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?
- 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.
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