Asset value (AV) and Earnings power value (EPV). Know the 3 scenarios - AV > EPV, AV = EPV and AV < EPV

What you have got then is two pictures of value: 

1. You have got an asset value
 2. You have got an earnings power value
 
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? If it is an industry in decline, make sure you haven’t done a reproduction value when you should be doing a liquidation value.  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 in the situation you see?  It has got to be bad management.  Management is using those assets in a way that can not generate a comparable level of distributable earnings.  

AV is Greater Than EPV 

• In this case the critical issue—it would be nice if you could buy the company—but typically you pay the reduced EPV and all that AV is sitting there.
• Then you are going to be spending your time reading the proxies and concentrating on the stability or hopefully the lack of stability of management. 
• Preeminently in that situation, the issue is a management issue. 
• The nice thing about the valuation approach is that it tells you the current cost that management is imposing in terms of lost value.  That is not something that is revealed by a DCF analysis. And there are a whole class of value investments like that.
• One of the great contributions to the theory of this business is Mario Gabelli’s idea that really what you want to look for in this case is a catalyst that will surface the true asset value.
• You can wait and sometimes that catalyst may be Michael Price or Mario Gabelli if they own enough of the company.  I would like to encourage those investors who are big enough to make that catalyst you.  

AV Equals EPV 

• The second situation where the AV, the reproduction value of the assets = EPV are essentially the same.
• That tells a story like any income statement or balance sheet tells a story.  It tells a story of an industry that is in balance.  
• It is exactly what you would expect to see if there were no barriers-to- entry. 
• And if you look at this picture and then you analyze the nature of the industry—if you say, for example, this is the rag trade and I know there are no competitive advantages—you now have two good observations on the value of that company. 
• If it ever were to sell at a market price down here, you know that is what you would be getting. You are getting a bargain from two perspectives: both from AV & EPV so buy it. 

EPV in Excess of AV 

• We have ignored the growth, but I will talk about it in a second#. The last case is the one we really first talked about. You have got EPV in excess of AV. 
• The critical issue there is, especially if you are buying the EPV—is that EPV sustainable?
• That requires an effective analysis of how to think about competitive advantages in the industry.

Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School 
Edited by John Chew at Aldridge56@aol.com                           
studying/teaching/investing Page 26

 Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf



Related topic: #
Look at growth from the perspective of investment required to support the growth. Profitable Growth Occurs Only Within a Franchise.

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

Look at growth from the perspective of investment required to support the growth. Profitable Growth Occurs Only Within a Franchise.

Summary 
Now to summarize about growth:

1. growth at a competitive disadvantage destroys value,
2. growth on a level playing field neither creates nor destroys value, and
3. it is only growth behind the protection of barriers to entry that creates value.

Growth 
 

The standard view of short term analysts is that growth is your friend. Growth is always valuable.  That is wrong!  
 

Growth is relatively rarely valuable in the long run. And you can see why with some simple arithmetic.  I am not going to look at growth from the perspective of sales, I am going to look at it from the perspective of investment required to support the growth. 

• Now the investment required to support the growth is zero then of course it is profitable—that happens almost never (For Duff & Phelps or Moody’s perhaps). 
• At a minimum you have A/R and other elements of working capital to support growth. 

Suppose the investment required is $100 million, and I have to pay 10% annually to the investors who supplied that $100 million dollars.   The cost of the growth is 10% of $100 million or $10 million dollars.   

1.  Suppose I invest that $100 million at a competitive disadvantage. 

• Suppose I am Wal-Mart planning to compete against a well-entrenched competitor in Southern Germany, am I going to earn 10% on that investment?  Almost never.  In that case, I will be lucky to earn anything; perhaps I earn $6 million. 
• But the net contribution of the growth is the $10 million cost of the funds minus the $6 million benefit which is minus $4 million dollars for every $100 million invested. 
• Growth at a competitive disadvantage has negative value.  

 

2.  Suppose it is like the automotive industry or like most industries with no barriers to entry, it is a level playing field so the return will be driven to 10% cost by the entry of other competitors. 

• So I am going to pay $10 million, I am going to make $10 million so the growth has zero value.   

3.  Profitable Growth Occurs Only Within a Franchise 

• The only case where growth has value is where the growth occurs behind the protection of an identifiable competitive advantage. 
• Growth only has value where there are sustainable competitive advantages. 
• And in that case, usually, what barriers to entry means is there are barriers to companies stealing market share from each other.
• There is usually stable market share which is symptomatic of that last situation that means in the long run, the company will grow at the industry rate. 
• And in the long run, almost all industries grow at the rate of global GDP.   

