The Importance Of Entry Price

When is an investor most likely to permanently lose money?  When he/she enters an investment.  Therefore, investors should be extremely cautious before entering an investment.  In theory this sounds nice, but in practice the fear of missing out (FOMO) can cause investors to buy too early.  

Some basic math shows the risk of buying at elevated prices.  I recently looked at Adobe Systems Inc.  I haven’t done enough work on the company to have informed opinion about the success of their recent acquisitions and whether management is capable.  That said, I am used to their Adobe branded products because I use them frequently.  Therefore, I understand Adobe’s core product is fairly integral to a business setting and they are priced on a subscription basis.  

Wall Street loves subscriptions because they tend to reduce churn and increase revenue certainty.  Consumers tend to renew subscriptions (sometimes without even realizing it), tend to not request their money back once billed, and cannot defer purchases because a company simply bills their credit cards.  Therefore the existing revenue streams of subscription companies are very likely to continue.  Furthermore, price increases tend to be easier to pass on to consumers since there is less sticker shock (many consumers don’t even check their subscription bills). 

Another thing Wall Street loves is software companies.  Why?  Because once a software company gets traction with customers there is minimal incremental capital to signing up the next customer.  Therefore, most of the additional revenue becomes cash flow to the business.  Thus, once a software firm achieves a minimum viable scale each additional customer becomes immensely valuable (assuming the cost to acquire that customer is less than the lifetime value of the customer). 

Adobe is subscription based and has hit scale.  Therefore, Wall Street loves it.  I decided to take a look because there has been a sell off in tech stocks lately.  Below is a very simple back of the envelope model I built.

I built the model assuming that Adobe continued trading at roughly 30.2x free cash flow.  I decided to increase Adobe’s buyback ratio over time and allowed for free cash flow growth in excess of GDP growth.  These are reasonable assumptions because Adobe probably won’t need all the cash it generates and should be able to raise prices.   

This seems reasonable so far, but the results rest on the assumption that Adobe will continue to trade at 30.2x free cash flow.  Is that reasonable?  Perhaps.  The current yield on 30 year treasury bonds is roughly 3.4%.  The current yield on Adobe is 3.3% (1/30.2; the inverse of the free cash flow multiple).  So, investors are willing to accept slight less free cash flow yield than risk free bonds today because they deem Adobe’s growth and earning certainty worthy of that bet. It’s important to stress that Adobe currently trades at a lower cash flow yield than risk free assets. 

Interest rates have been depressed for a long time now.  I have no idea whether they will continue to stay at these levels or not.  But, its reasonable to ask what happens if rates revert to their long term average of ~4.5%.  For purposes of this illustration lets assume that happens over the next 3 years.  The investment result is below (assuming Adobe trades at a similar yield to 30 year bonds). 

In the example above the business performs exactly as it does in the first scenario.  However, the multiple contraction decreases a shareholder’s 5 year return from 35.3% to 9.0%.  In that scenario, a shareholder would earn less than 2% per year.  That return is certain to reduce a shareholder’s purchasing power over time.  

Therefore, identifying a business worthy of investment is a necessary but insufficient condition to becoming a good investor.  Tradeoffs must always be made.  Bad businesses will sell at extraordinarily cheap prices at times.  They may be worth buying.  Conversely, good businesses selling at extraordinarily high prices may not be worth the risk of wealth destruction.  Reasonable minds can differ about which companies to buy and sell.  But price and risk must be a critical part of the discussion.