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Part 3, The philosophy of value investing and part 5, real time value investing, are among the best from a moneymaking perspective. Montier lets his interests in value and investor behavior show as he progresses through the book in a well-structured way. However, the charts can be obtrusive and hard to follow, as they do not align with the text well and rarely have labeled axes. Apr 22, David rated it really liked it Very good overview of the benefits of value-investing..
It integrates behavioral psychological concepts into value investing. But some of the chapters of the book are repetitive, especially late in the book. Dec 21, Jonathan rated it liked it It's always nice to read a contrarian view, especially when it comes to value investing. And while I agree that many theories from the ivory towers do not translate to the real life experience of investors, I found Montier's writing a little annoying.
Countless typos aside no editor? I wanted to like this more, bu It's always nice to read a contrarian view, especially when it comes to value investing. I wanted to like this more, but the prose read like a textbook in a total snooze fest. I have a lot of respect for GMO Montier's firm , but my biggest disappointment with Value Investing is what I find to be all-too-common among folks who say, "everything you know is wrong.
Or, how they invest hopefully successfully on behalf of their clients. If anything, it makes you want to go passive. There are also companies with divisions performing so poorly that the record of the whole company suffers. If the stock price reflects the earnings often losses of the whole company, then the only thing management needs to do to turn things around and boost the share price is to kill the division. Most of these situations do not escape notice from the sharp eyes of Wall Street analysts, but there are always a few with situations novel or complicated enough to avoid detection.
We want to emphasize that all of this work is a starting point. The purpose of the search effort is to reduce the investment universe to a manageable size so that we can begin valuation analysis in depth. We can use com puterized screens of company or stock databases. We can look at the financial press for notice of spin-offs, other restructurings, or new bankruptcy filings. We can read trade publications to see which industries are distressed and where there is potential for consolidation and other value-enhancing changes.
We are examining possibilities for our portfolio, and those that pass these screens or eyeball searches have made our short list. But this is only the first step. The actual work of valuation begins after the candidates have been selected. Adherents to value investing as an investment discipline believe that financial securities, like all other assets, have an intrinsic value that can be determined by careful analysis.
Opportunities for profitable investment emerge when the current market price of the securities deviates significantly from this intrinsic value. This chapter argues that the methods pioneered by Graham and Dodd possess significant practical advantages over the commonly used alternatives. Therefore, the historical success of the value approach has not been an accident. The Present Value of Current and Future Cash Flows There is wide agreement in theory that the intrinsic value of any investment asset-whether an office building, a gold mine, a company selling groceries at the comer or groceries over the Internet, a government bond, or a share of General Motors stock-is determined by the present value of the distributable cash flows that the asset supplies to its owner.
Present value is properly calculated as the sum of present and future cash flows, both outlays and receipts, with each dollar of future cash flow appropriately discounted to take into account the time value of money see Appendix to this chapter. Graham and Dodd disciples accept the concept and the calculation of present value, as do all other fundamental investors. The techniques are taught at every undergraduate and graduate school of business.
Investment bankers and corporate financial officers use them. Governments depend on them to evaluate the returns from potential capital projects and other investments. Calculators are programmed to produce present value figures, and electronic spreadsheets have financial functions that will do the work.
Present value analysis is inescapable. But what is true in theory need not provide an appropriate model for finding intrinsic value in actual practice. Perhaps we should say that the practical value of present value analysis should be discounted. The standard way of calculating present values, and hence intrinsic value, is to begin by estimating the relevant cash flows for the current and future years out to a reasonable date, perhaps 10 years in the future. Then one selects estimates a rate for the cost of capital that is appropriate to the riskiness of the asset in question.
With these two figures it is possible to calculate the present value of each annual cash flow; summing them gives us the present value of all the cash flows for the years in question. The customary practice for dealing with the cash flows in the distant future is to come up with what is called a terminal value. The terminal value is invariably calculated by assuming that beyond year 10 or whatever year is the last for which we have done annual cash flow calculations cash flow grows perpetually at a constant proportional rate.
Under this assumption, the value of those cash flows, looking forward from the end of year 10, will be the projected cash flow for year 11 times a multiple. This multiple is equal to 1 divided by the difference between the cost of capital and the perpetual growth rate. We add that to the present value of our first 10 years of cash flows to get an intrinsic value for the current and all future cash flows. We should be struck here by a glaring inconsistency between the pre cision of the algebra and the gross uncertainties infecting the variables that drive the model.
We estimate rates of growth for 10 years and then another growth rate from the end of year 10 to forever. This is a heroic, not to say foolhardy, exercise. Suppose that in two or three years, the company faces more competition, technological challenges, a spike in its costs of materials that it cannot pass on to customers, or any of a host of reasonable possibilities that will curtail, and may even eliminate, the growth of its cash flow.
Imagine how accurate our estimates are likely to be for even a stable company like General Motors, much less for dynamic firms like Microsoft or Cisco Systems. We also assume that our company will have access to long-term financing at a predictable cost of capital on an ongoing basis. Yet who knows today what lenders will demand in five years, or how much potential share purchasers will require to buy new stock? Profit margins and required investment levels, which are the foundations for cash flow estimates, are equally hard to project accurately into the far distant future.
Worse still, valuations vary significantly if the underlying assumptions are off by only small amounts. Consider the terminal value and the cash flow multiple. If our estimate is wrong by only 1 percent in either direction for the cost of capital, the growth rate, or both, the terminal value multiple can vary from a high of 50 7 percent cost of capital minus 5 percent growth rate to a low of 16 9 percent cost of capital less 3 percent growth rate.
