Philosophy
Epoch believes that the key to understanding a company requires a focus on the cash generation drivers of the business—not a focus on accounting terms like earnings or book value. How does the business generate its free cash flow, and how does management allocate that cash for the betterment of the owners of the business; i.e., the shareholders?
It is the ability to generate free cash flow that makes a business worth anything to begin with, and it is the ability of management to allocate that cash flow properly that determines whether the value of the business rises or falls. There are only five things that management can do with a company’s free cash flow: pay a cash dividend, buy back stock, pay down debt, make an acquisition, or invest in internal projects. If a company can invest, either internally or in an acquisition, and generate a marginal return on invested capital (ROIC) that is greater than its marginal cost of capital, then making that investment will increase the value of the business. But if the return is going to be less than the cost of capital, making the investment reduces the value of the business, and management should return the capital to the shareholders instead through one of the three methods listed above. Accrual-based accounting measures such as earnings, and valuation metrics based on earnings, simply do not provide the relevant information as to whether a company is successfully generating free cash flow and whether management is allocating that cash flow properly.
Our Perspectives
The current hype about two-sided digital platforms, blitzscaling and winner-takes-most markets has fueled a surge in IPO listings and produced stratospheric valuations that are difficult to reconcile with free-cash-flow (FCF) fundamentals. The big question is, are we repeating the excesses of the dot-com boom? In this paper, we look at the reasoning used by those who think history is repeating itself including IPO supply, profitability and VC funding. We also look at the weaknesses in those arguments and why some believe that the current situation is different from the dot com bubble, such as median age of tech IPOs and sales growth. Finally, we explore how investors can look at these companies through a free cash flow lens.
June 19, 2019
Blitzscale and Hope: Unicorns, IPOs and the Fear of Repeating the Late 1990s
The current hype about two-sided digital platforms, blitzscaling and winner-takes-most markets has fueled a surge in IPO listings and produced stratospheric valuations that are difficult to reconcile with free-cash-flow (FCF) fundamentals. The big question is, are we repeating the excesses of the dot-com boom? In this paper, we look at the reasoning used by those who think history is repeating itself including IPO supply, profitability and VC funding. We also look at the weaknesses in those arguments and why some believe that the current situation is different from the dot com bubble, such as median age of tech IPOs and sales growth. Finally, we explore how investors can look at these companies through a free cash flow lens.
Does a stock’s price and its P/E ratio tell you how much a company is worth? Conventional wisdom says yes, but we think otherwise. In this paper we explore:
- The theory behind the discounted cash flow (DCF) valuation model and the underappreciated role that ROIC plays in the model
- The P/E ratio and find that it does not tell us what most people think it does, nor does its offshoot, the P/E to growth (PEG) ratio
- How we can use what we have learned about the DCF model to deconstruct P/E ratios in the real world to better understand what they do tell us
June 17, 2019
The P/E Ratio: A User’s Manual
Does a stock’s price and its P/E ratio tell you how much a company is worth? Conventional wisdom says yes, but we think otherwise. In this paper we explore:
- The theory behind the discounted cash flow (DCF) valuation model and the underappreciated role that ROIC plays in the model
- The P/E ratio and find that it does not tell us what most people think it does, nor does its offshoot, the P/E to growth (PEG) ratio
- How we can use what we have learned about the DCF model to deconstruct P/E ratios in the real world to better understand what they do tell us
If there is a “small-cap effect” then why has the Russell 2000 underperformed the Russell 1000 over time?
January 18, 2019
The Size Paradox
If there is a “small-cap effect” then why has the Russell 2000 underperformed the Russell 1000 over time?
China’s mercantilist behavior, underscored by its “Made in China 2025 initiative,” is in conflict with U.S. demands for greater IP protection, a level playing field and improved market access. Left unresolved, free trade and globalization will be in retreat, with broad economic implications beginning with manufacturers.
December 10, 2018
Trump, Tech and Trade
China’s mercantilist behavior, underscored by its “Made in China 2025 initiative,” is in conflict with U.S. demands for greater IP protection, a level playing field and improved market access. Left unresolved, free trade and globalization will be in retreat, with broad economic implications beginning with manufacturers.
While the e-Commerce index as a whole appears frothy, many companies in the sector do possess sound and promising business models. For investors, the key to success is understanding how these business models should be valued. In this paper we examine the reasons e-Commerce may be a bubble, the reasons it may not and a free cash flow based methodology for valuing e-Commerce companies.
September 13, 2018
Is e-Commerce a Bubble?
While the e-Commerce index as a whole appears frothy, many companies in the sector do possess sound and promising business models. For investors, the key to success is understanding how these business models should be valued. In this paper we examine the reasons e-Commerce may be a bubble, the reasons it may not and a free cash flow based methodology for valuing e-Commerce companies.
Three developments (the unwinding of QE, the soaring US budget deficit and the impending wall of maturities, especially of corporate bonds) will engender higher volatility and wider credit spreads. There is also a risk that interest rates will start rising for “bad” reasons (that is, an increase in fixed income supply). Each of these outcomes would be a headwind for high duration strategies.
July 2, 2018
The Return of Price Discovery
Three developments (the unwinding of QE, the soaring US budget deficit and the impending wall of maturities, especially of corporate bonds) will engender higher volatility and wider credit spreads. There is also a risk that interest rates will start rising for “bad” reasons (that is, an increase in fixed income supply). Each of these outcomes would be a headwind for high duration strategies.
Modern Portfolio Theory (MPT) dominates investment thinking today, but the pre-MPT view of the world still holds valuable insights. Our new white paper explores the limits of MPT in aiding successful investing.
April 13, 2018
The Limits of Theory
Modern Portfolio Theory (MPT) dominates investment thinking today, but the pre-MPT view of the world still holds valuable insights. Our new white paper explores the limits of MPT in aiding successful investing.
The Digital Age and the transition from “atoms” to “bits” implies a capital-light economy in which technology is being substituted for labor and physical assets. Its impact is widespread and stretches beyond the technology sector. In the third part of our technology focused series we explore:
- The evolution of technology and why it is so noticeable today
- The key differentiator between the first and second machine ages
- Technology’s impact on microeconomic factors such as demand and marginal revenue
- Why the digital age entails a radical reevaluation of macroeconomics
- Implications for investors
January 31, 2018
When “Bits” Meet “Atoms”
The Digital Age and the transition from “atoms” to “bits” implies a capital-light economy in which technology is being substituted for labor and physical assets. Its impact is widespread and stretches beyond the technology sector. In the third part of our technology focused series we explore:
- The evolution of technology and why it is so noticeable today
- The key differentiator between the first and second machine ages
- Technology’s impact on microeconomic factors such as demand and marginal revenue
- Why the digital age entails a radical reevaluation of macroeconomics
- Implications for investors
It has long been common practice in the investment world to divide the market up into “value stocks” and “growth stocks.” What do these labels really mean? “Value” connotes that the stocks in this category are undervalued, and should therefore outperform over time, while “growth” implies that these are stocks with faster earnings growth.
December 7, 2017
What Do We Mean When We Talk About Value?
It has long been common practice in the investment world to divide the market up into “value stocks” and “growth stocks.” What do these labels really mean? “Value” connotes that the stocks in this category are undervalued, and should therefore outperform over time, while “growth” implies that these are stocks with faster earnings growth.