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

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
1. Average operating margin of core business over a period
2. Multiply this margin by current sales = estimated operating earnings = EBIT
3. Multiply by (1 - average tax rate) = sustainable, distributable net operating profit after taxes (NOPAT)
4. 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)

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
1. Cash return from current earnings power
  - Dividend
  - Net stock buybacks
  - Net interest payments / net debt repurchases
2. “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
3. “Active” growth
  - Valuation creation factor: <1, ~1, >1
  - Improving operational efficiency > Growth initiatives outside core markets
4. Fade rate
  - No franchise lasts forever
  - Rule of 72: fade rate = 72 / half life in years
5. Cost of Capital
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%