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

http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

WHAT IS BOOK VALUE?

WHAT IS BOOK VALUE?

The book value of a company is generally considered its net worth; the book value per share would be the net worth of a company divided by the number of shares outstanding.

BENJAMIN GRAHAM DEFINITIONS

There is a need, in considering the book value of a company share, to know what certain terms mean - and who better to explain them than the doyen of investment analysis, Benjamin Graham. His definitions are:

Tangible assets: Assets either physical or financial in character eg plant, inventory, cash, receivables, investments.

Intangible assets: Assets which are neither physical nor financial in character. Include patents, trademarks, copyrights, franchises, good will, leaseholds and such deferred charges as unamortised bond discount.

Graham took the view in Security Analysis that intangible assets should not be taken into account when calculating book value; hence, in this sense, book value per share would be the same as net tangible assets per share (NTA) as opposed to net assets per share (NA).

So, the assets of a company can be either tangible or intangible and, on this point, Benjamin Graham and Warren Buffett appear to have differences in importance.

How To Analyze Real Estate Investment Trusts

Posted: May 7, 2011

David Harper

Contact | Author Bio

ARTICLE HIGHLIGHTS

• A real estate investment trust is a real estate company that issues common shares.
• An REIT must agree to pay out at least 90% of its taxable profit in dividends.
• REITs are analyzed like stocks, but the depreciation of property is considered.

A real estate investment trust (REIT) is a real estate company that offers common shares to the public. In this way, an REIT stock is similar to any other stock that represents ownership in an operating business. But an REIT has two unique features: its primary business is managing groups of income-producing properties and it must distribute most of its profits as dividends. Here we take a look at REITs, their characteristics and how they are analyzed.

Tutorial: Exploring Real Estate Investments

The REIT Status

To qualify as an REIT with the IRS, a real estate company must agree to pay out at least 90% of its taxable profit in dividends (and fulfill additional but less important requirements). By having REIT status, a company avoids corporate income tax. A regular corporation makes a profit and pays taxes on its entire profit, and then decides how to allocate its after-tax profits between dividends and reinvestment; an REIT simply distributes all or almost all of its profits and gets to skip the taxation.

Types of REITs

Fewer than 10% of REITs fall into a special class called mortgage REITs. These REITs make loans secured by real estate, but they do not generally own or operate real estate. Mortgage REITs require special analysis. They are finance companies that use several hedging instruments to manage their interest rate exposure. We will not consider them here.

While a handful of hybrid REITs run both real estate operations and transact in mortgage loans, most REITs focus on the "hard asset" business of real estate operations. These are called equity REITs. When you read about REITs, you are usually reading about equity REITs. Equity REITs tend to specialize in owning certain building types such as apartments, regional malls, office buildings or lodging facilities. Some are diversified and some are specialized, meaning they defy classification - such as, for example, an REIT that owns golf courses. (For more insight, see 5 Types Of REITs and How To Invest In Them.)

Analyzing REITs

REITs are dividend-paying stocks that focus on real estate. If you seek income, you would consider them along with high-yield bond funds and dividend paying stocks. As dividend-paying stocks, REITs are analyzed much like other stocks. But there are some large differences due to the accounting treatment of property.

Let's illustrate with a simplified example. Suppose that an REIT buys a building for $1 million. Accounting requires that our REIT charge depreciation against the asset. Let's assume that we spread the depreciation over 20 years in a straight line. Each year we will deduct $50,000 in depreciation expense ($50,000 per year x 20 years = $1 million).

Let's look at the simplified balance sheet and income statement above. In year 10, our balance sheet carries the value of the building at $500,000 (a.k.a., the book value): the original historical cost of $1 million minus $500,000 accumulated depreciation (10 years x $50,000 per year). Our income statement deducts $190,000 of expenses from $200,000 in revenues, but $50,000 of the expense is a depreciation charge.

However, our REIT doesn't actually spend this money in year 10; depreciation is a non-cash charge. Therefore, we add back the depreciation charge to net income in order to produce funds from operations (FFO). The idea is that depreciation unfairly reduces our net incomebecause our building probably didn't lose half its value over the last 10 years. FFO fixes this presumed distortion by excluding the depreciation charge. (FFO includes a few other adjustments, too.)