So in these three situations, the growth only matters in the last one where its profitable (growing within a franchise) is.

• And the critical issue in valuation is either management or the G&D approach will tell you the extent to which that is important or you have a good reliable valuation and there is no value to the growth because there are no barriers to entry. 
• Or it is down here (growth is profitable) and there obviously you want to get the growth for free.
• You could pay a full earnings power value and get a decent return. (Buffett with Coke-Cola in 1988).  

Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School 
Edited by John Chew at Aldridge56@aol.com                           
studying/teaching/investing Page 27

Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

You are a lot better estimating the Cost of Capital without using fancy formulas

Estimate the Cost of Capital 

You have to estimate the cost of capital.  

First of all, the cost of equity will always be above the cost of the debt.  Secondly, the most expensive cost of equity is the type that venture capitalists have to pay.  If you read the VC magazines, they will tell you what returns they have to show on their old funds to raise money on their new funds.  These days that number is 15%.  Without doing any betas, you know the cost of equity is between 7% and 15% which is a lot better than the beta estimates.  

• Usually for the low risk firm with not a lot of debt, the cost of capital will be about 7% to 8%. 
• For a medium risk firm these days with reasonable debt, it will be about 9% to 10%.  
• For high risk firms, it will be 11% to 13%.

You are a lot better doing that than trying to estimate using fancy formulas.  So you get a cost of capital.

And the nice thing about not including the growth is that errors in the cost of capital are typically not that big. If you are 1% off in the WACC, you are 10% error in the valuation and that is not a killer error in valuation. 


Notes from video lecture by Prof Bruce Greenwald

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

 

 

Cue:  7/11

Value Investing Process by Prof Bruce Greenwald

Greenwald Value Investing Class on February 12, 2008 

Retail stocks are in the tank so investors may be unreflectively selling. You will find many low market to book stocks.  You will find growing companies being dumped indiscriminately. But remember at the end of the day why are you applying this type of search strategy?   Because when you think this stock is a bargain you have to be able to explain why you are the only one who spotted that opportunity.  You have to have some rational for why the opportunity exists. 

You start with sensible search

Then value the stock: basically look at three basic elements of value: 
1. Asset Value
2. Earnings Power Value
3. Franchise Value   


Value Investing Process
SEARCH:  Obscure, distressed, Poor performance, small
VALUATION: Asset Value, Earnings Power Value
REVIEW: key issues, collateral evidence, personal biases
MANAGE RISK:  Margin of Safety, patience, You

Anybody does a DCF, I just throw it out.  Unless it is associated with a short term liquidation.

We spoke about asset values (AVs) and earnings power value (EPV). Earnings, if they are sustainable, are supported either by assets or by barriers to entry. If you had a company with a lot of earnings but no assets what sooner or later will happen to profits if there are no barrier to entry in this market?   They will be competed away.  I can do that for no assets.  No net assets, no barriers to entry and then no protection, no value.

The value of Growth is the least reliable element of value.  
You have to be able to forecast what is going to happen to growth.  It is not just looking there now and applying a value to it, you have to forecast what the changes are going to be. When you look at these things when you have done them yourself, if you look at terminal values for growing companies, you ought to have an immediate sense that it is highly sensitive to the assumptions.  And that is not comforting to a value investor who wants to have an immediate sense of what they are buying with a reasonable amount of certainty.


Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School

When you are considering buying growth stocks:

 

1.  Verify the existence of a franchise

2.  Earnings return is 1/P/E.

3.  Identify cash distribution in terms of dividends and buybacks

4.  Identify investment return of retained earnings

5.  Identify organic (low investment growth)

6.  Compare to the market (representing D/P & growth rate) - is this positive or negative?

I will give you the numbers from three years ago which we applied to a bunch of firms.  
We will look at WMT, AMEX, DELL and GANNETT. 


Company        Business                                                   Adjusted ROE
WMT              Discount Rate                                             22.5%
AMEX            High-end CC                                              45.5%
Gannett           Local NP & Broadcasting                          15.6%
Dell Direct      P/C Supply & Logistics Organization       100% 


Company          Sources of CA                          Local Economies of Scale
WMT                Slight customer captivity            Yes
AMEX              customer captivity                       Some
Gannett             customer captivity                        Local
Dell                   Slight customer captivity             Yes 


Perspective Return on the US Market 

(1) 6% return based on (1/P/E) plus 2% inflation = 8%
(2)  2.5% (Dividends/price) plus 4.7% growth = 7.2% return 

Expected Return equals 7%.   Range is 7% to 8%.  

