VALUE: A QUEST A time-tested approach to investment valuation
INVESTMENT VALUATION By: Tim Corcoran
WHY THIS FRAMEWORK ? A framework should only be accepted if it satisfies two tests: • Factual • Theoretical Let’s begin by seeing what factual grounds there are for accepting this strategy.
FACTUAL GROUNDS Two factual bases for accepting this theory: • The performance records of those who have used this strategy in the past are impressive • Academic tests confirm the viability of the strategy
THE KING Ben Graham 1894 - 1976
Ben Graham • Developed a set of principles to be followed in undertaking ANY investment. • These principles are found in his texts Security Analysis and The Intelligent Investor How have those who have followed these principles performed?
Walter Schloss William Ruane Warren Buffett 16.1% 1956-1984 17.2% 1970-1984 21.4% 1965-2006 Above are just three disciples of Graham, each with impressive performance. Here are a few more…
HOLD ON! Those previous performance records span the greatest bull market in American history. Would those investors perform as well in today’s market?
The Canadian Buffett In the performance table, Francis Chou’s 8.98% annualized performance is hardly comparable to that of his American counterparts. A particular drag on Chou’s performance was his fund’s 2008 return of -29.30%. Removing this return , Chou’s annualized performance is 14.34%. The Financial Crisis of 2008 was a formidable time for even the best investors. Chou was no exception. If we omit this year, from Chou’s record we can see that Graham’s principles can lead to success EVEN in today’s market.
Graham and Dodd’s First Principle A strategy of buying securities when their prices are significantly below their intrinsic value will produce superior investment returns in the long-run. ACADEMICS tested this principle through: mechanical selection tests
FORMAT FOR MECHANICAL SELECTION TESTS • For a universe of stocks, gather annual price and fundamental data (EPS, BVPS, CFPS) over a specific time period • For each year within the time period, divide price by fundamental data in order to produce a measure of intrinsic value • Rank each year`s intrinsic value estimates from highest to lowest • Place the lowest ranking stocks within one group and the highest ranking stocks within a separate group • For each year, determine the return on each individual stock within the separate groups • Aggregate the returns on the individual stocks to produce a total return for each group • Repeat this process annually and determine which group outperforms over the time period selected REMEMBER: According to Graham`s first principle, a strategy of buying stocks in the LOWEST GROUP should outperform.
Is there FACTUAL evidence supporting this strategy? • The strategy has worked for others! This is evident in the superior performance records of Graham disciples • Academia have confirmed the strategy’s viability in different markets, market states and EVEN countries YES!
Earlier it was stated that two conditions must be satisfied by a prospective investment strategy: • It is factually demonstrable • It is theoretically sound Factual evidence in support of the theory has been given. Let’s look at the theory behind it.
THE WORLD OF INVESTORS
STEP 1: Use a screening method in order to limit the universe of stocks to a manageable figure.
POSSIBLE SCREENING CRITERIA Low P/E, P/B, P/CF, P/S High B/M Decreasing ROE, EPS growth, Sales Growth, Asset Growth, and/or Profit Margins Stocks involved in corporate spin-offs Stocks traded heavily at year-end Stocks of companies experiencing financial distress or involved in legal proceedings
After winnowing the world of securities to a more manageable figure. Ben Graham suggested the following 7 criteria be demanded of stocks: • Current Ratio ≥ 1.5 • Debt ≤ 1.1 x Net Current Assets • No deficit in last 5 years • Current dividend • Earnings greater than 5 years prior • Price ≤ 1.2 x tangible book value • P/E ≤ 15
STEP 2: Calculate the Asset Value of the stock
First obtain the company’s financial statements from EDGAR (U.S. companies) http://www.sec.gov/edgar/searchedgar/webusers.htm SEDAR (Canadian companies) http://www.sedar.com/
Proceed through the most recent balance sheet line-item by line-item adjusting the values to reflect their true worth
Buffett demonstrated this appraisal technique in his 1962 partnership letter shown below:
GUIDELINES FOR NAVIGATING NAV
CASH AND MARKETABLE SECURITIES 100% of Cash and Marketable Securities should be included in the calculation of NAV.
