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Graham & Dodd and Modern Financial Analysis Joseph Calandro, Jr. PwC & the University of Connecticut December 13, 2011

Agenda

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Benjamin Graham Warren Buffetts 1995 GEICO acquisition DDM Modern Graham & Dodd Valuation Overview Warren Buffetts 1995 GEICO acquisition Graham & Dodd Critical valuation errors to avoid Forecast-related errors Growth-related errors How to avoid errors The Graham & Dodd valuation process Graham & Dodd and avoiding Critical valuation errors Recommended reading About the presenter
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Benjamin Graham
Benjamin Graham founded value investing in the 1920s-1930s - Heavily influenced by the new era boom of the 20s & the subsequent bust/Great Depression - Price arbitrage-based strategy: buying firms < liquidation value resulted in a margin of safety, which is the cornerstone of the approach, & is what differentiates an investment from a speculation for Graham & his students - Bottom-up, investment-by-investment approach - Value investors opposed modern financial economic theory (i.e., efficient markets, portfolio theory, capital structure doesnt matter, asset pricing models, option pricing models) from the beginning & thus tend to approach valuation & investment differently
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Warren Buffetts 1995 GEICO acquisition DDM

Below is a DDM valuation based on a popular case study
1995 Current dividend Expected dividend (low) Expected dividend (high) Average expected dividend PV expected dividend Expected sustainable growth Total present value/share Buffetts purchase price Stock price Price premium ~$70.00 $55.75 25.6% $1.00 $1.16 $1.16 $1.16 $1.04 $1.25 $1.34 $1.30 $1.05 $1.34 $1.55 $1.45 $1.05 $1.44 $1.79 $1.62 $1.06 $1.55 $2.07 $1.81 $1.06 $64.37 10.25% $69.63 (2) (3) (4) (1) (1) 1996 1997 1998 1999 2000 Terminal value

Notes 1. Dividend source Robert Bruner, Warren E. Buffett, 1995, Darden case services #UVA-F-1160, 1996, p. 11 2. TV = PV of A(DIV)200o * (1 + Expected sustainable growth) / (Cost of equity - expected sustainable growth) 3. Subjective estimate (or plug) against a discount rate of 11.2% 4. Sum of PVs for 1996 -2000 + the TV

This concept of an indefinitely favorable future is dangerous, even if it is true; because even if it is true you can easily overvalue the security, since you make it worth anything you want it to be worth. Beyond this, it is particularly dangerous too, because sometimes your ideas of the future turn out to be wrong. Then you have paid an awful lot for a future that isnt there. Your position then is pretty bad. Benjamin Graham quoted in Timothy Vick, How to Pick Stocks like Warren Buffett (NY: McGraw-Hill, 2001), p. 163

An un-resolvable contradiction exists: to perform present value analysis, you must predict the future, yet the future is not reliably predictable. Seth Klarman, Margin of Safety (NY: PwC Harper, 1991), p. 124

Modern Graham & Dodd Valuation Overview

Net Asset Value: reproduction-based, line-by-line Earnings Power Value: based on a level of historical earnings that should be sustainable into perpetuity Franchise Value: Sustainable competitive advantage Growth Value: least tangible (& thus most risky) All assumptions are upfront & transparent in each level of value (facilitating due diligence, integration efforts & value realization)

Franchise Value

Net Asset Value

Earnings Power Value

Growth Value

Adapted from: Bruce Greenwald, Judd Kahn, Paul Sonkin, & Michael van Biema, Value Investing From Graham to Buffett & Beyond (NY: Wiley, 2001), p. 44
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Warren Buffetts 1995 GEICO acquisition Graham & Dodd

NAV driven by significant goodwill EPV based on average operating margin FV driven by low-cost offering to a safe driver niche* GV based on normal growth earning 17.3% against a discount rate of 11.2%
* Significant strategic analysis is involved in validating a franchise. I profiled this in my book, but addressed it more thoroughly in a subsequent paper: Joseph Calandro, Jr., Growth-Based Franchise Opportunities: Lessons from the Geico Acquisition, Journal of Private Equity, Spring (2011), pp. 6-17 $120 $90
$69.00 $106.55

