Adding Simplicity To Valuation

Buffett has said something along the lines of “you don’t need to know the weight of a cow to know its fat.” This evaluation method can help the valuation process. It simplifies things and will enable you to make no-brainer investments if you find a business that is only going to get fatter over time.

I don’t use a complicated DCF in my valuation process (I’d rather hammer nails into my eyes than calculate WACC). I like to keep things even simpler, just try to forecast earnings in the future, apply an earning multiple, then discount it at a rate of return I want to present value. But if you know the business well, and can see quite easily that it has room for growth in one (preferably multiple) segments; then you can simply just know that your investment is likely to be highly profitable in the future.

Confused? Let me give you an example.

I’ll use an example I did recently which helped me make up my mind about buying Tencent. When I look at Tencent, I looked at its multiple segments. All the segments are interesting, but the Fintech and Business Services (FBS) segment stands out. This segment contains their payments and cloud businesses.

This is a super high-quality segment that has seen ridiculous growth. As much as people in the west love to think China’s foray into capitalism will end with the “beginning of tech regulation” I don’t think Tencent’s moat can be touched by competitors. Their user base is massive and they have large network effects with E-commerce in China and much of the rest of Asia.

If you want to do e-commerce in China, it’s hard not to use the services of either Tencent and/or Alibaba. These two companies account for over 90% of mobile payments in China. According to Canalys “China’s cloud infrastructure market grew 54% year on year in Q2 2021 to US$6.6 billion, led by Tencent Cloud, which grew 92%. Tencent Cloud accounted for nearly 19% of total cloud infrastructure spending in China, but remained third behind Alibaba Cloud and Huawei Cloud, and ahead of Baidu AI Cloud.”

In 2019 Tencent Cloud had revenues of US $2.4B. As of 2022 if we take a conservative 16% market share, they will be looking at US $5.6B in revenues. Cloud growth has been explosive. In 2026, the cloud in China is expected to be worth US $84.7B. At a 16% market share, that gives them revenues of $13.5B. At 10x revenue, this business would be worth US $135 billion. In another 5 years (2032), $270 billion doesn’t seem far-fetched.

Looking at their Fintech segment, WeChat Pay takes up ~40% of mobile payments, slightly lagging Alibaba. It’s hard to find margins for either WeChat Pay or AliPay. They have a monopoly in this area and do not want to disclose what they are raking in. So they obfuscate their revenues and earnings by consolidating their revenues in their financial statements.

In the west, multiple payment processors have different take rates. Tencent and Alibaba took market share from Union Pay, which had a ~2% take rate. Tencent and Ant Financial gave away advertising to new clients to increase market share. So I think we can use the same ~2%. If we look at Statista, they are forecasting US $4.48 trillion in mobile payments volume in China by 2026. If we take 40% of that, we get US $1.792 trillion in market share belonging to Tencent. At a 2% take rate, that gives them US $35.8 billion in revenue. At a profit margin of 30%, we get profits of US $10.74 billion.

It’s pretty tough to evaluate fintech in China, as there is clearly a massive discount to western peers. If you look at some of the smaller Fintech companies in China, they are trading at laughably low evaluations, literally, low single-digit PEs. Ant Group, which is much larger than these companies, was evaluated much closer to Western Peers. Given the size and scale of Tencent’s Fintech arm, I think evaluating it closer to Ant Group makes sense. In 2020, Ant Group was looking to IPO around $300B at a PE of 40. Since some of the new regulatory rules have changed Ant’s attractiveness, so it probably won’t fetch this much, whenever (if ever) it IPOs.

Using a more conservative 30x earning multiple we would get a US $322 billion valuation. Add the Cloud value in 2026 of US $135 billion, and you get to US $457 billion in value for the FBS segment. Tencent’s current market cap as of April 23rd is US $421 billion. If you pay current prices you not only get a discounted FBS segment, but you also get their equity portfolio, VAS segment, digital advertising, and “Others” segments all for free. These segments have all grown at ridiculous rates, so you will get a tonne of value from those.

This helped me make my mind up that Tencent was a no-brainer. I can attempt to evaluate those other segments (I have) but even if all those segments turn to crap (which is a very low probability of happening) you won’t lose any money as the FBS segment alone will cover the entirety of the investment. Just for reference, the FBS segment has been growing at a 78% CAGR from 2015 to 2021, multiple turns faster than the rate assumed in this hypothesis.

Therefore, I know this cow is fat, without having to know its exact weight.