Thursday, 9 October 2014

Where do you always want to start a valuation?


Asset Valuation 

Where do you always want to start a valuation?  You want to start with assets.  Why?  Because they are tangible.  You could technically go out and look at everything that is on the firm’s balance sheet. Even the intangibles like the product portfolio you could investigate it today without making any projections or extrapolations.  You could even investigate the quality of things like the trained labor force and the quality of their business relationships with their customers (I think this is very difficult to ascertain). 

Start with that. It is also your most reliable information. It is also all that is going to be there if this is not a viable industry, because if this is not a viable industry, this company is going to get liquidated.  And what you are going to see is the valuation in liquidation. And that is very closely tied to the assets.   In that case, with that strategic assumption, you are going to go down that balance sheet and see what is recoverable.  But suppose the industry is viable, suppose it is not going to die. How do you value the assets then? Well, if the industry is viable then sooner or later the assets are going to be replaced so you have to look at the cost of reproducing those assets as efficiently as possible.   So what you are going to do is you are going to look at the reproduction value of the assets in a case where it is a viable industry.  And that is where you are going to start. We will go in a second and a little more tomorrow about the mechanics of doing that reproduction asset valuation. But that is value that you know is there.  

Earnings Power Valuation

The second thing you are going to look at because it is the second most reliable information you are going to look at is the current earnings. Just the earnings that you see today or that are reasonably forecastable as the average sustainable earnings represented by the company as it stands there today.   

And then we are going to extrapolate.  We are going to say suppose there was no growth and no change what would the value of those earnings be? Let’s not get into the unreliable elements of growth. Let’s look secondly at the earnings that are there and see what value there is. And that is the second number you are going to calculate and the likely market value of this company.  But it turns out that those two numbers are going to tell you a lot about the strategic reality and the likely market value of this company.  


Suppose this is a commodity business like Allied Chemical and you have looked at the cost of reproducing the assets.  And you think you have done a pretty good job at that—And you could build or add buildings, plants, cash, accounts receivables and inventory that represents this business-- customer relationships, a product line--for a billion dollars.  This is usually going to be the cost for their most efficient competitors, who are the other chemical companies.  So the cost of reproducing this company is a billion dollars. Suppose on the other hand its earnings power is $200 million, and its cost of capital is 10% so the value of it s earnings which mimics its market value is two billion dollars ($200 million/0.10).  What is going to happen in that case?  Is that  two billion $ going to be sustainable?   $2 billion in earnings power value (EPV) is double the asset value (AV) of the company but there are no sustainable competitive advantages. If EPV is > than AV, then sustainability depends upon franchise value (“FV”). 

Well, think about what is going on in the executive suites of all these chemical companies. They are going to seed projects where they can invest $1 billion dollars and create two billion dollars of value.  What these guys love better than their families are chemical plants.  So you know those chemical plants are going to get built if there is not something to prevent that process of entry.

Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School 
Edited by John Chew at                           
studying/teaching/investing Page 24 

Additional notes:

Reversion to the Mean or the Uniformity of One Price 

As the chemical plants get built, what is going to happen to this chemical price?  It is going to go down. The margins will decline, the earnings power value and the market value of the company will go down. Suppose it goes down to a $1.5 billion.  Will that stop the process of entry?  No, not at all. Because the opportunity will still be there.  (Profits still above the cost of capital) 

In theory, the process of entry should stop when the cost of reproducing those assets equal the market value of those assets.  In practice, of course, it is easier to buy a puppy than to drown it later.  Once those puppies are bought, you are stuck with it.  The process of exit is slower than entry.   The same thing applies to chemical plants.  Once those chemical plants are built, they are likely to stay there for a long time.  Typically, the process may not stop there.  It applies equally to differentiated products. Suppose Ford, to reproduce their assets of the Lincoln division is $5 billion and the earnings power value and the market value is 8 billion. What is going to happen then?  Mercedes, the Europeans and the Japanese are going to look at that opportunity, and they are going to enter. 

Now do prices necessarily fall?  No, not in this case, they match Ford’s price. What will happen to Ford’s sales?  Inevitably they are going to go down because they will lose sales to the entrants.  What therefore will happen to their unit fixed costs?  The costs will rise.  Their variable costs are not going down, so their unit costs are going up.  The prices are staying the same, their margins are going down and their per units sold and their sales are going down, so what happens to profits here with a differentiated market and with a differentiated product?  Exactly the same thing.  

The differentiated products won’t save you. And that will go on until the profit opportunity disappears.  Unless there is something to interfere with this process of entry, sooner or later the market value of the company will be driven down to the reproduction value of the assets.  Especially, in the case of the Internet. You had companies that didn’t have any earnings that were $5, $10 or $15 billion dollars whose assets could be reproduced for $10 million or $15 million dollars.  Unless there is something to stop the process of entry, the earnings to support that are not going to materialize.  So what you are looking at is a decline.

No comments: