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In the course of my work I am frequently asked to place a value on a business a client wants to sell or acquire. There are several ways to determine value in such situations. Today we are going to focus on the value of listed companies (stocks). Warren Buffett has stated most people should drop their money into an index fund and let it ride. If you are like me you follow Warren’s advice, but invest a portion of your money in individual stocks anyway.
There are numerous books on Warren Buffett and his style of investing. These books glance over the process Warren uses, focusing on tidbits of advice Warren has given over the years. Reading Graham and Dodd’s Security Analysis exposes how difficult it can be to value a company. Since Graham and Dodd, our understanding of value creation has grown and Warren Buffett uses the new analysis tools in his investing style.
The best book on corporate valuation today is Valuation: Measuring and Managing the Value of Companies by McKinsey & Company. Normally I would ask you to run to your library, but this book is not available in most libraries. Another reason to invest in owning Valuation is the depth of the material. You will want to highlight as you read and make notes in the margin. You will come back again and again to this book as you consider investments.
Valuation is used as a textbook in many business schools. At over 800 pages you will want to take your time as you drink from the knowledge provided. I will share some of this information below, but want to outline a few different ways to purchase Valuation. I managed two hedge funds in the first decade of this century. Books like Valuation allowed me the opportunity to earn outsized returns.
There are three ways to buy Valuation. I provided the book cover image in this article three times explaining what each purchase involves. The first image is linked to Amazon to purchase only the book. This is what I use. The second image links to Amazon to purchase the book bundled with a workbook to help you learn and retain the information you are reading. The final image links to a bundled book with software. The software allows you to plug in information from an annual report and produces the information contained in Valuation. In short, the software eliminates the need to do the math yourself.
What is Value?
It is impossible to share the entire book with you here. Instead, I will show you a simple way to evaluate a company to determine if it is a good candidate for purchase. “Companies that grow and earn a return on capital that exceeds their cost of capital create value.” (Phrases in this article in quotations are direct quotes from Valuation.) Value is described in monetary terms. A company investing in research and development or capital equipment must earn a return greater than the cost of capital or they are destroying value.
“Creating shareholder value is not the same as maximizing short-term profits.” When Warren Buffett finds an undervalued company he does not expect the stock price to instantly reflect his perceived value after he buys it. As you will see shortly, value discovered takes time to reveal itself in the stock price. Warren Buffett’s greatest secret is patience. He buys great companies at a discounted price and waits as the company continues to increase value for shareholders.
Overemphasis on reported earnings is a poor way to discover value. Short-term profits can easily be inflated or manipulated. A manager may cut advertising or R&D, artificially inflating short-term results. Public corporations are notorious at stripping out certain expenses and listing them in notes in the annual report. Many wages are hidden in stock buy-backs. Public companies buy back their own stock only to issue it as options to management. The amount reported in earnings is less than the real cost to the corporation. The Earnings Report only provides a glimpse of a company’s income and expenses and is easily manipulated. The cash flow statement offers a better view of the company’s finances and exposes value creation or destruction.
“As a result of their focus on short-term EPS, major companies often pass up value-creating opportunities.” When you make your own investment decisions versus investing in an index fund you need to find companies with managers willing to forego short-term profits for long-term value creation. There are ample opportunities in the stock market to find undervalued companies working hard to create value. Short-term investors frequently avoid stocks based solely upon reported EPS. They pass companies growing real long-term value.
Return on Invested Capital
ROIC is the single most valuable tool investors like Warren Buffett use to discover hidden value. The ability of a company to invest capital and create revenue growth over a sustained period of time determines how much value management creates. As long as the ROIC is more than the cost of capital value is created. ROIC less than the cost of capital actually destroys value.
“Growth, ROIC, and cash flow are mathematically linked.” Reported EPS is not linked in the same manner. Cash flow will reveal ROIC and growth over time. Companies with a high ROIC do better when they focus on growth while low ROIC companies benefit from increasing their ROIC. Faster growth rarely fixes a ROIC problem.
Here is a real life example from the book. From 1985 to 2012, Walgreens and General Mills earned similar shareholder returns. Walgreens grew after-tax operating profits at 13 percent per year while General Mills grew 9 percent. Over this period Walgreens grew profits by 25 times whereas General Mills grew earnings only 9 times larger. “The reason General Mills could create the same value as Walgreens despite 30 percent slower growth, was that General Mills earned a 29 percent ROIC, while the ROIC for Walgreens was 16 percent.”
Without a positive rate of return on capital a company cannot grow or create value. The greater the sustained ROIC, the greater the value creation.
A simple illustration can help us visualize ROIC in action. From the book we will use the example of Value Inc. versus Volume Inc.
