I have discussed in a previous post the discounted free cash flow valuation method. Another technique I use and prefer is the Earning Power Value and reproductive asset value (EPV). The reasons why I prefer this technique are many among them:
- It ignores growth and future projections of sales. Growth projections are always faulty and if they materialize it is by sheer luck.
- Discounted cash flow models ignore the balance sheet and this one incorporate it as part of the valuation.
- This method is more conservative.
- It gives me an indication if management is able to exploit effectively its assets and competitive advantages.
In the following I will give an overview step by step guide to conducting the valuation. Valuation is conducted in two separate steps:
- Estimation of asset reproductive value
- Determination of EPV
1. Asset Reproductive Value
Asset reproductive value is the cost of assets needed by a new entrant to compete in an equal manner with an incumbent in the industry. This step can be very involved and need some industry and company insight. You need the company's most recent balance sheet to begin. Valuation will be easiest for current asset and liabilities in general, however more involved with the fixed assets portion of the balance sheet.
You start with book values of the balance sheet, generally it is easier to value the top items and it gets harder as you go down the account list. In the following I will present a table with each major category of assets and the needed adjustment to be made to arrive at a reproductive asset value.
|Cash and marketable securities||Generally there is no adjustment needed as cash is cash and marketable securities are marked to market and represent fair value|
|Account receivables (AR)||the reproduction cost is greater than the book value generally, as companies write off bad debt and apply doubtful debt allowance to AR. At a minimum you add the allowance of bad debt to book value of AR as any new entrant will experience defaults and such expenses.|
|Inventory||In a liquidation scenario it is valued at zero but at an operating level you have to value it at FIFO basis. If the firm is valuing it using LIFO then add the LIFO reserve back to the balance sheet number to arrive to reproduction value.|
|Deferred tax assets||PV of cash savings if the company is anticipating to use them if the company is in no position to use these assets then value them at zero.|
|Building & Land|
Generally this item will never be replaced at less than original cost. If the land and buildings are a critical then you have to asses the market value and it is usually upwards as land are booked on the balance sheet in historical terms and undervalues current market values. For example retailers like Home Depot and Sears have purchased all their location years ago therefore their balance sheet value understates the true economic cost for a new competitor that want to compete against them.
To get proper value you need to apply similar transaction values to the company's buildings and land on a location by location basis. This can be one of the hardest steps in the process and the more research intensive.
|Plants & Equipment|
In general there is a long term trend of equipment efficiency and advancement so historical value of plants and equipment may be higher than what a new entrant into the industry might have to pay. Here a familiarity of the industry production method and technologies will help.
On going plants use the price for unit production capacity value. What is the market value or production price per unit of output for other comparable companies. Example, what is the price of tonnage of aluminum in the market multiplied by how many tonnage does the plant produce gives a reproductive value for the aluminum plant.
|Deferred taxes liabilities||PV of cash to be paid in the future if the company is profitable. But if it is anticipated to generate losses then you have to push payment into the future further and will be valued less.|
|Accounts payable||Book value is a good reproductive value for this account and no adjustment is needed.|
|Long term liabilities||Market value of debt as a new entrant will have to issue debt at current interest rates which may be different than the historical prices of the company debt. You can look these up using yahoo finance.|
Please note that if you are attempting this valuation on a viable industry then it is reproductive valuation. However if the industry is not viable then liquidation values should apply, in other words serious discounts should be applied to the assets.
2. Earning Power Value
Earning power value: is the second aspect of the valuation of a business. Basically EPV is...
A business's ability to generate profit from conducting its operations. Earnings power is used to analyze stocks to assess whether the underlying company is worthy of investment. Possessing greater long-term earnings power is one indication that a stock may be a good investment.
or in a mathematical equation EPV= Adjusted Earrings/ cost of capital
The calculation assumes no growth and current earning is sustainable over the long run. This is one of the great advantages of the technique as it does not muddy the valuation process with future predictions. It evaluate a company based on its current situation. However to arrive at EPV there are several adjustments to be made to the Earnings figure as follows:
- Operating earning or EBT is the start point.
- You need to adjust EBT for the business cycle and cyclicallity by taking a 7 year Average of operating earning, which will include at least one economic downturn. You can do this by averaging the company's EBT margin over 7 years and apply it to current year's sales, and viola it will adjust for cyclicallity and business cycle.
- Next deduct the 7 year average of non-recurring charges or normalize these expenses to reflect their economic nature. Non recurring charges are part of doing business and they will arise in the future so I do not see why you need to exclude them.
- Apply Tax rate the figure derived in step 3, which is the average tax rate of the company over the last 7 years. Alternatively use the general 33% corporate tax rate to avoid tax schemes implemented by different companies.
- Add depreciation of the most recent year.
- Next deduct adjusted Depreciation: true depreciation is the cost to the company to make it at the end of the year in the same situation at the beginning of the year. Accounting depreciation is irrelevant as it can be higher because capital goods prices go down due to technology advancement, or it can be lower in inflationary environment where reproduction costs is higher then accounting depreciation underestimates true economic cost, so you have to adjust for it by using maintenance capital expenses (CAPEX) as the true measure of depreciation. You can calculate maintenance CAPEX by:
- Calculate the Average Gross Property Plant and Equipment (PPE)/ sales ratio over 7 years
- Calculate current year's increase in sales
- Multiply PPE/Sales ratio by increase in sales to arrive to growth capex
- Maintenance CAPEX is the Capex figure from the cash flow statement less growth capex calculated above, which is the true depreciation for the company
- Cost of capital estimation: estimate by judgment or use company cost of capital as discussed in my earlier post here.
- Divide the adjusted earnings calculated in step 6 by cost of capital in step 7 to get EPV.
The final step is to compare the per share reproductive asset value in step 1 (Assets-liabilities/ # of shares) to EPV per share calculated in step 2 and you got a value of the business. Companies with sustainable competitive advantage should have a higher EPV than asset value and the difference is the franchise value. If the reverse is true management is destroying shareholder's value by earning less that the assets capability and you can conclude that the business is a commodity business with no attractive ROIC profile.
If you require more details on this technique, I recommend buying Bruce Greenwald's book: Value Investing: from Graham to Buffett and Beyond. I also recommend watching the following lecture by Prof Greenwald about the subject, you can view it here.
I hope the above helps.
Sources: Value Investing: from Graham to Buffett and Beyond by Bruce Greenwald, Security Analysis by Graham and Dodd, Investopedia.com