Over our past few monthly commentaries, we’ve discussed investments using Game of Thrones metaphors: castles (the company), moats (competitive advantage), and knights (strong management). This is our third and final piece – determining whether the investment is worthy of client capital.

“It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.”

Warren Buffett

Over our past few monthly commentaries, we’ve discussed investments using Game of Thrones metaphors: castles (the company), moats (competitive advantage), and knights (strong management). This is our third and final piece ‐ determining whether the investment in a particular castle is worthy of client capital.

Philosophically, we believe it’s the free cash flow that makes the business worth owning in the first place, and how management allocates that free cash flow that determines whether the value of that business rises or falls in the future. That was discussed in detail in our February commentary.

This is not a novel concept – any book on quality investing will provide pages explaining how the value of any asset is its future cash flows discounted back to today, at a rate compensating for time and risk.

At this point, we’ll go out on a limb and suggest most investors focus on earnings. Not surprising, really, as earnings are the best estimate of a company’s profit assuming “generally accepted accounting principles” and the topic most widely discussed by street analysts and media. However, accounting practices match up revenues and expense largely through various accrual methods (eg. recognizing certain revenue or expense items for which cash hasn’t yet changed hands) and don’t give an accurate depiction of the capital allocation strategy deployed by management.

For example, if a company decides to make an investment to its business, the cost (cash outlay) of that investment is felt immediately. However, in accounting terms, the cost is amortized over time. Therefore, being aware of the time value of money (dollars are worth more today than in the future), the return on the investment is more accurately reflected by measuring your cash output today against future cash received. Basic accounting convention doesn’t accurately reflect that value.

Multiples of earnings, book value or cash flow are simply shorthand versions of net present value and only capture a small component of a discounted cash flow analysis. And the pure price‐driven methodologies – like technical analysis or momentum – confuse stock price with value.

As such, we believe the best valuation methodology stems from discounting the future cash flow of a company over long periods of time. Which is why it’s necessary to have a long investment time horizon. Developing a fair value for a company using a discount model with a long time horizon would be quite irrelevant if one was thinking to sell the investment in one or two years.

As we frequently explain to clients, the fair value derived by our discount models is still simply an estimate – it’s never precise. Each of our investment models (one for every investment we look at) is built on assumptions. By modeling out the future, those assumptions become more explicit – whether it’s the growth of revenue versus expense, expanse of margins, or interest charges, all have to be input and therefore explained as part of our valuation assessment. Over time, new information arises that will impact the model and expected fair value. So our current model simply reflects our best estimate of the fair value of the investment.

Why is all this so important to investors? As we’ve written extensively in the past, effective wealth creation is achieved, not by outperforming bull markets, but by ensuring capital isn’t destroyed when markets retreat. This is the anathema to current contentions that passive management outperforms active management. The analyst cannot outperform extended bull markets, particularly given the need for prudent risk mitigation. The impact of FAANG stocks on the SP500 performance over the past few years, or the rise of Nortel to over 40% of the TSX index in the late ‘90s are examples of this risk.

While market emotions may devalue prices in general, holding investments that have a measurable fair value based on a conservative set of assumptions against future cash flow will guard against too much weakness and provides the opportunity to purchase more when prices do retreat.