The Value Bridge: Zooming In on Copart's Growth
Getting beyond a simple framework using Copart as a real-world example
Going Deeper On Growth
In a prior post, I examined growth as a concept: How it adds value, and the different ways companies can grow (i.e., margin expansion and/or reinvestment via retained earnings).
Here, I go deeper and present a framework for thinking about the sources of growth embedded in our assumptions using a real-world example of Copart (Disclosure: Long).
The “Standard” Approach
The typical approach of taking the current earnings yield + growth = holding return isn’t wrong. It’s just consolidating a whole bunch of assumptions. I want to take apart those assumptions and examine them in greater detail.
Copart
No Growth Scenario
The Base scenario is no growth.
I’m making certain assumptions, which you can agree or disagree with, but the basic logic is sound.
Here we arrive at a sustainable level of earnings, which are assumed to be distributable and distributed. At a 10% discount rate, it’s worth $13.5 billion.
We can say, then, that the market is pricing in $14 billion of additional value. But how, and when, does that value happen?
Perpetual Growth
This analysis shows that Copart must grow 5.5% forever to justify its current price. Note that the model deducts the capital required for that growth.
You can’t have your cake (growth) and eat it (distribute it) too!
The problem is that companies don’t grow at a linear rate forever. A typical growth pattern has a period of growth followed by slowing or sustained growth thereafter, perhaps (gasp!) followed by a period of decline.
Disaggregated Growth
I think it’s worth going deeper and thinking about the components of growth. Here I’m guided by the excellent work of Bruce Greenwald in Value Investing: From Graham to Buffett and Beyond, 2nd Ed.
A few things are going on here, so I’ll break them down:
We start with the base earnings, the same $1,349 million from above.
I’m assuming the company can retain $500 million a year in growth capex (depreciation = maintenance capex is already in earnings). See the capital progression table below to follow the effect on capital employed.
From that investment, I’m assuming the company can earn 30% after-tax, which is based on historical performance.
Finally, I’m also assuming the company will expand its operating margin by 5 percentage points over ten years, or 50bps/year. This assumption is rooted in continued economies of scale in G&A expense in the US (again, proven by historical figures), and improvements in international margins.
The whole 10 year progression looks like this:
We then have to decide what to do with the terminal value. We can either assume no growth or some sort of Y11-forever perpetual growth. With this model, we can see what that looks like.
No growth: Adds $11.9 billion to the present value, resulting in a value of $10.2b + $11.9b = $22.1b.
Perpetual 3% growth: Adds $3.4b for $15.3b total terminal value or $25.5b total.
The summary looks like this:
Taking It Apart Further:
But we can go deeper and examine all of the sources of value in what I’m calling a value bridge.
The value bridge shows you exactly where growth adds value.
Existing earnings power is about half of the value
Growth requires investment, and that comes in the form of deferred current distributions totalling almost $3.1b on a present value basis.
However, Reinvestment adds $4.3b of present value.
Then another $5.8b of reinvestment value comes from the terminal value
We can also see the effect of margins, not only on the Y1-Y10 cash flows but also on the terminal value.
Finally, the impact of the terminal growth rate is shown, here $3.4b.
A Work In Progress
While I agree with Greenwald that DCF models, in general, do more harm than good (combining good current info with poor future info), the mechanics of growth require an expansion of assumptions to view each component in its proper context. You can call it a DCF model if you like; I don’t think it’s quite what Wall Street considers one.
The real value isn’t in having a high-powered calculator to spit out a number. Instead, it’s thinking through each part, reasoning based on what you’ve learned about the company and what seems reasonable, and considering the magnitude of each component and the risks of it getting disrupted.
Even if imperfect, at the very least, we’re able to take apart the growth equation and move beyond “grow at an average of 5.5% forever” to a more robust view of the parts and their timing.
Let me know what you think about this approach. Is it clear enough? What’s not so clear? What did I get wrong?
Hit reply, leave a comment, or shoot me an email.
Here’s the full model:
More thoughts? Let me know in a private message or leave a comment.
Stay Rational!
Adam
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