Wal-Mart. Dell, Gannett and AMEX.

If you are thinking of investing in them, what do you want to know first? 

Is there a franchise here?

• Does WMT have CA? Yes, regional dominance and it shows up in ROE, adj. for cash of 22%. 
• Amex is dominant in their geographic and product segments. Amex dominates in high end credit cards.  
• Gannett is in local newspapers. ROC is 15.6% if you took out goodwill then ROIC would be 35% or higher.  -- 

Ross: CA can’t be just sustained, allow to grow.  CA, EOS and CC.  

Do you think different type of CA are better for allowing you to grow.  They are therefore worth looking at?  Are those franchises sustainable. 

 

With WMT there is some customer captivity in retail but there are big local and regional Economies of Scale.

• When WMT goes outside these Economies of scale they have no advantages. 
• If they go against competitors outside their regional dominance, they will be on the wrong side of the trade.  

AMEX dominates high end credit cards. 

• Do they have customer captivity? 
• (Note: Amex has been using more and more debt to generate high ROE, so the risk profile is higher). 

Comparison to the Market

• They track well because if you look at reinvestment returns, it is high because people are not investing a lot in equities. 
• Look at organic growth which is higher than it is today. 
• On the other hand, multiples have gone up. 
• There has been a secular increase in multiples of 1% to 2%.
• You have to ask yourself, is it reasonable to earn a 7% to 8% return on equities in the present climate where long bonds are earning 4%?  Historically the gap has been 8%.  

Should you use a cost of equity of 7% to 9% vs. 9% to 11%.  I think that we are talking about real assets.  That is a good question. 

• One of the things you want to do is use a lower cost of capital than 9%.
• But all of a sudden all these stocks have EPV well above their asset values. 
• Now some of that will be in intangibles.

But what should be happening?  Investment should be going up, but they are not.

• So it looks like for practical purposes with a market multiple of 16 and 2x book value, the real returns are significantly lower than that.  
• So if you have the opportunity to invest in businesses with returns greater than that, you want to value the income streams at 9% to 11% rather than 7% to 9%. 

Amex is trading back at 17 times.  Growth rate at 15%.  A classic growth stock.

• A 6% return. 
• They are committed to returning 6% to shareholders, but the 6% cash distribution will be 4%.
• They are reinvesting 2%.
• We know what they are doing with that money. They are lending it to their customers, by and large.            

 

 

Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

     

 

Calculating investment returns from growth stocks - returns from dividends and share buybacks, returns from retained earnings (reinvestment by the company) and returns from organic growth.

The calculation in the short run is not that hard to do.

1.  First you have to know where the money is going.

• Is WMT expanding in Mexico or is WMT expanding somewhere in Europe where it has no competitive advantages. 
• You can look at the simple economics with and without infrastructure costs and you see the returns if they have to build the infrastructure are about 7% to 8% which is below their cost of capital (Kcost). 
• If they can add stores to an existing infrastructure (stores near existing supply depots and other WMT stores), then the returns are more like 17% to 20%.
• But you ought to know enough about the economics of growth stocks, so you know those numbers. 

2.  You know what the reinvestment return is. 

• If the return is 20% after tax and their cost is 10%, what each dollar they reinvest worth?   $2 because they are earning 2x the cost of capital.  
• So what you are going to do is take that reinvestment return—that 5% that is reinvested and multiply it by the difference between the capital return and cost of capital.
• If they are earning 7% and Kcost is 10%, they are destroying at the rate of 3%.

3.  Is reinvesting in cash a good idea—no.

• A crappy return. 
• The longer they hold that cash the lower the return is in terms of reinvestment.   
• You are losing the return on that cash. 

So you look at the earnings return, what you get in cash, the fraction that is distributed either through buy backs and dividends and the fraction that is reinvestment and the value creation characteristics of the reinvestment.    

 

4.  Then certain companies get returns essentially without much investment--which is that if you own a franchise, even without conscious expansion, that franchise will sometimes grow.   The incremental investment involved is negligible. 

• When WMT sees an increase in SSS, it typically doesn’t have to build any new stores. 
• Especially if it is a price increase, its doesn’t have to add new people or add SKUs.
• What is the capital investment required for that increase in sales?  Only inventory.
• If their inventory turns are 8 times, then for every $1 of sales, they make about 7.5 cents in profit.
• That organic growth generates returns of about 16%. 
• They are higher than that in reinvestment because typically they will refinance two-thirds of the inventory investment with debt.
• So you will be getting returns of 150% on the capital you invest to support that organic growth. 

