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Professor Bruce Greenwald
Value Investing Principles
• Identify enterprises whose value as a
business is reliably calculable by you (circle of competence)
• Among those enterprises, invest in those
whose market price (equity plus debt) is below your calculated value by an appropriate margin of safety (1/3 to 1/2)
Value Investing Process
• Cheap • Ugly • Obscure • Otherwise Ignored
• Assets • Earnings Power • Franchise
REVIEW • Key Issues
• Collateral Evidence • Personal Biases
• Margin of Safety • Some Diversification • Patience – Default Strategy
Systematic Biases 1. Individual z z z Loss Aversion Hindsight Bias Lotteries 5 . Institutional z z z Herding – Minimize Deviations Window Dressing (January Effect) Blockbusters 2.
Value Investing Process SEARCH • Cheap • Ugly • Obscure • Otherwise Ignored VALUATION • Assets • Earnings Power • Franchise REVIEW • Key Issues • Collateral Evidence • Personal Biases RISK MANAGEMENT • Margin of Safety • Some Diversification • Patience – Default Strategy 6 .
Tax =0) • Cyclical situation • Leverage • Mgmt.Valuation Approaches – Ratio Analysis Cash Flow Measure Earnings (Maint.A (Maint. = Depr only) EBIT-DA (Maint. = Depr + A. Inv. = 0) Range of Error (100%+) 7 . Inv. Inv. Inv. Quality • Cost of Capital (Risk) • Growth EBIT . = Depr + A) x Multiple Depends on: • Economic position EBIT (Maint.
Valuation Approaches Net Present Value of Cash Flow Value = 6 CF (1 +1 R ) t=0 t f 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: z z z z z z Forces: z Market Size Market Share Market Growth Price/Cost Tech Management Performance Cash Flows Required Investments Margins Consumer Behavior Competitor Behavior Cost Pressures Technology Tech Management Performance z z z z z Cost of Capital X 8 NPV </> Market Value .
. Good Information (Precise) Bad Information (Imprecise) = Bad/Imprecise Information (2) Sensitivity Analysis is Based on Difficultto-Forecast Parameters which co-vary in fairly complicated ways Cost of Capital Profit Margin Required Investment Growth 9 ..Shortcomings of NPV Approach in Practice (1) Method of Combining Information 20 NPV = CFo +CF1 1 1+R + … +CF20 1 1+R + .
profits stable.e. • Firm enjoys sustainable 9%) competitive advantage • Growth rate 7% of • Competitive advantage is sales.Valuation Assumptions Traditional: • Profit rate 6% • Cost of capital 10% Strategic: • Industry is economically viable • Entry is “Free” (no • Investment/sales 60% incumbent competitive advantage) • Profit rate +3% (i. firm grows with industry 10 .
Organize valuation components by underlying strategic assumption No Competitive Advantage Growing Competitive Advantage 11 .Value Investing Basic Approach to Valuation “Know what you know”. Circle of competence 1. Organize valuation components by reliability Most Reliable Least Reliable 2.
Basic Elements of Value Strategic Dimension Growth in Franchise Only Franchise Value 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 12 .
Exit Industry Market Value Net Asset Value Entry Chemicals (Allied) $2B $1.010B ? Remember.5B $1.0B $1B $1B $1B Yes (P p MV p) Yes Stop Yes (Sales p MVp) Yes Stop Automobiles (Ford) $40B $30B $25B $25B $25B $25B Internet $10B $0.Industry Entry . 13 . Exit is Slower than Entry.
Value Reproduction Value Book Book + Allowance Book + LIFO Orig Cost r Adj Years R & D Years SGA Accounts Receivable Book Customer Relationships0 Net Net Wk Cap 14 . AL Debt Def Tax. Reserves Bottom Line Book Book Book Book Fair Market DCF Net Repro Value Basic GrahamDodd Value Book Book 0 0 0 0 0 Private Mkt.Asset Value Assets Cash Inventories PPE Product Portfolio Organization Licenses. Franchises Subsidiaries Liabilities A/P. AT. Value Private Mkt.
Assumption: –Current profitability is sustainable z z 15 .Earnings Power Value = “Earnings” * Cost of capital z Second most reliable information earnings today Calculation –“Earnings” – Accounting Income + Adjustments –Cost of Capital = WACC (Enterprise Value) –Equity Value = Earnings Power Value – Debt.Earning Power Value z Basic Concept – Enterprise value based on this years “Earnings” Measurement z 1 .
“Earning Power” Calculation (1)Start with “Earnings” not including accounting adjustments (one-time charges not excluded 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 ¾ This yields “normalized” EBIT (5)Multiply by one minus Average tax rate (no pat) (6)Add back excess depreciation (after tax at ½ average tax rate) ¾ This yields “normalized” Earnings (7)Add adjustments for unconsolidated subs. pricing power. etc 16 . problem being fixed.
