Basic Structure of Investment Process

and Valuation

Professor Bruce Greenwald

1
 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
3
4
Systematic Biases

1. Institutional
z Herding – Minimize Deviations
z Window Dressing (January Effect)
z Blockbusters

2. Individual
z Loss Aversion
z Hindsight Bias
z Lotteries

5
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 x Multiple

Earnings Depends on:

(Maint. Inv. = Depr + A)
• Economic position
EBIT
• Cyclical situation
(Maint. Inv. = Depr + A; Tax =0)

• Leverage
EBIT - A
(Maint. Inv. = Depr only) • Mgmt. Quality

EBIT-DA • Cost of Capital (Risk)

(Maint. Inv. = 0)
• Growth

Range of Error (100%+)

7
Valuation Approaches
Net Present Value of Cash Flow

∞
Σ CF (1 +1 R )
t
1
Value = t = CF0 *
t=0 R-g

Note: NPV Analysis encompasses ratio analysis

(NPVdiseases are ratio analysis diseases)
Note: NPV is theoretically correct

In Practice:
Revenues
Parameters: Forces:
z Market Size z Consumer
Behavior
z Market Share Margins
z Competitor
z Market Growth
Behavior
z Price/Cost
Required z Cost Pressures
z Tech Investments z Technology
z Management
z Tech
Performance
Cash Flows z Management
Performance

Cost of Capital X
NPV </> Market Value
8
Shortcomings of NPV Approach in
Practice
(1) Method of Combining Information
20
1 1
NPV = CFo +CF1 + … +CF20 + ...
1+R 1+R

Good
Bad Information
Information
(Imprecise)
(Precise)
= Bad/Imprecise Information

(2) Sensitivity Analysis is Based on Difficult-

to-Forecast Parameters which co-vary in
fairly complicated ways

Cost of
Capital
Profit Required
Margin Investment

Growth

9
 Valuation Assumptions

Traditional: Strategic:

• Profit rate 6% • Industry is economically

viable
• Cost of capital 10%
• Entry is “Free” (no
• Investment/sales 60% incumbent competitive
advantage)
• Profit rate +3% (i.e.
9%) • Firm enjoys sustainable
competitive advantage
• Growth rate 7% of
sales, profits • Competitive advantage is
stable, firm grows with
industry

10
Value Investing
Basic Approach to Valuation

“Know what you know”; Circle of

competence

1. Organize valuation components by

reliability
Most Reliable Least Reliable

2. Organize valuation components by

underlying strategic assumption
No Competitive Growing Competitive
Advantage Advantage

11
 Basic Elements of Value

Strategic Dimension

Growth in Franchise Only

Franchise Value
Current Competitive Advantage

Free Entry
No Competitive
Advantage

Asset Value Earnings Power Total Value

Reliability Value
Dimension • Tangible • Current • Includes
• Balance Sheet Earnings Growth
Based • Extrapolation • Extrapolation
• No • No Forecast • Forecast
Extrapolation

12
 Industry Entry - Exit

Industry Market Value Net Asset Value Entry

Chemicals $2B $1B Yes (P ↓ MV ↓)

(Allied) $1.5B $1B Yes
$1.0B $1B Stop

Automobiles $40B $25B Yes (Sales ↓ MV↓)

(Ford) $30B $25B Yes
$25B $25B Stop

Internet $10B $0.010B ?

Remember, Exit is Slower than Entry.

13
Asset Value
Assets Basic Graham- Reproduction
Dodd Value Value
Cash Book Book
Accounts Receivable Book Book + Allowance
Inventories Book Book + LIFO
PPE 0 Orig Cost ± Adj
Product Portfolio 0 Years R & D
Customer Relationships0 Years SGA
Organization 0
Licenses, Franchises 0 Private Mkt. Value
Subsidiaries 0 Private Mkt. Value

Liabilities
A/P, AT, AL Book Book
Debt Book Fair Market
Def Tax, Reserves Book DCF

Bottom Line Net Net Wk Cap Net Repro Value

14
Earning Power Value

z Basic Concept – Enterprise value based on this

years “Earnings”

z Measurement
1
- Earnings Power Value = “Earnings” * Cost of capital

z Second most reliable information earnings today

z Calculation
–“Earnings” – Accounting Income + Adjustments
–Cost of Capital = WACC (Enterprise Value)
–Equity Value = Earnings Power Value – Debt.

