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Notes From Peking University's Fall 2020 Value Investing Course - Lecture 2

Key points from Chang Jing's 2nd lecture

October 18, 2020

The topic of Chang Jing's second lecture was intrinsic value. He discussed sources of intrinsic value, basic elements of intrinsic value, advantages and disadvantages of different valuation methods and important factors to consider when calculating intrinsic value. He also shared a great case study. Below are my notes.

Intrinsic value

Intrinsic value is a core concept in value investing. It's also applicable to the product and services a business offers. The value of a product is determined by its utility to us. For instance, used stamps are worth more than new stamps.

In order to understand intrinsic value, we have to ask questions like what is the nature of a business and why do companies even exist? Businesses exist because they can create value for the society and they have to make a profit to sustainably operate. The nature of business dictates how we should look at intrinsic value. But when we calculate intrinsic values, we need to assess the current level of cash flow, and potential future cash flow, during its lifetime and discount it back.

Cash flow-generating businesses have intrinsic values. Therefore, as shareholders, our ownership in the business is worth some value because we have the rights to share the cash flow generate by the business. Our stock certificate represents actual ownership of a business, so our stock certificate is worth something. But because this certificate is easily tradable, price often deviates from the value. As Warren Buffett (Trades, Portfolio) has famously said, "price is what you pay, value is what you get."

China's stock market reform is an important milestone. Before the stock market reform, only government could actually own equities in all kinds of businesses. After the stock market reform, individuals could own a piece of the state-owned enterprises and publicly traded non-state-owned businesses. But the stock market reform also opened up doors for short-term speculators who are willing to pay different prices than business owners. The voting machine was created.

The importance of intrinsic value and the calculation of intrinsic value is different for controlling shareholders, minority shareholders and speculators. Shareholders also have to be aware of agency problem, namely conflicts of interest between shareholders and managers. Managers have certain responsibilities for shareholders and vice versa.

Chang emphasized the difference between long-term investing and arbitrage. The risks are different for long-term investors and speculators.

Basic elements of intrinsic value

Bruce Greenwald's intrinsic value framework is the most common one as well as a scientific one. Greenwald proposed the three elements approach. The three elements are asset value, earnings power and growth value. Sometimes the three overlap. For instance, assets can be further broken down into operating and non-operating assets. Earnings power can be derived from operating assets, competitive advantages and operating efficiency. The part of earnings power derived from operating assets, in this case, overlaps with asset value.

The three sources of intrinsic value can be ranked by reliability. Asset value is recorded on the balance sheet according to accounting rules. But the actual market value might be different from book value. Book value itself doesn't require much of an estimate, but adjustments to book value require some projections.

Assessing earnings power requires more estimates and a big assumption is that the current earnings level is infinitely sustainable.

Assessing growth value requires judgments, estimates and projections. Therefore, it is the most unpredictable.

From a strategic or competitive dynamics point of view, asset value can be thought of as the value of the enterprise in a perfectly competitive market with no barrier to enter. Earnings power can be thought of as values derived from franchise power and operating efficiency. Growth value is derived from moat, franchise value and industry growth, among other factors.

Discounted cash flow

Important factors to consider for discounted cash flow models include present value, future value, inflation, purchasing power, cost of capital and opportunity cost.

For instance, what discount rate should be used? Is it cost of capital, opportunity cost or inflation rate? What implications does it have if we use different discount rate?

There are three different formulas in practice: discounted cash flow, enterprise value and value to equity shareholders.

Other valuation methods include dividend discount model, ratio analysis, discounted future earnings and internal rate of return.

Shortcomings of the discounted cash flow model:

  1. It ignores the balance sheet.
  2. It mixes good information with bad information, and bad information plus good information equals bad information.
  3. The results of the calculation are very sensitive to predictability and interactions between different parameters. For instance, weighted average cost of capital and capital expenditure are more predictable than growth and profitability.

Asset value

There are three ways of calculating asset value. The easiest is the basic Graham-Dodd value, which only includes assets that can be converted into cash right away. The result is the net-net value. A second way of valuing assets is to use reproduction value, which is the amount of monetary spending required to purchase the assets required to reproduce the same business operation. Some estimates are required. Finally, we can also use liquidation value, which is the value of the assets if we were to liquidate the business. It also requires a certain amount of estimating.

Earnings power

Earnings power is derived from franchise value and competitive advantages. Greenwald defines earnings power value using the following formula:

Earnings Power Value = Earnings * (1/cost of capital)= Earnings Power Value of Business Operations + Excess Net Assets

Earnings power equals GAAP operating income plus adjustments, after considering a full cycle profit margin level. Cost of capital equals weighted average cost of capital. And equity value equals earnings power value minus debt obligations.

Greenwald's framework is one way of thinking about earnings power. It's based on the theory of rational economists. As mentioned earlier, the biggest assumption here is that current earnings are infinitely sustainable. Embedded in this assumption are other assumptions such as constant tax rate and constant profit margins, both of which are not constant in practice.

There are three scenarios:

  • Scenario 1: EPV < asset value. In this scenario, earnings power value is less than assets value because of an incompetent management team, terrible industry dynamics or both factors.
  • Scenario 2: EPV = asset value. This is the case in a perfectly competitive market.
  • Scenario 3: EPV > asset value. In this scenario, earnings power value is more than assets value because of the existence of moat, or superior industry characteristics, or a combination of the two.

Value of growth

Growth means profitability growth, not revenue growth. Growth can be further broken down into three parts: moat, industry growth and new business opportunities. We also need to pay attention to the quality of growth, which means that revenue growth can translate into free cash flow growth. We also have to assess how much capital expenditures are required to generate growth and how much growth can be generated by each unit of capital expenditure. Similarly, we have to assess the period of time during which growth is sustainable, and the risk factors that may dampen the growth of business. And last but not least, we have to be able to parse out growth from natural upward momentum during business cycle and economic cycle upswings.

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About the author:

A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

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