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🔮Crystal Balls Break. This Doesn't.
Published 3 days ago • 4 min read
Unless you've lived under a rock, I'm sure you've seen the news about Tesla lately. Their European sales dropped a whopping 49%, even while the overall EV market is growing! And all this backlash against Elon because of his role in the Trump administration.
This reminds me of what fund manager Pulak Prasad has been saying for years: discounted cash flow analysis is tough. Who could have predicted two years ago that Tesla would face this kind of situation? Not a single analyst had "Elon runs DOGE department in second Trump administration" on their bingo card when forecasting Tesla's future cash flows!
It just goes to show that predicting a company's cash flows 5 or 10 years into the future is nearly impossible when most companies struggle to forecast even a few quarters ahead accurately.
I'm reading "Investing for Growth" by Terry Smith, which discusses the concept of shareholder value creation. It's pretty simple when you break it down. A company creates value when it delivers returns above the cost of the capital used to generate them.
Think about it like your own finances - if you borrow money at 10% but only earn 5% on it, you get poorer. If you invest it and earn 20%, you get richer. Companies work the same way.
That's why I've become a big fan of looking at Return on Capital Employed (ROCE). It's basically just operating cash flow divided by the sum of shareholders' equity and net debt. In a nutshell, this means ROCE shows how good a company is at turning its money into profit.
I find this much more useful than just looking at EPS or PE ratios. Sure, those are simple to calculate, but they have serious flaws. A company can actually increase earnings per share while destroying shareholder value if it invests money poorly.
I listened to Chris Bloomstran on the Acquirers Podcast, and he made some interesting points about Costco (COST). He bought Costco back in 2004 at around 18 times earnings, which he says was actually understated because a third of their warehouses weren't fully profitable yet (it takes about 7-8 years for a Costco warehouse to reach full profitability).
Fast-forward to today, and Costco trades at almost 60 times earnings! Bloomstran admits the "dumbest thing" he ever did was selling shares over the years. The stock has been a 20+ bagger since he first bought it. But he doesn't think buying Costco at today's valuation makes sense. Even with 7.5% revenue growth, he believes the stock is "seven or eight years ahead of itself."
While holding great companies through periods of high valuations often works out (as it did with Coca-Cola in the 90s), buying at those nosebleed valuations is a different story. Bloomstran believes that if Costco's multiple returns to a more reasonable 25x (from 60x), investors buying today might not see positive returns for 5-7 years.
So, what does this mean for us regular investors? I think the approach is still to keep it simple. Look for companies with strong ROCE and ask, "Will this company be more profitable five years from now?" But also be mindful of the entry price—buying a great business at a too high valuation can lead to years of underperformance.
Pro tip: Finchat.io shows the 5Y ROCE average in any company overview's far lower left-hand corner. Here's the link for Costco, and we see it's a very tasty 25.5%!
I love what Terry Smith says: "There are two types of people - those who know they can't predict the future and those who don't know they can't predict the future."
The best strategy for most of us isn't trying to time the market or do complex calculations—it's finding great businesses with strong track records of high ROCE, staying invested in them, and letting compounding work its magic. We should also be patient enough to wait for reasonable entry points. After all, even the best business in the world can be a poor investment if you pay too much for it.
That's it, and I'd love for you to reply and share what you think about valuation when you buy a stock. I'll respond to every reply!
😁THANK YOU to all who responded to the last newsletter!!
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Each week you'll learn how to be a better dividend investor and follow the journey of a welder with a passion for passive income to $1,000,000 and beyond.
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