Approaches to Investing

Long Term

Short Term

Efficient Market
Asset Allocation
Cost Minimization

Fundamental Fundamental Technical

(Value)
(Value)

Momentum
Price/Volume Patterns

Levels
Mkt. Price vs.
Value

Changes
Current Price + Forecast Change
Micro
Macro

We Are Here
Relative Rarely Done Well
(Shliefer, Vishny, Lakonishok)
1

Essentials of Value Investing

Long-Term Fundamental (Look at Underlying Businesses)

Specific Premises:
Mr. Market is a Strange Guy

Prices diverge regularly from fundamental

values

You Can Buy Underpriced Stocks

Fundamental values are often measurable

Fundamental Value Determines Future

Price

Buying underpriced stocks plus patience

implies superior returns

Real S&P 500 and Trend

Value Investing in Practice

Long-Term Fundamental (Look at Underlying Businesses)

1) Look Intelligently for Value Opportunities (low P/E,

M/B)
Mr. Market is not Crazy about Everything
This is the first step not to be confused with
Value Investing
2) Know What You Know
Not All Value is Measurable
Not All Value is Measurable By You (Circle of
Competence)
3) You Dont Have to Swing
Value Implies Concentration not Diversification
(look for Margin of Safety)
At Worst, Buy the Market

Microsoft Valuation (in 2000)

Assume:
50% dividend payout (now zero)
40% annual growth in sales, earnings (by 2010 28 times
current size)
15% discount rate (15% desired return)

Terminal Value

Valuation:

(depends on conditions in 2010

& beyond)
2000

2010

Dividends
15%Value

85%Value

Value = current price (i.e. 110) 80x earnings.

10

Value Investing the Approach

Search
(Look systematically for undervaluation)

Value

Review

Manage Risk

11

Search Criteria
Obscure

Undesirable

Small Capitalization
Spin-Offs
Boring (Low Analyst Coverage)

Financial Distress, Bankruptcy

Low Growth, Low P/E, Low M/B
Industry Problems (Bad Loans,
Regulatory Threat,
Overcapacity)
Company Problem (Lawsuit,
Poor Subsidiary Performance,
Poor Year)
Disappointing (Long-Term
Under performance)

Supply, Demand
Privatizations
Imbalance - RTC
12

Stocks as Underpriced Assets

Stocks historically outperform bonds, etc.
Stocks are not that much more risky
But today
Stocks: E/P = 4% + 1 % = 5 % vs. 11%
Inflation

Historical

Bonds: 5% vs. 3 % at comparable inflation rates

Notes: 4 % vs. 2%

Stock under valuation not so clear

13

14

15

16

Systematic Biases

1. Institutional

Herding Minimize Deviations

Window Dressing (January Effect)

Blockbusters

2. Individual

Loss Aversion

Hindsight Bias

Lotteries

17

Loss Aversion - Example

In addition to whatever you own, you have

been given $1000.
Choose Between:

$1000 with Prob .5

$
0 with Prob .5

$500 with Certainty

In addition to whatever you own, you have

been given $2000.
Choose between:

-$1000 with Prob .5

$
0 with Prob .5

-$500 with Certainty

18

Summary of Search

Low M/B, P/E,

Growth
Disappointing
Rtns
Institutional
Psycho
Logical
Rationale

Search
(Look systematically for
undervaluation)

Obscure
Undesirable
SupplyDemand
Imbalance

Value

Review

Manage Risk

19

Value Investing the Approach

Search
(Look systematically for undervaluation)

Value

Review

Manage Risk

20

Valuation Approaches Ratio Analysis

Cash Flow Measure

Earnings

Depends on:

(Maint. Inv. = Depr + A)

EBIT
(Maint. Inv. = Depr + A; Tax =0)

(Maint. Inv. = Depr only)

(Maint. Inv. = 0)

Economic position
Cyclical situation
Leverage

EBIT - A

EBIT-DA

Multiple

Mgmt. Quality
Cost of Capital (Risk)
Growth

Range of Error (100%+)

21

Valuation Approaches
Net Present Value of Cash Flow

Value =

CF ( )
t=0

1
1+R

= CF0 *

1
R-g

Note: NPV Analysis encompasses ratio analysis

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

In Practice:
Revenues

Parameters:

Market Size

Market Share

Market Growth

Price/Cost

Forces:

Consumer
Behavior

Competitor
Behavior

Cost Pressures

Technology

Tech

Management
Performance

Margins
Required
Investments

Tech

Investment

Management
Performance

Cash Flows

Cost of Capital

NPV </> Market Value

22

Shortcomings of NPV Approach in

Practice
(1) Method of Combining Information

NPV = CFo +CF1

1
1+R

Good
Information
(Precise)

+ +CF20

20

+ ...

