One Easy Way to Improve Your Judgment

Analysis, Decision Making, Expected Value, Probability / Saturday, January 23rd, 2021

The mistake we often make when valuing a stock is overestimating the business growth potential, how much free cash flow it can generate, and so on. We extrapolate a spurt of excellent performance caused by temporary changes such as a brief supply and demand tailwind into the distant future. Or sometimes, we just fail to anticipate the actions of other competitors, new entrants, and changes in the industry. 

Imagine you’re about to make a bet on a soccer game. What do you do? You either pick your favourite team, or pick the one you’re familiar with if you don’t have a favourite, or pick the one that has won recently if you’re unfamiliar with both teams. That’s how we usually make predictions. But a better way is to place a probability on each outcome. There are only 3 outcomes in this case: the home team wins, a draw, or away team wins. You know you’re overconfident if you place a 100% chance on one team to win. So the moment you have to put a number on the chance of a draw or the opponent wins, you start thinking of what can possibly go wrong and question your own assumptions. The team that won their recent games has higher morale which makes them more likely to win, but they might also become complacent due to their past success. Their opponent isn’t in a good form lately, which could mean they’re more motivated to turn things around. It is this thinking process of what else can happen and seeing things from multiple perspectives that help us improve our judgment.

Coming back to investing, one way to hone these dragonfly eyes of seeing things through many lenses when you value a stock is to create a histogram. If a stock is worth say $7 bil in market capitalisation, the histogram will force you to think through the possible scenarios of why it might be worth less or more than $7 bil. This thought process keeps you open-minded and prepared for more possible outcomes. 

Take Ferrari because everyone is familiar with it. Ferrari’s market cap is around US$38 bil. with $846 million in earnings and $725 million in free cash flow. (Enterprise value is a better way to think about how much you’re paying for a business but for simplicity’s sake we assume the business has zero debt). 

Instead of thinking “Ferrari is worth X price.”, it’s better to think in a range like Ferrari is worth between $5 to $50 billion. That’s my range. My 95% confidence interval. That is to say, if there are 1,000 alternate universes and Ferrari charts its own course in each of those universes independent of one another, I expect to see Ferrari’s value to fall between $5 and $50 billion in 950 of those universes. 

Given that my 95% confidence interval is between $5 to $50 billion, I can divide this range into 9 outcomes, each with a $5 billion interval, and assign probabilities to them.

What are the chances that Ferrari is worth less than $10B? Based on its historical earnings and return on capital, it is very unlikely unless the brand becomes worthless. But it isn’t entirely impossible, so I give it a 1% probability. What about it worth between $10 to $15B? $15-20B? $20-25B? I’ll do this for each of the 9 outcomes.

How much Ferrari is worth isn’t important here. The key is this process pushes you towards the direction of thinking in multiple scenarios. What can make Ferrari worth less than its current market cap? Majority of Ferrari’s value comes from intangible assets, the brand. The Ferrari brand can lose its prestige by introducing too many models to a drop in resale value for older cars, lowered growth expectation, a shift in consumer preference to electric sports cars, loses its earning power, adverse impact from Formula One, unable to convert R&D spent into advanced powertrain technology etc. On the other hand, it is also possible that Ferrari can be worth more than its current market cap. Ferrari currently has a 0.05% penetration on the 18 million high net-worth individuals (HNWI) worldwide. They can continue to increase growth rate through a mix of price and volume growth, as they’ve done over the past few years, by introducing new line-ups and more product launches while increasing margin through pricing power.

This process of considering many possibilities means you’ve to synthesize all of them into a single conclusion. The aggregation of these possibilities improves judgment. In Superforecasting, Philip Tetlock wrote that you can easily improve your judgment by synthesizing your conclusion with your friend’s conclusion. What’s even better is to come up with as many different conclusions as you possibly can and aggregate them. Which is what we just did with Ferrari. You would achieve the wisdom of the crowd all by yourself. 

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