We should note that FFO gets closer to cash flow than net income, but it does not capture cash flow. Mainly, notice in the example above that we never counted the $1 million spent to acquire the building (the capital expenditure). A more accurate analysis would incorporate capital expenditures. Counting capital expenditures gives a figure known as adjusted FFO, but there is no universal consensus regarding its calculation.

Our hypothetical balance sheet can help us understand the other common REIT metric, net asset value (NAV). In year 10, the book value of our building was only $500,000 because half of the original cost was depreciated. So, book value and related ratios like price-to-book - often dubious in regard to general equities analysis - are pretty much useless for REITs. NAV attempts to replace book value of property with a better estimate of market value.

Calculating NAV requires a somewhat subjective appraisal of the REIT's holdings. In the above example, we see the building generates $100,000 in operating income ($200,000 in revenues minus $100,000 in operating expenses). One method would be to capitalize the operating income based on a market rate. If we think the market's present cap rate for this type of building is 8%, then our estimate of the building's value becomes $1.25 million ($100,000 in operating income / 8% cap rate = $1,250,000). This market value estimate replaces the book value of the building. We then would deduct the mortgage debt (not shown) to get net asset value. Assets minus debt equals equity, where the 'net' in NAV means net of debt. The final step is to divide NAV into common shares to get NAV per share, which is an estimate ofintrinsic value. In theory, the quoted share price should not stray too far from the NAV per share.

Top Down Vs. Bottom Up

When picking stocks, you sometimes hear of top-down versus bottom-up analysis. Top-down starts with an economic perspective and bets on themes or sectors (for example, an aging demographic may favor drug companies). Bottom-up focuses on the fundamentals of specific companies. REIT stocks clearly require both top-down and bottom-up analysis.

From a top-down perspective, REITs can be affected by anything that impacts the supply of and demand for property. Population and job growth tend to be favorable for all REIT types. Interest rates are, in brief, a mixed bag. A rise in interest rates usually signifies an improving economy, which is good for REITs as people are spending and businesses are renting more space. Rising interest rates tend to be good for apartment REITs as people prefer to remain renters rather than purchase new homes. On the other hand, REITs can often take advantage of lower interest rates by reducing their interest expenses and thereby increasing their profitability.

Capital market conditions are also important, namely the institutional demand for REIT equities. In the short run, this demand can overwhelm fundamentals. For example, REIT stocks did quite well in 2001 and the first half of 2002 despite lackluster fundamentals, because money was flowing into the entire asset class.

At the individual REIT level, you want to see strong prospects for growth in revenue, such as rental income, related service income and FFO. You want to see if the REIT has a unique strategy for improving occupancy and raising its rents. REITs typically seek growth through acquisitions, and further aim to realize economies of scale by assimilating inefficiently run properties. Economies of scale would be realized by a reduction in operating expenses as a percentage of revenue. But acquisitions are a double-edged sword. If an REIT cannot improve occupancy rates and/or raise rents, it may be forced into ill-considered acquisitions in order to fuel growth.

As mortgage debt plays a big role in equity value, it is worth looking at the balance sheet. Some recommend looking at leverage, such as the debt-to-equity ration. But in practice, it is difficult to tell when leverage has become excessive. It is more important to weigh the proportion of fixed versus floating-rate debt. In the current low interest rate environment, an REIT that uses only floating-rate debt will be hurt if interest rates rise.

The Bottom Line

REITs are real estate companies that must pay out high dividends in order to enjoy the tax benefits of REIT status. Stable income that can exceed Treasury yields combines with price volatility to offer a total return potential that rivals small capitalization stocks. Analyzing an REIT requires understanding the accounting distortions caused by depreciation and paying careful attention to macroeconomic influences.

by David Harper, CFA, FRM

In addition to writing for Investopedia, David Harper, CFA, FRM, is the founder of The Bionic Turtle, a site that trains professionals in advanced and career-related finance, including financial certification. David was a founding co-editor of the Investopedia Advisor, where his original portfolios (core, growth and technology value) led to superior outperformance (+35% in the first year) with minimal risk and helped to successfully launch Advisor.

He is the principal of Investor Alternatives, a firm that conducts quantitative research, consulting (derivatives valuation), litigation support and financial education.

