Thread by @hkeskiva

1/15

Sometimes I run into companies that make no sense with backward-looking fundamentals. Instead of thinking what a company is, one must think what it can become.

In this simple THREAD I'll briefly explain how #narrative valuation works. 🧵 👇

2/15

When a company has more potential than track-record, investor can use narrative valuation.

Being more reliant on future deliverables (e.g. market share, margins) than long track-record of fundamentals, it is also favored by early-stage investors, e.g. venture capitalists.

3/15

Take Chipotle Mexican Grill $CMG that sells high-quality, tasty Mexican food, but is priced like a blockhain and AI driven, machine-vision company:

P/S 7
P/E 166
P/FCF 100
EV/EBITDA 58

Fundamental investor in me feels little sick, but let's look through the narrative lens

4/15

Narrative valuation forces us to imagine where the company could realistically be in the future, and discount that value to current day.

For that, we need a set of credible assumptions that we can easily follow as time goes by to validate our hypothesis.

5/15

To come up with a somewhat credible narrative, let’s use a global player, McDonald’s, as a proxy. There were 40,000 “Golden Arches” in the world in 2019, but hamburgers tend to travel better than Mexican food.

Why?

6/15

Firstly, everyone doesn’t like spicy food. Secondly, some people really hate cilantro.

Hence, we shouldn’t assume similar global coverage
but maybe 1/4 of it, meaning that Chipotle could grow its restaurants from current base of 2,622 to 10,000, or one-fourth of 40,000.

7/15

Let’s say that in the low-interest world we live in today, Chipotle could grow to reach 10,000 restaurants within 10 years, nearly fourfold from today.

With larger-than-before scale, Chipotle should be able to exceed the high end of its historical profitability spectrum.

8/15

During the past decades, Chipotle's operating margin has been around 10% of its revenue. With larger scale, let's assume Chipotle to reach 30% operating margins, a level still well below McDonald’s operating margin of 40%.

Such a rosy future doesn't come without risks.

9/15

In other words, the uncertainty of this scenario in its ambitiousness is high.

To keep things simple, we assume 70% odds for permanent loss of capital (i.e. bankruptcy) and 30% odds for our narrative to hold.

In reality, of course, there is a lot of outcomes in between.

10/15

Let's also assume that we sell our shares after 10 years, at the end of our narrative laid out above.

As $CMG would be a huge success story, we can safely assume EV/EBIT of 20 at year 10, giving some room for error with respect to interest rate changes, for example.

11/15

Lastly, we need to discount Chipotle's value at year 10 to today's money.

Currently, 10-year yields are at 0.9% so we use that as our opportunity cost (discount rate).

12/15

By using our earlier assumptions, we can now formulate the following table and conclude a valuation of $35 billion for Chipotle $CMG.

Today, Chipotle's enterprise value is $41 billion. Therefore the current market value expects even better outcome.

13/15

It goes without saying that the narrative valuation approach is VERY susceptible to changes in the used assumptions.

For example, if 10-year yields would rise to 3% (level two years ago in 2018), our valuation would drop from $35 to $28 billion, i.e. a drop of 20%.

14/15

To learn more about the approach, I can highly recommend a book by @AswathDamodaran, Narrative and Numbers: The Value of Stories in Business.

Additionally, @bgurley's response to his Uber narrative valuation is golden, found here:

abovethecrowd.com/2014/07/11/how…

15/15

That’s it for today, folks.

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Much appreciate you taking your precious time for this 🙏 Happy New Year!

The end.