Adapted from The Old Man and the Tree: A Parable On Valuation Solomon, Schwartz & Bauman, Corporations - Cases and Materials at 143 (3d ed. 1996) and here
Once there was a wise guy named Willy who owned a chocolate factory. This chocolate factory was very fine indeed and Willy thought it was beyond imagination. It served the region and customers enjoyed the chocolate he produced. Last year the chocolate factory produced 16 million pounds of chocolate for $28 million. The factory recently had a special marketing tactic that went awry. Although Willy was a chocolatier at heart, he wanted to retire. He decided to see how much he could sell his chocolate factory for, so he went put an ad in the classifieds of the newspaper entitled: “For sale, chocolate factory - best offer.”
A gentleman named Benjamin Graham arrived at Willy’s door step with his geiger counter. He asked to look at the chocolate factory’s balance sheet, did a few calculations and offered to pay $5 million for the company. “The factory recently had a marketing flub with your golden tickets and uncertainties are present, so I’d like a large margin of safety. You sound like you’re in a hurry to retire. My offer would give me a decent return if I shut the company down and liquidated all the assets.” Willy laughed hysterically and said, “Now I know you might be able to find panic driven investors in the market willing to give you fire-sale prices like that, but the company is worth much more. I could liquidate my assets right now and realize much more than $5 million. No, thank you.”
Net Asset Value
A man named Marty Whitman then responded to the ad. Marty asked to see Willy’s books. “Your chocolate factory is well financed and growing despite the companies short term problems.” Willy happily agreed and was excited to hear his offer. Marty offered $6 million. “Your company has a net asset value of $8 million,” Marty stated, “I also want a margin of safety and would like a 25% discount to the net asset value.” Willy responded, “Well you aren’t as crazy as the first guy and I appreciate your offer, but my company returns extraordinary returns on net assets. I might accept your offer if my company needed to reinvest large sums of capital back into the business to maintain low single digit returns. This isn’t the case. I only need to invest small amounts of capital to maintain my double digit returns. You might find some Chinese chocolatiers willing to sell for your price. Look there.”
Another gentleman showed up to Willy’s door. He said his name was Joel Greenblatt (Trades, Portfolio) and after checking out the factory’s financial statements he offered $15 million. “Your company is high quality, despite some recent short-term problems. The factory has $3 million in operating earnings or EBIT. My hurdle rate is 20%, so I’d like to buy the company for $15 million.” Willy said, “You are right. My factory is high quality and our recent problems are only a blip on the radar screen. I respect your calculation, but my company is of unimaginable quality. Much higher than you think. We have many satisfied customers. Your $15 million offer is attractive but will not do.”
Peer Market Value
An undisclosed woman gave Willy’s cell phone a ring. She mentioned that she too was a chocolatier of an undisclosed public company and understood the business. She offered Willy $18 million without looking at his books. “Your recent problems have been effecting the market’s perception of chocolate companies. Our company’s share price has plummeted and our chocolate is more extraordinary than yours. Our offer includes a premium to the current market multiple of 6 times after tax earnings. We estimate that you have sold 15 million pounds of chocolate and have after-tax profits of $2 million.” Willy was astounded, “Wow. Your estimations are very accurate. However, despite your accurate estimations of our after-tax earnings and generous “premium”, we will not sell at that price. We know the market values have been artificially lowered because of the market perception of chocolate companies. Also, our chocolate is on par with your company’s and at a much cheaper price. We offer our customers more value than you.”
Net Present Value
A Wall Street businessman was the next person to contact Willy. He offered him $18.5 million for the business. “I’d say your company is excepted to have annualized growth of 4% and I estimate that your weighted average cost of capital to be 18%. Your company has had $3 million in operating profit and capital expenditures of $800,000. The net present value of this cash stream would would equal a price of ~$18.5 million.” Willy said, “I appreciate your fancy terms and projections. What if your calculations are wildly off the mark? Your calculation is of garbage in, garbage out quality. What about the quality of my business? What about the quality of my chocolate? I wish you luck on Wall Street.”
Great Company Value
An older gentleman with thick glasses and a cheap looking suit showed up to the factory looking for Willy. He was a jolly fellow and introduced himself to Willy as Warren Buffett (Trades, Portfolio). “I noticed your ad in the newspaper and love your chocolate. Who doesn’t love your chocolate? I’d like to buy your business for a good price.” Willy was curious, “You might like my chocolate, but you have to give me an attractive price for me to sell.” Warren giggled, “Of course. I looked at your books and notice you have a consumer franchise with high economic goodwill. These are important qualities for a business to have.” Willy asked, “What are these terms you call consumer franchises and economic goodwill?” Warren proclaimed, “Good question. I know your company has created many pleasant experiences for me and for many customers. Because of these countless pleasant experiences customers are willing to pay attractive prices and thus your company has returned extraordinary returns on small amounts of capital employed. This reputation is what I call a consumer franchise. Brand and reputation are very valuable, even though they aren’t stated on the books.” Willy was surprised, “That is exactly correct. I’ve spent years creating quality chocolate that customers love. My chocolate gives customers more than endorphin rushes from the chocolate. Customers also get kisses on Valentines Day when they give our chocolate as a gift.” Warren added, “For that extra brand quality customers are willing to pay $1.75 a pound instead of $1 a pound for a generic. That is a 75% higher price.”
Warren told Willy of a story where he made a previous business acquisition of a sub-par company. “I’d rather buy a company with high returns on net tangible assets. I once bought a textile company; boy was that a mistake. The textile company was very cheap, but for a reason. It had sub par returns on large amounts of net tangible assets. A company like that is not worth its net tangible assets. We were competing with China and other third world countries who had much lower production costs. Customers would compare our textiles with Indian textiles and would of course choose the cheapest one. The quality was similar. I learned my lesson that quality companies are much better investments. I’m willing to buy your company for much higher than the honest to god assets of your business.”
Willy really liked Warren’s thinking process and was willing to sell to him regardless of what price was quoted; he knew the price would be fair. Warren eventually offered $25 million for Willy’s factory even though the company had $8 million in net tangible assets. After-tax earnings were $2 million so Warren was willing to buy the factory for 12.5 earnings. Willy happily agreed “Mr. Buffett you are very wise. You understand my business and the quality of the company. Your offer is happily accepted.”
- There are many ways to value a company and none of them are incorrect. The more valuation tools you have in your tool chest the better. Just understand the company you are looking at and use the most appropriate valuation technique.
- There are many things to learn from the Gurus.
- Quality companies with low capital expenditures and high returns on their honest to god assets are more valuable than what general accounting often conveys. If you see such a quality company, then be willing to pay a premium.
- Be wary of fancy financial terms and projections.