Fundamental Principles of Value Creation

Ranking the Types of Growth that create value:

1.  Introducing new products to market
2.  Expanding an existing market
3.  Increasing share in a growing market
4.  Acquiring businesses.


High ROIC companies typically create more value by focusing on growth, while lower ROIC companies create more value by increasing ROIC.

Most often in mature companies, a low ROIC indicates

• a flawed business model or 
• unattractive industry structure.

Earnings and cash flow are often correlated, but earnings don't tell the whole story of value creation, and focusing too much on earnings or earnings growth can lead to straying away from the value-creating path.

When ROIC is greater than the cost of capital, the relationship between growth and value is positive.

When ROIC is less than the cost of capital, the relationship between growth and value is negative. 

When ROIC equals the cost of capital, the relationship between growth and value is zero.


With respect to countries, the core valuation principle is applicable, as made evident by the fact that U.S. companies trade at higher multiples than companies in other countries.

When comparing the effect of an increase in growth on a high ROIC company and a low ROIC company, a 1 % increase in growth will have a higher positive effect on the high ROIC company.

At high levels of ROIC, improving ROIC by increasing margins will create much more value than an equivalent ROIC increase by improving capital productivity.

Economic profit is the spread between the return on invested capital and the cost of capital times the amount of invested capital.



Investment rate = Growth / ROIC.   If the growth of a company is 2% and the ROIC is 10%, its investment rate is 20%.


Key Value Driver formula:

Value = NOPLAT * (1 - growth/ROIC) / WACC - growth

For a given company, given:

its next year's NOPLAT is $300
and for the foreseeable future

• its growth rate will be 5%, 
• the ROIC will be 15% and
• the weighted average cost of capital (WACC) will be 13%.

Using the key driver formula, the Value of the Company is:

= $300 * ( 1 - 5%/15%) / 13% - 5%
= $300 * (1/3) / 8%
= $200 / 8%
= $2,500

Recognising Real Value Creation

Data from both Europe and the United States found that companies that created the most shareholder value showed stronger employment growth.

In the past 30 years, there have been at least 6 financial crises that arose largely because companies and banks were financing illiquid assets with short-term debt.

Two activities that managers often use in an attempt to increase share price but that do not actually create value are 

• changes in capital structure (or financing of the firm) and 
• changes in accounting practices.

Maximising current share price is not equivalent to maximising long-term value because managers, who know more than shareholders about the firm's prospects, could slash crucial expenses to improve the stock price in the short term.  Eventually, this will catch up to the firm, and the long term stock price will suffer.

During the Internet boom of the late 1990s, many firms lost sight of value creation principles by blindly getting bigger without maintaining a competitive advantage.

THE BIG PICTURE. Investing is less about the stock price and more about the value of the business.

The Big Picture

Finding companies you know is only the beginning; the circle of competence is only meant to help you stay within your arena of expertise. 

Once you have generated a list of the companies you understand, the next step should be conducting an analysis of the financials. 

Don’t worry — you don’t have to be a finance whiz to understand the basics of the stock market. 

For example, Berkshire Hathaway’s investment philosophy is surprisingly simple: The company should have 
1.  consistent earning power, 
2.  good return on equity, 
3.  capable management and 
4.  be sensibly priced. 


Investing is less about the stock price and more about the value of the business — is it a good one?

Successful investing is more about learning over time and slowly expanding your circle of competence. For now, stick with what you know and focus on the long term. 

Anyone can find success in the stock market; you just have to keep it simple. 

As Buffett has famously said, “You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.” And you know what? $60 billion says he’s right.

Price is what you pay, value is what you get.

If stocks are bought without reference to value, they will in turn be sold without reference to value.

----

When prices increase at a greater rate than can be justified by business performance, they must eventually stagnate until the value catches up or they must retreat in the directions of the value.

Only when a stock is bought at less than its value can price increases that exceed incremental increases in value be justified.

Investing is the intention to seek a required rate of return (RR) relative to risk, based on an assessment of value.

Investing in stocks is not about buying scrip that will go up and down in price, but about investing long term in a sound business that represents good value at its present price.

Value? Growth? Both!