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues 1,000 1,050 1,102 1,158 1,216
Earnings 100 105 110 116 122
Investment (25) (26) (28) (29) (31)
Cash Flow 75 79 82 87 91
Revenues 1,000 1,050 1,102 1,158 1,216
Earnings 100 105 110 116 122
Investment (50) (53) (55) (58) (61)
Cash Flow 50 53 55 58 61
Value Inc. and Volume Inc. both have the same earnings and growth. Which company would you invest in? Which is creating more value? In our example, Value Inc. invests 25 percent of its profit while Volume Inc. needs to invest half of its profit to maintain the same level of profits growth. After five years, Value Inc. has nearly 50 percent more cash flow than Volume Inc. Volume Inc. is required to invest half its profit to maintain the same growth as Value Inc. This is why reported earnings do not tell the whole story and it is a wonder why so much emphasis is placed on that single number.
The ROIC is significantly different between the companies. A $25 investment produces a $5 increase in profit for Value Inc. while Volume Inc. invests $50 for the same return. Here is the math that ties Cash flow, growth, and ROIC together:
Growth = ROIC x Investment Rate
Value Inc. looks like this:
5% = 20% x 25%
And applying the formula to Volume Inc. is as follows:
5% = 10% x 50%
Volume Inc. needs a higher investment rate to accomplish the same growth.
Another consideration is the discounted value of future earnings. Time value of money and risk make future earnings worth less than current earnings. Investments made today fuel future earnings. Today’s investments lose their power as time depreciates equipment and new products (internally and from competitors) reduce the value of the investment.
There is a model in Valuation that helps further clear the fog around the math on value creation. I will not delve deeper into that math in this blog post. I do want to add one more piece to the above example of value creation, however. Let us assume Value Inc. was able to invest 40 percent of profits (instead of 25 percent) with the same ROIC. Should management engage such an endeavor? It depends if you are a short-term or long-term investor. If management does decide to make the additional investment, cash flow will be lower the first eight years, equal in year nine and higher in year ten and later. Reported profit will be higher each year, but cash flow will be lower in the early years. Dividends and share buy-backs are paid for from cash flow or borrowed money. So less cash flow will restrict dividends early in the investment, while higher cash flow in year ten and after provide more funds for dividends, share buy-backs, or more investment. There is the added risk an investment will not perform as planned.
Mature industries are easier to gauge than upstarts. Investing for the higher ROIC makes sense, but you also need to consider the industry. When searching for a company to buy you want to start with strong industries. Buying the best company in a strong industry provides a margin of error for any miscalculations. Not every bank will be a great buy. The strongest bank with the highest ROIC will probably continue to outperform its peers.
Management is also important. A management team with a reputation for performance is a powerful inducement for investment. However, when a management team’s reputation and a poor industry meet, the poor industry will win, producing poor results. Higher ROIC companies also command a higher price/earnings ratio. The PE ratio and reported earning only provide a check on your research. Using only reported earning in your investment decision making will require luck to win (and I don’t have much faith in luck).
By applying these methods of research it is possible to generate an outsized rate of return on your investments. You can beat the market and have one huge advantage over Warren Buffett: Warren Buffett needs to invest massive amounts of money to move the needle; you can invest a small amount in a small company where Warren Buffett cannot.
It is unfortunate when management games ROIC by cutting investment to artificially increase current stated EPS. By riding on past investments, poor managers can provide short-term results. Before long the price is paid as growth from past investments declines. In your research you need to beware of such foolish activities by a company. A company increasing investment with a solid ROIC will create value. Your research should always include several years of data to see the level of investment made each year and how productive that investment was.
The final rule is patience. Every business has its ups and downs, even good companies with high ROIC. The stock price will not immediately reflect its underlying value the day after you buy the company. Value is frequently revealed in layers, year after year, as quality investments compound excessive ROIC. More cash flow for the company means more value for you, as the shareholder.
Remember, “Value is driven by expected cash flows discounted at a cost of capital. Cash flow, in turn, is driven by expected returns on invested capital and revenue growth. Companies create value only when ROIC exceeds their cost of capital.”
As we finish this post, let’s engage in an experiment. Last week I bought a small number of shares in Netflix at $95.63. It is the first stock purchase I made this year. The stock was down after forward guidance by management disappointed. With information easily available online, discuss why you think I found Netflix a company worth buying? Why did I buy such a modest number of shares? My investment horizon is always years and decades, not weeks or months. If Netflix continues to fall I will buy a few more shares.
In the comments below discuss why you think I invested in Netflix the way I did. I will chime in periodically on comments with my thought process on this single investment. To prod the discussion, think about a few Netflix facts. Netflix recently entered 130 new countries (investment). Their earnings, cash flow, and growth do not reflected this investment because they just made the investment and will continue investing in this arena. Also think about margin of error and what could go wrong. Most of all, have fun.
More interesting books on investing and Warren Buffett.