Long Equity Valuation

LONG EQUITY
The Valuation
of Quality
Growth
Companies
Long Equity Fund
2022
Principle 1
Valuations are still photos of moving objects
Valuations are moment in

time snapshots of movement.
A photo of athletes running

captures the moment, but
does not tell you who is
going to win.
In the same way, a company’s

share price only reflects its
valuation at that moment in
time. It doesn’t tell you
what’s going to happen in
the future for the
underlying business.
Principle 2
Compare like with like
Not all earnings are equal. Here’s a reverse rank of different types of earnings:
5. Negative earnings
Expenditure > Revenue
4. Low return on investment earnings

Use billions to make millions
3. Cyclical earnings
Exposed to commodity prices and state of economy
e.g. airlines, banks, oil companies
2. Highly leveraged earnings

Capital intensive, e.g. banks
1. High ROI, non-cyclical, unleveraged earnings

Found in high quality consumer, tech and healthcare
companies
We only value companies that have high free cash flow (FCF) returns on capital, high FCF margins, high
FCF per share growth rates and pricing power. We can then compare the valuations of similar companies.
Valuation Model 1 - The Present
● Our preferred measure of valuation is the free cash flow (FCF) yield.
Free cash flow is the cash generated by a company after paying for
everything except the dividend. To calculate the yield we divide the free
cash flow by the company’s market value. We then compare the FCF
yield to the average FCF yield of our investable universe.
● While quality growth companies typically have high valuations, there is

always something trading at a comparatively attractive valuation.
● Ranking high quality companies by their FCF yield allows the investor
to pinpoint where there is currently the most value. Useful benchmarks
are the S&P 500’s Earnings Yield (the market most investors seek to
beat) and the 10yr Treasury Yield (the best proxy to the risk-free rate.
● While this is useful, remember that companies are moving objects - we

also need to factor in growth rates…
Valuation Model 2 - The Past
● We next need to examine what has driven recent share price growth. Here’s an example:
○ Over the last 5 years the semiconductor company, NVIDIA, has seen its share price grow
from $25.79 to $185.43. That’s an impressive 7.2x increase.
● The question is whether this increase is driven by a change in valuation or growth?
○ Share price growth = FCF Growth x Price/FCF Growth
○ Over the last 5 years NVIDIA grew its FCF-per-share from $0.56 to $3.12. That’s a 5.6x
growth rate.
○ We can now calculate the change in valuation, which is 7.2 / 5.6 = 1.3x.
○ This demonstrates that NVIDIA’s recent share price growth (7.2x) has been driven more by
its FCF growth (5.6x), than by the change in its valuation (1.3x).
Valuation Model 2 - The Past
The below table sets out the 5yr change in FCF and multiple for a selection of the companies in our
portfolio. For the majority of the holdings in our portfolio, recent FCF growth has outpaced the
change in multiple. L’Oreal being the exception here.
Valuation Model 3 - The Future
● Having looked at the company’s past, we now need to contemplate its future.
● NVIDIA, as of August 2022, has the following attributes:

○ Share price: $189.89
○ FCF-per-share: $3.21
○ Price-to-FCF (P/FCF): 59.16
○ In comparison, the S&P 500 has a P/E ratio of 20.9
● This information allows us to calculate the market’s implied growth rate for NVIDIA
● What is the market’s implied growth rate?
○ NVIDIA (trading at P/FCF=59.16) is more highly rated than the market (P/E=20.9).
○ For NVIDIA to trade at the market’s P/E (20.9), its FCF-per-share would need to be $9.09
$189.89 / 20.9 = $9.09 (remember, its FCF-per-share is currently $3.21)
● What is the market’s implied growth rate?
○ For NVIDIA to grow its FCF-per-share from $3.21 to $9.09, its FCF-per-share would need
to grow by 23.1% per year for the next 5 years. Let’s see if this is realistic.
● What is a realistic growth rate?
○ Five years ago NVIDIA’s FCF-per-share was $1.15. Today it is now $3.21. This is equivalent
to growth of 22.8% per year.
● The question for investors is: can a company that has grown its FCF-per-share by 22.8% a year
for the last 5 years, now grow its FCF-per-share by 23.1% a year for the next 5 years?
○ If you think the answer is yes, then you have found a company trading at an attractive
valuation.
The below table sets out, for a selection of our current holdings, the actual previous 5yr FCF growth
and the required future 5yr FCF growth required for their current valuations to equal that of the
market average.
Final thoughts on valuation
● Over the long-term the quality of a company’s

earnings and assets are more important than the
market valuation of its earnings and assets.
● Historically you could have paid expensive valuations

and still obtained significant returns.
● High FCF growth rates will offset low FCF yields (see
table).
● A high valuation doesn’t mean you’re overpaying:
○ Quality can be expensive
● A low valuation doesn’t mean something is cheap:
○ Maybe it’s cheap for a reason

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LONG EQUITY

Long Equity Fund

Valuations are moment in

A photo of athletes running

In the same way, a company’s

4. Low return on investment earnings

2. Highly leveraged earnings

1. High ROI, non-cyclical, unleveraged earnings

● While quality growth companies typically have high valuations, there is

● While this is useful, remember that companies are moving objects - we

● The question is whether this increase is driven by a change in valuation or growth?

○ Share price growth = FCF Growth x Price/FCF Growth

● NVIDIA, as of August 2022, has the following attributes:

● What is the market’s implied growth rate?

● What is the market’s implied growth rate?

● What is a realistic growth rate?

● Over the long-term the quality of a company’s

● Historically you could have paid expensive valuations

● A high valuation doesn’t mean you’re overpaying:

○ Quality can be expensive

● A low valuation doesn’t mean something is cheap:

○ Maybe it’s cheap for a reason

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