This is a range greater than three-to-one. In many-probably most-valuations, the terminal value is the largest component of the total present value. Investors are certainly aware of these difficulties, and there are ways of attempting to deal with them. One method is to simplify the valuation process by relying on multiple-based value calculations.
However, the key shortcoming of this approach is that multiplebased valuations are nothing more than present value calculations with some simplifying assumptions tacked on. In effect, they are terminal value calculations as of today.
They do not avoid the problems with present value calculations; they merely sweep them under the rug. Another widely employed approach to dealing with the uncertainties of present value is to perform an exhaustive number of sensitivity analyses. The purpose is to capture the full range of valuation possibilities. The problem here is that the range is usually quite large. Because the underlying parameters are linked together in complicated ways, it is not clear which of the many possible valuations is the likely one.
Sensitivity analysis has the virtue of making explicit the unreliability of present value estimates, but pointing out the problem is not the same as solving it. In fact, the unreliability problem is intrinsic to the practice of present value analysis as a means of determining intrinsic value. As commonly applied, that approach suffers from two fundamental defects. First, present value is the sum of individual cash flows from now into the distant future. It may be possible to make correct projections for the next few years; as the time lengthens, the projections invariably become less accurate.
In present value calculations, however, all these terms are simply added together. As every engineer knows, adding inaccurate to accurate information produces inaccurate information. An improved approach to valuation would attempt to protect reliable information from being corrupted; the present value method does not.
Second, the present value approach in practice relies on informationparametric values for operating variables-that is often simply not knowable, especially in the far distant future. Yet there are predictions that the professional analyst should be able to make about those far future years: whether the auto industry is likely to be economically viable, whether Ford will continue to operate at whatever competitive advantage or disadvantage it may enjoy today relative to its major rivals GM, Toyota, DaimlerChrysler, etc.
These are broad strategic judgments, and thoughtful analysts are better at making them than at predicting operating margins or costs of capital. Yet the present value approach cannot be readily adapted to incorporate the implications of these judgments for a valuation of the company.
The Graham and Dodd approach to valuation avoids both of these problems. It segregates information affecting valuation by reliability class, so that good information is not contaminated by poor information. It also directly uses the valuation implications of broad strategic judgments. A Three-Element Approach to Valuation: Assets, Earnings Power, and Profitable Growth The skepticism with which Graham and Dodd investors regard present value calculations of future cash flows might be nothing more than a worldly cynicism toward all systematic efforts at valuation if these investors did not offer an alternative approach that avoids the pitfalls of present value.
Fortunately for them, and for us, they have developed another valuation method. It is based on a thorough grasp of the economic situation in which a company finds itself. It refuses to pay anything for even the rosiest prediction that has no current or historical foundation.
Charlie Munger of Berkshire Hathaway said that if he were giving a test calling for an analyst to value a new dot-com internet company, he would fail anyone who answered the question. It would be rash to predict its cash flow in , but there are some things we can state with confidence. Element 1: The Value of the Assets First, we can speak about the present condition of the company. Following Graham and Dodd, we are going to start with an asset value for the firm.
We know that these accounting values are going to be more accurate for some assets than for others. Thus, as we work down the balance sheet, we accept or adjust the stated numbers as experience and analysis dictate. We do the same for the liabilities side of the balance sheet. At the end, we subtract liabilities from assets to obtain the current net asset value.
There is no need for us to forecast the future. The assets and liabilities exist today. Many of them are tangible or quasi-tangible, like money in the bank account as confirmed by the bank , and these can be valued directly with great precision.
Starting at the top of the balance sheet has another advantage. As we work down the asset list from cash at the top, whose value is unambiguous, to various intangible assets like goodwill, whose value is often highly problematic, we are made naturally aware of the decreasing reliability of the stated values.
Graham himself preferred to rely totally on current assets that could be realized within a year and whose accounting values did not vary far from the actual cash that could be obtained by selling them. Another aspect of asset valuation of which we may speak concerns the principle we employ to assign a value to each asset type.
For our Ford example, the choice depends on a strategic judgment regarding the future of the automobile industry in which the company operates. If the industry is not economically viable, if it is in the process of terminal decline, then the assets must be valued at what they are likely to yield in liquidation.
The more specialized the assets are for use in the automobile industry, the greater is the discrepancy between what the balance sheet says and the ac tual cash they will bring in a sale. Cash and accounts receivable will be fully valued, more or less, while plants, equipment, and even some units in the inventory will be valued at scrap.
Any goodwill or other intangibles the company lists on its balance sheet, representing what it paid for customer relationships or product designs bought when it acquired other companies, will be worth nothing. On the other hand, if the automobile industry is not going away, then these assets should be valued at reproduction costs, meaning the amount Ford or a competitor would have to pay to replace them today, at the currently most efficient way of producing them.
They are still used in an economically viable industry, and as they wear out, they will be reproduced at some cost. Again, the reproduction costs of cash, accounts receivable, and inventory are relatively easy to calculate and are close to accounting book value.
The farther down the list, the harder it is to make an accurate estimate of the value. But there are appraisers who make a living by valuing plant and equipment, so we are still dealing with a more solid item than the earnings growth rate 10 years into the future. Another judgment we may be qualified to make-especially if we are at all expert in the automobile industry-is a strategic judgment about where Ford will fit within the industry.
