The relationship between company valuation and industry-specific characteristics (growth potential, cyclicality, sustainability)

The most important thing is to overcome human psychology,
which means people need to be rational,
patient, and so on.
Many investors fail for this reason; the second most important is stock selection; the third is valuation.

Valuation is to ensure that after choosing a good company,
you get a good price.
So how do you know what is a good price? Therefore, you need to perform a preliminary valuation of the company,
not too precise,
just an estimate of its approximate value.

So how to perform valuation? The mainstream value investors in the market, including Warren Buffett himself,
all use the so-called discounted cash flow method.
The discounted cash flow method is not a specific formula,
so it cannot be called a precise method.
What we need is a kind of fuzzy precision,
because you cannot deeply understand many things.

It’s like dealing with a person,
you give that person a score,
50 points is fine,
80 points,
90 points, or whatever,
do you think that score can accurately represent that person? Similarly,
valuing a company is the same,
you estimate 5 million,
does it really worth 5 million? For example, two people both score 80 points,
but their performance might be completely different,
you can’t say they are the same.
So everyone should avoid rigid dogma.

Back to the point,
valuation is always better than no valuation,
without valuation, you won’t know how much the company is worth,
so if you want to buy,
you need to compare it with the market price,
so the only way is valuation.

So how to estimate? You can use indicators like the P/E ratio,
return on equity,
many people use different methods,
but each method has its own drawbacks.
Today, I will discuss from several dimensions of enterprise operation.

Since we’re talking about company valuation,
the main idea is to use future cash flows,
future cash flow is how much cash a company can earn each year in the coming years,
adding up over many years,
for example, if you buy a company that can operate continuously for 20 years,
say it earns 1 million this year,
1.2 million next year,
1.3 million the year after, and so on,
you discount these cash flows to get their present value.

Then, this is the value of your company.
You need to consider whether it’s worth buying,
whether the current price is too high,
or whether it is low compared to the current valuation.
You will find it actually has some similarities with the compound interest formula,
it involves two very important parameters.

One is the company’s return rate,
which varies each year,
understanding the change in return rate annually is crucial for valuation.
Therefore,
the growth rate of profit and return is very important,
because the return rate this year only represents the current return,
and next year it will be different.
So, its growth potential is what this means.

The second is the sustainability of the time period,
how long can it be maintained?
If you buy this company,
and it goes bankrupt in two or three years,
that’s not good.
For example, a company like LeEco,
has very good growth potential,
but after three or five years, it’s gone.
Whether this company is good or bad,
it’s a typical high-growth but poor sustainability company.

Some companies may have very good sustainability,
but not necessarily stability,
like steel companies, which can be unstable because they are cyclical,
every three to five years, when the country’s infrastructure construction peaks,
industry profits surge.
But during economic downturns,
profits plummet sharply.

For example, some crane manufacturers in China,
like Zhongke Technology,
these companies mainly produce heavy industrial equipment,
including trucks,
automobiles,
chemical industry,
cement, etc.,
these industries are cyclical,
income and profits are unstable.
And these companies usually have large fixed costs,
which ultimately fluctuate with market demand cycles.
If they are in a trough,
their profits can suddenly drop sharply,
they might increase this year,
but decrease next year.
This shows that their average growth rate is actually quite poor.
So, the long-term cash flow of such companies is not very optimistic.

Therefore,
focus on two aspects:
one is the current profit margin,
which is essentially return on equity.
Current ROE is related to profit margin,
scale turnover, and leverage.
Through DuPont analysis,
you can roughly know what the current ROE is,
and what the future ROE might be.
In fact,
it depends on the current ROE and the company’s profit growth rate.
These two factors determine the growth rate over several years or even annually,
so you need to give an average value.

Thus,
the profit growth rate of such companies is the biggest learning point,
the biggest challenge in valuing growth stocks,
because it involves changes in the industry,
technological changes,
market changes,
and operational changes.
Sometimes, the industry itself is like a pie,
it keeps growing,
which contributes to the growth rate.
On the other hand,
there is endogenous growth.
Maybe the pie doesn’t grow,
but due to industry characteristics,
the entire industry remains relatively stable,
internal digestion is slow,
market share per company is small,
suddenly a leading company starts consolidating and cleaning up the market,
eventually, the market concentration becomes very high,
and it accounts for 80-90%.

For example,
Qingdao Beer played this role over twenty years ago.
Thirty years ago,
the Chinese beer industry was like Germany,
with hundreds of breweries.
But after years of consolidation,
Qingdao Beer gradually increased its market share.
So, this is also a kind of growth,
companies can grow by increasing industry concentration,
because their profits increase each year.

As mentioned earlier,
cyclical industries have lower growth rates,
due to larger fluctuations.
In the first three years, they might grow 50% annually,
but in the fourth year, the cycle suddenly reverses,
and there could be a 200% decline.
Therefore,
the growth rate is a very complex subject,
many growth stocks need to be cautious of growth traps.

