The Value of Growth

This is the last part of the basics series on value investing. The series in its entirety can be accessed by clicking on the "basics" link under the topics section to the left. I hope this has lent a comfortable understanding of the value investing methodology. I can always be reached with questions or comments via email at "jonathan (at) jonathangoldberg (dot) com".

In the coming articles I hope to introduce you to a wealth of value investment opportunities and insights to continue to further your education in the field (and to put some money in your pocket at the same time). If there are any companies you feel may be value investments please email me with your suggestions as I may do a complete valuation and analysis along with recommendation. In comparing my notes with yours we may both learn a thing or two.

I do not profess to be an expert in the field, as my learning is ongoing, so I welcome any suggestions for topics as well as additional insights into items which may have been discussed previously.

Subscribing to the RSS feed via the orange button to the right is the best way to stay on top of new articles as I do not plan on posting each day... and some days I may even surprise you with a second helping. Thank you for reading, please continue and enjoy the ride!

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Valuing growth is the least reliable aspect of a valuation. Whereas with the net asset valuation we are valuing assets the company currently owns and with the earnings power valuation we are extrapolating already realized earnings, in valuing growth we are forecasting what we think will happen in the future. It is this forecasting which is highly sensitive to assumptions as well as other behavioral biases. One of these behavioral biases is the fact that investors tend to overpay for growth; the average investor may jump into a stock that everyone likes (also known as "herding") or assume that they know more about the the stock and its future than they actually do. As Mark Twain said, "It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so."

As value investors we want this growth for free. Sure we are willing to consider a stock more favorably because of the potential for growth, but we won't pay for something that we know to be so highly sensitive to assumptions. The most we are willing to pay for a security would be EPV (in the case of a franchise value with growth) - in such a case the value of growth is our margin of safety.

Unless a company meets the following two criteria there is just no way that value investors can consider it to have potential for growth:

1. Return on Invested Capital (ROIC) must be greater than the Weighted Average Cost of Capital (WACC), otherwise growth has no value.
2. The company must have a fully sustainable competitive advantage otherwise ROIC can not remain greater than WACC.

The valuation of a company that meets the above criteria for growth has two aspects which are different than our basic valuation, as follows:

1. Expenses that support growth need to be added back to the free cash flows that have been calculated. This includes items such as the growth portion of an R&D expense and the growth portion of a marketing expense. These are added back to the cash flows prior to removing taxes (at the EBIT line). We do this in order to adjust EBIT to earnings without growth, the same earnings we try to capture in each valuation.

2. EPV is modified by a multiplier for the value of growth. The equation to arrive at this multiplier can be found using some "valuation algebra" as shown in this book (the details of the multiplier are too in depth for this basics course but may be discussed in a future article). If the growth rate assumption used in the multiplier is reasonable and the modified EPV minus an appropriate margin of safety is greater than the original EPV, we would pay full EPV per share for the company at the most. If the modified EPV minus the margin of safety is less than the original EPV, we would pay at most the modified EPV minus the margin of safety. In this way we are obtaining the growth prospects of the company for free as we are merely substituting these prospects for the (or part of the) margin of safety.

Margin of Safety

As mentioned in earlier posts, value investors like to make use of assumptions that they can be relatively certain about (i.e. last twelve months' earnings, balance sheet valuations, etc). Even so, we know that nothing ever plays out as one would expect. As such, we make use of a "margin of safety". This means that we will never buy into a security at its full intrinsic value (unless there are some pretty certain growth prospects which will be discussed in the next post).

Once the intrinsic value is calculated, an appropriate margin of safety is considered in order to arrive at an entry price. If the security can be had for less than this entry price it should be purchased.

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For those readers that are just joining us now, this is the 5th installment of a "basics" course on value investing. This is important preparatory reading, especially if you are very new to value investing, in order to understand valuations which will be discussed on this site. You can access the entire course by clicking on the "basics" link under the topics heading to the left. I also recommend subscribing to this site's RSS feed by clicking the orange link to the right.

The next post will discuss the value of growth and will conclude the posts on value investing basics. There will definitely be more educational posts in the future but these 6 articles are the basics required in order to understanding an investment thesis on this site.