ACCOUNTS RECEIVABLE 85% of A/R should be included in NAV. This % is considered standard practice and is evident in Buffett’s 1962 letter.
INVENTORY • Determine if the inventory is commodity-like OR will face • the risk of obsolescence • More commodity-like the inventory, lower the discount • applied • IFRS mandates disclosure of the carrying amount of • inventory broken down by classifications. This should • assist in determining an appropriate discount rate
PPE First test the authenticity of reported PPE. Compare net PPE to cap ex found on the Cash Flow Statement. Determine number of years of cap ex that when added together produce a sum greater than net PPE. If a competitor could replicate the entire PPE for less than the sum of Cap Ex, PPE may be overstated and depreciation understated. Discount PPE A real estate appraisal can be obtained for Property. Deduct this amount from PPE to deal with the more arbitrary figures of Plant and Equipment. Equipment adjustments demand specific knowledge of the industry in question.
GOODWILL Zero value should be given to Goodwill in arriving at NAV. It is essentially a sunk cost.
DEFERREDTAX ASSETS DTAs, as refunds enjoyed in the future, should be discounted to the present in arriving at NAV. Use the company’s WACC as the discount rate. DTAs are typically consumed in 1 year.
BRAND RECOGNITION QUASI-ASSET • Does the company in question have considerable clout with its customers? • If so, add a quasi-asset for marketing because any competitor would have • to spend a significant portion on marketing to compete with incumbent • Take the average ratio of S,G, and A to Sales over previous 5 years. Apply • this ratio to the current sales figure. Make the assumption that 3 years • would be needed to compete with the incumbent and multiply this figure • by 3. Divide this figure by 2 assuming half S, G, and A is attributable to • running the business and the other half for marketing.
STEP 3: Deduct Liabilities to arrive at a Net Asset Value measure.
There are 3 liability types: • Spontaneous Arise from the normal course of business (Ex. Accounts Payable, Accrued Expenses) • Circumstantial Arise form the past circumstances of the entity (Ex. DTLs, legal liabilities) • Formal Outstanding debt of the company(Ex. LTD, STD, Preferred Shares)
TOTAL DEBT = BV Spontaneous Liabilities + BV Circumstantial Liabilities + MV Formal Debt
NET ASSET VALUE Net Asset Value is found by deducting Total Debt from the adjusted measure of asset value. Dividing this figure by the number of shares outstanding (which is readily available on the Balance sheet) will provide a per share estimate. FINALLY!
STEP 4: Adjust current earnings to arrive at a conservative estimate of future earnings
EARNINGS ADJUSTMENTS • COMPETITVE ADJUSTMENT • Adjust the figure downward further to reflect the fact that competition slowly erodes profits to reasonable levels. This adjustment is particularly warranted when the company has been enjoying overly prosperous times. Discretion is used here.
STEP 5: Add company cash to adjusted earnings
STEP 6: Determine a suitable discount rate to apply to adjusted earnings
Our method for calculating Earnings Power Value will deduct all debts, therefore we are interested solely in the cost of equity. But… which method to use? CAPM? Bond Yield + Risk Premium Approach? Fama French Three Factor Model? Pastor-Stambaugh model?
Cold hard Truth…. There is no sure-fire method for calculating an appropriate cost of equity. The investor can start The Credit Suisse Handbook estimates and use a variety of methods, adjusting for company- specific risk
Credit Suisse Handbook Equity PremiaRelative to Long-Term Government Bonds
STEP 7: Find the PV of Earnings as: [Adjusted Earnings + Cash] / Discount Rate
STEP 8: Deduct debt from PV of Earnings The investor should deduct MV of all debt from the PV of earnings in order to arrive at Earnings Power Value.
STEP 9: Contrast NAV and EPV Two general rules apply: • If NAV > EPV, company industry is overly competitive. Value being destroyed. Company cannot generate required return. Company value closer to NAV. 2. If NAV < EPV, company has understated its assets or firm has a competitive advantage. Value is created. Company value closer to EPV.