Value? Growth? Both!
By Julie Clarenbach January 2, 2009 Comments (0)
http://www.fool.com/investing/general/2009/01/02/value-growth-both.aspx?source=ihptclhpa0000001

The same company can be both a growth and a value stock. Value investing, after all, wants to buy companies selling at a discount to their intrinsic value. Growth investing wants to buy companies that will grow their bottom lines -- and presumably your investment -- many times over. But there's nothing excluding fast-growing stocks from being undervalued. That's why Warren Buffett himself said that "growth and value investing are joined at the hip."

Putting the puzzle together The other piece that gets lost in the "value vs. growth" debate is this: You shouldn't be buying only one stock anyway. You should be building a portfolio. And that portfolio should be -- say it with me now -- diversified.

One premise of diversification is that different kinds of stocks do better in different market environments. Putting together assets that don't move in the same direction at the same time will create the best chance for high returns with lower overall volatility. Notice how each of these different investment classes go into and out of fashion at different times:

Large Caps
Small Caps
International
REITs

So when you're picking stocks, make sure you choose from a variety of categories:

• Large-cap stocks, being more established, typically endure less volatility; small-cap stocks, on the other hand, are more risky but also have the potential to be more rewarding.
  
• Value stocks provide downside protection and a reasonable assumption of an upside, while growth stocks take advantage of room to double, triple, and quadruple in value.
  
• Domestic stocks take advantage of the unparalleled power of American industry -- but emerging economies, which don't always move in lockstep with developed economies, have room to grow much faster than ours.
  
• While they have may have a reputation for being slow growers, dividend payers have historically boosted performance for investors: From 1960 to 2005, about 80% of the market's returns came from reinvested dividends.
  
• Diversifying across industries ensures that your portfolio isn't wiped out from unforeseen economic, political, or natural disasters. While the credit crisis bankrupted numerous financials and pushed department store stocks down an average of 64% in 2008, discount stores, biotech, and waste management have held their own.

Your portfolio should have all of these: large caps and small, value stocks and growth, domestic stocks and international, as well as some dividend payers -- all from a variety of industries.

Whoa -- how many stocks are we talking here? It won't necessarily take dozens of stocks to diversify in all of these ways, because, as I mentioned earlier, the same stock can fit into multiple categories.

Take "technology, media, and financial services company" General Electric (NYSE: GE) as an example. Where would it fit on this list? It has a market cap of $170 billion, Morningstar considers it a value stock, it currently yields 7.9%, and while it's based in Connecticut, half of its revenue comes from outside the United States.
Or what about tiny China Fire & Security (Nasdaq: CFSG)? It's a $190 million growth company selling fire-protection products to Chinese corporations.
Every single stock you consider is going to fit many different categories, and thus will diversify your portfolio in multiple ways. The key is to fit your holdings together to achieve meaningful diversification, so that you can enjoy strong returns with minimal risk.

The Foolish bottom line

As important as diversification is, it's secondary to buying stocks worth holding for the long run.

But as you consider the world of stocks worth holding, you want to make sure you're blending them together for a portfolio that can earn you great returns while weathering all kinds of markets.

**Appraising the Value of a Business

Appraising the Value of a Business

Investment is most intelligent when it is most business-like.
( Benjamin Graham)

Value investing means treating an investment as though you were buying the entire business. If you were indeed buying a business, you would look for the following:
1. Income: Profits and strong positive operating cash flows exceeding capital requirements are good thing. A company starting at a loss and banking on future profits is starting in the hole, particularly considering the time value of money. Look for companies that produce more capital than they consume.
2. Income Growth: If income and cash flow are steady but unlikely to grow, there can be value. Without growth, time value depreciates earnings value over time. And competition and declining marketplace acceptance can erode the business. There’s little to make a stock price rise unless the market values the steady income stream incorrectly in the first place. Value investors should ignore the common “growth versus value” paradigm and consider growth part of the value equation.
3. Productive Capital Investment: If a company is able to invest additional capital productively – at a greater return than it would get by putting it in the bank – that indicates future value if the capital is available. A company should be able invest capital more productively than you can; otherwise, it makes sense for the company to return the capital to you, and for you to invest the capital elsewhere. If the company doesn’t have productive places to invest but pays you a good return (dividends or share buybacks), the company has value, but growth potential may be in question.
4. Rising Productivity and Falling Expenses: A good business makes increasingly better use of assets and creates more output per unit of input. Businesses that can do so are likely to generate more income sooner.
5. Predictability: Generally, a business with a predictable, steady income stream is more valuable than a company that has erratic or cyclical earnings. The erratic company may return as much money in the long run as the steady company, but the uncertainty surrounding the earnings stream requires a higher discount rate or margin of safety because you just don’t know. The higher discount rate reduces value. Look for simple and steady businesses that you understand.
6. Steady or Rising Asset Values: To the extent that asset values, particularly current assets, are steady or rising, higher returns, if and when paid out to the owners, will ultimately be the result. A company with falling asset values is suspect unless its productivity gains are significant.
7. Favourable Intangibles: Many things can affect or serve as leading indicators of business value. Management effectiveness, market presence, brand strength, customer base, intellectual property, and unique skills and competencies all play a part in driving business value. By nature, these items are hard to quantify but are part of the valuation playing field. Look for companies that do things right in the marketplace.