. +real estate.Earnings Power Value EPV Business Operations = Earnings Power x 1/WACC EPV Company = EPV Business Operations + Excess Net Assets (+cash.legacy costs) EPV Equity = EPV Company – Value Debt EPV EQUITY equivalent to AV EQUITY EPV COMPANY equivalent to AV COMPANY 17 .
Earning Power and Entry .Exit Case A: Value Lost to Poor Management and/or Industry Decline Asset Value EP Value Case B: Free Entry Industry 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 18 .
Forecast change not just stability (Earnings Power) Highly sensitive to assumptions Data indicates that investors systematically overpay for growth Strict value investors want growth for “Free” (Market Value < Earnings Power Value) z z z 19 .Total Value Including Growth z Least reliable .
E. CF0 1 * R-G vs. Do Not Discount Growing “Earnings” Streams) 20 .B.Value of Growth . CF0 * R Growth Rate WACC • Growth Requires Investment which reduces current (distributable) Cash Flow CF0 = “Earnings” y Investment Needed to Support Growth No Growth CF0 (N.Basic Forces At Work • Growing Stream of Cash Flows is more Valuable than a Constant Stream (relative to current Cash Flow) 1 I.
Value of Growth Quantitative Effects Investment: Cost of Funds: • $100 million • 10% (R) = $10M Return on Investment (%) Return on Investment ($) Cost of Investment Net Income Created Net Value Created 5% $5M $10M ($5M) ($50M) 10% $10M $10M 0 0 20% $20M $10M $10M $100M Qualitative Impact: Value Destroyed Competitive Disadvantage No Value Value Created Competitive Advantage Situation: Level Playing Field 21 .
Advantage and/or Superior Management Asset Value EP Value “Sustainability” depends on Continuing Barriersto-Entry 22 .Earning Power and Entry .Exit Case A: Value Lost to Poor Management and/or Industry Decline Asset Value EP Value Case B: Free Entry Industry Balance Asset Value EP Value Case C: Consequence of Comp.
Valuing Growth Basics z Growth at a competitive disadvantage destroys value (AT&T in info processing) Growth on a level playing field neither creates nor destroys value (Wal-Mart in NE) Only franchise growth (at industry rate) creates value z z 23 .
Value Investing Process SEARCH • Cheap • Ugly • Obscure • Otherwise Ignored VALUATION • Assets • Earnings Power • Franchise REVIEW • Key Issues • Collateral Evidence • Personal Biases RISK MANAGEMENT • Margin of Safety • Some Diversification • Patience – Default Strategy 24 .
Price Down $/Q AC (Efficient Producers) ROE = 12% No Entry No Profit Price Q Firm Position 25 .Consequences of Free Entry Commodity Markets (Steel) $/Q AC “Economic Profit” ROE (20%) > Cost of Capital Price Q Firm Position Entry/Expansion Supply Up.
Liz Claiborne ATT. NCNB Insurance Gannett. Citibank Cosmetics NY Times.Product Differentiation Branding (Profitability & Stability) Coca Cola Colgate Toothpaste Tide Marlboros Budweiser Harley-Davidson Intel Motorola Target. HP Gap. Cingular WellsFargo. Buffalo Evening News Dell. Walmart Verizon. Sprint JP Morgan. Chase. WSJ Cadillac Mercedes-Benz Sony (RCA) Maytag(Hoover) 26 .
Consequences of Free Entry Differentiated Markets (Luxury Cars) $/Q AC “Economic Profit” ROE (20%) > Cost of Capital Entry/Expansion Demand for Firm Demand Curve shifts left (Fewer Q sales at each Firm Position Price) $/Q AC ROE = 12% No Entry No Profit Demand Curve Q Firm Position 27 .
Incumbent) Firm Position Q Entrant No “Economic” Profit ROE = 12% No Entry Incumbent “Economic” Profit ROE = 20% Sources Proprietary Tech (Patent.Barriers to Entry Incumbent Cost Advantage $/Q ACEntrant ACIncumbent Demand (Entrant. Process) Learning Curve Special Resources • Not Access to Capital • Not Just Smarter 28 .
Computer Systems) • Broad Embedded Applications 29 .Barriers to Entry Incumbent Demand Advantage $/Q AC (Entrant. Incumbent) DemandIncumbent DemandEntrant Firm Position Q Entrant No “Economic” Profit ROE = 12% No Entry Incumbent Higher Profit. Sales ROE = 20% Sources Habit (Coca-Cola) • High Frequency Purchase Search Cost (MD’s) • High Complex Quality Switching Cost (Banks.
Barriers to Entry Economies of Scale Demand $/Q Demand (Entrant. Incumbent) $/Q AC Entrant Incumbent Firm Position Q No advantage Firm Position No advantage AC Q • Require Significant Fixed Cost (Internet) • Require “Temporary” Demand Advantage • Not the Same as Large Size (Auto + Health Care Co) 30 .
