Looking at the historical cash flow, the implied numbers seem like a tall order. To assess this profile, it is helpful to break down the numbers into more predictable variables such as sales, EBITDA, capitalised development costs and so on. Some of these components can be further broken down; sales, for example, can be divided into the number of subscribers multiplied by the average revenue per subscriber for each region.

While peeling back each layer improves accuracy, it also increases the danger of getting lost in the weeds. I identify the smallest number of inputs that account for the largest impact, then focus my attention on those.

The model template we use has around 200 rows. In Xero’s case we’ve added another 100 or so rows for additional detail. Here is an extract of the Xero model and visuals of some of the key variables implied by the $85 share price. 

The Legwork of Investing

The real work now begins, where we step into the world and explore the drivers of implied assumptions. This process involves asking questions which lead to the gathering of information, the analysis of that information and ultimately judgement as to how things are likely to unfold. Looking at Xero’s economic moat, for example, we might ask: Why was MYOB not able to defend against Xero even though it identified the threat many years ago?

The vast majority of our time and resources is dedicated to Legwork, it is the source of our investment conviction. I’ll provide more detail on this aspect of the investment decision in the next note.

the art of investing

An essential element of an investment decision is the judgement of the decision maker. This is partly a function of our wiring, partly experiences, and partly mind state. The emotion of fear, for example, can lead us to mis-perceive things as they are and mis-assess risks. As a student of Zen, I have come across teachings and practices that help cultivate my mind, and make better investment decisions.

I’ll share more about this aspect of the investment decision in a later note.

efficient allocation of attention

Over time, I have come to realise the most valuable resource I have is my attention, not just as an investment manager, but in life as a whole. Adopting the prism of investing, rather than trading, removes the need to predict what others are willing to pay for a stock. A byproduct of this is that it frees up my attention from predicting the mood of the market, allowing me to fully focus on each business’ capacity to generate free cash.

Using the implied cash flow approach is also helpful, as it removes the need to predict and quantify the most likely scenario. It allows more of my attention to be allocated to assessing downside risks. It also lets me compare opportunities without wondering if the probabilities underpinning say, the Xero and Alibaba valuations, are the same.

a word on traditional valuation metrics

Traders trying to predict Xero’s share price over, say, one to two years, typically use simple price-based valuation metrics. Xero, however, doesn’t stack up well using these metrics for a number of reasons.

First, Xero’s earnings are currently depressed, as a large portion of growth investment runs through the expense line. Therefore, the faster Xero grows, the lower its earnings. Historically, for most companies, the majority of growth costs would run through the balance sheet and get depreciated over time. Think factories for manufacturers, inventory and store fitout for retailers, plant and equipment for miners, land and buildings for Real Estate Investment Trusts and so on. The depressed earnings make the Price-to-Earning ratio, the most widely used traditional valuation metric, difficult to use.

Second, the earnings stream has a number of characteristics that are attractive to risk-conscious, long term investors including: recurring sales, low customer churn, long duration growth, and a strong balance sheet. Traditional valuation metrics typically don’t handle these factors well.

Finally, the company doesn’t pay out a dividend and has minimal hard assets, rendering metrics such as Dividend Yield and Price to Book of little use.

conclusion

Before finishing off, I do want to once again underline that our investment decisions are couched in a prism of part purchasing real businesses. The return we are aiming to achieve is the free cash generated by those businesses, relative to the price we paid, and not by fluctuations in the share price. There is always the risk the market mood will change, and Xero will fall out of favour, resulting in a decline in the share price. So long as the company generates the cashflows implied at our time of purchase, we will achieve our objective.

I hope this note has helped you understand the basic decision making framework for our investment in Xero. In the next two notes I’ll cover the art and legwork of investing this investment.

Appendix: application of dcf

Method One: Intrinsic Value

Here we calculate the Valuation (or Intrinsic Value) by forecasting the future Cashflows, discounted back using our 10% target Rate of Return. The difference between the Valuation and the share price is our upside (or downside) – the ‘margin of safety’. We invest in businesses with the highest upside.

In Xero’s case, our valuation per share might be say $100; given a share price of $85, the upside is 18% (($100-$85)/$85). We would invest in Xero if this 18% compares favourably with our alternate investment opportunities.

Method two: Intrinsic Value

*There is an implicit assumption that the cash retained by the company is reinvested at the required rate of return.