- Standard accounting is misleading with companies that earn high returns on very little net-tangible assets.
- Economic Goodwill is real and is hard to quantify but estimates using market rates gives a ball-park idea of a company's true net asset value.
- Winmark does not trade at 20x book, but 1.6x including Economic Goodwill. Historically, that is a lower multiple to pay for the company.
One of the most difficult concepts to understand in investing in quality companies is Economic Goodwill or the hidden value of intangible assets that quality companies are largely composed of.
Winmark Corporation (NASDAQ:WINA) continues to be a quality business, with high quality management and an attractive valuation that the market continues to misunderstand. It has been brought up by some of our readers that although all of the quality might be true, they just can't get comfortable paying 20 times book value for the company. We will describe why looking at the stated book value is actually missing the hidden assets of Winmark. We actually see the company to be trading for only 1.6x book value, including the company's hidden Economic Goodwill, which is not too far from the low point in 2008-2009.
We first learned value investing like many other value investors, through reading Benjamin Graham's Intelligent Investor and Security Analysis. He taught the importance of valuing the hard assets of businesses and buying those assets for significant discounts, in other words invest in net-nets where the downside is very limited. Throughout the years, however, there are fewer opportunities of finding net-net based valuations other than during times of extreme market pessimism.
Although Benjamin Graham's method of investing in cigar butts for very attractive prices works, Warren Buffett, Charlie Munger and some other investors have made large sums of money by investing in quality companies for what look to be fair prices. Warren Buffett reasoned that:
"Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is Economic Goodwill."
What the market oftentimes overlooks with quality companies is their Economic Goodwill or the true value of intangible assets such as brands, intellectual property and other intangible assets since normal accounting standards cannot quantify them. This then means that quality companies have misstated book values because little value is given to Economic Goodwill in financial reports.
Winmark's Economic Goodwill
Winmark Corporation is one of those quality companies that is able to generate significant market beating returns on virtually no tangible assets. As we have charted below, the company has been able to achieve returns on net-tangible assets that have on average beaten the market by a wide margin over the last decade. In the last twelve months the company has produced 128% returns on net tangible assets of $14 million - quite unbelievable returns.
Winmark is an oddity since it does not generate high returns from a brand such as Hershey (NYSE:HSY) or Coca-Cola (NYSE:KO) that sells products directly to consumers. Winmark generates their outsized returns from their relationships with franchisees and relationships with equipment lessees.
The true net-asset value of Winmark is actually much higher than the balance sheet states (currently $14 million) since the company's economic goodwill is not included. Investors then have to find the hidden value of the economic goodwill.
To get the economic goodwill of Winmark, or rather any company, we have to estimate what the market return rates are and reverse engineer how many assets - including intangible assets - would be needed to achieve those returns. We have estimated that the market rates that the company would likely to have achieved each year for the decade is ~8.5% based on the roughly average yield of bonds and the risk premium above the risk-free rate over the same time period. This return could also be a feasible return the company can produce from all of its assets.
To illustrate calculation of Economic Goodwill, we use the trailing twelve month figures of Winmark:
After-tax earnings = $18.7 million
Market returns and likely returns from true total of assets = ~8.5%
Net-Tangible Assets to achieve 8.5% with $18.7 million = $220 million
Stated net-tangible asset value = $14.6 million
Economic Goodwill or hidden assets = $205 million
We estimate that Winmark Corp is currently trading at 1.6 times net-tangible assets and not >20x net-tangible assets. To get an idea of how the company has historically traded, we have included the estimated economic goodwill for each year over the past decade. Note that we have smoothed out economic goodwill by keeping it steady in times of lower earnings since economic goodwill is likely to stay constant and grow.
While our chart is not intended for exacting accuracy - we will never know with exacting precision the true value of Winmark's Economic Goodwill - it does give us an idea of where the company has traded in the past. The lowest point that Winmark is likely to have traded at in terms of true net-tangible book value was 1.4 times during 2008 and 2010. With the benefit of hindsight, buying at those moments an investor would have realized significant market beating gains.
Largely, we think that the reason for the large bump in economic goodwill and of course earnings over the last 10 years has been attributable to Winmark's decision to get into the equipment leasing business and the company's share repurchases. The beauty of large economic goodwill is that Winmark needs $0 or very little to grow this asset and is highlighted after 2008 in the chart above.
It is a mistake to look at Winmark Corporation - and other quality businesses with huge returns on little tangible assets - from merely the price to stated book value to determine the company's valuation.
Accounting standards do not incorporate hard to quantify economic goodwill leaving some balance sheets to be highly misleading. Since this is the case, many quality companies might look like they are trading at high valuations when in actuality they are not, providing astute investors opportunities.
Winmark Corporation's financial reports might state that it has net-tangible assets of $14.6 million and is trading at 20 times book value. Looking deeper, WINA has hidden economic goodwill of approximately $205 million that continues to compound with $0 needed to be reinvested to grow that asset. Historically, 1.6 times real book value is a very attractive price to pay for Winmark Corporation. John Morgan knows this fact and has been putting his money as well as Winmark's to work by repurchasing shares.
Additional disclosure: This article is meant for instructional purposes and not meant as a recommendation to buy or sell. The only kind of intelligent investing is through your own due diligence.