Thursday, 9 October 2014

Two pictures of value: An asset value and an earnings power value.

Mechanically Doing a Valuation 

1.  Doing an asset valuation

Now, doing an asset valuation is just a matter of working down the balance sheet. 
  • As you go through the balance sheet, you ask yourself what it costs to reproduce the various assets.
  • Then for the intangibles list them like the product portfolio and ask what will be the cost reproducing that product portfolio. 
2.  Doing an Earnings power valuation

For the EPV, you basically have to calculate two things:  
  • You have to calculate earnings power which is the current earnings that is adjusted in a variety of ways.
  • You divide the normal earnings by the cost of capital.
There is an assumption in an earnings power value and part of it is being careful about what earnings are.  This is just a picture of what some of those adjustments look like.
  • You have to adjust for any accounting shenanigans that are going on, you have to adjust for the cyclical situation, for the tax situation that may be short-lived, for excess depreciation over the cost of maintenance capital expense (MCX).
  • And really for anything else that is going on that is causing current earnings to deviate from long run sustainable earnings.
  • So valuation is calculated by a company’s long-run sustainable earnings multiplied by 1/cost of capital.  
What you have got then is two pictures of value: 
1. You have got an asset value  (AV)
2. You have got an earnings power value  (EPV)
And now you are ready to do a serious analysis of value.
If the picture looks like case A (AV > EPV), what is going on assuming, you have done the right valuation here? 
  • What it means is say you have $4 billion in assets here that is producing an equivalent earnings power value of $2 billion.
  • What is going there if that is the situation you see? It has got to be bad management. 
  • Management is using those assets in a way that cannot generate a comparable level of distributable earnings.
  • If it is an industry in decline, make sure you haven’t done a reproduction value when you should be doing a liquidation value

Notes from video lecture by Prof Bruce Greenwald

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