1+R

Bad Information
(Imprecise)

= Bad/Imprecise Information

(2) Sensitivity Analysis is Based on Difficultto-Forecast Parameters which co-vary in

fairly complicated ways

Profit
Margin

Cost of
Capital

Required
Investment

Growth
23

Valuation Assumptions

Traditional:

Strategic:

Profit rate 6%

Industry is economically
viable

Cost of capital 10%

Investment/sales 60%
Profit rate +3% (i.e. 9%)
Growth rate 7% of
sales, profits

Entry is Free (no

incumbent competitive
advantage)
Firm enjoys sustainable
competitive advantage
Competitive advantage is
stable, firm grows with
industry

24

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
Advantage

Growing Competitive
Advantage

25

Basic Elements of Value

Strategic Dimension

Growth in Franchise Only

Franchise Value
Current Competitive Advantage

Free Entry
No Competitive
Advantage
Asset Value

Reliability
Dimension

Tangible
Balance Sheet
Based
No
Extrapolation

Earnings Power
Value

Current
Earnings
Extrapolation
No Forecast

Total Value

Includes
Growth
Extrapolation
Forecast

26

Industry Entry - Exit

Industry

Market Value

Net Asset Value

Entry

Chemicals
(Allied)

$2B
$1.5B
$1.0B

$1B
$1B
$1B

Yes (P MV )
Yes
Stop

Automobiles
(Ford)

$40B
$30B
$25B

$25B
$25B
$25B

Yes (Sales MV)

Yes
Stop

Internet

$10B

$0.010B

Remember, Exit is Slower than Entry.

27

Asset Value
Basic GrahamDodd Value

Assets

Reproduction Value

Cash

Book

Book

Accounts Receivable

Book

Book + Allowance

Inventories

Book

Book + LIFO

PPE

Orig Cost Adj

Product Portfolio

Years R & D

Customer Relationships

Year SGA

Organization

Licenses, Franchises

Private Mkt. Value

Subsidiaries

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

28

Asset Value Approaches

Approach

Graham

Book

Reproduction

Opportunities

None

Limited

More Extended

Value in Practice

Yes

Yes

Yes

None

Extensive

Industry Knowledge None

Stability/Reliability

High

Low

Intermediate

Goodwill

Historical

Reproduction

Debt

Book

Book

Est Market

(Low Debt)

(0 Enterprise)

(0 Enterprise)

Remember, Low M/B is very hard to beat.

29

Asset Value Issues

Management

Good adds value

Bad subtracts value

Private Market
Values

Potentially highly unstable

(EBITDA multiples of
Internet subs)

Reproduction vs.
Book

Better where accountants

misestimate
Tech trends
Real estate
Intangibles

M/B indicator close to M/Repro

value
Improvement requires
discipline

Non Viable
Industries

Value = Zero (except NWC)

30

Asset Value Risk Management

Private biases

Personal computer
industry
Psychological
experiments
Evidence of investment
behavior in life

Catalysts

Takeover
Reorganization
Management change

Importance of
If dont know, dont play
industry knowledge (Circle of Competence)
Hedging

Limited

Ultimately, Margin of Safety is risk

management tool
(Otherwise diversify)
31

Earning Power Value

Basic Concept Enterprise value based on this

years Earnings

Measurement
1
Earnings Power Value = Earnings * Cost of capital

Second most reliable information earnings today

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

Assumption:
Current profitability is sustainable

32

Earning Power Value Adjustments

Earnings = EBIT (From Financial Statement)
+ One Time Charge Adjustment (if charges before tax
average 20% of EBIT 5 years then reduce EBIT by
20%)
+Cyclical Adjustment (calculate peak-to-trough EBIT
variation say 20% of average. If a peak subtract 29%
of EBIT)
+Tax Adjustment (apply average tax rate to EBIT debt
tax shield in WACC)
+ Depreciation Adjustment (Depr + Amort Zero Growth
Capex)
+ Subsidiary Earnings Adjustments
+ Other Adjustments (Temporary Problem, Unused
Pricing Power).

