long period of time. It could actually be a week’s forecast ─ in
other words, CNBC commentators pulling the latest consensus forecast just that day. And that latest consensus forecast for the
period and time that the company is reporting has been updated over and over and over. So it’s not they missed by one cent; it’s
that they reduced the measuring period of a miss. If CNBC really wanted to get tough, they would
go back one year prior and say, “One year ago, this is what people expected as far as
EPS and, today, this is what the company delivered.” And that’s what I’m doing in this. So, first, I’m going to show you the situation
here. I’ve assumed that a deviation of 10% is accurate. If the analysts forecasted a hundred and the
company produced a hundred and ten, it’s accurate. If the company produced ninety, it’s an accurate
forecast. The chart shows the percentage of companies
where analysts’ forecasts were inaccurate by sector. So what we can see is that, in the best case
sector, telecoms, it shows consensus net profit forecast and it’s the only sector that’s better
than a coin flip. In fact, if we want to look at some
of the other sectors, what we can see is that the telecom sector is that ─ 42 companies,
on average, 50% of which were accurate, meaning, 42 were inaccurate. But what we can see is that energy and materials
were the least accurate of the sectors. And that gives us an idea of how bad or how
tough it is to forecast earnings. Now, let’s look at net profit margin volatility. What I’m looking at is the volatility of the
company’s margin over a period of time. Over the past decade, the highest variability
in net profit margin was in the utilities followed by energy. This is not saying that this is analysts’
forecast. We’re just saying what sectors are most volatile
when it comes to net profit margin. Now, the least volatile was consumer staples
and telecoms. These are the products that people are consuming
every day. In fact, when was the last the time you said,
“I’m not going to use my phone anymore because the charges are high?” ─ that doesn’t
happen very much in the telecom space ─ or “I’m going to stop drinking my morning coffee,
my consumer staple. I’m going to stop drinking that because prices
have gone up.” Ain’t going to happen! Now, what we can see from this is that the
biggest error actually comes from utilities which is a little bit odd because you’d think
that utilities are stable. But I would say that part of this has to do
with ─ first of all, utilities’ net profit margin is a function of the fact that utility
companies, oftentimes, have subsidiary investments that they’re investing in and that can cause
a lumpiness, plus there is a very lumpy nature to a utility company. I think that’s the reason. I haven’t looked into it in more detail. You may know more about it than I do. But that’s what I see. Let’s just use the period 2007 to 2016 that
we’ve just been looking at. And what we can see is that all the data that
comes out of this study over the past decade ─ net profit margin in the utilities sector
was as high as 16.5 and low as 3.5. In the consumer staple ─ coffee ─ the
net profit margin was most stable at 4.9 being the highest and 4.0 being the lowest over
the last ten years. Let’s look at a few quick case studies. Here is a company from Indonesia. It’s a real estate company. I looked at an analyst reports and the analyst
said, “We cut our 2016 forecast net margin to 17.8% to reflect the expected rise in interest
rates given the company’s plan to develop its Bandung project and existing high-rise
projects this year.” Now, you already may say that a net profit
of 17.8% is pretty high compared to the 5.5% that I talked about before. But the reality is that the real estate sector
tends to have a very high net profit margin. In 2016, consensus overestimated net margin
by 15 percentage points. In this case ─ the analysts as well as the
consensus ─ we can see that in 2016, the consensus was 20% and the actual was 5.5%
If we look at this particular company, what we can see is that the main reason for the
massive fall was weaker product mix, higher interest costs from higher leverage, and elevated
minority interest. Let’s look at another one. This is BTS, the Skytrain in Thailand. We have an analyst saying, “We think that
the anticipation of new state mass-transit projects will provide a significant earnings
upside for BTS expecting 2017 forecast net margin to be 33%.” Already, that’s a little terrifying ─ 33%. So what we can see is that the consensus overestimated
net margin by 11 percentage points in 2016. It didn’t come in at 33.3% that they had expected. Why did this happen? Unlike this analyst’s prediction, the net
margin declined to 24.3%. We can see that the main reasons were smaller
profit at the infrastructure fund that they have, VGI, and the property business and higher
interest expenses and losses among associates and JVs. So it’s very common that I see analysts being
overly optimistic and then the company not being able to deliver. Let’s look at another one. This is Media Prima in consumer discretionary
─ meaning, not like coffee which is consumer staple Consumer discretionary means people could
turn it on and off like buying a car or something like that. With the Summer Olympics and Euro Cup this
year, we still expect TV adex to grow at 5% YoY in 2016 and maintain our Fiscal Year 2016
net margin estimate of 9.8%. The problem is that for that period, 2016,
the net margin actually came in at minus 4.6. What happened for this company? Due to higher than expected losses at associate
Malaysia Newsprint Industries and higher depreciation, they had a loss. These are just some specific examples of companies
and forecasts that have analysts have done. What have you learned from this video? Number one, on average, cost of goods sold
account for 70% of revenue. You also learned that net margin is 5.5% throughout
the economic cycle over the last 15 years. You’ve learned to reduce forecasting focus
to mainly revenue and cost of goods sold. The rest of P&L doesn’t matter as much. And, most important, curb your optimism in
the area of forecasting. Stay optimistic in life. There you have it! We’ve gone through the nine valuation mistakes. We’ve looked at #2. Next time, join me and we’ll look at #3: Growing
fixed assets slower than revenue. See you there!

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About the Author: Oren Garnes


  1. Wonderful Andrew Stotz, I enjoyed watching first two mistakes in valuation videos and I learned something new. I was waiting for these videos since a while. Please keep the good work up and produce the remaining videos on Top 9 mistakes in valuation. Again I will be waiting for those. After that, i would expect a series of videos on valuation methods (DCF, Relative valuation, etc.). Please return back to the world what you have learned in over two decades of experience in investment industry. Thank you very much for the initiative

  2. Great points re Gross Margin… One person who's mastered supply chain optimization is Michael Dell.
    The GM / supply chain analysis doesn't hold true for software companies which have low COGS though.
    The more intangible the product sold, the more important SG&A + R&D vs COGS

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