z Assumption:
–Current profitability is sustainable

15
“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,

problem being fixed, pricing power, etc

16
Earnings Power Value

EPV Business Operations = Earnings Power x 1/WACC

EPV Company = EPV Business Operations

+
Excess Net Assets
(+cash, +real estate, - 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 Barriers-

to-Entry
18
Total Value Including Growth

z Least reliable - Forecast change

not just stability (Earnings Power)

z Highly sensitive to assumptions

z Data indicates that investors

systematically overpay for growth

z Strict value investors want growth

for “Free” (Market Value <
Earnings Power Value)

19
Value of Growth - Basic Forces At Work

• Growing Stream of Cash Flows is more

Valuable than a Constant Stream (relative
to current Cash Flow)

1 1
I.E. CF0 * vs. CF0 *
R-G 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.B. Do Not Discount Growing “Earnings” Streams)

20
Value of Growth
Quantitative Effects

Investment: • $100 million

Cost of Funds: • 10% (R) = $10M

Return on Investment (%) 5% 10% 20%

Return on Investment ($) $5M $10M $20M
Cost of Investment $10M $10M $10M
Net Income Created ($5M) 0 $10M
Net Value Created ($50M) 0 $100M

Qualitative Impact: Value No Value Value

Destroyed Created

Situation: Competitive Competitive

Level
Disadvantage Playing Advantage
Field

21
 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 Barriers-

to-Entry
22
Valuing Growth Basics

z Growth at a competitive
disadvantage destroys value
(AT&T in info processing)

z Growth on a level playing field

neither creates nor destroys
value
(Wal-Mart in NE)

z 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 “Economic Profit”
AC
ROE (20%) > Cost
of Capital

Price Entry/Expansion
Supply Up, Price
Down
Q
Firm Position

(Efficient Producers)
$/Q
ROE = 12%
AC
No Entry
No Profit

Price

Q
Firm Position
25
 Product Differentiation
Branding
(Profitability & Stability)

Coca Cola Cadillac

Colgate Toothpaste Mercedes-Benz
Tide Sony (RCA)
Marlboros Maytag(Hoover)

Budweiser
Harley-Davidson

Intel Motorola Dell, HP

Target, Walmart Gap, Liz Claiborne
Verizon, Cingular ATT, Sprint
WellsFargo, NCNB JP Morgan, Chase,
Citibank
Insurance Cosmetics
Gannett, Buffalo Evening News NY Times, WSJ

26
 Consequences of Free Entry
Differentiated Markets (Luxury Cars)
$/Q “Economic Profit”
AC
ROE (20%) > Cost
of Capital
Entry/Expansion
Demand for Firm
Demand Curve shifts left (Fewer
Q sales at each
Firm Position
Price)

ROE = 12%
$/Q
No Entry

AC No Profit

Demand
Curve
Q
Firm Position
27
 Barriers to Entry
Incumbent Cost Advantage
$/Q

ACEntrant

ACIncumbent

Demand (Entrant, Incumbent)

Firm Position Q

Entrant Incumbent Sources

No “Economic” “Economic” Profit Proprietary Tech
Profit (Patent, Process)
ROE = 20%
ROE = 12% Learning Curve
No Entry Special Resources

• Not Access to Capital

• Not Just Smarter

28
 Barriers to Entry
Incumbent Demand Advantage
$/Q
AC (Entrant, Incumbent)

DemandIncumbent

DemandEntrant
Firm Position Q

Entrant Incumbent Sources

No “Economic” Profit Higher Profit, Sales Habit (Coca-Cola)
• High Frequency
ROE = 12% ROE = 20% Purchase
No Entry Search Cost (MD’s)
• High Complex
Quality
Switching Cost (Banks,
Computer Systems)
• Broad Embedded
Applications

29
 Barriers to Entry
Economies of Scale
Demand Demand (Entrant, Incumbent)
$/Q $/Q

AC
AC
Entrant Incumbent
Firm Position Q Firm Position Q
No advantage No advantage

• 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 D-Incumbent

Loss Profit

Price (Both)

