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Greenwald Investment Series - Valuing Businesses by Reproduction Cost

January 24, 2012 | About:
John Emerson

John Emerson

Older readers may recall the lovable loser named Ralph Kramden who was portrayed by Jackie Gleason in the legendary sitcom, "The Honeymooners". Ralph was always concocting a hair-brained "get rich quick" scheme which would raise him out of his low-paying job as a metro bus driver so he could treat his wife to the finer things in life. Nowadays, one should be so lucky as to have a bus driver job in a major metro area. That wisecrack should be worth a good ”hardee-har-har" for fans of the old sitcom.

Anyway, Ralph did not need an elaborate scheme to get rich; all he really needed was a bit of patience and the ability to locate publicly traded companies which are trading at a substantial discount to their reproduction costs. In fact, what Ralph really needed was a "get rich slowly scheme" which utilized this value investing strategy and contained the principle of margin of safety.

If an investor can find a business which sells for much less than it would cost to replace or reproduce the company’s assets, then the investor may have discovered a significant value proposition with a legitimate margin of safety. That said, the investor must pay close attention to the following caveat: The business must be a viable entity going forward. If the business sells buggy whips, eight-track tapes, or carburetor kits, reproduction discounts are rendered meaningless since no value exists in recreating such businesses. Rule No. 1 in value investing remains: A business is worth the value of its future cash flows. Dying entities rarely bring much in the way of future cash flows for the owners of such businesses.

As we learned in a prior Greenwald article, businesses which are unlikely to produce future profits should be valued at liquidation value, rather than their reproduction value.

At the conclusion of this article I will describe the rational which explains why purchasing stocks at substantial discounts to their reproduction value is a much less risky proposition than buying stocks with low trailing P/E ratios. Most stocks which are selling at substantial discounts to the reproduction cost of their assets are either losing money or trading at high P/E multiples, hence the process runs counter to common sense. In other words, how can a company which is losing money be a safer investment than one which is currently making money? By the end of the article the distinction should be clear.

Reproduction Costs and Value

Ongoing businesses which contain few competitive advantages are generally worth the price it requires to reproduce their assets, so long as they are likely to continue to exist as a going entity. However, if the business contains some legitimate economic goodwill, the business is worth more than the sum of its reproduction value. We will defer our discussion of economic goodwill until a later date. The focus of today's discussion entails stocks which trade at a significant discount to the sum of their replacement value.

Let's suppose I reside in a small town in western North Dakota and I am fortunate enough to own a significant amount of rental properties. Let's say I have owned these properties for many years and until recently, the rent which I drew on the properties provided me with a steady earnings yield of 10% before interest, real estate taxes, and depreciation charges.

The oil boom has changed the rental dynamics of my small community and I find that I can now easily draw a 20% EBITDA earnings yield while keeping my properties fully rented and still maintain a clear conscience. Not surprisingly, new construction housing in starting up all over town; although the bitter winters in the area are hindering progress significantly.

Being an astute real estate person, I am watching the new construction market closely to decide when my windfall profits are likely to end. In fact, I am considering putting some of my properties on the market to take advantage on the temporary imbalance which exists between the current supply and demand for rental properties.

At what price should I consider offering my properties for sale?

According to valuation dynamics as expounded by Bruce Greenwald, the fair value of my properties would approximate the cost it would take to reproduce the housing in the longer term. Thus, if I could sell my properties for a figure significantly higher than the amount which it costs to build similar housing, I should consider selling some or all of my properties. On the other hand, if I can find a naive seller who is willing to part with their property at a significant discount to the cost it would take to build a comparable property, then I might consider adding to my property portfolio.

For the sake of simplicity I am going to leave tax considerations out of the equation. Let's say the cost to recreate a property which is comparable to one of my current rental properties is $100,000. I put the property on the market and I quickly get a solid offer of $125,000. Should I consider selling the rental property?

The decision is not clear cut; on one hand the offer represents a figure which is 25% higher than the cost to build a brand new property. I could easily build a new property which would require considerably less in maintenance capital expenditures in the immediate term and the 25% premium would go a long way towards appeasing the earnings gap while I waited for the new property to be constructed. Further it would seem that such an irrationally high offer would likely be withdrawn as soon as the prospective buyer came to his/her senses.

On the other hand, I am currently drawing a 20% earnings yield in terms of EBITDA on the property. That figure represents a significant amount of income which I would be sacrificing in the interim the name of recording a sizable capital gain. Additionally what if I was able to increase my rent significantly and increase the earnings yield on properties. I decide the key answer to the question lies in the sustainability of my earnings yield in the immediate to longer term.

