As it becomes mid-year, we would like to delve into the heart of value investing and how Third River seeks out companies that we believe are “bargains” by following the tenets of scholars of value investing. At the core of investing at Third River is the estimation of the intrinsic value of a company through a bottom-up approach. In this issue, we explore how Benjamin Graham and David Dodd approached equity valuation from a value standpoint.
With the pace of technology, the first, and perhaps most important judgment qualification is whether the company’s industry will continue growing and be healthy enough to thrive If is not, then the value of the company is based on the value of the liquidated assets. Graham and Dodd indicate that if the industry is mature or growing, then the value of the company should be based on “reproduction cost,” i.e. the cost for a new business to enter the industry and be a viable competitor.
After determining the life cycle of the industry, the next decision is how much of the balance sheet should be considered in the valuation. There is a wide degree of variance with the historical practitioners of investing. Graham only included currents assets while more modern portfolio managers tend to venture further down the balance sheet. At the discretion of the manager, the assets valued may include intangible assets. The margin of error is considerably greater when it comes to valuing intangibles such as brand recognition, customer loyalty or other difficult to measure assets.
The next step is the reproduction costs for all of the assets chosen for consideration, and the necessary adjustments for valuation. Measuring the assets at their near “fire-sale” prices determines the bare bones value of the company as a whole. This then indicates, “if the economic value of the assets is accurately reflected in the price at which the firm’s securities are being bought and sold. Opportunities lie in the gap between value and price.”
After careful analysis of the assets, the investment team then reviews the liability side of the balance sheet. Liabilities are broken out into three general categories: current liabilities (those costs associated with running the business), expenses only relevant to the company at hand, and formal debt. Generally, market value for debt is used as it is the most conservative and offers the most accurate picture of equity remaining in the company.
There are many approaches to the final value assessment. An investor may choose to take the sum of the current assets less all the liabilities to arrive at the most conservative estimate of the company’s equity (the Graham and Dodd net-net approach). Or, an investor may use the enterprise value (sum of the market value of debt and equity less cash) in comparison with the determined value of the assets. Inherently in all calculations, the investor is looking for a margin of safety when making the investment.
References: Benjamin Graham, The Intelligent Investor, 4th Revised edition. Eugene F. Fama and Kenneth R. French, “The Cross-Section of Expected Stock Returns, “ Journal of Finance, XLVII:2, June 2991, 427-465.
