Increasing The Probability Of Returns By Making The Right Assumptions
A friend of mine sent me a great video that got me thinking about the assumptions that need to be made in order to achieve a given rate of return. The point of the video was that in order for you to achieve a specific rate of return over a long time period, you must assume certain things will happen in order to make that return given the current valuation of the business. You can watch the video here.
Instead of looking at his examples, I want to do some examples from my portfolio because it's my blog and I'll do what I want! Let's look at Aritzia and Inmode, 2 of my holdings that I have done quite well on, but have no plans of selling anytime soon.
Let's get back to the framework from the video. The basic tenets I got from the presentation are the following:
In order to meet a pre-determined internal rate of return (IRR), you must make assumptions on the underlying economics of a business
If a company is expensive, this prices in the most optimistic outlook possible for a company. You must ask yourself if this outlook is a high or low probability event
If your bear hypothesis still gets you to your IRR you have an excellent margin of safety. This is because you should be getting into companies with a low probability of the bear hypothesis occurring. Meaning the higher probability events will actually increase your IRR from the minimum.
Looking at things like the total available market (TAM), market share, margins, net income, and revenue are all you really need to use. If a companies' current price is assuming the TAM will triple, while they increase their market share by 10%, all while increasing revenue and margins, you are most likely looking at a low probability event.
Let's start with my own IRR. I aim for a minimum of 15%, so we'll use that number and take a look at what you must assume if you buy it at current prices. Remember, this analysis doesn't tell if the company is high quality, it just tells you if the current price makes sense if you want to make a given return.
Aritzia at the end of the day is trading at $39.74 at a market cap of $4.23B as of January 12th, 2022. In order to make 15% IRR in a decade, the share price would need to be ~$159. I'll be using USD numbers even though it's Canadian. Here are the current numbers.
Net Margin: 9.1%
Net Income: 82.7M
I think a realistic PE for the Terminal value of the company is ~30. Yes, it's at 55 right now, but I don't see this being sustainable over a long time period. So we can look into the future, $159 share price at a PE of 30 would imply a net income of 5.3 EPS or (multiplying by current shares outstanding of 115.7m) 613.21M in net income.
This would require a compound annual growth rate (CAGR) in Net Income of ~24% which I deem a very, very low probability event. Revenues would need to be 8.46B. The women's clothing market in 2022 is 189B and looks to be growing at a CAGR of 2.4%. This means in 2032 you are looking at a TAM of ~252B, meaning you're assuming their market share would grow from its current share of .35% to 3.3%. Another low probability event. They are moving into men's wear, but I still don't think they'd be able to increase market share by as much as the assumption above.
So you can see from this analysis, that it's very unlikely you'll make 15% IRR if you purchase Aritzia at current prices.
Now let's have a look at Inmode. I'm taking numbers that just came in, they aren't official yet, but I'll take the low end, as I don't see them being below these numbers. Inmode is currently $55.74 at a market cap of 4.26B.
Net Margin: 48.5% (Insane)
Net Income: $173.1M
For a 15% IRR, the share price would need to be ~$220. Its current PE is 32. I think this is a fair terminal PE to use. This would make earnings in 2032 be around $6.87 EPS. For a Net Income of $588M. This assumes an earnings CAGR of ~16%. I don't think this earnings growth rate is out of the question by any means. I would actually say this would be a slightly bearish earnings rate for the company.
Current TAM of 47B in 2020, and has a CAGR of ~14% for the next decade or so. So the market should grow to ~$180B. This means INMD's current market share of .75% would need to get to .66%. This means that they could still cede market share to competitors (which they aren't doing) and still make the 15% IRR you're looking for. Given that INMD is highly profitable and just a much better business than competitors I see them being able to steal market share away, again showing the bear case or INMD at current prices should get you around a 15% IRR.
Now you might be asking why I own Aritizia if it's so expensive. There is a simple answer to that, I bought it at much lower prices. This gives me the margin of safety I want to make sure I can at a minimum, reach my IRR. As for INMD, it appears to be reasonably priced at the moment, but my weighting in it is already so recklessly large that I have no plans on increasing my position.