33

Earning Power Value Calculation

WACC = Cost of Capital = (Fraction of Debt) (RD) (1-Tax)

+ (Fraction of Equity) (Cost of
Equity)
Fraction of Debt = 1- Fraction of Equity Actual or
Potential

Zero Growth Capex =

Actual Capex - Growth Capex

Growth Capex = (PPE/Sales) * Sales

Balance Sheet

34

Earning Power and Entry - Exit

Value Lost to Poor

Management
and/or Industry
Decline

Case A:

Asset Value

EP Value

Free Entry
Industry
Balance

Case B:

Asset Value

EP Value

Consequence of
Comp. Advantage
and/or Superior
Management

Case C:

Asset Value

EP Value

Sustainability depends on Continuing Barriersto-Entry

35

Franchise Value Calculation

(A1) Cost of Capital

= 10%

(A2) Asset Value AV

= 1200M

(A3) Earnings Power Value = 2400M = 240M X (1 / 10%)

Earnings
Competitive Free Entry Earnings = 120M
= Cost of Cap. X Asset V
= 10% x 1200
Franchise Earnings = Earnings Free Entry Earnings
= 240

120

= 120
(A4) Sales = 2000M (Tax Rate = 40%) Power Value = 2400M
= 240M X (1 / 10%)
Franchise Margin = 120M 2000M = 6% after tax
Franchise Margin (pre-tax) = 10%
= (10% - 40% X 10% = 6%)
Tax
EP Value Implies Sustainable 10% Cost and/or Pricing
Advantage

36

Earnings Power Value Issues

Nature and sustainability of barriers-toentry (competitive advantage)

Sustainability of management quality

Quality of reinvestment opportunities

Value of cash
Subtract interest earned from
EBIT add
Cash to EP value

Inflation adjustment

37

Real Earning Power Value

Real Earnings = Earnings Inflation driven Investment
Real Cost of Capital = WACC Inflation Rate
Inflation Driven Adjustment = Net Assets (Not including
goodwill items) * Rate of Inflation

Example:
(A1) EP Value = 2400M = 240M * 10%
(A2) Net Assets (not including goodwill) =
Cash + AR + Inv. + PPE A/P AL AT = 800M
(A3) Inflation rate = 2%
Inflation Driven Adjustment = 2% * 800M = 16M
Real Earnings = 240M 16M = 224M
Real Earnings Power =

224
10% - 2%

= 224 = 2800M
8%

38

Summary of Basic Valuation

Compute:

Asset Value (Most reliable)

EP Value (Second most reliable)

Case A: Asset Value EP Value

(500M) (300M)

Value = EP Value
+ Catalyst Value

Case B: Asset Value = EP Value

(500M) (500M)

Value = 500M

Case C: Asset Value EP Value

(500M) (1000M)

Value = Asset Value

+ Sustainable
Fraction
of Franchise Value
(1000M-500M)

39

Summary of Valuation
Strategic vs. Traditional Approach

Traditional

Revenue

Oper Income
(EBIT)

Cash Flow

NVP

Market Size Estimate

Market Share

Operation Margin

Investment

Cost of Capital

National Income,
Growth, Consumer
Trends
Competitive
Responses;
Entry/Exit
Technology,
Costs;
Prices; Input
Costs
Technology,
Growth
Financial
Market
Conditions;
Risks

Value

Strategic: Is this the South Bronx of the Investment World?

40

Basic Strategy Framework

Porter Five Forces Probability Determinants

Substitutes

Suppliers

Customer

Industry
Competition
Entrants

Four Forces too many

41

Strategic Investment Forces

Entry-Expansion Barriers-to-Entry
Incumbent Competitive Advantage
Does this company enjoy competitive advantage that is
significant?

