I struggle with valuations of Topicus. I have read your SA piece, but struggle with the logic.
Bear with me here and I'll try to explain my thinking.
First, I want to point out that I don't believe in DCF models. They were designed for valuing internal investments (PPE) not for valuing stocks. Using them for equity valuations is like using a screwdriver on a nail. It isn't fit for purpose. First, there is no terminal value of a company. Second, using WACC results in companies with higher debt being valued more highly than companies with lower debt (go figure). Third, the CAPM part of the model relies on Beta which implies that the risk is higher after a stock price correction than before hand.
Anyway, I digress. Back to Topicus.
There are a number of catalysts that will generate shareholder returns over time. Revenue, Share Count, Margins, Multiples and Dividends.
Let's project ahead over the next 5 years.
Topicus top line at time of writing is $916m. Let us assume that they achieve annual growth of 25% (ambitious in the current economic climate). So by 2028 they have turnover of $2.8bn.
Let us assume that the share count remains unchanged. Constellation don't engage in buybacks and neither does Mark Leonard use SBC for remuneration. So this catalyst is zero rated for our purposes.
I assume zero dividends because capital is all allocated for growth (the Constellation / Berkshire Hathaway model). So dividends are out of our equation also.
I don't rely on income statement earnings but instead calculate Economic Earnings (a variation of free cash flow generated by the business, similar to Buffett's Owner Earnings concept). My Economic Earnings margin is currently 8.24%. Against a Gross Margin of 35.5% this is reasonable, particularly when you consider that the average CAPEX spend runs at circa 50% of GM and then one needs to account for OPEX, financing costs and taxes.
On an 8.24% Economic Earnings margin, one would assume that there is scope for moderate expansion. Let us be generous and say that by 2028 this has expanded to 12% (+45.6% on where we are now).
Against those ambitious top line growth and margin expansion assumptions, by 2028 the share price would be $391 and the total return for the shareholder would be 344.4% (34.76% CAGR) if all else were equal. Using prevailing risk free rates and the current equity risk premium, I would need to discount at 10% for NPV purposes and this would imply a share price valuation today of $243.
But all else is not equal. Topicus is currently capitalized at 5.29x sales. The sales multiple is contextual against margins. With the Gross margin at 35.5%, if Topicus had no Capex, no Opex, no financing costs and was not subject to taxes so all the gross profit fell to the bottom line, the investor would only be looking at a 6.7% earnings yield on investment. In today's environment that doesn't meet the hurdle rate for an intelligent investor given raging inflation, RFR of nearly 5% and equity risk premium at a similar level. Now factor in all of the costs of the business. Now the earnings yield drops to 1.56% at current market valuations.
The conclusion is that valuations are ridiculously stretched. I estimate that the business ought to be capitalized at around one quarter of the premium that it trades at today. Said differently, it will need to work off its huge over valuation in coming years which will result in a significant dilution of shareholders returns.
Forget 34.76% CAGR. Even with 25% annual top line growth and margins expanding by significantly to 12%, this kind of multiple contraction would see a total shareholder return over 5 years of -23.9% (-5.32% CAGR). That put's today's share price intrinsic value closer to $41.6.
And that is with very ambitious assumptions on sales and margins. If the business is unable to meet those assumptions then the return is even worse and the implied share price lower still.
I struggle with valuations of Topicus. I have read your SA piece, but struggle with the logic.
Bear with me here and I'll try to explain my thinking.
First, I want to point out that I don't believe in DCF models. They were designed for valuing internal investments (PPE) not for valuing stocks. Using them for equity valuations is like using a screwdriver on a nail. It isn't fit for purpose. First, there is no terminal value of a company. Second, using WACC results in companies with higher debt being valued more highly than companies with lower debt (go figure). Third, the CAPM part of the model relies on Beta which implies that the risk is higher after a stock price correction than before hand.
Anyway, I digress. Back to Topicus.
There are a number of catalysts that will generate shareholder returns over time. Revenue, Share Count, Margins, Multiples and Dividends.
Let's project ahead over the next 5 years.
Topicus top line at time of writing is $916m. Let us assume that they achieve annual growth of 25% (ambitious in the current economic climate). So by 2028 they have turnover of $2.8bn.
Let us assume that the share count remains unchanged. Constellation don't engage in buybacks and neither does Mark Leonard use SBC for remuneration. So this catalyst is zero rated for our purposes.
I assume zero dividends because capital is all allocated for growth (the Constellation / Berkshire Hathaway model). So dividends are out of our equation also.
I don't rely on income statement earnings but instead calculate Economic Earnings (a variation of free cash flow generated by the business, similar to Buffett's Owner Earnings concept). My Economic Earnings margin is currently 8.24%. Against a Gross Margin of 35.5% this is reasonable, particularly when you consider that the average CAPEX spend runs at circa 50% of GM and then one needs to account for OPEX, financing costs and taxes.
On an 8.24% Economic Earnings margin, one would assume that there is scope for moderate expansion. Let us be generous and say that by 2028 this has expanded to 12% (+45.6% on where we are now).
Against those ambitious top line growth and margin expansion assumptions, by 2028 the share price would be $391 and the total return for the shareholder would be 344.4% (34.76% CAGR) if all else were equal. Using prevailing risk free rates and the current equity risk premium, I would need to discount at 10% for NPV purposes and this would imply a share price valuation today of $243.
But all else is not equal. Topicus is currently capitalized at 5.29x sales. The sales multiple is contextual against margins. With the Gross margin at 35.5%, if Topicus had no Capex, no Opex, no financing costs and was not subject to taxes so all the gross profit fell to the bottom line, the investor would only be looking at a 6.7% earnings yield on investment. In today's environment that doesn't meet the hurdle rate for an intelligent investor given raging inflation, RFR of nearly 5% and equity risk premium at a similar level. Now factor in all of the costs of the business. Now the earnings yield drops to 1.56% at current market valuations.
The conclusion is that valuations are ridiculously stretched. I estimate that the business ought to be capitalized at around one quarter of the premium that it trades at today. Said differently, it will need to work off its huge over valuation in coming years which will result in a significant dilution of shareholders returns.
Forget 34.76% CAGR. Even with 25% annual top line growth and margins expanding by significantly to 12%, this kind of multiple contraction would see a total shareholder return over 5 years of -23.9% (-5.32% CAGR). That put's today's share price intrinsic value closer to $41.6.
And that is with very ambitious assumptions on sales and margins. If the business is unable to meet those assumptions then the return is even worse and the implied share price lower still.
(see this Microsoft case study as an analogy: https://rockandturner.substack.com/p/rule-1-price-matters)
I wonder if Topicus will suffer the same fate.
I welcome your comments.