But the implications of this strategic situation-no competitive advantage or disadvantage for the firm-are important. Competitive advantages enjoyed by incumbent firms in any industry are equivalent to barriers to entry against potential competitors. In fact, the two terms are simply different ways of identifying an identical situation. If there are no barriers, we have a level economic playing field. All the firms, both those already in the business and new entrants who might like to take part, have equal access to production technologies, resources, and customers.
There is nothing to prevent either existing competitors from trying to expand or new players from joining in. Imagine that we find a company, First-In, operating on a level playing field. What happens? So we see First-In confronted by newcomers, expanding competitors, or both. A load of new capacity starts to come on line. Either prices fall or, for differentiated products, each producer sells fewer units.
In both cases, profits decline, and market value drops with them. Capacity continues to expand, and profits and market value continue to sink. Competitors suffer the same fate; everybody sinks. This basic process also works in the opposite direction. Asset value in strategic terms corresponds, therefore, to the free-entry no competitive advantage, level playing field value of the firm-a circumstance that probably characterizes a substantial share of all industries and markets.
Thus, for Ford, calculating the reproduction value of the assets in the spirit of Graham and Dodd enables us to say a number of important things with reasonable confidence. Unless mismanagement of the company impairs their worth-a situation not unheard of-the Ford Motor Company is worth at least this identifiable asset value.
But without barriers to entry or competitive advantages, it is worth no more. To transform current earnings into an intrinsic value for the firm requires us to make assumptions both about the relationship between present and future earnings and about the cost of capital. Because we need to rely on these assumptions, intrinsic value estimates based on earnings are inherently less reliable than estimates based on assets.
The traditional Graham and Dodd earnings assumptions are 1 that current earnings, properly adjusted, correspond to sustainable levels of distributable cash flow; and 2 that this earnings level remains constant for the indefinite future. Because the cash flow is assumed to be constant, the growth rate G is zero. The adjustments to earnings, which we discuss in greater detail in Chapter 5, include 1. Taking into account the current position in the business cycle and other transient effects; the adjustment reduces earnings reported at the peak of the cycle and raises them if the firm is currently in a cyclical trough.
Considering other modifications we discuss in Chapter 5. The goal is to arrive at an accurate estimate of the current distributable cash flow of the company by starting with earnings data and refining them. To repeat, we assume that this level of cash flow can be sustained and that it is not growing.
Although the resulting earnings power value is somewhat less reliable than the pure asset-based valuation, it is considerably more certain than a full-blown present value calculation that assumes a rate of growth and a cost of capital many years in the future. And while the equation for EPV looks like other multiple-based valuations we just criticized, it has the advantage of being based entirely on currently available information and is uncontaminated by more uncertain conjectures about the future.
Also, there is an important and close connection between the EPV of a firm and its strategic situation, and the line of connection runs through the reproduction cost of the assets. When we consider economically viable industries, there are three possible situations. In this case, management is not using the assets to produce the level of earnings that it should. The cure is to make changes in what management is doing. In the second, the EPV and the asset value are more or less equal.
This is the situation we would expect to see in industries where there are no competitive advantages. If a careful analysis of the structure of costs and customer demand supports this conclusion we discuss this type of competitive advantage in Chapter 5 , then the asset valuation and EPV reinforce one another, and our confidence in both is increased. We have ignored here the value of the future growth of earnings. But we are justified in paying no attention to it because in evaluating companies operating on a level playing field, with no competitive advantages or barriers to entry, growth has no value.
The return these companies earn on the capital invested in them just equals the cost of acquiring that capital, and there is nothing left over for the previous investors. Thus, the EPV that equals the asset value defines the intrinsic value of the company, regardless of its growth rate in the future. In the third situation, if the EPV, properly calculated, is significantly higher than the reproduction costs of the assets, then we are looking at an industry setting in which there must be strong barriers to entry.
Firms within the barriers will earn more on their assets than will firms exposed to the humbling experience of seeing new entrants join the party with no handicap for arriving late. For the EPV to hold up, the barriers to entry must be sustainable at the current level for the indefinite future. The difference between the EPV and the asset value is the value of the franchise enjoyed by the company in question.
Competitive advantages enjoyed by incumbent firms constitute barriers to entry that protect the incumbents from profit-eroding competition. In fact, the three terms all describe the same basic phenomenon. The defining character of a franchise is that it enables a firm to earn more than it needs to pay for the investments that fund its assets. The EPV is greater than the asset value; the difference between the two, as we said, is the value of the franchise.
Therefore, the intrinsic value of a firm is either the reproduction costs of the assets, which should equal the EPV, or those assets plus the competitive advantages of the firm that underlie its franchise. The initial judgment that has to be made in this connection is whether the firm currently has a competitive advantage, and, if so, how strong and sustainable it is. This is a judgment that we can sensibly make.
For Ford, we forecast that no competitive advantage was likely to emerge over the next two or three decades. We might be proven wrong, but given the history of competition in the motorcar world, that is the way to bet. The opposite would be true for Coca-Cola. It has had years of higher-than-normal profitability. It makes sense to believe that its competitive advantage will persist, neither more nor less powerful, into the foreseeable future.
Element 3: The Value of Growth When does growth contribute to intrinsic value? We have isolated the growth issue for two reasons. First, this third and last element of value is the most difficult to estimate, especially if we are trying to project it for a long period into the future. Uncertainty regarding future growth is usually the main reason why value estimations based on present value calculations are so prone to error.
By isolating this element, we can keep it from infecting the more reliable information incorporated into the asset and earnings power valuations. However, as we explained earlier, growth on a level economic playing field creates no value. It will be useful to review why. Growth in sales that finds its way to the bottom line net income would seem to imply that there is more money available to investors.