Yes Being industry creates value

No Efficient Operation may create value

Others enjoy advantage stay out. (Being in industry

destroys value)
What about entrant advantages?

No good after entry you become incumbent.

Existing Competitor Dynamics Degree of

Competition (Phillip Morris)

Share the Wealth (Workers, Customers) Value

Chain Dynamics

42

Consequences of Free Entry

Commodity Markets (Steel)
$/Q

Economic Profit

AC

ROE (20%) > Cost

of Capital
Entry/Expansion

Price

Firm Position

Supply Up, Price

Down

(Efficient Producers)

$/Q

ROE = 12%

AC

No Entry
No Profit

Price

Firm Position

Q
43

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
No Profit

AC

Demand
Curve
Firm Position

Q
44

Barriers to Entry
Incumbent Cost Advantage

Entrant
No Economic
Profit

Incumbent
Economic Profit
ROE = 20%

Sources
Proprietary Tech
(Patent, Process)

ROE = 12%

Learning Curve

No Entry

Special Resources
Not Access to Capital
Not Just Smarter
45

Barriers to Entry

Incumbent Demand Advantage

Entrant

Incumbent

No Economic Profit

Higher Profit, Sales

ROE = 12%

ROE = 20%

No Entry

Sources
Habit (Coca-Cola)
High Frequency
Purchase
Search Cost (MDs)
High Complex
Quality
Switching Cost
(Banks, Computer
Systems)
Broad Embedded
Applications
46

Barriers to Entry

Economies of Scale

Require Significant Fixed Cost

(Internet)
Require Temporary Demand
Advantage
Not the Same as Large Size
(Auto + Health Care Co)

47

Barriers to Entry

Economies of Scale

Advantages are Dynamic and Must be Defended

Fixed Costs By:
Geographic Region (Cohrs, Nebraska Furniture
Mart, Wal-Mart)
Product Line (Eye Surgery, HMOs)
National (Oreos, Coke, Nike, Autos)
Global (Boeing, Intel, Microsoft)

48

Barriers to Entry - Sustainability

Static Demand Advantages

Tied Customers

Exploitation
Pricing, focus on Own Customers
No advantage with Virgin customers
Shrinkage over time as base
changes

Static Cost Advantages

Cost efficiency in Own technology

No advantage with virgin
technology
Shrinkage with technology change

Economies-of-Scale + Dynamic Demand Advantage

Principal sustainable advantage
Constant vigilance

49

Other Barriers-to-Entry

Government, Regulatory, Public

(Lead based Gas Additives; Cigarettes)
Informational (Who Knows What)
(Banks, Financial Services, HMOs)

50

Performing Strategic Analysis

(1)

Industry Map

(2)

Do barriers
Exist?

(3)

What
Competitive
Advantages?

(4)

Future Strategy,
Profitability

Identify Industry

Industry History

Demand? Cost?
Economies-ofScale?

51

Performing Strategic Analysis

Apple Computer - Industry Map
Industry: Chips

Software
Hardware
Microsoft,
Intel, AMD, Dell, HP,
Gateway, IBM, Apple,
Motorola,
Compaq,
Oracle,
Apple
Apple
Netscape

Networks
AOL

Components
Power Supply
Co.s, etc.
Step 1:

Identify Segments

Step 2:

Identify firms in each segments

Step 3:

If firms are the same, treat

segments as Single Industry
If firms are different, treat segments
as Separate industry
If in doubt, treat segments as
separate industries

For Apple Segment Are:

Chips
Hardware
Software

52

Performing Strategic Analysis

Do Barriers/Competitive Advantage Exist

53

Performing Strategic Analysis

Nature of Barriers-to-Entry Competitive Advantage

54

Other Strategic Considerations

Cooperation within Barriers

Coke Pepsi
Cigarette Makers

Division of Spoils in Value Chain

Strategic alliances
You can not take home, if you dont bring
(NuKote)
Employee Power (unions, Prof. Services
firms)

