Grahamites

# Notes From Peking University's Fall 2020 Value Investing Course: Yutong Bus Case Study

## Comprehensive case study of how to calculate intrinsic value

In order to illustrate the three-element approach for calculating intrinsic value, Chang Jing went through a comprehensive case study of Zhengzhou Yutong Bus Co. (SHSE:600066). For simplicity purposes, I'll use Yutong throughout this discussion.

Basic information about Yutong is included in the following Bloomberg snapshot.

As of Oct. 15, with share price of 16.86 yuan (\$2.52) and 2.2 billion shares outstanding, Yutong's market cap is 37.3 billion yuan. Currently it has a trailing price-earnings ratio of 28 and forward price-earnings ratio of 25.6.

Below are snapshots of Yutong's stock returns since its initial public offering. It debuted in 2003 and since then, it's been a great compounder with total returns of 3008.4%, which transaltes into a 22.7% annual compound rate. Over the same period of time, the Shanghai Composite Index's total return is merely 215.86%, or an annual compound rate of 7.08%.

But the past five years tell a different story. Our Value Investing Program started in the fall of 2015, since then, Yutong's stock performance has not been very good. The total return for the past five years is only 16.6%, or 3.09% annualized. It trails the Shanghai Composite.

Yutong is a good company, but if you buy it at the wrong time at the wrong price, you will not get good returns, even for five years. But what is a good price? This is where margin of safety plays an important role. But first of all, we have to know what Yutong's intrinsic value is. How should we think about and calculate its intrinsic value? Here we'll apply Bruce Greenwald's framework.

Greenwald's framework breaks the intrinsic value down into three parts – asset value, earnings power and growth value. Let's go through Yutong's asset value first.

Asset value

 (figures in RMB billions) 2019 2018 2017 2015 Operating Assets 6.6 9.6 7.9 1.4 Working Capital 2 5.1 3.6 -3.3 PP&E 4.6 4.5 4.3 4.7 Non-Operating Assets 9.8 5.8 5.5 9.7 Cash and equivalent 7.2 2.9 1.7 6.7 Salable investments 1.9 2.2 3.2 3 Investments in subsidiaries 0.7 0.7 0.6 0

We have excluded goodwill and intangibles because it's hard to give them a reasonable assessment of how much they are worth. We have also excluded other hard-to-assess operating and non-operating assets.

On the operating assets side, there's some big change for working capital. In 2015, Yutong's working capital is negative 3.3 billion yuan, which means Yutong's suppliers and customers are paying the company cash to support its operations. This is a very favorable situation. But things changed in 2016 and 2017 as governments became large customers for Yutong's electric buses. Previously, Yutong's customers prepaid for their orders. But the government orders are credit sales, so Yutong's accounts receivable ballooned up. And in 2019, there were some policy changes in terms of how the government would pay suppliers, so Yutong's accounts receivable declined from 9.6 billion yuan to 6.6 billion yuan.

In terms of property, plant and equipment, it barely changed over the past five years. If we add up working capital and PP&E, we get total operating assets. We could tell that operating assets declined by 3 billion yuan in 2019, compared to 2018. This change in operating assets showed up on the balance sheet as increases in cash and cash equivalents, which we consider as non-operating assets.

Other non-operating assets include available for sale securities and investments in subsidiaries and related companies. They didn't change much.

Earnings power value

Yutong's market capitalization is 37.5 billion yuan. According to our calculation above, Yutong's operating and non-operating assets totalled 16.4 billion yuan. There's a gap of 21.1 billion yuan. This difference can be viewed as the premium the market participants are willing to pay over Yutong's assets. Why does this premium value exist? As we mentioned previously, the existence of premium over asset value is due to the existence of a moat, operating efficiency or superior industry characteristics. In this case, if we read Yutong's annual reports and its competitors' annual reports, we can determine that Yutong has superior profitability due to its more efficient operations and superior management team. We'll call this economic goodwill.

When we think about Yutong's sustainable earnings power, we also have to think about external factors and competition. For instance, China's high-speed railway has definitely taken market share from inter-city bus operators who are Yutong's end customers. Increasing private passenger car ownership also means more people will drive themselves rather than take long-distance buses. There are a lot of factors which will impact Yutong's earnings power. After considering all of them, we may tentatively come to the conclusion that Yutong's current earnings power is 2 billion yuan a year. This is a very big assumption because in the future it could go down.

But let's assume 2 billion yuan is Yutong's earning power. What would be the earnings power value? One way to calculate this is to use the historical market return as the discount rate. Over the past 20 years, the market has returned about 7% a year, which gives us a multiple of roughly 14 times. Two billion yuan times 14 gives us 280 billion yuan. This is one way of calculating Yutong's earnings power value.

Growth value

When we calculate Yutong's earnings power value, we made a very big assumption – Yutong's earnings power is infinitely sustainable at 2 billion yuan. This can easily be wrong. It could be lower and it could be higher. Because it's operating in a very mature industry, earnings power is more likely to go down than go up. On the other hand, Yutong can find new growth opportunities or it can make its operations more efficient. If this happens, then earnings could go up.

Another thing we have to consider is the management team. Yutong's founder is close to retirement . It's not clear how long he can run the company. What would happen to Yutong if there's a big management team? It's not very clear at this point.

It seems that we shouldn't assign any value for growth considering all of the above.

Putting it all together

If we add up the three elements of intrinsic value for Yutong, we get approximately 29 billion yuan, compared to its current market capitalization of 37.5 billion yuan. There is no margin of safety if our calculation of Yutong's intrinsic value is absolutely correct. But again, we've made many important assumptions when calculating the intrinsic value. These assumptions could very easily be wrong. So our conclusion is debatable. What we have go through is just an exercise of how to think about intrinsic value.

Grahamites
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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