After pondering the key question, I decide to sell the property based upon Greenwald's philosophy since it is highly probable that my EBITDA-based earnings yield will quickly return to its standard norm or less as new houses are constructed. This housing boom is likely to increase supply and drop rental prices since home building has limited barriers to entry, and virtually every real estate investor is privy to the current supply shortage in the area. When supply increases sufficiently, the market value of my real estate will drop precipitously, as will the earnings yield on the investment properties.

In all businesses which lack significant barriers to entry and contain little in the way of competitive advantages over their rivals, high earnings yields are ephemeral in nature. Competitors quickly move into such areas filling supply needs. Excess demand is quickly sopped up and profits for the businesses invariably drop precipitously.

Frequently, the profits for such businesses drop below historical norms as a supply glut ensues and excess inventory is dumped on the market at prices well below their historic levels. It is during such times that stocks or real estate properties frequently sell well below their replacement values.

As inventories build, weaker competitors drop out and supply gradually returns to a more acceptable level. The level generally reaches a point where the business owners can record a suitable profit. The process tends to overshoot on both ends, that process is typical in all bust and boom cycles. The time to buy low-quality stocks are when they struggling to earn money not when they are prospering. Generally that period corresponds with the point when the companies are approaching their highest discount to reproduction value. Of course if the balance sheet of the business brings it survival into question, no margin of safety exists and the stock should be avoided.

In the case of our mythical landlord, it is highly unlikely that the temporary windfall will last long enough to justify ignoring the premium to reproduction price which he has been offered. The exception would exist only if a high rate of growth in housing demand would extend into the foreseeable future and it will take years for competitors to construct a over supply. Only in rare cases would the prospects of exaggerated future cash flows for an extended period justify holding the property when it could be reproduced at a significant discount to its current offering price.

Nail Salons and Reproduction Costs

In my neck of the woods, nail salons have been cropping up faster than dandelions on vacant lots. Obviously, a significant demand for the salons exists and numerous entrepreneurs have been attempting to exploit that demand.

It occurs to me that opening a nail salon requires few barriers to entry other than the small bank roll which is required to lease a property and furnish the building. Additionally, it seems that any enterprising manicurist could easily become a business owner and directly threaten the profits of the existing salons.

In virtually all sectors, a finite amount of demand exists and when the sector becomes oversupplied; diminished profits generally ensue for the business owners in that sector. It appears to me that nail salons are a perfect candidate for the aforementioned phenomena since the various shops appear to hold little in the way of competitive advantages.

Let's examine the intrinsic value of a nail shop as defined by its reproduction value. Specifically, as a private owner, at what price would I consider purchasing such a business?

If I am an astute value investor and a follower of Bruce Greenwald, I am aware of the fact that a trailing P/E ratio is not always the best way to define the intrinsic value of a business.

Let's say that "Tiger Lil's Nail Salon" is being put up for sale. Being an astute businessman I immediately request to see the books for the business for the trailing five years to ascertain the profitability of Lil's business.

The business recorded excellent profits until the last year when net income slide approximately 25% below its historic norms. I inquired about the reason for the profit drop and Lil informed me it was due to the fact that she had been unable to maintain a full staff during the last year. She explained that she been staffed with only six salon workers rather than eight as in previous years. She assured me that she had room in the building for a full staff and that the profits would return to normal once the staff was replaced and the business could once again be run at full capacity.

I am not interested in excuses but I note that she still earned $100,000 in after tax income in 2011. It would seem that the business was still highly profitable and she was only asking a price of $200,000 to purchase the business. That translated into a sum of merely 2x the current earnings. In other words, at the current rate of profitability I could pay for the business in only two years. The offer seems intriguing but I began to think that the price appeared almost too good to be true.

Being an astute student of Greenwald, I decide to investigate exactly how much it would cost me to start up a new nail salon as opposed to purchasing Tiger Lil's. I find out that to in order to lease, renovate and furnish another salon, it would cost me about $100,000.

I note that all my equipment would be new and I could save $100,000 in the process but I would have to move to a different location and wait for the remodelers to finish before I could start making money. I reveal my findings to Lil and she immediately drops the price of the salon to $150,000 and expresses to me that is her rock bottom price.

The question remains, is the business worth $150,000? The price reflects a premium of $50,000 to the reproduction value of the business; however, the price of the business is only 1.5 times its trailing earnings.

The answer to the question depends upon whether the business has any legitimate economic goodwill. Economic goodwill can be defined as the value of a business over and above the sum of its assets. In other words, it measures the sum of its intangible assets which will insure its profitability in the future without regard to competition. Economic goodwill will be discussed in detail in a future article.

