Bruce Greenwald’s "Value Investing: From Graham to Buffett and Beyond" is in many ways a modern update of some of the core principles laid out in Graham and Dodd’s "Security Analysis." Greenwald, along with his co-authors, incorporates some new developments in value investing theory, and provides examples of more modern value stories. Of particular interest is their treatment of what they describe as Graham and Dodd’s "Three Element Approach" to value investing.
The value of the assets
“We begin with the balance sheet and examine the value of the company’s assets at the end of the most recent operating period, as determined by the company’s accountants. We know that these accounting values are going to be more accurate for some assets than for others. Thus, as we work down the balance sheet, we accept or adjust the stated numbers as experience and analysis dictate. We do the same for the liabilities side of the balance sheet. At the end, we subtract liabilities from assets to obtain the current net asset value.”
This first step establishes the baseline minimum that a company can be worth based solely on the value of its assets. Some value investors consider this to be analogous to the liquidation value of the business. There are a number of caveats that need to be borne in mind when adjusting the value of the assets. Cash, accounts receivable and inventory are relatively easy to value. But the value of items like goodwill, intellectual property and highly specialized equipment may deviate substantially from the stated book value.
Earnings power value
“The second most reliable measure of a firm’s intrinsic value is the second calculation made by Graham and Dodd, namely, the value of its current earnings, properly adjusted. This value can be estimated with more certainty than future earnings or cash flows, and it is more relevant to today’s values than are earnings in the past. To transform current earnings into an intrinsic value for the firm requires us to make assumptions both about the relationship between present and future earnings and about the cost of capital. Because we need to rely on these assumptions, intrinsic value estimates based on earnings are inherently less reliable than estimates based on assets.”
This calculation assumes that the current earnings will at least be sustained going forward. Greenwald states that the earnings power value (EPV) of a company is equal to the adjusted earnings times 1/R, where R is the current cost of capital. Earnings need to be adjusted for a number of factors, which include: what stage of the business cycle the company is in, sector cyclicality, once-off accounting charges and so on. Even though EPV is less reliable than asset value, it at least assumes zero growth, in contrast to some of the more rosy models used by Wall Street analysts.
The value of growth
“When does growth contribute to intrinsic value? We have isolated the growth issue for two reasons. First, this third and last element of value is the most difficult to estimate, especially if we are trying to project it for a long period into the future. Uncertainty regarding future growth is usually the main reason why value estimations based on present value calculations are so prone to error. By isolating this element, we can keep it from infecting the more reliable information incorporated into the asset and earnings power valuations. Second, under many commonly encountered strategic situations, growth in sales and even growth in earnings add nothing to a firm’s intrinsic value.”
Growing revenues do not always translate to an increase in value. On the contrary, this growth may be accompanied by a disproportionate increase in the debt load, or at the very least, may eat up a larger and larger proportion of cash flow to fund itself (as with many fast-growing companies in the technology sector). However, growth can be a part of a value calculation, if the company in question has a secure moat and operates with a significant competitive advantage. If it does, it can enjoy the benefits of increased growth and not have to worry about a rival eating its lunch. Conversely, a company that operates at a competitive disadvantage is unlikely to increase value through growth.
Summary
The three elements are presented in order of decreasing importance. Asset value is the most tangible and easily calculable, so it is given the most weight. Earnings power value requires more assumptions, but can still be a useful piece of the puzzle. Growth is notoriously hard to estimate, and does not always correlate with an increase in value, so it is given the least importance. By combining these differently weighted elements, an analyst is able to come to a rough approximation of the company's value.
Disclosure: The author owns no stocks mentioned.