Read more: http://www.investopedia.com/articles/04/030304.asp#ixzz1hP7YdcJp

Rights Issue increases Shareholder Equity and dilutes NAV per share and Dividend per share.

How much should you pay for a business? Valuing a company (2)

Asset value

An obvious starting point for valuing a company is to look at the asset base of that organisation. On this basis the company would be worth its net asset value. There are some limitations to this approach:

Book value - Accountants usually value fixed assets at what they cost, depreciated to reflect the reducing value as items are worn out in use. Book value may not be an accurate reflection of the real value.

• This can apply when land and buildings were bought some time ago, and have grown in value; or 
• if the value of these assets has reduced significantly since purchase, due to new technologies. 
• There may also be a factor that has previously been ignored, such as environmental issues. Disposal or land remediation costs could wipe out any asset value.

Normally a company will have a fixed asset register that lists all its assets, and the current depreciated book value of those assets. A similar register might also exist for its other assets.

Working capital - Again, we must understand whether these items are accurately stated.

• Stock (inventory) is usually valued by accountants at what it cost. This may be far more than we can sell it for, especially if it is out of date. 
•  Debtors (receivables) is money owed to us by customers. How much of this might be bad debt (i.e. invoices that may never get paid)? 
•  Creditors (payables) is money we owe our suppliers. How much has our company avoided paying to improve its cash flow?

Intangible assets - This can take the form of

• goodwill (the difference between what we pay for an acquisition and what the assets are valued at) or 
• capitalised costs (such as research or start-up costs).

As there are no physical assets to underwrite these, the net assets may be overstated if these elements are high.

Investments - There might be some investments in other companies, which accountants will value at what was paid for them, rather than their realisable value in the market.

Unstated assets - Accountants usually put no value in the books on such things as people, brands, intellectual property, market position, forward order book etc. This means that the net asset figure alone might seriously understate the company value. This can apply especially in service-based businesses that have few tangible assets.

Also read:

Valuing a company (1)

Valuing a company using Asset Value (2)

Valuing a company using Multipliers (3)

Valuing a company using Market Capitalisation (4)

Valuing a company using Non-Financial Measures & Balanced Scoreboard (5)

Valuing a company using Cash Flows (6)

Company Valuation: NAV and DCF

Company Valuation

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Whenever people talk about equity investments, one must have come across the word "Valuation". In financial parlance, Valuation means how much a company is worth of. Talking about equity investments, one should have an understanding of valuation.

Valuation means the intrinsic worth of the company. There are various methods through which one can measure the intrinsic worth of a company. This section is aimed at providing a basic understanding of these methods of valuation. They are mentioned below:

Net Asset Value (NAV)

NAV or Book value is one of the most commonly used methods of valuation. As the name suggests, it is the net value of all the assets of the company. If you divide it by the number of outstanding shares, you get the NAV per share.

One way to calculate NAV is to divide the net worth of the company by the total number of oooutstanding shares. Say, a company’s share capital is Rs. 100 crores (10 crores shares of Rs. 10 each) and its reserves and surplus is another Rs. 100 crores. Net worth of the company would be Rs. 200 crores (equity and reserves) and NAV would be Rs. 20 per share (Rs. 200 crores divided by 10 crores outstanding shares).

NAV can also be calculated by adding all the assets and subtracting all the outside liabilities from them. This will again boil down to net worth only. One can use any of the two methods to find out NAV.

One can compare the NAV with the going market price while taking investment decisions.

Discounted Cash Flows Method (DCF)

DCF is the most widely used technique to value a company. It takes into consideration the cash flows arising to the company and also the time value of money. That’s why, it is so popular. What actually happens in this is, the cash flows are calculated for a particular period of time (the time period is fixed taking into consideration various factors). These cash flows are discounted to the present at the cost of capital of the company. These discounted cash flows are then divided by the total number of outstanding shares to get the intrinsic worth per share.

Book Value (Net Asset Value)

Synonyms:
Net asset value
Book value
Balance sheet value
Tangible-asset value
Net worth

= Total value of a company's physical and financial assets minus all its liabilities.

It can be calculated using the balance sheets in a company's annual and quarterly reprots.

From total shareholders' equity, subtract all "soft" assets such as goodwill, trademarks, and other intangibles.

Divide by the fully diluted number of shares outstanding to arrive at book value per share.