Why don’t returns get bid away by entrants whose store economics have improved?  That is where the existence of a franchise is crucial. If there were no barriers to entry, then gains would be get competed away by additional competitors.  So it is only growth behind those barriers that creates value.  

 

5.   You want to look next—you have your cash return, your investment return and then the return from organic growth and compare that to the return of the market to get a feel for your margin of safety is in terms of returns–then you want to see what will change that picture in a sustainable way.

 

 

Recap: 
Verify the existence of a franchise

Cash earnings return is 1/P/E.

Identify Cash distribution in terms of dividends and buybacks

Identify organic (low investment growth)

Identify investment return-multiple a percent of retained earnings

Compare to the market representing D/P & growth rate.

Identify options positive and negative.


Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

Growth creates value only when the company has a competitive advantage. If there were no barriers to entry, then gains would be get competed away by additional competitors.

Why don’t returns get bid away by entrants whose store economics have improved? 

• That is where the existence of a franchise is crucial.
• If there were no barriers to entry, then gains would be get competed away by additional competitors. 
• So it is only growth behind those barriers that creates value.  

When you look at growth, this is what you look at: 
1.  First is verify the franchise.  If you don’t have a franchise, then growth is worth $0.

• Look at historical returns, share stability. 
• Look for sustainable competitive advantages. 

2.  Then calculate a return. 

• You don’t look at a P/E ratio, you look at an earnings ratio.
• If you are paying 14x earnings, it is a 7% if that P/E ratio stays the same and the earnings stay the same. You pay 11 times, it is 9%. 8 times, then 12.5%.  

3.   Out of that return there are two things that can happen to you—the first is that give it to you in your hot little hand in cash. What are you getting in cash?

• If it is a 8 times multiple, it is a 12.5% return.   
• The dividend is 2.5% and you are buying back 5% in stock per year, you are getting 7.5% in your hot little hand.
• If dividends and buyback policies are stable, then what are you getting.
• There are not stable then you have to estimate what they will be over time.  
• But you want to know what fraction of the earnings get distributed.
• So if 11 times multiple and they historically distribute a third of the earnings, 1/11 is a 9% and 1/3 of that is a 3% distribution. 

4.  What happens to the other 6%?  

• That gets reinvested—there the critical thing about the value is how effective do they reinvest that money?
• So in growth stocks, capital allocation is critical.
• Because (mgt.) is typically keeping most of your money and you care about how effectively they are investing it.      

5.  You want to look next—you have your cash return (3), your investment return (4) and then the return from organic growth.

 

6.  Compare that to the return of the market to get a feel for your margin of safety is in terms of returns–then you want to see what will change that picture in a sustainable way.  

 

 

Recap:  When you are considering buying growth stocks:

 

1.  Verify the existence of a franchise

2.  Earnings return is 1/P/E.

3.  Identify cash distribution in terms of dividends and buybacks

4.  Identify investment return of retained earnings

5.  Identify organic (low investment growth)

6.  Compare to the market (representing D/P & growth rate) - is this positive or negative?

 

 

 

Explanatory notes:

 

Dividends, buybacks & reinvestment of retained earnings:  So you look at the earnings return, what you get in cash, the fraction that is distributed either through buy backs and dividends and the fraction that is reinvestment and the value creation characteristics of the reinvestment.     

Organic growth:  Then certain companies get returns essentially without much investment--which is that if you own a franchise, even without conscious expansion, that franchise will sometimes grow.   The incremental investment involved is negligible.

 

 

 

Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

Value Investing in Practice

Value Investing in Practice Long-term - Fundamental (look at underlying business) (1) Lookintelligentlyforvalueopportunities(LowP/E,M/B) o Mr. Market is not crazy about everything o This is the first step not to be confused with Value Investing (2) Knowwhatyouknow   Not all value is measurable   Not all value is measurable by YOU (Circle of Competence) (3) Youdon'thavetoswing PATIENCE

Value Investing: the Approach Search (Look Systemically for under valuation) Value Review Manage Risk

  Value implies concentration not diversification. (Look for a Margin of Safety)   At worst Buy the Market) There are three parts to being effective:

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

Greenwald Lecture at Gabelli Value Investing Conference

Published on 16 Jun 2014

Professor Bruce Greenwald lecture at Gabelli Value Investing Conference at Princess Gate, London in 2005. He looks at the art of value investing and investment processes.