Value Investing the Approach

Search
(Look systematically for undervaluation)

Value

Review

Manage Risk

Review

Key Issues -- EPV BUY (Growth Buy) Franchise Asset Buy Management Collateral Evidence Insiders, Other Investors Personal Biases

Earning Power and Entry - Exit

Case A:

Value Lost to Poor Management and/or Industry Decline

Asset Value EP Value

Case B:

Free Entry Industry Balance

Asset Value EP Value

Case C:

Consequence of Comp. Advantage and/or Superior Management

Asset Value EP Value

Sustainability depends on Continuing Barriers-to-Entry

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Summary of Valuation
Strategic vs. Traditional Approach

Traditional

Market Size Estimate

National Income, Growth, Consumer Trends Competitive Responses; Entry/Exit Technology, Costs; Prices; Input Costs Technology, Growth Financial Market Conditions; Risks

Revenue

Market Share

Oper Income (EBIT)

Operation Margin

Cash Flow

Investment

NVP

Cost of Capital

Value

Strategic: Is this the South Bronx of the Investment World?

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Basic Strategy Framework

Porter Five Forces Probability Determinants

Substitutes

Suppliers

Customer

Industry Competition
Entrants

Four Forces too many

Strategic Investment Forces

Entry-Expansion Barriers-to-Entry Incumbent Competitive Advantage Does this company enjoy competitive advantage that is significant? Yes Being industry creates value No Efficient Operation may create value Others enjoy advantage stay out. (Being in industry destroys value) What about entrant advantages? No good after entry you become incumbent.

Existing Competitor Dynamics Degree of Competition (Phillip Morris) Share the Wealth (Workers, Customers) Value Chain Dynamics

Consequences of Free Entry Commodity Markets (Steel)

$/Q AC
Economic Profit ROE (20%) > Cost of Capital

Price Q Firm Position

Entry/Expansion Supply Up, Price Down

$/Q AC

(Efficient Producers) ROE = 12% No Entry No Profit

Price Q Firm Position

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Consequences of Free Entry Differentiated Markets (Luxury Cars)

$/Q AC
Economic Profit ROE (20%) > Cost of Capital Entry/Expansion Demand for Firm Demand Curve shifts left (Fewer Q sales at each Firm Position Price)

$/Q AC

ROE = 12% No Entry No Profit

Demand Curve Q Firm Position

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Barriers to Entry Incumbent Cost Advantage

$/Q

ACEntrant ACIncumbent Demand (Entrant, Incumbent) Firm Position Q

Entrant
No Economic Profit ROE = 12% No Entry

Incumbent
Economic Profit ROE = 20%

Sources
Proprietary Tech (Patent, Process) Learning Curve Special Resources

Not Access to Capital Not Just Smarter

Barriers to Entry Incumbent Demand Advantage

$/Q

AC (Entrant, Incumbent)

DemandIncumbent DemandEntrant Firm Position Q

Entrant
No Economic Profit ROE = 12% No Entry

Incumbent
Higher Profit, Sales ROE = 20%

Sources
Habit (Coca-Cola) High Frequency Purchase Search Cost (MDs) High Complex Quality Switching Cost (Banks, Computer Systems) Broad Embedded Applications

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Barriers to Entry Economies of Scale

Demand $/Q Demand (Entrant, Incumbent) $/Q

AC Entrant Incumbent Firm Position Q No advantage Firm Position No advantage

AC Q

Require Significant Fixed Cost (Internet) Require Temporary Demand Advantage Not the Same as Large Size (Auto + Health Care Co)

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Barriers to Entry

Economies of Scale
$/Q
Loss D-Incumbent Profit Price (Both) AC D-Entrant Sales Entrant Sales Incumbent

Advantages are Dynamic and Must be Defended Fixed Costs By: Geographic Region (Coors, Nebraska Furniture Mart, Wal-Mart) Product Line (Eye Surgery, HMOs) National (Oreos, Coke, Nike, Autos) Global (Boeing, Intel, Microsoft)

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Barriers to Entry - Sustainability

Static Demand Advantages Tied Customers

Exploitation Pricing, focus on Own Customers No advantage with Virgin customers Shrinkage over time as base changes Cost efficiency in Own technology

Static Cost Advantages

No advantage with virgin technology Shrinkage with technology change

Economies-of-Scale + Dynamic Demand Advantage Principal sustainable advantage Constant vigilance

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Sources of Franchises
Proprietary Technologies/ Learning
Japanese as the future RCA DuPont Cisco Pharmaceuticals Bubble Wrap (Sealed Air)

Captive Customers
Mercedes-Benz IBM Coors Phillip Morris (Marlboro) Coca Cola Tide Microsoft Amazon Local Doctor

Economies-of-scale
Nebraska Furniture Mart Oxford (HMO) Winn-Dixie Kmart Wal-Mart Microsoft Dell Boeing Intel
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Other Barriers-to-Entry

Government, Regulatory, Public (Lead based Gas Additives; Cigarettes) Informational (Who Knows What) (Banks, Financial Services, HMOs)

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Performing Strategic Analysis

(1)

Industry Map

Identify Industry

(2)

Do barriers Exist?

