In the 3Q 2017 Northstar Market Report we highlighted our focus on free cash flow (FCF)¹ as one mark of superior company fundamentals. We also showed how we could discern the market’s implied in perpetuity FCF growth expectations for a particular company from the current share price and how this provides a useful shorthand or high level approach to valuation.

Apple Inc. and Gilead Sciences Inc, the two companies referred to in the article, have experienced differing fortunes over the subsequent twelve months and so we thought it would be useful to revisit the premise in these examples as an illustration of Northstar’s disciplined approach to valuation.

Gilead falls short of market expectations

Recall we sold our clients’ entire holding in Gilead at $85 per share in early September 2017, premised on our view that the FCF growth rate required to satisfy market expectations at the time was likely to prove too challenging.

And so it has proved to be FY18e FCF looks set to decline by 21%, leading to a share price return since our disposal of 11%.

Apple valuation proves conservative

Readers will also recall our decision to retain exposure to Apple, albeit at reduced weights across client portfolios. We highlighted the “peak pessimism” evident in Apple’s forward FCF Yield of 15.1% at a share price of $91 in April 2016, which sparked a rally to $160 by September 2017.

Exposure to Apple across our client portfolios had peaked at 6.8% at the end of 1Q 2017, a point at which Apple traded at $143 per share, inline with our Base Case intrinsic value estimate of $144.

While Apple consistently traded above our Base Case valuation from this point, the benefit of our scenario approach to valuation is evident, in that we could rely on our alternative or Bull Case scenario, giving more credence to higher handset shipments and average selling prices, and which resulted in upward revisions to Apple’s FCF forecasts as well as our own intrinsic value estimate.

Recognising that our initial estimates were proving too conservative relative to the quarterly results Apple has reported over the past year, we have nevertheless acted prudently, by continuing to reduce exposure, as the margin of safety to even our most bullish estimates has shrunk.

We sold our clients remaining holding in Apple in early August at $208.30, confident that the information and guidance revealed in the most recent results are fully reflected in our valuation.
Figure 6. Apple Inc. Northstar Intrinsic Value Scenarios. Source: Northstar Asset Management.
The benefit of a probabilistic approach to valuation

It should be clear from the chart above, that while our intrinsic value estimates were revised higher over the course of the past year-and-a-half, the range of potential outcomes, i.e. the difference between the Bull and Bear Case scenarios, also narrowed.

This is a function of the greater conviction we were able to build in the investment case as well as the reduced forecast risk, which comes with more information and insight into the business.

Equally, by employing alternative scenarios we give recognition to the fact that valuation is never a precise exercise and new information and varied assumptions need to be assimilated and tested.

Developing these scenarios also ensures that clients’ exposure to high quality businesses with strong underlying fundamentals is not cut short too early, whilst understanding and recognizing the downside risk inherent in a Bear Case scenario.

1 Free Cash Flow – A useful measure to Identify Companies Worth Owning - Northstar Market Report Q3 2017.