Stock market as a conduit for transferring wealth

The stock market is a conduit for transferring wealth from those who confuse price with value to those who do not, and from the impatient to the patient.

An investor, armed with knowledge of what their stock is worth, will sit tight and ony buy and sell when the price created by speculative traders is most advantages. Real investors don't generate a lot of brokerage fees.

Also, if a recommendation by advisory newsletters is not accompanied by an assessment of value and the business performance that created the value, a stock can only be bought on faith and sold on ignorance.

Disparity between Price and Value

"The business performance creates the value - the price creates the opportunity."

We are taught that value is the price a willing but not anxious vendor is prepared to accept and a buyer is prepared to pay. However, such a definition applies to collectables, commodities and resources that are subject to variations in supply and demand.

Although stock prices are also generated by supply and demand, their value is not. Positive sentiment will increase demand (optimistic buyers) and reduce supply by limiting the number of willing sellers, while negative snetiment will have the opposite effect.

Although few would support the notion that the value of a financial security such as a stock is determined by the influence on prices of greed, fear, optimism and pessimism (market sentiment), reality implies the opposite.

At his breakfast meeting address to the Philanthropy Roundtable on 10th November, 2000, Charlie Munger said:

"It is an unfortunate fact that greed and foolish excess can come into prices of common stocks in the aggregate. They are valued (priced) partly like bonds, based on roughly rational projections of value in producing future cash. But they are also valued (priced) partly like Rembrandt paintings, purchased mostly because their prices have gone up, so far. This situation, combined with big 'wealth effects', at first up and later down, can conceivably produce much mischief."

Let us try to investigate this by a 'thought experiment'. One of the big British pension funds once bought a lot of ancient art, planning to sell it ten years later, which it did at a modest profit. Suppose all pension funds purchased ancient art, and only ancient art with all their assets. Wouldn't we eventually have a terrible mess on our hands, with great and undesirable macroeconomic consequences? And wouldn't this mess be bad if only half of all pension funds were invested in ancient art? And if half of all stock value became a consequence of mania, isn't the situation much like the case wherein half of pension assets are in ancient art?

One thing we know with absolute certainty is that stock prices and their value can vary hugely. If price and value were synonymous, all stocks whose future business performance was in accordance with market expectations would produce similar long-term investment returns - a notion tha is contemporaneously accepted as valid, although universally acknowedged in retrospect as false. Market commentators who fail to recognise this by referring to market prices as valuations, are by inference treating stocks as common commodities.

Althoug prices are deemed to reflect consensus, it should be remembered that prices are determined not by the majority of shareholders who are uninterested in buying or selling at the current temporary price, but by the tiny minority who are.

Following the adage that says it's impossible to be reasoned out of a belief that we were never reasoned into in the first place, if stocks are bought without reference to value, they will in turn be sold without reference to value.

Warren Buffett says:

"What could be more exhilarating than to participate in a bull market in which the reward to the owners of the business become gloriously uncoupled from the plodding performance of the business themselves? Unfortunately, however, stocks can't outperform businesses indefinitely."

When prices increase at a greater rate than can be justified by business performance, they must eventually stagnate until the value cathces up or they must retreat in the directions of the value. Only when a stock is bought at less than its value can price increases that exceed incremental increases in value be justified.

It is useful to understand some of the reasons for the disparity between price and value.