Industry History

(3)

What Competitive Advantages?

Demand? Cost? Economies-ofScale?

(4)

Future Strategy, Profitability

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Performing Strategic Analysis Apple Computer - Industry Map

Industry: Chips Software Hardware Microsoft, Intel, AMD, Dell, HP, Gateway, Apple, Motorola, IBM, Compaq, Oracle, Apple Apple Netscape Networks AOL

Components Power Supply Co.s, etc. Step 1: Step 2: Step 3: Identify Segments Identify firms in each segments If firms are the same, treat segments as Single Industry If firms are different, treat segments as Separate industry If in doubt, treat segments as separate industries For Apple Segment Are: Chips Hardware Software

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Performing Strategic Analysis

Do Barriers/Competitive Advantage Exist?
Profitability Above Cost of Capital (12%) for sustained periods Especially for dominant firms Intel (Y) Compaq, Dell, Gateway, IBM (Maybe) Microsoft (Y)

Chips: Hardware: Software:

Share Stability Do market shares change hands? Does Dominant competitor change? Is there significant entry?
Year: Compaq IBM Apple Dell Total 1990 28 18 22 4 72 Share 39 25 31 6 100 1998 30 12 14 20 76 Share 39 16 18 26 100 Change 0 9 13 20 10.5

Chips, Software Hardware Software, Chips

High Stability, Low Entry Low Barriers High Barriers

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Performing Strategic Analysis

Nature of Barriers-to-Entry Competitive Advantage

Chips (Strong) Hardware (Weak) Demand Cost Economies-ofScale Apple Yes Yes/Maybe Yes Disadvantage No No Maybe Level (?)

Software (Strong) Yes (Very Strong) No Yes Disadvantage (Some advantage)

Where is Apple Going? Is integrated Strategy Appropriate? Is Steve Jobs going to save Apple in the Long run?

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Other Strategic Considerations

Cooperation within Barriers

Coke Pepsi Cigarette Makers

Division of Spoils in Value Chain

Strategic alliances You can not take home, if you dont bring (NuKote) Employee Power (unions, Prof. Services firms)

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Summary of Strategic Investment

Without Competitive Advantage no Value in Franchise Competitive Advantage must be identifiable and sustainable In particular, Are existing Competitive Advantages Sustainable or are they likely to erode? If in doubt, do not pay for franchise Ideally look for hidden franchise
Unused pricing power (Coke, Cereals) Poorly performing divisions
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Franchise Value Calculation

(A1) Cost of Capital = 10% (A2) Asset Value AV = 1200M (A3) Earnings Power Value = 2400M = 240M X (1 / 10%) Earnings Competitive Free Entry Earnings = 120M = Cost of Cap. X Asset V = 10% x 1200 Franchise Earnings = Earnings Free Entry Earnings = 240 = 120 (A4) Sales = 2000M (Tax Rate = 40%) Power Value = 2400M = 240M X (1 / 10%) Franchise Margin = 120M 2000M = 6% after tax 120

Franchise Margin (pre-tax) = 10% = (10% - 40% X 10% = 6%) Tax EP Value Implies Sustainable 10% Cost and/or Pricing Advantage

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Summary of Basic Valuation

Compute:

Asset Value (Most reliable) EP Value (Second most reliable)

Case A: Asset Value EP Value Value = EP Value (500M) (300M) + Catalyst Value Case B: Asset Value = EP Value Value = 500M (500M) (500M) Case C: Asset Value EP Value Value = Asset Value (500M) (1000M) + Sustainable Fraction of Franchise Value (1000M-500M)

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Real Earning Power Value

Real Earnings = Earnings Inflation driven Investment Real Cost of Capital = WACC Inflation Rate Inflation Driven Adjustment = Net Assets (Not including goodwill items) * Rate of Inflation

Example: (A1) EP Value = 2400M = 240M * 10% (A2) Net Assets (not including goodwill) = Cash + AR + Inv. + PPE A/P AL AT = 800M (A3) Inflation rate = 2% Inflation Driven Adjustment = 2% * 800M = 16M Real Earnings = 240M 16M = 224M Real Earnings Power = 224 = 224 = 2800M 10% - 2% 8%

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