May 1, 2008

Business scalability and valuation

My pervious post was about business scalability, a term used by Rakesh jhunjhunwala frequently. I attempted to lay out my understanding of the term in that post.

Business scalability is a critical factor in valuation. As I detailed on my post on
intrinsic value, the DCF formulae can be used to calculate this number. There are two key variables in the formuale – Free cash flow and the duration of the same before the terminal value is applied. This duration also referred to as CAP (competitive advantage period) is the time period during which the company is able to earn above its cost of capital. Beyond this period the company earns its cost of capital and hence is valued at its terminal value.

A company with a scalable business will be able to grow its free cash flow faster (higher growth) and also have a higher CAP at the same time. Now higher the growth and CAP, higher is the intrinsic value. If you can identify such a company much before the market does, as Rakesh jhunjhunwala and other top investors are able to, then the returns are very very high.

However identifying such companies is not easy. The most common error I have seen with analysts is that they identify the market opportunity, pick a company most likely to do well and stop at that. The analysis should also involve analysing the business model in detail, identifying the key drivers of performance and doing an assessment of these drivers. If this sounds complicated, then it is. The value is not easily apparent and requires quite a bit of analysis and digging around. All this has to be done before the market recognizes the company and bids up the price.

I think this approach to investing is a very advanced form of investing. It is not easy for a novice investor to practise this form of investing easily. One should have a keen understanding of business models, valuations, economics and other aspects of investing. Graham or deep value investing requires much lesser expertise and also has more diversification of risk. However this form of investing, where an investor can correctly identify a scalable business, is the key to long term riches.


Anonymous said...

Isn't business scalability the same as the first two points(Sales growth in existing products and management push for new products) in Phil Fischer's Scuttlebutt approach ? The concept of Business scalability might fit into Fischer's framework.

As a value investing novice, I am regular reader of your blog and have been immensely benefited by your blog. I wanted to ask you this question. Why we don't get to see Phil Fischer type of analysis/ideas(or Buffett's Coke or Gillette type of ideas) on your blog


Rohit Chauhan said...

Hi gopal
you can fit the concept of business scalability with phil fischer's concept.

phil also referred to companies which can grow profitablity for a long period of time. one of his favourite companies was motorola. I think scuttlebutt was process to find and analyse such companies.

regarding your next question - i initially started out with a more focussed portfolio approach influenced by fisher and buffett. however over time i have moved more towards graham's approach and the main reason for that is more personal ...due to my job and other constraints, it is not feasible for me to do real scuttlebutt - talk to customer, suppliers, company officials etc . as a result i have to limit my self to what i can read and find on the internet.

with these limitations, i cannot concentrate my portfolio. and so the absence of that type of analysis


Rathin Shah said...

Hi Rohit,
Thanks for your comments on Business scability. I am trying to think over the businesses which you spoke about (Bharti). Will read the MD&A section from its AR.

Once again, really grateful to u!