Reading Notes: Value Investing
Valuation Method #1
Net present value (NPV) using discounted cash flow (DCF)
- Sum of present and future cash flow, discounted with the time value of money
- Hard to measure intrinsic values since small changes in variables yield huge differences in outputs
- Doesn’t take growth into account
- Ignores balance sheet
- Terminal value often dominates the overall value
Valuation Method #2
Graham and Dodd Approach (3 elements of value)
- Value of assets
- The cost to reproduce the same business with the same assets
- Potential disparity between book value and reproduction cost
- Earnings Power Value (EPV)
- Assume the business neither grows or shrinks
- EPV = Earnings Power / R
- R = cost of capital (currently measured constant future)
- Has the advantage of being based entirely on currently available information
- Value of Growth
- In many cases, growth creates no intrinsic values to a business
- Best applied to franchise businesses with moats
3 Cases
- Case A: EPV < Asset values (reproduction cost)
- Case B: EPV ~= Asset values
- Case C: EPV > Asset values
- Without barriers of entry, competition will intensify and drive profits down until EPV ~= Asset
- Franchise value: enjoy the delta between EPV and reproduction cost due to moat
Barriers of entry (Moat)
- Barriers of entry exists iff the incumbent has competitive advantages that a new entrant cannot match
- Competition drives down profits
- A successful entry should raise the question: “If we can do it, why not others?”
- Customer captivity
- “How hard it is to acquire that target market share”
- Privilege access to customers
- Habits / High purchase frequency
- High searching costs
- High switching costs
- Government-granted licenses
- Powerful bias towards keeping the current “mission critical” systems
- Generally longer lived
- Proprietary technology
- Generally of short duration in high-tech sector
- Economies of scale
- Operational efficiency (better margins, lower costs)
- “the most efficient firms in an industry typically have cost structures that are between one-half and one-third of the industry average.”
- “First, achievement of operational excellence is a marathon, not a sprint. It requires constant attention to incremental improvement. This in turn calls for a management organization focused on driving such improvements, including a CEO who makes it a high priority.”
- With the same fixed cost, you can lower unit costs if you sell more
- Network effects
- Density > Global size
- Sustainable competitive advantages ultimately rest on economies of scale
- Operational efficiency (better margins, lower costs)
Not all growth creates value
- Growth only creates value when investments on growth earn more than the cost of capital
- Growth requires investment, which reduces cash that can be distributed today
- Without competitive advantages and barriers to entry, growth will create little or no value
- Case A: investments earn less than the cost of capital
- Case B: neither creates nor destroys value since moat is not expanded
- Case C: franchise businesses growing within existing areas of competitive advantages (moat), hence growth creates significant value
Growth (Organic)
- Organically from market conditions (ie. Local population growth, rising income levels)
Growth (Active Investments)
- Expanding into adjacent markets (where the incumbent enjoys moats)
- Extending competitive advantages
- Within its existing overheads in sales, distribution and management
- Extend profitability
- Expanding into new markets (ones that the incumbent has no moats)
- Usually a mistake
- “For growth to create value in new markets, the firm has to benefit from competitive advantages within these markets.”
Calculating EPV
- EPV = EP / R
- Value of company’s ongoing core operations
- EP: Earning Power
- Average operating margin of core business over a period
- Multiply this margin by current sales = estimated operating earnings = EBIT
- Multiply by (1 - average tax rate) = sustainable, distributable net operating profit after taxes (NOPAT)
- In addition, adjust for depreciation, expensed investments, replacement Capex
- R: Required Return or Weighted average of cost of capital
- Capital sources
- Debt
- Equity = Risk free rate + beta * (market risk premium)
- Capital sources
Margin of safety
- Enterprise Market Value = Market cap - extraneous assets + outstanding debt
- Margin of safety = Enterprise Intrinsic Value / Enterprise Market Value
- Why add outstanding debt? Because you are inflating the market cap and reducing the margin of safety
Equity vs. Enterprise Values
- Enterprise value = Asset values on an equity basis + debt - extraneous assets
- Equity valuation = Earnings power on an enterprise basis - interest payments
- “Equity asset values must be compared to equity earnings power values and the costs of acquiring a firm’s equity. Enterprise earnings power values must be compared to enterprise asset values and enterprise acquisition costs.”
- “Firms seeking to dominate these virgin markets must be extremely disciplined—focus on one market at a time—and superb at execution.”
Franchise (“Good” business)
- “only for firms protected from competition by sustainable competitive advantages, those that can earn above their cost of capital on growth investments, does growth create value.”
- “There are no good businesses in a competitive environment with relentless change.
- Periods of temporary prosperity will attract enthusiastic entry.”
- In the absence of barrier of entry, product differentiation alone cannot sustain a good business.
- Businesses with moats are the exception not the rule
- “Franchises are overwhelmingly niche businesses as large global markets are difficult if not impossible to dominate.”
- The primary characteristics of a franchise business: it dominates its local market
- Value-creating growth occurs within or adjacent to its existing dominant market position
- Failed cooperation and testosterone-driven competition will lead to growth that does not create value
- Spotting a franchise is difficult. Value investors like to operate within their circle of competence, where the knowledge they have accumulated can be applied
- “The best defended monopoly is a single store in a town too small to allow for a second one.”
Valuation Method #3
Valuation of Franchises
- Where growth can creates significant long-term value
- Focus on the long-run future, which takes advantages of the lower taxes and transactions costs that come with long holding periods
- 5 components
- Cash return from current earnings power
- Dividend
- Net stock buybacks
- Net interest payments / net debt repurchases
- “Organic” growth in earnings, thus value (since it’s a franchise)
- Demand/population/income growth
- Exercise of pricing power (increase price)
- Cost reduction
- Organic growth in earnings should exceed that in revenues
- “Active” growth
- Valuation creation factor: <1, ~1, >1
- Improving operational efficiency > Growth initiatives outside core markets
- Fade rate
- No franchise lasts forever
- Rule of 72: fade rate = 72 / half life in years
- Cost of Capital
- Cash return from current earnings power
- total return = cash (dividend + buyback) + growth rate (organic + active) - fade rate
- margin of safety = total return / cost of capital
- Improves buy decisions but not sell decisions. Buffett plans never to sell.
Source of information
- Identify your circle of competence
- A network of able, like-minded investors whose areas of expertise complement your own
- Behaviors of the insiders
- Look dispassionately at consensus views and other views
- Value investors are human beings with all the same underlying instincts as non-value investors
- Identify and deal with your own cognitive biases
- Keep a record of decisions made
- Research needs to extend beyond the company in question to market variables and financial performance of other firms in the industry
SP500 Valuation
- Net common payout(“Cash”) return (dividends + buybacks): 4-5%
- Growth return (organic + active investments) = earnings growth = 176/90=(1+x)^10 = 6.9% ~= 7%
- Fade rate: 1% (inefficiency during rebalancing)
- Total return: 10-11%
- Actual return: 4400/1600=(1+x)^10 = 10.6%