Nike. HMO’s) • National (Oreos. Autos) • Global (Boeing. Wal-Mart) • Product Line (Eye Surgery. Intel. Nebraska Furniture Mart. Microsoft) 31 . Coke.Barriers to Entry Economies of Scale $/Q Loss D-Incumbent Profit Price (Both) AC D-Entrant Sales Entrant Sales Incumbent Q • Advantages are Dynamic and Must be Defended • Fixed Costs By: • Geographic Region (Coors.
Varieties of Competitive Advantage Producer (Cost) Supply – Proprietary Technology or Resources Consumer (Revenue) Demand – Customer Captivity Economies-of-Scale (plus Customer Captivity) Key to Sustainability Sustainable Competitive Advantage implies market dominance. 32 .
Circuit City) Intel (Texas Instruments.Competitive Advantage Strategy Implications • Analysis on a market-by-market basis •Large global markets are difficult to dominate • Local markets (Physical. et al) Verizon (ATT. Sprint) Pharmaceuticals 33 . product geography) are ones susceptible to domination Microsoft (Apple. IBM) Wal-Mart (K-Mart.
Assessing Competitive Advantages/ B-to-E Strategy Formulation •New Market Entry -No Barrier No Profit -Outside Barriers Losses -Need Potential Barriers. •Maintaining Established Position -No Barriers No Position (Hard to Create from Nothing). Variable Cost Technology. 34 . not yet in place. -Enhancement ·Product Line Extension ·Increase Purchase Frequency ·Increase Complexity ·Accelerate Progress ·Emphasize Fixed vs.
1/PE (3) Identify cash distribution portion of earnings return (Dividend + Repurchase) (4) Identify organic (low investment) growth (GDP ) (5) Identify reinvestment return (Multiple of Pct retained Earnings ) (6) Compare to market return (D/P & growth) (7) Identify options positive/negative 35 . History – Returns – Share Stability Sustainable competitive advantages (2) Calculate earnings return – i.e.Procedure in Practice (1) Verify existence of franchise i. ii.
S. Market (1)6% (1/PE) + 2% (inflation) = 8% (2)2.7% (growth) = 7.Prospective Returns US & India Markets U.5% (D/P) + 4.5% India Market (1)4% (1/PE) + 5% (inflation) = 9% (2)2% (D/P) + 7% (growth) = 9% Expected Return = 9% 36 .2% Expected Return = 7.
Hindustan Unilever: Market Dominance Source: Company website showing AC Nielsen – Quarter Ended Sept 2007 value shares 3737 .
1% 20% 55.75 45.61 16% 2003 11096.06 12% 46.059 25 204.70 31.8% 23% 48.3% 16% 58.25 47.7% 23% 37.788 26 216.02 16% 2004 10888.008 (crores) 23 P/E Ratio Share Price 181.55 3838 .Hindustan Unilever: Financial returns (Indian Rupees) Revenues crores Net profit margin Return on capital Return on Assets 2002 10951.587 26 143.53 11% 2006 13035.4% 20% Stock information Market cap 40.419 31 197.38 11% 2005 11975.50 43.
76 31.7% 33.4 % As Earnings Per Share* grew … . and Italics show VL Estimate for 2007.2% 30. 2000 2001 2002 2003 2004 2005 30.3% 32%* 1.5 2.2% 2006 2007 42.37 .Infosys: Performance Return on Total Capital Declined….51 .25 .00 1.3% 37. especially in 2000 … * Source: Value Line Data. 3939 .6% 27.31 .00 The Stock Price ($US ADR) shows extremely high multiples / growth expectation.
Simple Examples Franchise Verification Company Wal-Mart Business Discount Retail Adjusted ROE 22.0% + 40 .6% Dell Direct PC Supply to Large organizations 100.5% American Express Gannett High-end Credit Cards & Services Local Newspapers & Broadcasting 45.50% 15.
Simple Examples Franchise Verification Sources of Competitive Advantage Sources of Competitive Advantage Company Wal-Mart Customer Captivity? Slight Customer Captivity Economies-of-Scale? Local Economies-ofScale Some Economies-ofScale Local Economies-ofScale Economies-of-Scale American Express Gannett Customer Captivity Customer Captivity Dell Slight Customer Captivity 41 .
0% + Option Dell = 0% + 5% (?) + ? = 5.5% = 15. Growth –3%) = 10% - 1% - 2.0% = 7. Growth – 13%) (2% x 2) Gannett (P/E – 11. Growth –15%) 42 .0% + Growth +Option (P/E – 20.5% + (x1 Capital Allocation) 3.5% + Option (P/E – 17 ½. Growth – 11 ½%) American Express = 4% + 4% + 7.5% = 9.Calculated Growth Stock Returns CASH RE GROWTH TOTAL Wal-Mart = 1.5% + Option (P/E – 17.5% + 4.
Appendix 43 .
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