The Choice of a Valuation Method

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By Hugo Roque of

Bruce Greenwald

Bruce Greenwald, professor at Colombia University and heir of the tradition of value investing teaching at that university from the father of the theory, Benjamin Graham (who taught Warren Buffett), presents in his book Value Investing: From Value Investing: From Graham to Buffett and Beyond , an interesting framework for analyzing investment opportunities.

He divides the possible methods of assessment in 3: Assets Valuation, Earnings Power and Franchise Value. Noting the difficulty of estimating with a high degree of certainty results that are distant enough in time, Bruce has focused his studies on more concrete methods and intuitive assessments, always based on the principles of value investing. Of course, depending on the elements of value that a particular business has, its method of assessment should match them entirely.

1) Evaluation of Assets: Applies to companies with lots assets, very low returns on capital, in very competitive, capital intensive industries and quoting close to its book value. These companies value is derived from the value of its assets and therefore the analysis must rest entirely on the company’s balance sheet and the measure of the real value of those assets. Current assets such as cash and deposits, should normally be considered at 100% (or near) their value in the balance sheet. Non-current assets such as machinery, buildings or land and also intangible assets such as goodwill, should be carefully weighed and analyzed for the calculation of its real value. Summing all assets and subtracting all debts we get the value of equity that must be compared with the market capitalization of the company to determine whether there is margin of safety for investment.

2) Earnings Power: For companies with the capacity to generate reasonable results over the economic cycle, with good rates of return, in competitive industries and with no major prospects for growth, but profitable. In this case, most likely the stock should trade above its book value reflecting exactly its ability to generate profits for the future which would translate into value for shareholders. In this case the value of the firm comes from these future results and the analysis should focus on this projection. As these kinds of companies don’t have growth prospects, its evaluation will assume that their results remain constant indefinitely. Thus, the calculated value is simply the division of normal earnings for the company (may be an average of its earnings over the economic cycle) and divide it by a reasonable discount rate for the business. This is a very similar valuation to the real estate valuation method based on capitalization rates, which divides the year’s income of a property (ie its total earnings) by a rate of return required by the owner. These methods are similar because in both cases we assume that earnings of these assets will not grow in the future (or could only grow at a very low constant marginal rate) but the discount rates used are different in order to reflect the different levels of risk of the different asset classes.

3) Franchise Value: Companies with excellent rates of return on its invested capital, with businesses that possess credible competitive advantages and with good prospects for future growth, allowing the estimation of earnings and cash flows with a high degree of predictability. The natural method to evaluate this kind of companies is the very popular discounted cash flow model, in which starting from the prediction of future cash flows for the business, assuming certain growth rates and other assumptions of operational efficiency, those results are discounted to present using a reasonable/conservative discount rate for the business. This model is more subject to the sensitivity of forecasts, so it’s important to note that it should only be applied in the analysis of companies with great potential for future profit generation and durable competitive advantages. Once obtained the value of the business, again it is compared with its market value of the firm to assess whether there exists a comfortable margin of safety for investment.

Warren Buffett, the greatest investor of all time, focuses on the search and analysis of these kinds of opportunities. In these cases however the valuation method may not be the most important element of analysis. Determining whether a business will remain, in fact, a great business is the most determinant assessment.

Most companies do not even fit in any of these categories because they could be out of the circle of competence, could have different characteristics than the ones mentioned or could simply present a case where it’s difficult to ascertain its prospects. But it’s the ones that fit the value investing glove that with should concentrate.

In his book, Bruce Greenwald, within each methodology, specifies the calculation methods he follows for each variable used in the analysis. Personally I prefer to focus on more practical and simpler calculations. But the method’s essence is the same. I leave you with a link to a presentation of Bruce’s methods of analysis and valuation.


Hugo Roque

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