Why should we be long-term oriented? - On investment (31)

Why should we be long-term oriented?

We need to be a long-term oriented investors does not necessarily because this slogan sounds great and has better publicity nor because we have to hold the targeted company forever no matter what. It’s only because the long-term prospective would be the most of the valuation, mathematically.

Let’s consider the following 4 secarios:

The Scenario 1 is similar to projects alike business, e.g. real-estate, as it only has limited period of time. This 3 year project example clearly shows that in a limited life business its valuation and PE can only be calculated to its lifetime discounted FCF (free cash flow) summation and its growth rate is actually non-essential.

The Scenario 2 is mostly common in some cyclical and static business which only enjoys a short period of growing and for the rest of time would be in a more stationary mode.

For this kind of business, the terminal PE can only assigned to 12.5, a number barely more than 10. Even so, its terminal value stands for its 85% of the total valuation.

The Scenario 3 is a well-run and more common growth opportunity which provides a 5 year 15% compound growth rate and a terminal 3% consistent grwoth rate. For this case, a justifiable terminal PE would be 20 and initial maximum PE would be 32. The terminal value, which stands for the part after the 5 years in the future would have 82% of the total valuation. 

The Scenario 4 is truly exceptional company which expected to acchieve a relatively longer term growth period with pretty fast and stable growth rate at 30% and to grow a persistent 5% afterwards. In this case, its terminal value stands for its 91% of the total valuation and its initial PE can go as high as 81!

The preceding scenarios and examples give us at least two lessons:

Lesson 1: the terminal value, the longer term perspective, matters most in valuation 

That’s why we should focus on the long term potential of each opportunity. To do that we should focus on several aspects:

1, whether it has a long runway to grow?

2, whether it truly has competition advantage that can protect it from furious rivary?

3, whether it has capable management to deliever?

Lesson 2: the purpose of the near term performance is to have a window to peek into the future 

Nevertheless, the fact of terminal value matters most can never mean the incoming and short term performance does not matter at all?

The fact that the terminal outlook is so far away from now, the long term situation is based on our current perception and imagination of an opportunity, which can be a total false or with great deviation. The fact that people are so good at extrapolating current situation into a further future makes the current facts works as the trajectory of futures outlook. That’s why sometimes, a minor foundamental beat or miss would make investors excited or dismayed about the much longer future and that’s why there are so much volatility of some growth stocks.

At end of day, the price is based on the perceptions of all the market participants as a whole on the foundamental projections, thus, these impression based valuation outcome can vary extremely as we human often do. In other words, the foundamentals can seldom change faster than our imaginations.

There is certainly no crystal ball and easy ways to look into the future.

For us, to truly understand a growth opportunity, we should:

1, always focus on the longer term; that said, to be a good investor, we need to be imaginative;

2, keep an eye on the current movements and trajectories and be able to correct when things go sour;

3, Be aware of the fact that most of the linear extrapolating can go wrong or with great deviation;

In short, we need to be long-term oriented but also be able to correct once necessary.

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