The stock market is filled with individuals who know the price of everything but the value of nothing.
– Phillip A. Fisher
*Phillip A. Fisher was one of the greatest pioneers of growth investing. His contributions to investors include Conservative Investors Sleep Well, and notably Common Stocks and Uncommon Profits.
Some investors believe that growth and value are two opposite extremes, be one or the other. But the reality is, as Buffett puts it; value and growth are actually joint to the hip. Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. Value Investing: From Graham To Buffett and Beyond written by Greenwald, Kahn, Sonkin and Van Biema greatly captures the framework that is value investing.
The book consists of three parts, this includes an introduction to (I) value investing, (II) three sources of value, and (III) value investing in practice. This book provides a wonderful application of the three sources of value (part II) with a case study of WD-40 and Intel, explaining in detail the valuation process. In addition, it profiles 8 of the very best investors, from Graham to Buffett, to Edwin and Walter Schloss and beyond.
Below I will briefly review some specifics of part II; the three sources of value, as I believe it is critical in investing, and would be highly beneficial for anyone looking into this field. I will generalize the concepts in part II, but I strongly recommend that you give this book a read to truly understand the frameworks and the information it intended to provide.
Greenwald et al. places emphasis on valuation as follows: The value of assets, earnings power value (EPV), and the value of growth, all in that exact order.
The liabilities are always 100% good. It’s the assets you have to worry about.
The Value of Assets:
Using a Graham and Dodd valuation, we begin at the balance sheet and evaluate the company’s assets. This shows us the health of the company: is the firm loaded with cash or debt? What are the shareholders entitled to if all debt was paid? If we are in a declining industry, we value the assets at liquidation cost. In a stable industry, we must value assets at reproduction cost (which is the cost a competitor or new entrant would incur to reproduce all its assets).
Under the asset side of the balance sheet, we find the two main component of current assets and long term assets. Assuming accurate information of the balance sheet, under reproduction cost we would likely value current assets such as cash, marketable short-term securities without any adjustments. Accounts receivables and inventory should be adjusted depending on allowances and turnover ratios. Longer term assets such as PPE should be estimated based on consistent depreciation rate, market value and reproduction of equipment costs. Interesting accounting entries are goodwill, intangibles, R&D (hidden assets); these all require thorough analysis as their value may range significantly. For instance, Coca Cola’s extensive value lies in its Goodwill. Its years of advertising, customer loyalty are ingrained in its intangibles, for a competitor to replicate Coca Cola (or attempt to), it would pay dearly, in money and time.
Moving away from assets to liabilities, Greenwald et al. classifies liabilities in three categories. Applying a reproduction approach to these liabilities, it is likely to take these liabilities as stated. These categories include (I) Operational liabilities (spontaneous): which include liabilities such as accounts payable to suppliers, wages, accrued taxes and expenses related to operations, (II) Past circumstances liabilities (circumstantial): one time or uncommon charges that would not be pertinent to new entrants, these include deferred tax liabilities and legal liabilities (breaking the law), (III) Outstanding debt: includes long term debt.
Now with the value of asset reproduction and value of total liabilities, we subtract the latter from the first (asset reproduction value – total liabilities) and assess the potential for investment. Clear examples along with accounting entries are provided in Chapter 4.
Earnings Power Value:
The EPV formula is as follows:
EPV = Adjusted Earnings x 1/ R
R = Current Cost of Capital (usually measured in terms of WACC)
Adjustments to earnings include resolving discrepancies between depreciation and amortization, taking into account business cycle, and applying other reasonable modifications in specific situations. The reason for adjustments is to smooth out one time outlier expenses to arrive at distributable cash flow; money that the shareholders are entitled from the firm while keeping operations intact. This method assumes that earnings are constant (so, there must be a relatively sustainable competitive advantage) and no growth.
There are 3 identifiable cases after applying the formula: (I) If your calculated EPV is lower than the value of asset reproduction, then the assets are not being used efficiently, (II) when your calculated EPV equates (or is close) the value of asset reproduction, it may be because the industry has no competitive advantage (perhaps no one has a significant “upper hand”), (III) when your calculated EPV relatively exceeds the asset reproduction value, the evaluated firm may have some form of competitive advantage. Chapter 5 discusses EPV, while later chapters will walk you through its application.
As previously stated, we begin by valuing asset reproduction value, then earnings power value, and lastly growth; in that specific order. The reason the value of growth is prioritized last, according to Greenwald et al. is because it is most difficult to estimate. A conservative value investor is concerned about not losing money, and projections entail a great deal of uncertainty, especially long future projections which are prone to error. Growth itself has to be supported by in increase in assets, sales, accounts receivables or equipment. In order to do so, it must be funded through either new borrowings, retained earnings, or issuing new shares; all which cut into the cash and value to be available for shareholders. For this reason, growth value is not the primary concern for conservative value investors. Chapter 3 and 7 details growth value.
I highly recommend this book to anyone looking to start with a value investing approach. I liked that it illustrates valuation in a conservative order, starting with the balance sheet, moving onto earnings power (although perhaps free cash flow should be considered too- JMO) then growth. Greenwald et al. thoroughly applies the three valuation process in Chapter 6 and 7 using WD-40 and Intel as case studies, making it clear and understandable. The study of some of the greatest value investors is a valuable plus. You can find this book on Amazon: here.
Thank you for reading 🙂
The most important investment you can make is in yourself.