Basic Structure of Investment Process and Valuation

Professor Bruce Greenwald

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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)

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
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Individual ! ! ! Loss Aversion Hindsight Bias Lotteries 5 . Institutional ! ! ! Herding – Minimize Deviations Window Dressing (January Effect) Blockbusters 2.Systematic Biases 1.

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 .

Valuation Approaches – Ratio Analysis Cash Flow Measure Earnings (Maint. Quality • Cost of Capital (Risk) • Growth EBIT (Maint. = Depr + A) x Multiple Depends on: • Economic position • Cyclical situation • Leverage • Mgmt. = 0) Range of Error (100%+) 7 . Inv. Inv. Inv. Tax =0) EBIT . = Depr + A. Inv.A (Maint. = Depr only) EBIT-DA (Maint.

Valuation Approaches Net Present Value of Cash Flow Value = ! CF (1 +1 R ) t=0 t " t = CF0 * 1 R-g Note: NPV Analysis encompasses ratio analysis (NPVdiseases are ratio analysis diseases) Note: NPV is theoretically correct In Practice: Parameters: ! Revenues Forces: ! 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 ! ! ! ! ! ! ! ! ! Cost of Capital X 8 NPV </> Market Value .

Shortcomings of NPV Approach in Practice (1) Method of Combining Information 20 NPV = CFo +CF1 1 1+R + … +CF20 1 1+R + ... 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 .

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 .e. profits stable. • Firm enjoys sustainable 9%) competitive advantage • Growth rate 7% of • Competitive advantage is sales.

Organize valuation components by reliability Most Reliable Least Reliable 2. 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.

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 $1.5B $1.010B Yes (P # MV #) Yes Stop Yes (Sales # MV#) Yes Stop ? Automobiles (Ford) Internet Remember.0B $40B $30B $25B $10B $1B $1B $1B $25B $25B $25B $0.Industry Entry . 13 . Exit is Slower than Entry.

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. Franchises Subsidiaries Liabilities A/P. Value Reproduction Value Book Book + Allowance Book + LIFO Orig Cost $ Adj Years R & D Years SGA Accounts Receivable Book Customer Relationships0 Net Net Wk Cap 14 . AT. Value Private Mkt. AL Debt Def Tax.Asset Value Assets Cash Inventories PPE Product Portfolio Organization Licenses.

Assumption: –Current profitability is sustainable ! ! 15 .Earning Power Value ! Basic Concept – Enterprise value based on this 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.

pricing power. etc 16 .“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 " 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) " This yields “normalized” Earnings (7)Add adjustments for unconsolidated subs. problem being fixed.

+real estate. .legacy costs) EPV Equity = EPV Company – Value Debt EPV EQUITY equivalent to AV EQUITY EPV COMPANY equivalent to AV COMPANY 17 .Earnings Power Value EPV Business Operations = Earnings Power x 1/WACC EPV Company = EPV Business Operations + Excess Net Assets (+cash.

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.Earning Power and Entry . 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) ! ! ! 19 .Total Value Including Growth ! Least reliable .

B. CF0 1 R-G vs. Do Not Discount Growing “Earnings” Streams) 20 . CF0 1 R * * WACC Growth Rate • Growth Requires Investment which reduces current (distributable) Cash Flow CF0 = “Earnings” # 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) I.Value of Growth .E.

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 Qualitative Impact: 5% $5M $10M ($5M) ($50M) Value Destroyed Competitive Disadvantage 10% $10M $10M 0 0 No Value 20% $20M $10M $10M $100M 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 .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.Earning Power and Entry .

Valuing Growth Basics ! 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 ! ! 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 .

Consequences of Free Entry Commodity Markets (Steel) $/Q AC “Economic Profit” ROE (20%) > Cost of Capital Price Q Entry/Expansion Supply Up. Price Down Firm Position $/Q AC (Efficient Producers) ROE = 12% No Entry No Profit Price Q 25 Firm Position .

Product Differentiation Branding (Profitability & Stability) Coca Cola Colgate Toothpaste Tide Marlboros Budweiser Harley-Davidson Intel Motorola Target. NCNB Insurance Gannett. Cingular WellsFargo. Sprint JP Morgan. Liz Claiborne ATT. WSJ Cadillac Mercedes-Benz Sony (RCA) Maytag(Hoover) 26 . Buffalo Evening News Dell. HP Gap. Citibank Cosmetics NY Times. Chase. Walmart Verizon.