The problem with growth traps is overestimating the growth rate,
for example, LeEco experienced high growth in previous years,
leading everyone to believe that this speed would continue for the next five years.
However,
the following year, it experienced a catastrophic decline,
which is the core issue.
So, understanding growth rates is a big topic,
I will keep emphasizing this in future episodes,
and will illustrate these points with examples later.

The second aspect is sustainability,
like LeEco and gaming companies,
if they perform well this year,
but cannot sustain next year or suddenly fail,
then it’s not good.
The same applies to mask manufacturers,
for example, in February,
everyone wanted masks.
But after three months,
if competitors flood the market or their business cannot be maintained,
it shows poor sustainability.

Industries with poor sustainability are often because they change too fast.
One is technological disruption,
which can wipe out competitors.
Another is demand suddenly disappearing,
like masks, where demand just vanished.
In most cases,
companies need a moat to maintain sustainability,
if their industry is relatively stable,
with continuous demand,
an important factor is whether the company has a moat.
And,
you hope that your demand itself doesn’t change much.
For example, liquor,
even though young people are drinking less white wine,
the base of white wine drinkers is large.
If 1% of the market stops drinking white wine,
but the remaining 99% increase their consumption by 1%,
they can recover the lost 1% market share.
Or by raising prices by 1%,
they can also bounce back.
In such cases, the industry has better sustainability.

Of course,
some industries have good sustainability but are not very stable,
and are quite cyclical.
For example, steel,
steel demand has always existed,
people will always need it,
just like real estate,
it exists continuously,
but its stability is not very good.
For example,
real estate might have a cycle every ten years,
while steel might only have a three or four-year cycle,
so its stability is relatively poor.
Poor stability affects the growth rate,
and the average growth rate will be lower.

Such industries still have some sustainability,
so sometimes don’t confuse sustainability and stability with cyclicality,
these need to be distinguished.
For example,
some consumer products,
like disposable items that are not replaced for many years,
have relatively poor sustainability.
For example, if you sell a refrigerator today,
people might not need to buy a new one for five or six years or even ten years,
so their consumption cycle is long,
and the operational sustainability for the producer is relatively poor.
In contrast, selling liquor, diapers, or milk,
has very good sustainability,
because once you drink it today, you need to drink again tomorrow.
This kind of product has good sustainability,
so you can see that different industries have different characteristics,
such as sustainability,
growth rate,
cyclicality,
industry concentration,
stability,
return on equity, etc.
For example, some industries have low profit margins but high turnover,
like Walmart,
which is engaged in retail and also has good cash flow.

Therefore, when choosing industries and companies,
you need to pay attention to these aspects,
considering these dimensions because they all ultimately aim to achieve good cash flow.
Why focus on cash flow? Because a company’s valuation is ultimately based on cash flow,
which is the underlying logical framework.
How is valuation and future cash flow determined?
One is time,
the other is the annual return on equity,
and what determines annual returns?
It depends on current earnings and growth rate.
Current return on equity, based on DuPont analysis,
can be divided into three parts:
profit margin,
scale turnover,
and leverage.

How to view the growth rate of profit margin?
As mentioned earlier, industry growth,
endogenous industry concentration growth,
cyclicality, and so on.
Also, whether the industry or enterprise is changing rapidly,
whether consumer habits are changing quickly,
or whether the company has a moat from its own perspective,
and whether it has differentiation.
Product features that are easy to consume quickly,
and after being consumed, immediately need to be repurchased,
rather than durable goods,
which can be used for a long time after purchase.
You need to observe these aspects
to determine what makes a good industry.
Because a good company must be in a good industry,
having a good industry doesn’t necessarily mean the company is good,
but companies in bad industries are generally not good,
so avoid low-probability events,
the efficiency of finding gold in a trash heap is very low,
since everyone’s time and energy are limited,
you should focus on high-efficiency activities.
If you want to find gold,
you should go to a gold mine,
not search in a trash heap.

Therefore,
a company’s current profit,
growth rate,
and sustainability are very important.
Profit relates to return on equity,
which is a key parameter in cash flow.
Sustainability and growth rate are also crucial,
because they are related to time,
referring to the relationship between the company and cash flow over a future period.
One company can sustain for 20 years,
another only 5 years,
and their cash flows will definitely differ.
Because the longer the period,
the more experience it accumulates,
and more experience naturally brings more wealth,
which increases intrinsic value.

Alright, today I will share this with everyone,
integrate these concepts,
consider valuation,
future cash flow,
industry characteristics,
scale,
profit margin,
growth rate, and
sustainability.
All these factors influence the company’s investment return and time value.
By comprehensively considering these factors,
a more complete concept can be derived.