But growth generally has to be supported by additional assets: more receivables, more inventory, more plant and equipment. That cuts into the amount of cash that can be distributed and thereby reduces the value of the firm. For firms that are not protected by barriers to entry and thus do not enjoy sustainable competitive advantages over their rivals, the new investment produces returns that are just enough to offset the costs of the new investment.
The net gain is zero. Recall the example of the firm operating on a level playing field. Its intrinsic value has grown not at all. For firms operating at a competitive disadvantage i. We shall discuss this phenomenon in more detail in Chapter 5. The only growth that creates value is growth in markets where the firm enjoys a competitive advantage. In the language we used earlier, only franchise value creates growth value. The magnitude of this last element of value is not easy to calculate when it is positive.
The growth-related uncertainties of valuation cannot be eliminated completely. However, we know that in many-if not most-situations, the value is zero no franchise or even less competitive disadvantages. By paying careful attention to the strategic underpinnings of a franchise, we may actually obtain superior estimates of the value of growth as we discuss in Chapter 7. Nevertheless, growth is the most uncertain source of value and is, therefore, the element of value for which the Graham and Dodd-oriented investor is least willing to pay full price.
The first slice represents the asset value. Under conditions of free entry and no competitive advantage, this is all the value there is. The second slice, which is the difference between the asset value and EPV, represents the franchise value of the firm.
Superior management may be considered here as a variety of franchise value, though it is probably less durable than a competitive advantage in its pure form. Estimates about the value of this slice are less reliable than estimates of asset value. Figure 3. Of all the estimates, this one is the most difficult to make and therefore the least reliable. A value investor may in fact conclude that the intrinsic value of the firm lies somewhere within this slice, and then compare that after a suitable reduction to provide for a margin of safety to the market price to see if a purchase makes sense.
But our investor will understand how much detailed knowledge of the industry and good judgment this decision requires. He or she will have a far better idea of what he or she is paying for than will someone relying on a net present value calculation, even one that includes every conceivable sensitivity analysis.
There are only two conditions in which we are likely to find these results. In the second, the industry is operating with more than normal excess capacity. Either it has expanded too rapidly ahead of an anticipated increase in demand or it has not shrunk quickly enough to adjust to a permanent decline.
Careful investigation can determine which of these conditions, poor management or excess capacity, is responsible. If it is poor management, then potential value may be unlocked by a catalyst, such as a takeover or even the threat of one, that will either bring in new faces or concentrate the attention of the incumbents. He or she will also look to purchase shares when the market prices them far enough below this intrinsic value to provide a sufficient margin of safety. Discrepancies between asset value and EPV suggest both an opportunity and a caution.
If the gap can be closed because of better management, then the intrinsic value of the firm will increase, which should be quickly reflected in its market price because the earnings will grow i. On the other hand, the fact that the assets are not producing the earnings they should may indicate that the firm is operating at a competitive disadvantage.
If the firm raises additional capital to invest for growth, that investment will tend to destroy rather than add to value. When separate valuations of the assets and of the earnings power produce figures that are approximately the same, we have confirmation of the accuracy of the intrinsic value estimate.
The agreement between the two approaches suggests that the quality of the management is average and that the firm enjoys no competitive advantages over its rivals. These conditions may be directly verified. Do newcomers regularly enter the industry to take advantage of overvaluation or poor management, or are conditions more stable?
Does current management produce average returns on invested capital, or are they consistently better or worse? Value investors will purchase shares when there is a margin of safety between this intrinsic value and the market price, and they will assign no value to any future growth. Finally, if the EPV is substantially greater than the asset value, that difference is due to either superior management or the fact that the firm benefits from significant competitive advantages.
In any reasonably large group of competing firms, a few will be blessed with exceptional management. Their virtue is already reflected in the higher earnings power. It can only decline with any fall off in the quality of management in the future. Therefore, a realistic value investor will make a negative adjustment to EPV, realizing that management is not going to get better and that it may certainly deteriorate. In the short run, this superior management may squeeze some value out of growth, provided that growth is in areas where it has expertise.
But a value investor is not likely to pay for the full EPV of this firm in the hope that future profitable growth will provide the margin of safety, unless he or she is convinced that this superior management is young, healthy, loyal, and deep. The more common condition that explains an EPV that is greater than the asset value is when a firm enjoys substantial competitive advantages over potential rivals, thanks to barriers to entry, and thus can earn more on its assets than is possible in a more competitive environment.
We have called this extra earnings power the franchise value of the firm. We will discuss franchise value and how its durability can be assessed in Chapter 5. The value of the franchise lies not only in its current earnings power but also in the possibilities for profitable growth.
If the value investor identifies a firm with a franchise and good prospects for growing the fran chise, then he or she might pay for the full EPV of the firm, in the expectation that the margin of safety will be created by the difficult-to-measure but clearly genuine value of growth. We have described a situation in which one approach to valuationnet present value calculations-is theoretically correct and precise and can be applied equally well to any asset that produces a flow of income or cash to its owner.
Unfortunately, this approach has two defects: 1 it lumps together estimates based on good information with those based on very uncertain assumptions, tainting the lot; and 2 it relies on making accurate estimates of events that are a long way in the future. The other approach to valuation puts more emphasis on current information and on fundamental competitive conditions. It depends on specific knowledge about particular industries and assets, and it places less faith in projections of rosy futures unless substantiated by current hard data.
This is the discipline of value investing in the Graham and Dodd tradition. During periods of investor euphoria, value investing will appear stingy and pessimistic in its estimates of intrinsic value. Its requirements that value be found in assets and earnings power will seem antediluvian when radically new technologies or other innovations are promising a boundless future for cuttingedge companies whose first profitable quarter is always a few quarters away.
