The first step in Seessel’s valuation method is to use to 2-3 year forward earnings instead of historical. His recommendation is not to use a crazy 10-year forecast, but to recognize that these business are growing so fast and, especially if they have a strong moat, are highly likely to grow in the near term.
Next, you have to make adjustments to the expenses. First, normalize regularly, excluding one-time expenses and correcting tax rates.
Then Seessel makes adjustments to expenses like R&D and Sales and Marketing. The argument for this is that GAAP forces these costs to be fully expensed in the period they incur. However, for tech companies like Google, for example, a percent of this R&D is going towards search algorithm improvements which have a useful life of more than a year. This is growth R&D, not maintenance R&D. So the investor has to make an estimate of what percent of R&D and is growth, create the asset for them and amortize it over 3 years or so.
Similarly, Sales and Marketing, especially for SaaS, creates a very sticky customer relationship. This relationship can exist for many years, and is effectively an asset. The investor should also adjust for this, creating a customer relationship asset on the balance sheet and amortizing it over 3-5 years.
It should also be noted however, that you cannot just blindly make these adjustments in order to improve the appearance of earnings for a tech business. You have to be honest and ask, is this spending building an off-balance sheet asset, or not. Try to find evidence for such an adjustment such as churn ratios which tell you the length of the customer relationship, or qualitative reporting on where R&D is going.
It may give you an uncomfortable feeling making these kinds of adjustments. That is reasonable. However, recognize that this is hardly less dubious than forecasting a businesses earnings out ten or twenty years. Furthermore, you don’t have to trust in these inputs alone. You can do sensitivity analyses to see how much the valuation makes sense given changes to your inputs.
Connections
Value Investing Requires A Paradigm Shift In The 21st Century
Link Explanation: This note is really the solution to the linked note above. While the linked note points out the issues that value investors have faced over the past 2 decades, the current note proposes a solution. It is an attempt to make the qualitative, more quantitative, so that value investors can succeed in the digital age.
Detailed Forecasting Adds Little Value
Link Explanation: It is worth paying attention to this note in relation to the current one. Seessel is making some aggressive assumptions when it comes to analyzing these businesses. In fact, his favourite example, Amazon, has not outperformed the index in several years, meaning this method, would not have worked. I think its more important to simply understand that high valuation businesses depend on growth to meet those expectation, and it is perfectly possible for that to occur. However you want to justify it can always be done, but that doesn’t mean you will be right.