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Theodor Tonca
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Mere mensch, investor (Chairman & CEO of Graham Theodor & Co. Ltd.), and an all around nice guy.

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  • Business Analysis: Working Paper 0 comments
    Mar 14, 2011 11:33 PM

     One of the questions I have frequently been asked lately is: “How do you analyze businesses?”

     I usually respond by noting that determining a company's intrinsic value is a subjective operation.

    It is nearly impossible to determine a company's precise value but it is not hard to determine its approximate value and that is the aim, to be approximately right and not precisely wrong.

    With that in mind, I think the following will be helpful to anyone that is interested in learning how to properly analyze potential investments from a value perspective.

    Definition

    Value investing in the manner initially defined by Benjamin Graham & David Dodd entails the strategy of purchasing securities only when their market prices are significantly below the calculated intrinsic value.

    This difference between value and price is thought of as buying with a “margin of safety”

    The objective is to purchase a proverbial dollar for 50 cents or less.

    While the objective is simple the actual task is anything but. The goal of this paper is to show one how they can assess with reasonable certainty the approximate intrinsic value of potential investment targets.

    Here are a few of the simplest and most accurate methods which I have personally utilized for the past

    five and half years to get one started in determining a company's intrinsic value:

    Asset Based Valuation

    NCAV (Net Cash Asset Value)

    This shows how to calculate the classic “Net-Net” as utilized by the father of value investing

    Benjamin Graham himself.

    Current Assets-Total Liabilities = NCAV

    This is both the simplest and most conservative estimate of a company's intrinsic asset value. As a rule, Benjamin Graham only looked to purchase company's which were valued at a discount to their net cash asset value by 33% or more.

    Today, value investors are hard pressed to find company's valued at such a significant discount and would be happy to pay 100% net cash asset value for a company and acquire both its earnings and any potential growth for free. This equates to essentially paying only liquidation value for a company and nothing more.

    Reproduction Costs

    This type of analysis requires much more specialized knowledge about both the business and the industry in which it participates.

    In this instance we attempt to assign a value to each asset on the company's balance sheet in an attempt to determine what the inherent reproduction cost of all the assets is.

    Example:

     

    Assets

    $

    Reproduction Value

    Value Assigned

    Cash & Cash Equivalents

    1,112,000

    1,112,000

    100%

    Accounts Receivable

    1,967,000

    983,500

    50%*

    Inventory

    52,080,000

    34,372,800

    66.00%

    Capital Assets (Real Estate, Machinery, Equip)

    22,368,000

    3,355,200

    15.00%

    Intangible Assets

    1,545,000

    154,500

    10.00%

    Future Income Tax Credit

    108,000

    108,000

    100.00%

    Prepaid Expenses

    3,303,000

    3,303,000

    100.00%

    Forex Contracts (Used for hedges)

    70,000

    0

    0.00%

    Total

    82,553,000

    43,389,000

     

    *Retail installment accounts are typically valued for liquidation at this rate. Avg. about 50%

    As one can plainly see from the example above, the liquidation value or reproduction costs of assets is usually far below what is stated on a corporate balance sheet. It is from the reproduction value figure that investors must deduct all liabilities to ascertain a company's true asset value.

    Again, when it comes to asserting reproduction values to assets the better one understands the company and the industry in which it operates the better (and more accurate) the estimate they can place on its assets.

    Earnings Based Valuation

    EPV (Earnings Power Value)

    The most conservative earnings based valuation and hence why I utilize it as it falls in line with my foremost investment objective which is to maintain the safety of my principal.

    Adjusted Earnings x 1/Cost of Capital = EPV

    Earnings Power Value is what I believe to be the second most reliable measure of asserting a firm's intrinsic value, behind estimates based on assets.

    The simple goal of EPV is to accurately estimate the currently distributable cash flow of the company. 

    To do this we analyze the earnings data and make adjustments where necessary. For example:

     

    Figures

    Original

    Adjusted

    Net Sales

    98,176

    98,176

    Cost of Goods Sold

    51,963

    31,177

    Gross Profit

    46,213

    66,999

    Operating Expenses

     

     

    Selling, General & Admin.

    39,349

    31,479

    Depreciation & Amortization

    843

    674

    Operating Income

    6,201

    34,846

    Interest Expense

    464

    464

    Income Before Taxes

    5,557

    34,382

    Net Income

    2,601

    22,348

    Earnings Per Common Share

    0.04

    0.34

    After making adequate adjustments to the cost of goods sold, selling, general & admin. As well as depreciation & amortization which takes into account amounts actually spent on increasing sales and brand awareness while determining actual business expenses and costs more accurately we arrive at the above stated figures.

    After making these necessary adjustments and arriving at a more accurate earnings figure all that remains to be done is simply assume that these cash flow figures will be sustained and experience no growth whatsoever. We then divide this figure by a reasonably determined cost of capital (rate of  interest at which the company can reasonably borrow money) to arrive at our EPV for the firm and thus its earnings based valuation.

    By dealing only in current facts and figures and not relying whatsoever on future growth or cost of  capital projections like a discounted cash flow analysis or the like would we arrive at a much safer valuation figure.

    Growth Based Valuation

    Like any value investor I would advise not paying anything for even the rosiest projections of future growth unless they have some basis in current and past figures. If one does see stable growth then they must first, determine if the growth is taking place within the franchise and if the firm does indeed enjoy a competitive advantage in the marketplace.

    If this is 
    found to be the case only then can a growth based valuation be estimated. One such method is:

    Benjamin Graham Valuation

    EPS x 7 + 1.5G x 4.4/4.60 = V

    EPS is the trailing 12 month's earnings per share, 7 is the PE ratio of a stock with zero growth, G is the estimated growth rate for the next 5 years, 4.4 is the minimum required rate of return when  investing, 4.60 is the current 20 year AAA corporate bond yield, V is the intrinsic value of the company.

    This is the original growth valuation formula employed by Graham as described in Security Analysis.

     

    However, be forewarned as this method of valuation is much riskier than both an asset or current earnings based valuation simply because of the fact that we are making projections about the future which are always extremely imprecise.

    Summary

    As always there is much more to be said about business analysis than contained in a brief paper such as this, many more things to be considered and much more expertise to be imparted by those with much greater knowledge than myself.

    However, I would like to add a few further words for consideration. Namely, that many insights can be gleaned from performing and then comparing asset, earnings and growth based valuations to one another. Doing this will enable one to better understand certain qualitative aspects of the business in question, such as if the reproduction cost of the assets is greater than the EPV then in all likelihood that implies that current management is not earning an adequate return on its current assets or it can also be that the industry in which the business is involved in is operating with excess capacity. Further analysis can determine which of these scenarios is factual.

    Another very important thing to remember is to always perform a follow up analysis on companies  held in your portfolio to ascertain if the initial reason you made your purchase is still valid. I usually do this on a half yearly basis.

     Sources: Security Analysis 1934 Edition By Benjamin Graham & David Dodd | The Intelligent Investor By BenjaminGraham | Value Investing By Bruce Greenwald

     

     

     



     



     

     

     

     

     



    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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