Value investors understand that there are some games at which they are not adept, and the only sensible course is to decline to play. Appendix The Present Value of Future Cash Flows The process by which money to be received at various dates in the future can be equated with money in hand today is called discounting.
The term discount refers to the fact that we prefer to have a dollar in hand today rather than the promise-even the iron-clad guarantee-of a dollar at some time in the future. The bank will pay us interest if we give them the dollar, as will other collectors of funds.
We can think of the discount rate as the equivalent of the interest rate in reverse, the rate at which the future money is reduced to determine its present value. As with the interest rate, part of the discount is to compensate the investor for inflation, and the rest is for risk and the willingness to part with the money. The present value of the future cash flow is reduced more the longer we have to wait for it. The expression that captures this relationship is the time value of money.
Combined with the right algebra, the concept allows us to transform a whole series of future values into their value today. The two variables we need are time, which is almost always stated in years, and the other expression that we have called both interest and the discount rate. Both terms refer to the rate at which people will voluntarily commit funds to acquire the asset in question.
Other phrases for this concept that are more or less equivalent are rate of return which is how much the investor demands and cost of capital which is how much the user of the funds has to pay for them. At the end of year 10, it also repays the principle amount. What is the present value of the bond, given this stream of payments?
But suppose that after the bond is issued, interest rates on this kind of investment increase to 9 percent. What happens to the present value of the bond? The net present value of the cash flows would be zero, which only means that we receive back the present value of our current outlay.
One of the cardinal rules of investing is not to make investments that have a net present value of less than zero. For many traditional value investors, this has been essentially the only step. But even within this restricted approach, the investor has to make judgments about the reliability of the information and the strategic situation of both firms and industry in order to make accurate calculations of the value of the assets. The strategic judgments concern the future economic viability of the industry or industries in which the firm operates.
If the industry is in serious decline, then the asset values of the company should be estimated based on what they will bring in liquidation. Since there will be no market for capital goods tailored to specific requirements of the industry, they will basically be sold for scrap. On the other hand, if the industry is stable or growing, then the assets in use will need to be reproduced as they wear out.
These assets should be valued at their reproduction cost. The reliability issue is largely a question of how far down the balance sheet the investor chooses to go. At one extreme, Benjamin Graham considered only current assets cash, accounts receivable, inventory, etc. These can be determined within a narrow margin of error using either a liquidation or reproduction cost basis. The error band here is certainly wider, and valuing these assets, especially the intangibles, has required both skill and imagination.
Obviously, this effort is worthwhile only for firms operating in viable industries; intangibles are worthless if the industry disappears. If the industry has no future, then neither does the firm, at least in its present form. In that case, the income will shrink and drag down the value of those assets that cannot be transferred, particularly specialized equipment and intangibles such as organizational capital and customer relationships.
If the industry is thriving, even a failing firm may sell transferable assets for decent prices to more successful companies in the industry. Table 4. Perhaps this was a temporary setback and the firm will be able to convince its lenders to extend it more money to meet its interest obligations. All we want to be able to do is estimate the value of the assets if the firm is to be liquidated see Table 4.
Accounts receivable will probably not be recovered in full, but since it is trade debt and there are plenty of specialists who know how to collect it, we estimate that we can realize 85 percent of the stated amount. What the inventory will bring depends on what it is. For a manufacturing firm, the more commodity-like the inventory, the less the discount necessary to sell it. It is those tie-dyed T-shirts that have to be marked down, not the cotton yarn. We estimate in this case that we can realize 50 percent on the inventory; if the inventory is highly specialized, then the valuation would have to be substantially lower.
In those situations in which the value of the inventory is critical to the overall valuation, an expert appraiser can be called in to determine a value that is more precise than our back-of-the-envelope estimate. Detailed knowledge of the real estate and the equipment is necessary to come up with an accurate estimate. Certain broad principles apply. Generic assets such as office buildings will be worth far more, relative to their book value, than will specialized structures such as chemical plants.
We have put down 45 percent as another quick and dirty valuation; if this entry is critical, we can hire another expert to do the appraisal. We ascribe no value to the goodwill; it merely represents the excess over fair market value that the firm paid in making those acquisitions that may have gotten it in trouble. Certainly not a traditional equity purchaser, no matter how value-oriented. But there is room for gain here, provided one is a specialist in buying up distressed debt.
Though it looks fairly certain that if the company is liquidated there will not be enough money left to pay anything to owners of either common or preferred shares, there probably will be funds for the owners of the debt. Everything else can flow to the holders of the debt. If the discount is steep enough, and there is enough value in the property, plant, and equipment, this might be a lucrative opportunity for an expert in distressed debt securities and liquidation values.
Many of the values in liquidation are based, if not on fire-sale prices, then on far from the best use to which the asset might be devoted. Opportunities lie in the gap between value and price. We have already made the case that for a firm in a viable industry, the economic value of the assets is their reproduction costs-that is, what it would take a would-be competitor to get into this business.
How do we make these estimates? We will start with another fictitious firm, this one involved in developing and manufacturing some highly engineered and specialized connectors used in computers, communications, and other electronic equipment.
What adjustments do we need to make here to get at reproduction costs? Cash is cash and nothing is required. For marketable securities, we have to find the current market prices. This may be difficult if the securities are not liquid, but generally this category is used only for securities that are actively traded. The serious work starts with accounts receivable; from here on, the book value should be adjusted up or down to get a more realistic reproduction cost.