$60 $30 $0

$44.15

NAV

EPV

GV

Where NAV equals Net Asset Value, EPV equals Earnings Power Value, & GV equals Growth Value (Franchise Value (FV), or the positive difference between EPV & NAV, is not expressly illustrated). All calculations are mine
Source: Joseph Calandro, Jr., Applied Value Investing (NY: McGraw-Hill, 2009 ), p. 56
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Critical valuation errors to avoid

Prof. Rubacks Critical Valuation Errors to Avoid Error # 1: Forecasts are aggressive Error # 2: Cycles are ignored Error # 3: Forecasts are not consistent Error # 4: Terminal value timing Error # 5: Inconsistent assumptions Error # 6: Long-term growth rates are aggressive Error # 7: Discount rates are conservative or aggressive Error # 8: Changing capital structure is not considered Error # 9: Control premiums Error #10: Multiples are inappropriately applied How to Avoid These Errors Rule # 1: Focus on common-sense economics Rule # 2: Use more than one valuation approach Rule # 3: Dont be mechanical
Source: Richard S. Ruback, Know Your Worth: Critical Valuation Errors to Avoid, HBS Press - Faculty Seminar Series, August 1, 2004, http://hbr.org/product/know-your-worth-critical-valuation-errors-to-avoid/an/6433C-MMC-ENG
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Forecast-related errors
Error # 1: Forecasts are aggressive Error # 2: Cycles are ignored Error # 3: Forecasts are not consistent Error # 7: Discount rates are conservative or aggressive Error # 8: Changing capital structure is not considered Heavily skeptical going in. Remember the earlier quote: An un-resolvable contradiction exists: to perform present value analysis, you must predict the future, yet the future is not reliably predictable. Seth Klarman, Margin of Safety (NY: Harper, 1991), p. 124 Conservatively-oriented - Derived a level of past earnings over time (including cycles) - Expected improvement can be an input if estimated conservatively - Hard multiple guideline: not > 16-20x Margin of Safety is the final control to mitigate forecasting risk Forecasting errors can nevertheless be relatively common: The process of valuation, while seemingly mathematical, is in reality psychological and quite arbitrary. Benjamin Graham and David Dodd, Security PwC 8 Analysis 6th Ed. (NY: McGraw-Hill, 2009 [1934]), pp. 85-86

Growth-related errors
Error # 4: Terminal value timing Error # 5: Inconsistent assumptions Error # 6: Long-term growth rates are aggressive Error #10: Multiples are inappropriately applied VERY skeptical going in. Remember the earlier quote: This concept of an indefinitely favorable future is dangerous, even if it is true; because even if it is true you can easily overvalue the security, since you make it worth anything you want it to be worth. Beyond this, it is particularly dangerous too, because sometimes your ideas of the future turn out to be wrong. Then you have paid an awful lot for a future that isnt there. Your position then is pretty bad . Benjamin Graham quoted in Timothy Vick, How to Pick Stocks like Warren Buffett (NY: McGraw-Hill, 2001), p. 163 - Normal growth (more mature firms like GEICO): relates growth to current values - Super normal growth (explosive growth phase; venture capital) Conservatively derived based on NAV & EPV inputs (helps ensure consistency) - Reinvestment risk assessed in the context of a franchise Margin of Safety is the final control to mitigate growth risk
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- Using GV as the basis for a margin of safety (paying full EPV so long as growth provides an acceptable margin)

How to avoid errors

Rule # 1: Focus on common-sense economics Rule # 2: Use more than one valuation approach Rule # 3: Dont be mechanical 1. Skepticism, Conservatism, a rigorous valuation process (see the next 2 slides), & the Margin of Safety principle facilitate common sense analysis 2. NAV & EPV are different valuations, which most of the time will lead to ~the same value (base case value), which helps to control for forecasting risk - EPV > NAV = potential franchise - EPV < NAV = potential turnaround opportunity 3. value investing is not a paint-by-numbers exercise. Skepticism and judgment are always required. Seth Klarman, The Timeless Wisdom of Graham and Dodd, Security Analysis 6th Ed. (NY: McGraw-Hill, 2009 [1934]), p. xviii - Assumptions transparent in each level of the valuation; subject to validation (especially Franchise Value) December 2011
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The Graham & Dodd valuation process (a)