Intrinsic Value

The intrinsic value (IV) of a potential investment is arrived at by comparing the results of the Net Asset Value (NAV) and Earnings Power Value (EPV) analyses.

If EPV is less than NAV then the intrinsic value for the company is derived from EPV and adds value for the probability of a catalyst taking place within the company that would bring the value of the company to its competitive state (NAV).

If EPV is equal to NAV then it would seem that the company being studied has no competitive advantage. Therefore, EPV and NAV would define the intrinsic value.

If EPV is greater than NAV then the company has what is referred to as a "franchise value". To be willing to pay for this franchise value, the investor must deem it to be sustainable. In this case the intrinsic value is derived from NAV plus added value for the probability of the company maintaining its franchise.

Value Investors' Fund (VIF) Investment Club

If you live in the GTA and would like to meet regularly with other value investors then I encourage you to check out the VIF Investment Club. I am starting the club and will be looking for input on the club's future direction from the other founding members (maybe YOU... founding membership meeting is set for August 11th).

From the club's website:

"This group was created as a forum for like-minded value investors to meet in person and to share specific investment ideas as well as to discuss value investing in general.

The logistics of a real money member-run fund will be explored and discussed amongst the founding members.

You are encouraged to join if you are an experienced value investor as well as if you are new to the philosophy but wanting to learn. We look forward to meeting you!"

Earnings Power Value

Earnings Power Value (EPV) is an estimate of the value of a company from its ongoing operations. The beauty of EPV, for value investors, is that the numbers used to calculate it are NO GROWTH free cash flows. No growth free cash flows just mean that we are only subtracting from cash flows the amount of capital expenditure required to sustain the business. By using no growth free cash flows we eliminate, to a great degree, attempts to predict future growth and as such arrive at a number which we can be fairly certain of; we are using today's earnings, with the assumption that current profitability is sustainable. This isn't to say that some companies can't expect significant growth, but as value investors we refuse to pay for it.

Though we are using today's earnings (today's no growth free cash flows) in calculating EPV, we are normalizing these earnings to the business cycle. This eliminates the effects on profitability of valuing the firm at different points in the business cycle. Ideally, this means that we are considering the average operating profit (as a percentage of total sales) over 5-8 years. This average would then be applied to current sales. Other adjustments to be made to the current year's cash flows would be to account for average expected one-time gains/losses.

The final step in calculating EPV is to divide the final cash flow number by the cost of capital. This gives us the present value of a perpetuity without any estimation of growth. That is your EPV.

Unlike net asset value (NAV) which is an equity value, the EPV result is the enterprise value of the firm; that is, adjustments need to be made to trim this down to equity value. In the investment articles on this site, EPV will refer to the equity value (per share) resulting from an EPV analysis.

A Quote - Benjamin Graham

"The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgement." - Benjamin Graham

Net Asset Value

Determining a figure for the replacement value of the balance sheet is the first step I take in arriving at the value I would pay for a company. This includes marking up land and buildings to current market values, adding assets and liabilities for operating leases, as well as adding intangible assets such as customer relations, product portfolio and licenses. Once complete, simply subtract the liabilities from the assets to find the net asset value (NAV) of the company. Dividing this by the number of shares outstanding yields the NAV per share.

This NAV is what you would expect an optimally performing company in the industry to be worth. All assets would be bid to their fair value in a perfectly competitive environment. That is, in a perfectly competitive environment an optimally performing company's ROIC would be equal to its WACC.

Now in the real world the NAV of a company is not necessarily equal to its actual worth. There will be companies that are under-utilizing their assets (will be worth less than NAV) as well as companies that hold a franchise value (worth more than NAV as they are not in "perfect" competition). As such, the next step is to find the earning power of a company in order to arrive at a value based on actual cash flows. This will be discussed next.

ROIC vs. WACC

Over the next couple of posts I will be providing you with the basic knowledge you need in order to understand my value investing methodology. Also, if you haven't done so already you may want to subscribe to my RSS feed so that you receive the posts as they are published (link is to the right). Think of this as a mini-lesson in value investing. Enjoy!

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Return on Invested Capital (ROIC) is one of the first things I calculate in order to get a sense of whether or not management is taking the company in the right direction. ROIC is essentially the return that the company generates via its invested capital.