Many financial statements will specify how much has been deducted to arrive at this net figure. That amount can be added back, or an average of similar firms can be used. The stated number may be too high or too low by a substantial amount. Our attention should be drawn to an inventory that has been piling up if it equals days worth of the cost of goods sold in the current year, whereas previously it had averaged only days, then the additional 50 days may represent items that will never sell or will sell only at closeout prices.
In this instance we would be justified in reducing the reproduction cost downward. By contrast, if the company uses a last in, first out LIFO method for keeping track of inventory costs, and if the prices of the items it sells have been rising, then the reproduction cost of the inventory is higher than the published figures indicate. This difference is the LIFO reserve, the amount by which the current cost of any item exceeds the old, recorded cost.
Prepaid expenses, like rent or insurance, are what they are: small and realistic. They generally require no adjustment. Deferred taxes, as an asset, are future deductions or refunds the company will get from the government. Since we are interested in the value of the assets today, we ought to get the timing of the reductions or payments and calculate their present value.
In our example, deferred taxes are listed as a current asset; this firm expects to cash them in within the year. But they might just as easily have been noncurrent, in which case the present value analysis has more signifcance. The adjustments we end up making to the book value of current assets in most cases are not going to be large enough to matter. After all, the assets are current because we expect them to be turned into cash within a year, so there has been little time for great disparities between recorded costs and reproduction costs to build up.
The situation changes when we examine noncurrent, or fixed assets. Either the land is worth that much to our company because of the easier access it provides, or else we sell it and move elsewhere, pocketing the difference. In either case, the gap between the book value and either the costs of reproducing it or the net gains from an outright sale is large enough to catch our eye.
Property, plant, and equipment, generally stated as net of accumulated depreciation, are the largest noncurrent assets for most companies. Though listed together on one line in the balance sheet, they are distinct from one another in the manner and degree to which their reproduction cost may deviate from book value.
Property as land does not depreciate. Depending on one of the three cardinal rules of real estate i. The company may have to sell the property or change the use to which it puts the land in order to realize this added value. It may still cost the new entrant extra funds to acquire similar property, but perhaps not so much as the market value of this particular parcel. In any case an adjustment to the book value is called for. It may mean structures, like the factory, the office building, the string of motels that run from Bangor to Bakersfield, or the oil refinery.
It may also mean that fiberoptic cable our company has just installed to link together every large city in the country and several outside it. First, the depreciation rules by which the company reduces the value of its plant may bear only the slightest resemblance to what is actually happening to the economic value of the asset. Buildings may be depreciated over a year period, down to zero, when in fact their market value and the cost of reproducing them is going up.
The same is true for parts of the telecommunications infrastructure that has become so central to our economy; the cable may last for decades, but our company has written it down to nothing. Second, inflation can warp the values just as radically. We may be overstating our income by understating the real expense. Equipment may be the easiest to value at reproduction costs. It is de preciated over its useful life, and if it lasts somewhat longer, we are ahead of the game. The book value of the incumbent may inflate the true costs of reproduction; no one would reproduce the equipment in place.
The adjustments made to equipment require a case-by-case analysis, which in turn depends on specific knowledge of the firm and the industry. The adjustment made to the equipment account, like that for plant, may be up or down, but it is not so likely to be massive. The difference between the two is tossed into the goodwill account, where it will be reduced over a long period of time by an annual amortization charge against earnings.
Our question here is not annual cash flow but the reproduction cost of goodwill to the new entrant. Can we ignore it entirely because it is so intangible, or do we have to analyze it carefully to see whether it represents an economic value?
Analysis wins out, as always. Imagine that your business wants to buy the entire Coca-Cola Company, every share, every vat of syrup, every copyrighted jingle, every red logo. In the s, shares of Coca-Cola KO traded between 6 and 26 times book value. If you are rich enough to get your hands on the whole thing, the single largest entry on the asset side of your new balance sheet is almost certainly going to be goodwill.
Is it economically worthless? Obviously not. Any potential competitor will have to pay dearly for the value of the brand, consumer loyalty, distribution networks, and all the other things that make Coca-Cola one of the two or three best franchises in the world. But there are cases in which the economic value of goodwill is suspect. There is a goodwill entry for the extra money needed to buy the other firm, but it does not represent any economic value.
A new entrant does not need to reproduce anything here in order to compete. This goodwill represents a prior blunder, and we are justified in ignoring it entirely in coming up with our asset-based valuation. Goodwill appears because of a corporate takeover or other transaction that requires an accounting entry to keep the balance sheet in balance.
The same business practices that made the acquired firm worth more than the fair market value of its tangible assets e. In trying to determine the intrinsic value of the firm, we need a way to estimate the real worth of these hidden assets. That depends on how long a product keeps generating sales for the company. But suppose we find that the average lifespan of an aircraft frame design in its product portfolio is 15 years.
The drug companies present an even more forbidding hurdle. Firms Source: Compustat data tapes. Developing customer relationships also costs money-money that never appears as an asset. Although this information may be difficult for outsiders to obtain, a well-run company knows how long it takes to woo a new customer before an initial sale is made. We can regard the money spent on sales before the order is signed as an investment in future business relationships, some of which will never materialize.
A new competitor does not start with an order book full of business or a list of devoted customers; it has to build or buy established customer relationships. The amount it needs to spend depends on the sales cycle: how many months of selling, general, and administrative expenses the company has to pay out before it starts to take orders and make sales. It also needs time to develop the internal systems that allow it to function.
