Summary of Search

L Low M/B, P/E, M/B P/E Growth Disappointing Rtns Institutional Psycho Logical Rationale

Search
(Look systematically for undervaluation)

Obscure Undesirable SupplyDemand Imbalance

Value

Review

Manage Risk

Value Investing the Approach

Search
(Look systematically for undervaluation)

Value

Review

Manage Risk

Valuation Approaches Ratio Analysis

Cash Flow Measure Earnings

(Maint. Inv. = Depr + A)

Multiple Depends on: Economic position

EBIT
(Maint. Inv. = Depr + A; Tax =0)

Cyclical situation Leverage Mgmt. Quality Cost of Capital (Risk) Growth

EBIT - A
(Maint. Inv. = Depr only)

EBIT-DA
(Maint. Inv. = 0)

Range of Error (100%+) g ( )

Valuation Approaches
Net Present Value of Cash Flow

Value =

CF (1 +1 R )
t=0
t

= CF0 *

1 R-g

Note: NPV Analysis encompasses ratio analysis (NPVdiseases are ratio analysis diseases) Note: NPV is theoretically correct

In Practice:
Revenues Parameters: Market Size Market Share Market Growth Price/Cost Tech Management Performance Cash Flows Required Investments Margins Forces: Consumer Behavior Competitor Behavior B h i Cost Pressures Technology Tech Management Performance

Cost f C it l C t of Capital

X
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NPV </> Market Value

Shortcomings of NPV Approach in Practice

(1) Method of Combining Information
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NPV = CFo +CF1

1
1+R

+ +CF20

1
1+R

+ ...

Good Information (Precise)

Bad Information (Imprecise)

= B d/I Bad/Imprecise Information i I f ti

(2) Sensitivity Analysis is Based on Difficultto-Forecast Parameters which co-vary in fairly complicated ways
Cost f C t of Capital

Profit Margin

Required Investment

Growth
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Valuation Assumptions

Traditional: Profit rate 6% Cost of capital 10% Investment/sales 60% Profit rate +3% (i.e. 9%) 3% Growth rate 7% of sales, profits

Strategic: Industry is economically viable Entry is Free (no incumbent competitive advantage) Firm enjoys sustainable competitive advantage Competitive advantage is p g stable, firm grows with industry

Value Investing
Basic Approach to Valuation pp

Know what you know; Circle of competence Know know ; 1. Organize valuation components by reliability Most Reliable Least Reliable

2. Organize valuation components by underlying strategic assumption g p No Competitive Advantage Growing Competitive Advantage

Basic Elements of Value

Strategic Dimension g

Growth in Franchise Only Franchise Value F hi V l Current Competitive Advantage

Free Entry No Competitive Advantage

Asset Value Earnings Power Value Total Value

Reliability Dimension

Tangible Balance Sheet Based No Extrapolation

Current Earnings Extrapolation No Forecast

Includes Growth Extrapolation Forecast

Industry Entry - Exit

Industry

Market Value

Net Asset Value

Entry

Chemicals (Allied)

$2B $1.5B $1.0B $1 0B

$1B $1B $1B

Yes (P MV ) Yes Stop S Yes (Sales MV) Yes Stop

Automobiles (Ford)

$40B $30B $25B

$25B $25B $25B

Internet

$10B

$0.010B

Remember, Remember Exit is Slower than Entry. Entry

Asset Value
Assets Basic GrahamDodd Value Reproduction Value

Cash Accounts R i bl A t Receivable Inventories PPE Product Portfolio Customer Relationships Organization Licenses, Franchises Subsidiaries Liabilities A/P, AT, AL Debt Def Tax, Reserves Bottom Line

Book Book B k Book 0 0 0 0 0 0

Book Book All B k + Allowance Book + LIFO Orig Cost Adj Years R & D Year SGA Private Mkt. Value Private Mkt. Value

Book Book Book Net Net Wk Cap

Book Fair Market DCF Net Repro Value

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Asset Value Approaches

Approach Opportunities Value in Practice Graham Book Reproduction

None Yes

Limited Yes None Low Historical Book

( (0 Enterprise) p )

More Extended Yes Extensive Intermediate Reproduction Est Market

( (0 Enterprise) p )

Industry Knowledge None Stability/Reliability Goodwill Debt

High 0 Book
( (Low Debt) )

Remember, Remember Low M/B is very hard to beat. beat

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Asset Value Issues

Management Good adds value Bad subtracts value

Private Market Values

Potentially highly unstable ( (EBITDA multiples of p Internet subs)

Reproduction vs. p Book

Better where accountants misestimate

Tech trends Real estate Intangibles M/B indicator close to M/Repro value Improvement requires discipline di i li

Non Viable Industries

Value = Zero (except NWC) ( p )

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Earning Power Value

Basic C B i Concept E t t Enterprise value based on this i l b d thi years Earnings Measurement 1 Earnings Power Value = Earnings * Cost of capital Second most reliable information earnings today Calculation Earnings Accounting Income + Adjustments Cost of Capital = WACC (Enterprise Value) Equity Value = Earnings Power Value Debt Debt. Assumption: Current profitability is sustainable

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Earning Power Calculation

(1) Start with Earnings not including accounting adjustments (one-time charges not excluded dj t t ( ti h t l d d unless policy has changed) (2) Earnings are Operating earnings (EBIT) (3) Look at average margins over a business/Industry cycle (at least 5 years) (4) Multiply average margins by sustainable (usually current) revenues This yields normalized EBIT (5) Multiply by one minus Average tax rate (no pat) (6) Add back excess depreciation (after tax at average t rate) tax t ) This yields normalized Earnings (7) Add adjustments for unconsolidated subs, problem being fixed, pricing power, etc

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Earnings Power Value

EPV Business Operations = Earnings Power x 1/WACC EPV Company = EPV Business Operations + Excess Net Assets (+cash, +real estate, - legacy costs)

EPV Equity = EPV Company Value Debt EPV EQUITY equivalent to AV EQUITY EPV COMPANY equivalent to AV COMPANY

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Earning Power Value Calculation

WACC = Cost of Capital = (Fraction of Debt) (RD) (1-Tax) + (Fraction of Equity) (Cost of Equity) Fraction of Debt = 1- Fraction of Equity Actual or Potential

Zero Growth Capex =

Actual Capex - Growth Capex

Growth Capex = (PPE/Sales) * Sales Balance Sheet

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Search Beyond Cheap, Ugly

Growth at a ReasonablePrice (Greenblatt) (Profitable) Cheap (Low P/E) (25%) Strong (High ROIC) 17 - years Small (All Stocks) +8-10% Above Value Premium

Cheap but Not Discuting (Piotroski) Among Low M/B Cheap 8 -9 good Look at: ROA + or CFO + or 20 years (23%) ROA + or CFO ROA + or +8-10% Above Value Lever + or Premium Liquid + or No EQ-Offer EQ Offer + or 0-1 bad 0 1 b d G Margin + or A Turn + or -

goodbad = 23%

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Earning Power and Entry - Exit

Case A:

Value Lost to Poor Management M t and/or Industry Decline

Asset Value EP Value

Case B:

Free Entry Industry y Balance

Asset Value EP Value

Case C:

Consequence of Comp. Advantage and/or Superior Management

Asset Value EP Value

Sustainability depends on Continuing Barriersto-Entry

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