While this is obviously a useful metric to compare a company against its peers, as mentioned, I like to use this in order to look inside the company itself and see if management's actions are taking the company in the right direction. In order to do this I compare ROIC against the company's Weighted Average Cost of Capital (WACC). This is my estimation of the company's cost of capital to the equity and debt holders, on a weighted average basis.

If ROIC is greater than WACC then we can assume that growth adds value. On the other hand, if ROIC is less than WACC then value is actually destroyed as the company invests more capital; for every dollar of investment the company attracts it pays out more than it earns with it. In the latter case we would want to see management improve the company's ROIC before investing any more capital. Ideally, the company would actually sell non-performing assets in order to get ROIC in line with WACC.

Just because a company's ROIC is less than its WACC does not make it a poor investment. If management is committed to divesting non-performing assets and improving the return on the capital currently employed, and you feel there is a great possibility of them succeeding, then it may be just the investment opportunity you have been waiting for.

Short Video on Value Investing

I just stumbled upon this video which was made by Columbia Business School. It features Bruce C. Greenwald - the Robert Heilbrunn Professor of Finance and Asset Management - speaking and lecturing about value investing. It is definitely worth the 5 minute viewing in my opinion, no matter what your level of knowledge. Always nice to see someone so passionate about value investing as motivation to stick to the discipline.

The video can be seen here.

Over the following weeks you can look forward to insights and valuations on some stocks I have been following. I have had some interviews this week so didn't have time to do such posts justice but I can't wait to share my opinions with all of you.

Value in Bonds

As I'm in the midst of a job search I haven't dedicated as much time as I would have liked to getting this blog started. I'm hoping to increase the frequency of posts as I am able. In the meantime you may consider subscribing to the RSS feed so that you automatically receive new posts.

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Market prices for fixed income securities can be volatile just like those for equities, especially for those bonds with longer maturities. As you may be aware, Benjamin Graham describes bargain issues as those stocks and bonds particularly worthy of a security analyst's investigation. In terms of bonds these bargain issues are bonds that are deemed to be safe investments but which still sell at so low a price "as to offer a chance of considerable enhancement in market value". This is why we want to find bonds of a higher quality which are trading at a discount to bonds of a lower quality. In most cases bonds would be trading cheaply because their safety is questionable but this is not always the case. As in equities, there are always a small number of cases where a security may be trading at a discount while still meeting strict investment standards. Fundamentals still reign supreme in fixed income though, so not only do you want a company that may have been battered by the market and investor sentiment (even if correlated with a higher yield on the fixed income security), but you want to be confident that your contrarian views are correct. The bonds are only valuable so long as the company is still in existence!

The concept of finding value in fixed income securities is relatively straightforward, but where do we begin to look for these bargains? If the equities of certain companies may have been negatively affected, creating value opportunities within the equity market, then perhaps the fixed income securities of these companies may be a good place to start. As there is no apparent systematic way to segment corporate bonds into value and growth categories, The Brandes Institute went back to a study they conducted on equities and then studied the bonds that the companies in the study had issued. Their main findings were as follows:

• There were more issuers with debt outstanding within the value companies.
• The bonds issued by companies within the value group delivered a better total return than the bonds issued by the growth companies over subsequent 3 year periods from 1990 to 2007.

What is interesting from the findings of the study is that one would assume the difference in total return to be merely due to the value bonds' lower average credit rating and subsequently higher average spread. As such, The Brandes Institute compared the Lehman Brothers U.S. Aggregate Corporate A Index (a proxy for bonds of the growth companies which had a credit rating of "A" on average) to the Lehman Brothers U.S. Aggregate Corporate BAA Index (a proxy for bonds of the value companies which had a credit rating of "BBB+" on average). Over the same period as the study, these indices showed a difference in total returns of 14 basis points versus the approximately 69 basis point annualized total return difference between the value and growth bonds in the Brandes Institute study. The total return advantage for bonds of value companies therefore can not be fully explained by credit quality or yield spread.

It's difficult, if not impossible, for a retail investor to build a bond portfolio with adequate diversification. Perhaps there would be demand for a fixed income ETF that invests solely in the fixed income of the low price-to-earnings universe of stocks, which is commonly used as a generalization for the universe of value stocks.