These systems, which include information technology, human resource policies, and other unglamorous but essential procedures, are vital to its functioning. No company-certainly no public company-springs like Athena, fully armed from the brow of Zeus. The company may hold licenses from government agencies that permit it to operate in certain areas, such as the right to broadcast radio and television signals, to sell alcoholic beverages from a particular address, or to run a gambling casino.
It may hold a real franchise that is difficult or impossible to reproduce; owners of professional sports teams need franchises to play in the league, and bottlers of Coca-Cola need franchises to turn concentrate into soda. There may be limitations on the rights of the holders of some of these licenses and franchises to dispose of them to third parties, but even the most restricted of them are assets that new entrants will have to reproduce in order to compete.
And some certainly can be sold, generally with approval from the license or franchise grantor. The surest method for assigning a value to the license or franchise is to see what similar rights have sold for in the private market, that is, to a knowledgeable buyer who is paying for the whole business. There are ways to compare situations that initially look dissimilar. Recent sales in the private market provide a benchmark for valuing the license or franchise of the company under analysis. The same approach can be used in valuing a subsidiary business within the corporation.
Private market purchases of similar businesses provide a basis for determining the worth of the subsidiary. Instead of using the price paid per subscriber or other operating figure, the standard practice is to use a multiple of cash flow, like EBITDA. Say, for example, that a property and casualty insurance company has bought or built a subsidiary that provides online information to insurance adjusters on the price and availability of replacement auto parts.
This information is available to all insurance firms, who pay for it by a combination of subscription fees and usage charges. Although it serves the insurance industry, the subsidiary is really a different business. Its success has nothing to do with careful underwriting or skillful investing. It is an information services provider, and it has the added ap peal of living on the Web, at times the neighborhood of choice.
In arriving at a value for the whole insurance company, it makes sense to break out the earnings and assets of the information subsidiary and to look at the price at which comparable information services companies have sold in the private market.
Perhaps the insurance company will take advantage of the higher price to earnings multiples afforded to Web-based businesses and sell this subsidiary, or spin it off and retain some of the shares. Whatever it decides to do, its value is enhanced by the ownership of this other business, which deserves a separate valuation.
The assets are one side of the balance sheet, the liabilities the other. The oldest principle in accounting is that assets have to equal liabilities plus equity. The arithmetic reason is simply that equity is what is left after liabilities are subtracted from assets, so the balance sheet balances by definition.
But the financial reason is that liabilities and equity are the sources of funds that support the assets, which are the uses to which those funds are put. If our task is to determine the value of a company based on the reproduction costs of its assets, we really want to know how much money an investor or business person would have to lay out to acquire or replicate those assets. To arrive at an answer, we have to examine the liabilities side of the balance sheet to see what we would need to spend.
For this purpose and many others, it is useful to think of liabilities as falling into three categories. First are those liabilities that arise intrinsically from the normal conduct of the business: accounts payable to suppliers, accrued vacation and other wage costs due to employees, accrued taxes due to governments, and other accrued expenses. Most of these are current liabilities, due within a year.
They represent credit extended to the company for which the company pays no interest. Within reason-unreason here being that suppliers are so annoyed at late payments that they refuse to ship new ordersthe larger these spontaneous liabilities are, the less investment the company needs to fund its assets. We can simply subtract the book value of these liabilities from the reproduction value of total assets to arrive at the reproduction value of net assets.
This is what a new entrant would have to pay to duplicate what this firm has. The second class of liabilities consists of those obligations that arise from past circumstances that are not pertinent to a new entrant. For ex ample, deferred tax liabilities or liabilities incurred because of adverse legal judgments e. Liabilities like these do not reduce the investment a potential entrant will have to make, but because they are genuine obligations that will have to be paid, they do need to be subtracted from the asset value to see what this firm is worth to investors.
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|Where is sports betting legal draftkings||This difference is the LIFO reserve, the amount by which the current cost of any item exceeds the old, recorded cost. The Industrial Approach to Uncovering Value In Chapter 1 we mentioned a legion of studies that employ a mechanical approach to stock selection for connecticut betrivers various investment styles. The end of the year has historically been a good month to pick up the value stocks that window-dressing managers have tossed out in order to avoid listing them in the year-end report. Detailed knowledge of the real estate and the equipment is necessary to come up with an accurate estimate. As every engineer knows, adding inaccurate to accurate information produces inaccurate information.|
|Ufc betting odds 167 bus||On the other hand, the fact that the assets are not producing the earnings they should may indicate that the firm is operating at a competitive disadvantage. In either case, the gap between the book value and either the costs of reproducing it or the net gains from an outright sale is large enough to catch our eye. Value investors understand that there are some games at which they are not adept, and the only sensible course is to decline to play. It is the rare company that can expand beyond its franchise and still retain its profitability. In that case, the income will shrink and drag down the value of those assets that cannot be transferred, particularly specialized equipment and intangibles such as organizational capital and customer relationships. Once investors know that cheap stocks outperform expensive stocks, they should bid up the price of the cheap stocks and eliminate the superior performance.|
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Warren Buffett Value Investing Warren Buffett is the most successful and famous value investor in the world for a good reason. Unlike Graham, Buffett is willing to pay higher prices for companies he considers good. Buffett will buy more expensive stocks that meet his criteria. Another difference between Warren and Graham is that Buffett will buy large amounts of what he considers good stocks.
When he analyzes a stock, Buffett pays the most attention to its cash flow and assets. Buffett will pay extra for companies with a healthy rate of growth like Apple. Berkshire Hathaway will sell companies with a slow rate of growth. Another Buffett belief is that investors need to keep large amounts of cash on hand. Investors need lots of cash so they can take advantage of opportunities fast, Buffett teaches.
