APPLIED VALUE INVESTING
THE PRACTICAL APPLICATIONS OF BENJAMIN GRAHAM’S AND WARREN BUFFETT’S VALUATION PRINCIPLES TO ACQUISITIONS, CATASTROPHE PRICING, AND BUSINESS EXECUTIONBy JOSEPH CALANDRO, JR.
The McGraw-Hill Companies, Inc.
Copyright © 2009 Joseph Calandro, Jr.
All right reserved.
ISBN: 978-0-07-162818-1
Contents
Chapter One
THE BASICS AND BASE-CASE VALUE
Every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise. Benjamin Graham
There should be some advantage to the valuation process in cases where asset values coincide with and reinforce the earnings power value. We may then be able to return to the older, private business approach and to say that in the case of Company X the fair value of the shares is the same as its book value because the earnings, dividends, and prospects support the book value. Benjamin Graham and David Dodd
INTRODUCTION
At its core, the Graham and Dodd approach to valuation and investment is a method for identifying and profiting from significant price-to-value gaps. While all long-side investors intend to “buy low and sell high,” Graham and Doddbased practitioners (who are popularly referred to as “value investors”) seek to buy at a level that is appreciably less than an investment’s intrinsic value, or its inherent worth. The result is a margin of safety that “is available for absorbing the effect of miscalculations or worse than average luck.” In other words, by investing in “businesses with satisfactory underlying economics at a fraction of the per-share value,” Graham and Dodd practitioners significantly increase the probability that their investments will be successful, or at least not ruinous. The uniqueness of this approach is perhaps best illustrated in a diagram, such as the one presented in Figure 1-1.
The diagram plots price on the x axis and value on the y axis, inasmuch as value is a function of price, and highlights the difference between a Graham and Doddbased opportunity and risk. An investment is an opportunity if it is offered for less than its intrinsic value, and an investment is a risk if it is offered at or above its intrinsic value. Risk in this context means that there is no financial buffer, or margin of safety, between the value of an investment and the price at which it is offered. Such an investment is risky because the only way to profit from it is through growth, which is extremely intangible and is influenced by a variety of internal and external factors.
Note that both General Electric (GE) in 1939 and Microsoft are listed as risks in the diagram. Graham and Dodd themselves commented on GE in the second edition of their seminal work Security Analysis, which was published in the year 1940:
We have intentionally, and at the risk of future regret, used an example here of a highly controversial character. Nearly everyone on Wall Street would regard General Electric stock as an “investment issue” irrespective of its market price and, more specifically, would consider the average price [in 1939] of $38 as amply justified from the investment standpoint. But we are convinced that to regard investment quality as something independent of price is a fundamental and dangerous error.
I will have more to say about GE in the coming pages, but comments similar to these could be made about Microsoft today. For example, according to Columbia University Professor Bruce Greenwald and his coauthors, “The ability of even the best analysts in the year 2000 to forecast accurately Microsoft’s earnings at 10 years in the future is likely to be limited. Under these circumstances, it is impossible to justify Microsoft as a value investment.”
Benjamin Graham originally found investment opportunities in net-net stocks, or stocks that were selling for less than their net-net value, which is calculated as current assets less total liabilities. Graham referred to this approach as cigar buttstyle investing because it involved buying troubled companies for what amounted to appreciably less than their liquidation value, which was analogous to picking up spent cigar butts that have a couple of puffs left in them. Cigar buttstyle investing has, for the most part, been arbitraged away; for example, the late 1970s was probably the last time it could have been used on any scale in the capital markets of the United States.
To put this into perspective, consider a 1979 article published by Forbes magazine titled, “The Return of Benjamin Graham: Think of a Time When Stocks of 191 Important American Corporations Are Selling for Less than Net Working Capital per Share. Are We Talking about 1932? No, 1979” (October 15, 1979, pp. 158161). Table 1-1 is an excerpt from that article, and it illustrates market conditions that represent near nirvana for traditional Graham and Doddbased investors.
Capital markets have become substantially more efficient (or, more accurately, proficient) since 1979, and therefore Professor Greenwald and his coauthors updated the traditional or cigar butt style of Graham and Dodd valuation and investment to better reflect the dynamics of modern financial markets. Value is now discerned, and investment opportunities assessed, along a unique continuum such as the one shown in Figure 1-2.
As can be seen from Figure 1-2, the value continuum begins with net asset value, the most tangible level of value, then proceeds to earnings power value and franchise value (or the value of a sustainable competitive advantage) before ending with growth value, the last and least tangible level of value. Not all investments require the utilization of all four levels along the continuum, however. In fact, the valuation of most firms will probably not proceed to the third level, franchise value, because most firms do not operate with a sustainable competitive advantage. In these valuations, earnings power value will not exceed net asset value, as it does in Figure 1-2, but instead will relatively reconcile to it, as illustrated in Figure 1-3.