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 Firm Position Q 27 .

Barriers to Entry Incumbent Cost Advantage $/Q ACEntrant ACIncumbent Demand (Entrant. Process) Learning Curve Special Resources • Not Access to Capital • Not Just Smarter 28 . 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 Demand Advantage $/Q AC (Entrant. Sales ROE = 20% Sources Habit (Coca-Cola) • High Frequency Purchase Search Cost (MD’s) • High Complex Quality Switching Cost (Banks. Computer Systems) • Broad Embedded Applications 29 . Incumbent) DemandIncumbent DemandEntrant Firm Position Q Entrant No “Economic” Profit ROE = 12% No Entry Incumbent Higher Profit.

Barriers to Entry Economies of Scale $/Q Demand 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 .

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. Microsoft) 31 . Wal-Mart) • Product Line (Eye Surgery. Nebraska Furniture Mart. HMO’s) • National (Oreos. Nike. Intel. Coke. Autos) • Global (Boeing.

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 .

IBM) $ Wal-Mart (K-Mart. Sprint) $ Pharmaceuticals 33 .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. Circuit City) $ Intel (Texas Instruments. product geography) are ones susceptible to domination $ Microsoft (Apple.

34 . •Maintaining Established Position -No Barriers % No Position (Hard to Create from Nothing).Assessing Competitive Advantages/ B-to-E Strategy Formulation •New Market Entry -No Barrier % No Profit -Outside Barriers % Losses -Need Potential Barriers. -Enhancement ·Product Line Extension ·Increase Purchase Frequency ·Increase Complexity ·Accelerate Progress ·Emphasize Fixed vs. not yet in place. Variable Cost Technology.

History – Returns – Share Stability Sustainable competitive advantages (2) Calculate earnings return – i. 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 . ii.e.Procedure in Practice (1) Verify existence of franchise i.

S.2% Expected Return = 7. Market (1)6% (1/PE) + 2% (inflation) = 8% (2)2.5% India Market (1)4% (1/PE) + 5% (inflation) = 9% (2)2% (D/P) + 7% (growth) = 9% Expected Return = 9% 36 .5% (D/P) + 4.Prospective Returns US & India Markets U.7% (growth) = 7.

Hindustan Unilever: Market Dominance Source: Company website showing AC Nielsen – Quarter Ended Sept 2007 value shares 3737 .

53 11% 2006 13035.61 16% 2003 11096.02 16% 2004 10888.70 31.38 11% 2005 11975.008 (crores) 23 P/E Ratio Share Price 181.06 12% 46.419 31 197.25 47.55 3838 .Hindustan Unilever: Financial returns (Indian Rupees) Revenues crores Net profit margin Return on capital Return on Assets 2002 10951.7% 23% 37.1% 20% 55.587 26 143.059 25 204.788 26 216.4% 20% Stock information Market cap 40.75 45.8% 23% 48.50 43.3% 16% 58.

Infosys: Performance Return on Total Capital Declined….3% 37. 3939 .3% 32%* 1.7% 33. 2000 2001 2002 2003 2004 2005 30.76 31. and Italics show VL Estimate for 2007.51 .31 .2% 2006 2007 42.37 .2% 30.25 .00 1.5 2.4 % As Earnings Per Share* grew … .00 The Stock Price ($US ADR) shows extremely high multiples / growth expectation. especially in 2000 … * Source: Value Line Data.6% 27.

0% + 40 .50% 15.6% Dell Direct PC Supply to Large organizations 100.Simple Examples Franchise Verification Company Wal-Mart Business Discount Retail Adjusted ROE 22.5% American Express Gannett High-end Credit Cards & Services Local Newspapers & Broadcasting 45.

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 .

Growth – 11 ½%) American Express = 4% + 4% (2% x 2) + 7.5% + 4. Growth –3%) = 10% - 1% - 2. Growth – 13%) Gannett (P/E – 11.Calculated Growth Stock Returns CASH RE GROWTH TOTAL Wal-Mart = 1.5% = 15. Growth –15%) 42 .5% = 9.5% + Option (P/E – 17 ½.0% = 7.0% + Growth +Option (P/E – 20.5% + (x1 Capital Allocation) 3.5% + Option (P/E – 17.0% + Option Dell = 0% + 5% (?) + ? = 5.

Appendix 43 .

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