Investors also need cash to cover emergency expenses and to borrow against them. Like Graham, Buffett is a contrarian famous for his skepticism of the market, the media, investors, and the investment industry. Buffett dismisses investment fads, popular wisdom, professional fund managers , and new technologies.
In recent years, Buffett has become increasingly critical of the wealthy and the American political system. Buffett is a celebrity who has achieved rock-star status among investors. Unlike most investors, Buffett emphasizes a cash flow and rate of growth over the share price. Buffett does not take a lot of risks in his investing. He makes large investments in stable, simple businesses, including insurance, consumer goods, retail, finance, and media.
Too many people are focused on short-term trading to make money, which is much riskier. Many people, however, swear by Buffett and his investing wisdom. Actually, the answer is a resounding YES! We have actually distilled it all into our blockbuster article called: Value Investing Concepts Most value investors base their investing decisions on three basic concepts. Each of these concepts is a big idea that underlies value-investment philosophy.
Instead, Buffett values companies he invests in as if he was buying the entire business for cash. Once these investors calculate intrinsic value, they compare it to the share price and market capitalization. If the intrinsic value is substantially higher than the market capitalization, you can consider the company a value investment. Buffett arrives at the intrinsic value by studying financial numbers and doing real-world research on its business model and competitors.
A simple way to think of intrinsic value is the cash value of everything a company owns. A slightly more complex estimate will include cash flows or projected cash flows. Most value investors use several methods of analysis to arrive at intrinsic value.
There is no single best formula for intrinsic value. Instead, investors usually base intrinsic value on the calculation that best fits their belief of what makes a great company. In classic value-investing theory, the margin of safety is the level of risk an investor can live with. The margin of safety is an estimate of the risk a stock buyer takes. This metric the single most significant valuation metric in our arsenal as it is the final output of detailed discounted cash flow analysis.
The break-even analysis is the share price at which you can begin making money from a stock. Today the Margin of Safety is one of the key concepts of value investing. There are many risks that fundamental analysis cannot estimate, including politics, regulatory actions, technological developments, natural disasters, popular opinion, and market moves.
The margin of safety you use is the level of risk you are comfortable with. If you are risk-averse, you will want a high margin of safety. A risk-taker, however, could prefer a low margin of safety. Both value and growth investors use fundamental analysis.
To understand value investing, you need to have a good grasp of fundamental analysis, intrinsic value, and margin of safety. Not all value investors use these concepts. Buffett will occasionally purchase stocks he likes, even if the market price exceeds the margin of value. Investors need to understand these concepts are theoretical guidelines and not concrete rules.
There will be many stocks that make money but violate some value investing concepts. Value investors, instead, use a variety of valuation methods. Some popular methods for valuing a company in the fundamental analysis are listed next. A good definition of book value is anything that the company can sell for cash now. Examples of book value assets include real estate, equipment, inventory, accounts receivable, raw materials, investments, cash assets, intellectual property rights, patents, etc.
Tangible Value — Tangible value is the potential value that investors can easily calculate. A good example of tangible value is the market price for equipment or real estate. Tangible book value could include only physical assets and cash investments. A good rule of thumb is that an asset is intangible if there is no guarantee it will make money. Enterprise Value — The enterprise value is the total value of the company, including market capitalization.
Enterprise value is the price another company could pay for a corporation. A classic formula to calculate enterprise value is market capitalization plus assets plus cash and equivalents minus debt. Apple has a high franchise value because of its reputation for making dependable, innovative, and high-quality products.
This enables Apple to charge higher prices and sustain high-profit margins while maintaining a loyal customer base. They usually calculate dividend value by subtracting the annualized payout from the share price. The annualized payout is the amount of dividends generated by a share of stock in the past year. Negative Enterprise Value — A company has a negative enterprise value when the cash on the balance sheet exceeds its market capitalization and debts.
Value investors look for negative enterprise value because it is a sign that Mr. Market is undervaluing a company. Graham considers preferred stock a liability. The idea is to learn how much money a company will have left after it sells all the cash assets and pays all obligations. One should be comfortable when assuming that the adjusted current earnings is a viable and stable representation of its future earnings power.
The adjustments should entail e. Then, the earnings should be discounted with an appropriate rate. The authors substantiate this claim by stating that an increase in revenue often demands a corresponding increase in costs. For instance, the company in question would often need to invest in additional assets, stock, equipment, factories etc.
Hence, the company would need a competitive advantage that ensures the earnings power EPV significantly and viably exceeds the asset value or, the costs of keeping the asset base in a good condition. I hope that the above exposition has expanded your understanding of earnings power as well as the value of assets and growth. Hall of Fame This was definitely the most enjoyable part of the book in my opinion.
On these pages, eight highly regarded value investors and their approaches are portrayed. The eight giants are outlined below. Glenn Greenberg is the epitome of concentration. The industry must have entry barriers, increasing demand, and facilitate high profit margins and earnings. The business must have an intelligent management team who can reinvest or allocate capital at high rates of return. Finally, all of this must be offered at an attractive price. Robert has a remarkable gift of spotting future investing legends.
He has — among others — been an early investor in partnerships managed by Benjamin Graham, Warren Buffett and Walter Schloss. Seth Klarman, the legendary investor and author of Margin of Safety , is scouting for securities that are cheap measured on several metrics, e. The common characteristic is a huge margin of safety the gap between market price and intrinsic value.