55

Summary of Strategic Investment

Without Competitive Advantage

no Value in Franchise
Competitive Advantage must be
identifiable and sustainable
In particular, Are existing
Competitive Advantages
Sustainable or are they likely to
erode?
If in doubt, do not pay for
franchise
Ideally look for hidden franchise
Unused pricing power (Coke, Cereals)
Poorly performing divisions
56

Total Value Including Growth

Least reliable - Forecast change

not just stability (Earnings Power)
Highly sensitive to assumptions
Data indicates that investors
systematically overpay for growth
Strict value investors want growth
for Free (Market Value <
Earnings Power Value)

57

Value of Growth - Basic Forces At Work

Growing Stream of Cash Flows is more
Valuable than a Constant Stream
(relative to current Cash Flow)

Growth Requires Investment which

reduces current (distributable) Cash
Flow

58

Value of Growth - Basic Algebra

59

Valuing Growth

Case 1:

ROC Return on Capital Cost of Capital R

Then ROC G = R G
= 1 (for all growth rates)
RG
RG

e.g. (ROC = R =
10%)
ROC = R when there
are no Barriers-to-Entry
(i.e. no competitive
advantages level
playing field) then
Growth has no Value.

G = 0%

ROC G
R-G

10 - 0
=1
10 - 0

G = 2% ROC G =
R-G

10 - 2 = 1
10 - 2

G = 8% ROC G =
R-G

10 - 8
=1
10 - 8

60

Valuing Growth

Case 2:

Competitive disadvantage with growth

ROC less than cost of capital

then ROC G < R - GROC G < 1

RG

and ROC G gets smaller with higher growth rates.

RG

e.g.
(ROC = 8%, R=10%)

Higher Growth at a
Competitive
Disadvantage Destroys
Value

G = 0% ROC G= 8 - 0 = .8
R-G
10 - 0
G = 2% ROC G = 8 - 2 = .75
R-G
10 - 2
G = 8% ROC G = 8 - 8 = 0
R-G
10 - 8

61

Valuing Growth

Case 3:

ROC is greater than R Firm enjoys a competitive

advantage (franchise)
Shares are stable G = Industry Growth Rate

then ROC G is greater than R G

and ROC G is greater than 1 and increasing in G.

RG

e.g. (ROC = 15%, R =

G = 0% ROC G = 15 - 0 = 1.5
10%)
R-G
10 - 0
G = 2% ROC G =15 - 2 = 1.625
R-G
10 - 2
Only within Franchise
Growth creates Value

G = 8% ROC G = 15 - 8 = 3.5
R-G
10 - 8
62

Valuing Growth Basics

Growth at a competitive
disadvantage destroys value
(AT&T in info processing)
Growth on a level playing field
neither creates nor destroys
value
(Wal-Mart in NE)
Only franchise growth (at
industry rate) creates value

63

Valuing Growth - How much Does it

Add?

64

Valuing Growth
High (Unstable) Growth

65

Valuing Growth
Breakeven Growth Rate

66

Valuing Growth
Keep-In-Mind

Very hard to do
Very hard to determine margin of
safety
Evidence is that Investors
systematically overpay
Best growth is hidden (zero cost
growth)
Unused pricing power

Temporary problem

Underperforming divisions

67

Summary of Valuation

Search
(Look systematically for undervaluation)

Value

Review

Manage Risk

68

Managing Risk Overall Valuation

Review biases

Look for asset protection

Adequate margin of safety (1/3)

Identify catalysts (create

catalysts?)
Appropriate search rationale

69

Summary of Valuation
Asset
Value

EP
Value

Most
certain
but mgt.?

Medium
certain
Sustainable?

Growth
Value

MV < AV,
EPV

AV < MV <
EPV

AV, EPV <

MV

BUY

Assess Comp.
Adv.

Lots of
Luck

Uncert
ain

Sustainable?

Yes

No

BUY

Lots of
Luck
70

Summary of Valuation

Strategic Dimension

Growth in Franchise Only

Franchise Value
Current Competitive
Advantage

Free Entry
No Competitive
Advantage
Asset Value
Reliability Dimension Tangible

Balance Sheet
Based
No
Extrapolation

Earnings Power
Value

Current
Earnings
Extrapolation
No Forecast

Total Value

Includes
Growth
Extrapolatio
n
Forecast

71