Company Quality is a tool that illustrates a company’s business quality, to highlight fundamental differences between companies. It’s a set of quantitative scores to reflect qualitative factors. These quantitative scores are grouped into five categories, each assessed on a number of quantitative and qualitative questions structured into different sub-categories. Each sub-category is allocated a number of points and weighted differently according to how important they are deemed to be. The total number of points for these key sub-categories makes up the rating for each category respectively, based on a scale that ranges from 0 to 10. The overall rating for each category is indicated by the size and color’s intensity of the bar shown in the chart below.
Our Leadership rating represents an assessment of the ability of the board and executive team to lead the company in the best interests of the shareholders. Companies need highly qualified management to execute a plan to create long-term shareholder value, even if it comes at the expense of short-term results. A good board and management can make a mediocre business concept profitable, while a poor one can even lead a strong company into crisis.
Our Ownership rating represents an assessment of the ownership exercised for longer-term value creation, Owner commitment and expertise are key to a company’s stability and the board’s ability to take action. Companies with a dispersed ownership structure without a clear controlling shareholder have historically performed worse than the market in general over time.
Our Profit outlook rating represents an assessment of a company’s potential to achieve long-term stable profit growth or resiliency. Over the long-term, the share price roughly mirrors the company’s earnings trend. A company that does not grow may be a good short-term investment, but is usually unwise in the long term.
Our Profitability rating represents an assessment of how effective a company has historically utilised its capital to generate profit. Companies cannot survive if they are not profitable.
Our Capital strength rating represents an assessment of a company’s operational risks and ability to pay in the short and long term. The core of a company’s capital strength is its balance sheet and cash flow. Even the greatest potential is of no benefit unless the balance sheet can cope with funding growth.
In fundamental analysis the intrinsic value of a stock represents the discounted sum of all future (but uncertain) net payouts that will accrue to an investor from the company’s operations. At Redeye, we use a discounted cash flow (DCF) model to discount future cash flows back to today at a rate that reflects the riskiness (or uncertainty) of those cash flows. But we don’t primary employ the DCF model as a method of determining a definite value, but rather as a way of understanding uncertainty about value.
In addition to our cash flow-based analysis we often use a comparables approach to make snapshot comparisons between similar companies within industries or to measure value versus sector or market averages. Only to indicate whether it is fairly priced relative to some benchmark or peer group in the short term. In essence this gives a “quick and dirty” way to indicate how much investors are willing to pay for similar companies today. Yet price and value are two very distinct concepts.
As far as DCF modeling is concerned, at Redeye we assess the risk/reward by determine what we think a company is worth today (Base Case), what it could be worth on the upside if management executes its business plan (Bull Case), and what the downside could be if the company stumbles (Bear Case). The key here is to allow for outliers by focusing on the range of possible outcomes, from upside to downside scenarios, rather than a single most likely scenario. Daniel Kahneman once explained this, “Plans are best-case scenarios. Let’s avoid anchoring on plans when we forecast actual outcomes. Thinking about ways the plan could go wrong is one way to do it.”
When it comes to probabilities, we always try to think like a statistician to generate an unbiased baseline prediction, when assuming probabilities of those scenarios. But we also try to use specific information about the case to adjust the baseline prediction, if there are particular reasons to expect the optimistic bias to be more or less pronounced in this project than in others of the same type.
Instead of trying to project a company’s cash flows to infinity in our DCF models, a terminal value is applied to cash flows beyond the next two to three years. For many high-quality businesses, the calculation of this rate can be sensibly informed by their exposure to structural growth drivers, which, in turn, can justify higher growth rates than GDP. The structural growth component can be driven by secular market trends, technological leadership, a superior business model or any type of durable competitive advantage.
At Redeye, margin of safety is heavily conscious of what could go wrong, not what the discount is to fair value. We argue that a reasonable margin of safety is achieved when a stock is purchased at price below or on par with our Bear Case. Looking more closely at the Bear Case scenario will help one to have a more balanced view than just focusing on the potential upside in the Bull Case scenario. Hence, Redeye’s concept of valuation range enables conviction to buy when everyone else is selling. Though, any worst-case scenario is often more consequential than the forecast itself.
The Bull case serves the sell discipline in order to identify a potential exit. The key here is to really think long-term in the bull case and be patient. Patient enough to hold good investments at least until the market is willing to recognise its full potential. Once a position is taken, the Bull Case will help to avoid premature selling. Just because prices are not attractive enough to buy is not a reason to sell. However, a position in a company should be sold entirely when the share price reflects the Bull Case or when cash is needed to take advantage of a superior opportunity elsewhere.
Catalyst Potential is a tool for our analyst to flag specific catalysts that may drive the share price. Investors can use it for identifying and analyzing ongoing or future events that will have a significant impact on performance of publicly traded stocks. In dealing with the future, we think about four things: (a) Catalyst Type; what might happen, (b) Potency; the potential impact on the share price if it happens, (c) Likelihood; the probability of that it will happen, and (d) Time frame; when it is expected to happen.
Identify important events (short and longer term in duration) that could be catalysts to cause the stock to perform significantly different than its peers or the broader market, i.e. what will need to happen to drive a change in investor perception and share price? Don’t just assume pricing will be up.
Estimate the potency of the event to move the share price up or down and the likelihood for respectively up- and downside scenario to occur rated on a scale of 0 to 3.