I refer to the value profile shown in Figure 1-3 as base-case value because the firms that reflect it are for the most part simply fulfilling their fiduciary (or base-case) duty; in other words, the firms are generating profit consistent with the cost of their capital and the reproduction value of the assets under their controlno more, no less. Despite the relatively common occurrence of the base-case value profile, it can present a lucrative investment opportunity if it is offered at a reasonable margin of safety (or discount from estimated value). This is illustrated in the introductory valuation of Delta Apparel, Inc.
BASE-CASE VALUATION
In October of 2002, the equity of Delta Apparel, Inc. (stock symbol DLA), hit one of my screens as a possible investment opportunity. At the time, DLA stock was selling at $14.00 per share, and thus the valuation objective was to determine if that price qualified as a Graham and Doddbased investment (in other words, to determine if the stock fell within the upper left quadrant of Figure 1-1). To make this determination, I will follow the value continuum shown in Figure 1-2 level by level, beginning with net asset value (NAV).
NAV involves transforming a firm’s balance sheet from historical cost to a reproduction- based value so that it more accurately represents economic value. To me, balance sheet analysis sets the tone for every valuation; however, I realize that it is not very popular outside of the value investing community. It is difficult to understand the reasons why this is the case, especially when one considers how successful value investors have been at exploiting balance sheetdriven insights. Indeed, it has been argued that, “The special importance that Graham and Dodd placed on balance sheet valuations remains one of their most important contributions to the idea of what constitutes a ‘thorough’ analysis of intrinsic value.”
Net asset valuation is very much dependent on one’s circle of competence, as investors must know which balance sheet adjustments they are able to make themselves and which require the services of professional appraisers or independent experts. The efficient and effective use of one’s circle of competence (or knowledge base) is critically important in all forms of valuation, but it is absolutely fundamental to the Graham and Dodd approach. Consider Warren Buffett’s remarks on the subject:
Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.
As noted earlier, one of my investment screens “selected” DLA as a possible investment opportunity, and thus my evaluation of that opportunity began with NAV, as illustrated in Table 1-2.
The exhibit is based on financial data contained within DLA’s 2002 Form 10-K (fiscal year ending June 29, 2002). Parenthetical notes in the final column of the exhibit reflect valuation adjustments of mine that are explained in the following narrative. For example, the first asset in Table 1-2 is cash. The 100% reflected in the “Adjustment” column reflects the fact that no adjustment was made to this asset, and therefore the reproduction value of $4,102 equals the 2002 accounting (or book) value of $4,102. Note that all dollar figures are in thousands unless otherwise specified.
The first adjustment, denoted (1A) in Table 1-2, adds the bad debt allowance back to accounts receivable to arrive at an estimate of this line item’s economic value. It is necessary to add this allowance back onto the balance sheet in order to reproduce this particular asset adequately. Professor Greenwald and his coauthors explain the reason for this as follows:
A firm’s accounts receivable, as reported in the financial statement, probably contains some allowance built in for bills that will never be collected. A new firm starting out is even more likely to get stuck by customers who for some reason or another do not pay their bills, so the cost of reproducing an existing firm’s accounts receivables is probably more than the book amount. Many financial statements will specify how much has been deducted to arrive at this net figure. That amount should be added back.
The second adjustment, (2A), is simply the present value of the deferred tax asset and the deferred tax liability. The adjustment calculations are based on a simple discount factor, which is calculated as follows: 1/(1 + 0.1177)1 = 89%, where 0.1177 is the estimated discount rate for DLA that was used.
The third adjustment, (3A), pertains to property, plant, and equipment (PPE) and involves analyzing the historical cost of the five given categories of PPE items, gross of depreciation, and then applying adjustment factors to each category to approximate the reproduction value of each item. For example, the historical cost of items (3A-b) to (3A-e) was reduced by 50%, which is a rule-of-thumb-based adjustment, while the category of land, buildings, and construction (3A-a) was increased by 125%, given the generally increasing nature of real estate values at the time. Note that these adjustments are rough but informed approximations; according to Graham and Dodd:
Security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish either that the value is adequatee.g., to protect a bond or to justify a stock purchaseor else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.
In short, the objective of Graham and Doddbased valuation is not to come up with an exact valuation number; rather, the objective is to be “approximately right rather than precisely wrong” with respect to a valuation. Put another way, it may not be possible to value an asset with 100% accuracy, but it is possible to value it within an acceptable margin of safety. Doing so is inherently dependent upon one’s circle of competence, the importance of which was commented on earlier.