AC

D-Entrant
Sales Sales Q
Entrant Incumbent

• Advantages are Dynamic and Must be Defended

• Fixed Costs By:

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

31
 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
 Competitive Advantage Strategy
Implications

• Analysis on a market-by-market basis

•Large global markets are difficult to

dominate

• Local markets (Physical, product

geography) are ones susceptible to
domination
„ Microsoft (Apple, IBM)

„ Wal-Mart (K-Mart, Circuit City)

„ Intel (Texas Instruments, et al)

„ Verizon (ATT, Sprint)

„ Pharmaceuticals

33
 Assessing Competitive Advantages/
B-to-E Strategy Formulation

•New Market Entry

-No Barrier ⇒ No Profit

-Outside Barriers ⇒ Losses

-Need Potential Barriers, not

yet in place.

•Maintaining Established Position

-No Barriers ⇒ No Position
(Hard to Create
from Nothing).

-Enhancement
·Product Line Extension
·Increase Purchase Frequency
·Increase Complexity
·Accelerate Progress
·Emphasize Fixed vs. Variable
Cost Technology.

34
Procedure in Practice

(1) Verify existence of franchise

i. History – Returns – Share Stability
ii. Sustainable competitive advantages

(2) Calculate earnings return – i.e. 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
Prospective Returns
US & India Markets

U.S. Market
(1)6% (1/PE) + 2% (inflation) = 8%

(2)2.5% (D/P) + 4.7% (growth) = 7.2%

Expected Return = 7.5%

India Market
(1)4% (1/PE) + 5% (inflation) = 9%

(2)2% (D/P) + 7% (growth) = 9%

Expected Return = 9%

36
 Hindustan Unilever: Market Dominance

Source: Company website showing AC Nielsen – Quarter Ended Sept 2007 value shares
3737
 Hindustan Unilever: Financial returns

(Indian 2002 2003 2004 2005 2006

Rupees)
Revenues 10951,61 11096,02 10888,38 11975,53 13035,06
crores
Net profit 16% 16% 11% 11% 12%
margin
Return on
capital 46.8% 48.7% 37.3% 58.1% 55.4%
Return on
Assets 23% 23% 16% 20% 20%

Stock information

Market cap 40,008 45,059 31,587 43,419 47,788

(crores)
P/E Ratio 23 25 26 31 26

Share 181.75 204.70 143.50 197.25 216.55

Price

3838
 Infosys: Performance

Return on Total Capital Declined….

2000 2001 2002 2003 2004 2005 2006 2007

42.3% 37.2% 30.6% 27.7% 33.4 30.2% 31.3% 32%*

%
As Earnings Per Share* grew …
.25 .31 .37 .51 .76 1.00 1.5 2.00
The Stock Price ($US ADR) shows extremely high multiples /
growth expectation, especially in 2000 …

* Source: Value Line Data, and Italics show VL Estimate for 2007.
3939
Simple Examples Franchise Verification

Company Business Adjusted ROE

Wal-Mart Discount Retail 22.5%

American High-end Credit Cards 45.50%

Express & Services

Gannett Local Newspapers & 15.6%

Broadcasting

Dell Direct PC Supply to 100.0% +

Large organizations

40
Simple Examples
Franchise Verification

Sources of Competitive Advantage

Sources of Competitive Advantage

Company Customer Captivity? Economies-of-Scale?

Wal-Mart Slight Customer Captivity Local Economies-of-

Scale

American Customer Captivity Some Economies-of-

Express Scale

Gannett Customer Captivity Local Economies-of-

Scale

Dell Slight Customer Captivity Economies-of-Scale

41
 Calculated Growth Stock Returns

CASH RE GROWTH TOTAL

Wal-Mart = 1.5% + 4.5% + 3.5% = 9.5% + Option

(P/E – 17, Growth – 11 ½%) (x1 Capital

Allocation)

American = 4% + 4% + 7.5% = 15.5% + Option

Express

(P/E – 17 ½, Growth – 13%) (2% x 2)

Gannett = 10% - 1% - 2.0% = 7.0% + Option

(P/E – 11, Growth –3%)

Dell = 0% + 5% + ? = 5.0% + Growth

+Option
(P/E – 20, Growth –15%) (?)

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Appendix

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