Back to the selling price for Tiger Lil's. I would suggest that the buyer pay no more than the reproduction cost of $100,000 for the business based upon the following observations:

1) Nail salons are not likely to possess any economic goodwill.

2) Nail salon employees are likely to start their own business and offer their services at a lower price.

3) Revenues and the prices charged for nail salons services are likely to contract on an ongoing basis since the business holds no real barriers to entry and the market is getting saturated.

To sum things up, when evaluating businesses such as nail salons which possess little in the way of barriers to entry, no margin of safety exists in the form of trailing earnings. It is likely in such cases that the business will lose earnings power as time passes and competition increases. Therefore, such businesses should be valued by their replacement value of its assets instead of their trailing P/E ratios.


Once again, I shall quote Ben Graham from Chapter 20 of "The Intelligent Investor: "Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions."

I would only add that in most cases, those losses are accrued by investing in low-quality businesses which are trading at a premium to their reproduction costs, even though their P/E ratios appear to be low and in many cases their growth prospects appear to be favorable.

As Paul Harvey used to say, "Now you know, the rest of the story." The average investor is not adept at identifying durable competitive advantages and legitimate economic goodwill; therefore, the average investor is much better served by focusing on the reproduction value of a business rather than its earnings power.

The next edition of the Greenwald Investment Series will focus on earnings power and economic goodwill.

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 4.1/5 (46 votes)


LwC - 2 years ago
Thanks Mr. Emerson for another well written article. I gave it five stars to reflect not just the content but also my appreciation of the effort it takes to write such an article.

Unfortunately, I note that one other reader gave your effort just two stars without any explanation as to why he/she judged your article to be lacking, and did so within just 20 minutes of its posting-hardly enough time to even have read it!

IMO such "drive by" low ratings are a weakness in GuruFocus's ratings system. My guess is that it was given by one of the "Greenwald haters" who lurks under the WWW rocks and pops out just to take a shot at Greenwald, and then scurries back under the rock until next time.

Good luck to you.

Cesc - 2 years ago
Great article Mr Emerson.

John Emerson
John Emerson - 2 years ago

Thank you for the kind comments, it is my intent to explain value theory in everyday language. As Mr. Buffett explains, "investing is simple but not easy". Unfortunately, many time authors do not relate the "simple" theory to everyday businesses and when that is coupled with the jargon of value investing, it frequently makes simple ideas appear complex. Believe me if investing was as complicated as many believe it to be, I would be buying nothing but index funds.
Jayb718 premium member - 2 years ago
Great article!
Adib Motiwala
Adib Motiwala - 2 years ago
Thanks for the article John!!

I have an example company for you. Valero (VLO). Would you consider it as the kind of company to be evaluated as a going concern and valued on replacement value of assets? I have no expertise in confidently valuing the assets. I know what they are on the books for. Refineries are sold and we have some data to value refineries based on complexity and capacity and location. However, these change rapidly based on market conditions.

How would you think about this situation.

John Emerson
John Emerson - 2 years ago

You hit me in an area that is beyond the my circle of competence, however the fact that US had not built a new refinery in decades indicates that to me that significant barriers to entry exist in the industry. I would assume that many of the barriers are environmental regulations as well as logistical. Thus as far as guestimating the cost involved in building a new refinery, the point is probably moot.

Obviously refineries are extremely cylical so the business should probably be valued on its 10-20 year cyclical adjusted earnings yield. I would pay extreme attention to the capital expenditures of course, since the cost of repairs and updates may or may not simulate depreciation costs.

Finally, I would think long and hard about what would ruin the long term earning power of the business. The US is not going to lose long term demand for gasoline soon but one needs to consider all the other factors involved.

For the most part, the best way to invest in cyclical stocks is to buy them when they appear to be expensive and sell them when they start to look cheap. In other words buy when the trailing PE is high but the cyclical-adjusted earnings are favorable and sell when the situation reverses.

Bear in mind I know little about the sector.

Ramands123 - 2 years ago

Thanks ...
Adib Motiwala
Adib Motiwala - 2 years ago
Thanks John. Its a tough one for most people - the refineries. I did value VLO using 10 year earnings, I looked at average P/S, P/B and P/E and found it quite attractive at the time of writing.

VLO had a nice 50% plus run up and then it was back to a discounted valuation. I think the sector is more of a trading mechanism as earnings and the stock are so volatile quarter over quarter...Thats just my feeling after owning the stock for 3 years.
Aintpopularbut - 2 years ago

Is he going to cover railroads?

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