The fourth adjustment [denoted (4A)] pertains to goodwill. Goodwill in this context does not refer to the excess paid for an asset over its book value; rather, it refers to the intangible assets that a firm uses to create value, such as its product portfolio, customer relationships, organizational structure, competitive advantage, licenses, and so on. When estimating the value of intangible assets such as these, the modern Graham and Dodd approach “add[s] some multiple of the selling, general, and administrative line, in most cases between one and three years’ worth, to the reproduction cost of the assets.” Therefore, multiplying DLA’s 2002 selling, general, and administrative expense of $11,468 by 1, or the low end of the range just described, derived the goodwill adjustment used in my valuation. This is an intentionally conservative estimate, which is a key facet of the Graham and Dodd approach.
Proceeding to the two liability adjustments:
Note (5A-a) reflects a liability for future lease payments of $6,867, the source of which was Note 8 of DLA’s 2002 Form 10-K.
The Form 10-K was also the source for the option adjustment, note (5A-b), which was found in Note 10 and derived by multiplying the total shares available for future option grants of 959.2 by the weighted-average exercise price of $3.94 (or the simple average of $3.880 and $4.001), which equals an estimated option liability of $3,779.7. Regarding option valuation, there are more mathematically intensive ways to calculate this kind of adjustment, but for practical purposes, the method used here provides a reasonable approximation of the value of DLA’s outstanding option liability.
Adding these two adjustments gives the total $10,646.7 adjustment reflected in note (5A).
Processing these adjustments produces an estimated reproduction valuebased NAV of $78,004.6, which when divided by the number of shares of DLA’s stock that are outstanding gives a per share value of $19.4, which is 27.3% greater than the book value of $61,278 that is listed on the balance sheet. To validate this spread over DLA’s book value, I will proceed along the modern Graham and Dodd value continuum to the next level of value, earnings power value (EPV).
EPV adjusts income that a firm has already earned to arrive at an estimate of income that is sustainable in perpetuity. Significantly, it is not an objective of earnings power valuation to forecast future earnings and then discount those earnings back to a present value. To illustrate the mechanics of EPV, consider my calculations for DLA, which are presented in Table 1-3.
As with my NAV valuation, a parenthetical note in the table designates an adjustment that is discussed in the following narrative.
The first note, (1E), pertains to DLA’s 2002 operating income or earnings before interest and taxes (EBIT). Based on analysis that I conducted at the time, I concluded that this level of operating earnings was, on average, sustainable, and therefore I used it as the foundation for my EPV estimate.
The second note, (2E), pertains to the option expense of $282.1, which was derived by multiplying the estimated $0.07 option dilution per share by the number of shares outstanding.
The third note, (3E), involves depreciation, which can be a somewhat challenging adjustment for someone viewing the calculations for the first time. Before I explain the mechanics of this particular adjustment, please review my calculations for it, which are presented in Table 1-4.
In discounted cash flow (DCF) valuation, the noncash adjustment of depreciation is added back dollar for dollar (but netted out by subtracting capital expenditures and changes in net working capital). However, in Graham and Doddbased valuation, EPV does not encompass growth; therefore, only that portion of depreciation that is needed to “restore a firm’s assets at the end of the year to their level at the start of the year” is added back for valuation purposes. This adjustment is consistent with the reproduction-based approach used to derive NAV and can be considered an earnings-based complement to it.
Following this introduction, EPV depreciation adjustments become a simple matter of following the calculations. Consider the calculations for DLA in 2002 that are summarized here:
The $1,957 growth CAPEX = (PPE of $22,992/2002 sales of $131,601) x the $11,201 change in sales.
The $3,297 zero-growth CAPEX = CAPEX of $5,254 growth CAPEX of $1,957 (see the previous bullet point).
The $3,093 depreciation adjustment = depreciation of $6,390 zero-growth CAPEX of $3,297 (see the previous bullet point).
The fourth note, (4E), pertains to the interest earned on the cash that is reflected on the balance sheet, which I estimated at 3.5% or $143.6.
The fifth note, (5E), is pretax earnings, which equals EBIT minus the options expense plus the depreciation adjustment (see Table 1-4 for details) minus the interest earned on cash, for a total of $13,004.3.
The sixth note, (6E), refers to the tax adjustment, which was derived by multiplying the ratio of the income tax expense to earnings before taxes (EBT) by pretax earnings of $13,004.3, which produces a tax expense of $4,291.7.
Earnings, note (7E), is simply the difference of the tax expense and pretax earnings, which amounts to $8,712.6.
(Continues…)
Excerpted from APPLIED VALUE INVESTINGby JOSEPH CALANDRO, JR. Copyright © 2009 by Joseph Calandro, Jr.. Excerpted by permission of The McGraw-Hill Companies, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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