Value Investing: From Graham to Buffett and Beyond
by Bruce Greenwald, Judd Kahn, Paul Sonkin and Michael van Biena, published 2001
Three valuation approaches
In the world of value investing, there are three essential ways to value a business: studying the balance sheet (asset values), studying the income statement (earnings power) or studying the value of growth.
Greenwald and company recommend using each approach contingent upon the type of company being analyzed.
The asset value (balance sheet) approach
The virtue of balance sheet analysis is that it requires little extrapolation and anticipation of future values as the balance sheet ostensibly represents values which exist today. (Note: technically, for balance sheet values to be accurate they must have a meaningful connection to future cash flows and earnings which can be generated from them, but that is beside the present point.) Additionally, the balance sheet is arranged in such a way that the items at the top are items whose present value as stated on the balance sheet is more certain because they are closer to being converted into cash (or requiring immediate cash payment), whereas those toward the bottom are less certain. The implication here is that companies trading closer to the value of net assets nearer to the top of the balance sheet are more likely undervalued than those trading closer to the value of net assets nearer to the bottom of the balance sheet.
Putting these principles into practice, when using the balance sheet method, companies which are not economically viable or are experiencing terminal decline should be valued on a liquidation basis, looking at net current asset values and severely discounting long-term fixed assets (and perhaps completely writing off the accounting value of goodwill and certain intangible items). On the other hand, companies whose viability as going concerns is fairly certain should be valued on a reproduction cost basis when using the balance sheet method, meaning calculating a value for replacing the present assets using current technology and efficiencies.
In an industry with free-entry, a company trading for substantially more than $1 per $1 of asset reproduction costs will invite competition until the market value of that company falls. Similarly, a company trading for substantially less than $1 per $1 of asset reproduction costs will find competitors exiting the industry until the market value of the company rises back to the reproduction cost of the assets. Without barriers to entry which protect the profitability of these assets, the assets are essentially worth reproduction cost as they deserve no earnings power premium.
For these firms, the intrinsic value is the asset value.
The earnings power (income statement) approach
Whereas the asset value approach relies more strongly on present market values, the earnings power valuation approach begins to introduce more estimation of the relationship between present and future earnings, as well as the cost of capital. These are decidedly less certain valuations than the asset value method as they rest on more assumption of future phenomena.
The primary assumptions are that,
- current earnings, properly adjusted, correspond to sustainable levels of distributable cash flow, and,
- that this earnings level will remain approximately constant into the indefinite future.
Based upon those assumptions, the general equation for calculating earnings power value (EPV) is:
EPV = Adjusted Earnings x 1/R
Where “R” is the current cost of capital.
Earnings adjustments, where necessary, should be made on the following basis:
- rectifying accounting misrepresentations; the ratio of average recurring “one-time charges” to unadjusted reported earnings should be used to make a proportional adjustment to current earnings
- depreciation and amortization adjustments; reported earnings need to be adjusted by the difference between stated D&A charges and what the firm actually requires to restore its assets at the end of the year to the same level they were at at the beginning of the year
- business cycle adjustments; companies in the trough of their business cycle should have an addition to earnings in the amount of the difference between present earnings and average earnings, while companies at the peak of their cycle should have earnings adjusted by the difference between average earnings and present earnings (a negative number)
There is a connection between the EPV of a firm and its competitive position. In consideration of economically viable industries:
- EPV < asset reproduction cost; management is not fully utilizing the economic potential of its assets and the solution is for management to change what it’s doing, or for management to be replaced if it refuses to do so or proves incapable of doing so
- EPV = asset reproduction cost; this is the norm for firms in industries with no competitive advantage, and the proximity of these two values to one another reinforces our confidence that they have been properly calculated
- EPV > asset reproduction cost; this is a sign of an industry with high barriers to entry, with firms inside the barriers earning more on their assets than firms outside of them. For EPV to hold up, the barriers to entry must be sustainable into the indefinite future
The difference between the EPV and the asset value of the firm in question in the third scenario is the value of the franchise of the firm with barriers to entry. In other words, the firm’s intrinsic value should equal the value of its assets plus the value of its franchise.
Similarly, in the second scenario, no premium is granted for the value of growth because with no competitive advantages, growth has no value (the cost of growth will inevitably fully consume all additional earnings power created by growth in an industry characterized by free-entry competition).
The value of growth
The value of growth is the hardest to estimate because it relies the most on assumptions and projections about the future, which is highly uncertain.
Additionally, growth has little value outside the context of competitive advantage. Growing sales typically need to be supported by growing assets: more receivables, more inventory, more plant and equipment. Those assets not offset by greater spontaneous liabilities (accounts payable, etc.) must be funded somehow, through retained earnings, larger borrowings or the sale of additional shares, reducing the amount of distributable cash and therefore lowering the value of the firm.
For firms operating at a competitive disadvantage, growth actually destroys value. Otherwise, growth only creates value within the confines of a competitive advantage. This uncertainty of growth and the competitive context of it leads the value investor to be least willing to pay for it in consideration of the other potential sources of value (assets and EPV).