According to Benjamin Graham & David Dodd A general definition of intrinsic value would be that value which is justified by the factse.g., assets, earnings, dividends, definite prospects (Security Analysis 3rd Ed. (NY: McGraw-Hill, 1951 [1934]), p. 16) - Value is subjective not intrinsic hence the importance of justifying estimates based on the facts Seth Klarman noted that Value investing, the strategy of buying stocks at an appreciable discount from the value of the underlying business, is one strategy that provides a road map to successfully navigate not only through good times but also through turmoil (MIT Remarks, 10/20/07, http://www.designs.valueinvestorinsight.com/bonus/bonuscontent/ docs/Seth_Klarman_MIT_Speech.pdf, p. 7) As Michael Lewis observed in Moneyball Its looking at process rather than outcomes, Too many people make decisions based on outcomes rather than process (p. 146)
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The Graham & Dodd valuation process (b)

Screening Quantitative - low market-to-book, low price-to-earnings, high dividend yield, etc.; Qualitative - business cycle analysis, franchise-based research, special situations (such as bankruptcies, spin-offs & restructurings), etc. Initial Valuation Net Asset Value(NAV) Adjustments Appraiser, Auditor; Consultant, Expert input on select balance sheet adjustments Earnings Power Value (EPV) Analysis Earnings-based inquiries & investigative items Franchise Value (FV) Analysis Financial Strategy-based inquiries, & corresponding questions for executive management Growth Value (GV) Analysis Consistent strategic themes that can support growth initiatives? Final Valuation

The most common source of mistakes in management [&, I believe, in investment] decisions is the emphasis on finding the right answer rather than the right question. Peter Drucker, The Practice of Management (NY: Harper Row, 1954), p. 351

Source: Calandro (2009), p. 203

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Graham & Dodd and avoiding Critical valuation errors

NAV Prof. Rubacks Critical Valuation Errors to Avoid Error # 1: Forecasts are aggressive Error #2: Cycles are ignored Error # 3: Forecasts are not consistent Error # 7: Discount rates are conservative or aggressive Error # 8: Changing capital structure is not considered Error #4: Terminal value timing Error # 5: Inconsistent assumptions Error # 6: Long-term growth rates are aggressive Error #10: Multiples are inappropriately applied Error # 9: Control premium How to Avoid These Errors Rule # 1: Focus on common-sense economics Rule # 2: Use more than one valuation approach Rule # 3: Dont be mechanical EPV x x x x x x x x x x FV GV

x x x x

x x x x

x x x x

x x x

x x x

x x x

x x x

Used properly, Graham & Dodd can help to mitigate the risk of Critical Valuation Errors; however, it cannot eliminate the risk: valuation is an art, not a science. Seth Klarman, The Timeless Wisdom of Graham and Dodd, Security Analysis 6th Ed. (NY: McGraw-Hill, 2009 [1934]), p. xviii
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Recommended reading
Security Analysis 6th Ed., by Benjamin Graham & David Dodd (edited by Seth A. Klarman) Margin of Safety by Seth A. Klarman The Intelligent Investor - Revised Ed. by Benjamin Graham (edited by Jason Zweig) Benjamin Graham: Building a Profession edited by Jason Zweig Financial History Magazine by the Museum of American Finance Moneyball by Michael Lewis (particularly relevant to those in corporate) Value Investing: From Graham to Buffett & Beyond by Bruce Greenwald, et al. Applied Value Investing by Joseph Calandro, Jr. Richard S. Ruback, Know Your Worth: Critical Valuation Errors to Avoid, HBS Press - Faculty Seminar Series, August 1, 2004,
http://hbr.org/product/know-your-worth-critical-valuation-errors-toavoid/an/6433C-MMC-ENG
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About the presenter

Joseph Calandro, Jr. is a Managing Director at PwC & a Finance Department faculty member of the University of Connecticut where he designed & taught MBA courses on value investing and risk management & insurance Joe has published widely including the book Applied Value Investing (NY: McGraw-Hill, 2009), & journal articles in the Journal of Private Equity, Journal of Alternative Investments, Strategy & Leadership, etc. A list of his publications--some of which are downloadable--is available at the Social Science Research Network (http://ssrn.com/author=357310). Joe has also presented papers at conferences in the U.S., U.K., & Canada

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