My question pertains to circumstances in which your estimated reproduction cost of assets is above your EPV. If this circumstance arises not because of managerial incompetence or malfeasance, but rather because the industry as a whole has significantly overinvested and faces excess capacity, does this change what you use as your estimate of intrinsic value?
No. You have to normalize your earnings power value, EPV, (See Graham’s discussion in Securities Analysis, 2nd Ed.) using a long-enough period like ten years to average mid-cycle (if highly cyclical company) earnings and eliminate the highest and lowest values. Reproduction value will have to decline to EPV or, mostly likely, EPV has to rise to reproduction value as capital leaves the industry.
Do a search on CSinvesting (use search box at top right corner of this blog) and look up Maritime Economics. Then Capital Returns. Right now Shipping companies are not able to cover their voyage costs, but new builds trade above scrap. The market estimates that eventually rates have to normalize and ship owners cover their costs.
Am I wrong to think that although this industry is viable, you should use your calculated EPV as the more conservative estimate of intrinsic value rather than current reproduction cost of assets because presumably some of the capacity that will subsequently come offline will be that of the firm you are valuing? Accordingly, the firms in this industry will return to earning the cost of their invested capital but this will be achieved through some combination of increased prices as capacity comes offline and a reduction in individual capital bases.
The only circumstance I can think of in which this situation warrants using the current reproduction cost of assets would be if all the capacity that exited the market was the capacity that belonged to firms other than the one you are valuing.
In Chapter 3, we defined the EPV of a firm as earnings after certain adjustments time 1/R where R is your current cost of capital. The adjustments mentioned:
- Undoing accounting misrepresentations, such as frequent one-time charges that are supposedly unconnected to normal operations. The adjustment consists of finding the average ratio that these charges bear to reported earnings before adjustments, annually, and reducing the current year’s reported earnings before adjustment proportionally.
- Resolving discrepancies between depreciation and amortiztion, as reported by the accountants, and the actual amount of reinvesatment the company needs to make in order to restore a firm’s assets at the end of the year to their level at the start of the year. The adjustment adds or subtracts this difference.
- Taking into account the business cycle and other transient effects. The adjustment reduces earnings reported at the peak of the cycle and raises them if the firm is currently in a cyclical trough (know your company and industry to do this effectively!)
- Applying other modicifations as are resonable, depending on the specific situation.
The goal is find distributable cash flow (owner’s earnings) Buffett used EBITDA minus maintenance capex for pre-tax owner’s earnings where maintenance capex kept the business competitive at the current level of operations. If a competitor in your motel business puts in HD TV, then you might lose customers to your competitor unless you join the “arms race.”
Reproduction value is a signpost. If the reproduction of a mine today is above the required capital returns, then you know that capital will have to be leaving the industry. Who will build and/or operate a new mine. Know your industry. Mines can take over a year to shut-down or restart. Finding an economical deposit and building a mine may take over 25 years. You have to have industry knowledge to make a reasonable assessment. Make sure you give youerself a big margin of safety.
Take bulk shipping companies, you can see that new orders are slim and scrapping is taking place, so supply will be lessening. The question is how long before supply/demand equals. The pendulum swings.
Follow up Questions
I have an additional question. This one is regarding Greenwald’s discussion of expected growth rate. He says that your expected return on a growth stock is the (current earnings yield*payout ratio)+(current earnings yield * retention ratio *ROE/r) + organic growth. I really appreciate how intuitive it is and how it forces you to focus on the core issues that generate returns on growth stocks. Moreover, I understand that the formula is not intended to spit out an exact figure of prospective returns, but rather to guide the investor towards a yes no decision about whether or not the stock can be reasonably classified as a bargain.
But one issue I have remains–it seems to me that to a certain extent the organic growth and reinvestment growth are comingled, at least to the extent that Greenwald suggests estimating organic growth by looking at the growth of the market that the business is in. I suppose I’m just worried about any embedded circularity/double counting in disaggregating the growth figure into two figures that may have some overlap with one another. Thank you.
Answer: I don’t know if I fully understand your question. You need to separate maintenance capex from growth capex. So the change in sales over the change in fixed assets shows you total capex, so then you need to subtract maintenance capex to see the remainder, growth capex. You either find maint. capex in the 10-K or call the CFO/Inv. Relations.
Can you help help me to make the estimates on current earnings, I know Bruce said to do five years average, but he also said add back one time charge, and any cyclicality. Conversely, Joel Greenblatt mention he add back pension liabilities, is he talking about adding back maintenance cap ex ? This is the only issue I have been having for the last year.. I would appreciate your help.
If you are figuring Enterprise value, then you need to add back liabilities to the market cap, including operating leases, unfunded pension funds, long-term debt, etc. Then deduct non-operating cash –depending upon the business, usually 2% to 3% of sales.
You want to figure out what distributable earnings the company can give you, the owner. Depreciation and Amortization is an accounting principle while maintanance capex is a TRUE cost to stay in business.
You drive a cab so your fares minus expenses, including maintenance of running your cab and REPLACING it.
IF you can’t figure out a company, then pass on it.