A Value Investing Toolkit (3): Going Concern Value
Leading up to the International Value Investing Conference on October 23 and 24, Jos van Bommel, associate professor of Finance at the University of Luxembourg, will regularly share his insights on some basic tools and concepts relating to value investing.
3. Going Concern Value
Value Investors believe that the Enterprise Value as determined by Mr. Market does not always equal the Intrinsic Value of a business. One way of estimating the Intrinsic Value of a business is to add the value of the assets that make up the firm’s Invested Capital, assets can be grouped into the Operating Working Capital, of which the value is relatively easily to find, and the firms’ Long Term Assets, of which the bookvalues may deviate substantially from the values reported in the financial statements. Historically, the “Book to Market ratio” has been a surprisingly good predictor of future stock returns, and has given rise to the puzzling value premium. A recent article found that “Book-to-Market” was a key explanatory “factor” of the investing success of Warren Buffett.
In the current century however, Warren Buffett and other value investor will mostly consider the earnings power of a business, rather than asset values. In business schools we teach since many years that the value of a firm is the discounted value of its future Free Cashflows, defined as the operating cashflows less the investments made to increase these cashflows in the future. Finance professors explain that profitable firms are growing, and can even have negative free cashlows for some time, but that eventually cashflows are expected to become positive. An example is Amazon, a profitable market leader that had negative cashflows for decades and could eventually flourish thanks to competitive financial markets that patiently waited for the firm’s harvesting years.
We teach students to make a model (typically in excel) to forecast a firm’s free cashflows sufficiently far into the future until they become positive and stable and start growing at a constant rate. We then discount the projected free cashflows at a reasonable discount rate (the so-called Cost of Capital) to obtain the theoretical Discounted Cash Flow (DCF) value of a business. This DCF value had better be higher than the Invested Capital. If it is not, the firm should not grow but instead liquidate itself..
In academia we have gone to great lengths to understand and estimate the Cost of Capital. Many models and formulas have been proposed and tested. We generally agree that this discount rate depends on risk, particularly “systematic” or “market” risk, and other factors such as liquidity and size. Interestingly though, very few colleagues teach their students that the Cost of Capital should also depend on the time horizon, and that it is reasonable to use a lower discount rate for existing cashflows from existing operations than for projected cashflows deriving from future growth.
Value Investors know better, and often only consider cashflows from current “proven concept” operations, and disregard growth opportunities altogether! They divide the DCF value into the Going Concern Value and the net present value of future growth opportunities, which is often seen as a bonus, but not as a key reason to invest.
The Going Concern Value is defined as the DCF value if the company would not invest in growth. This value is therefore the present value of a perpetuity of the existing cashflows of a company, and can be estimated relatively easily by dividing these cashflows by the cost of capital. Alternatively we could find the DCF value of current operations by multiplying the cashflows with a multiple. To see this, consider a firm with annual cashflows of €100, and a cost of capital of 8%. The firm’s DCF value can be found by dividing 100 by 8% or multiplying it by 12.5.
The discount rate that Value Investors use to value a Going Concern, is often quite low. One respected Value Investor told me that for a first screen he uses only 6%. This makes sense because interest rates nowadays are essentially zero, and the risk of Going Concern cashflows are relatively low. Clearly the risk of future, not yet realized, cashflows is much higher. A relatively safe yield of 6% in today’s market is indeed very attractive!
The key then is to estimate the sustainable (annual) cashflows. Many value investors choose either the Operating Profit or “EBIT” (Earnings Before Interest and Taxes), or the slightly higher EBITDA that does not include Depreciation and Amortization charges. The latter number is closer to a firm’s actual available cashflow, because Depreciation and Amortization are not paid in cash. The problem however is that EBITDA is not a long term sustainable cashflow. To keep a concern going in the long run, firms need to renew and replace their depreciating assets. For this reason, my preferred point of departure is the EBIT, to which I make adjustments to make sure that this cashflow estimate is truly sustainable in the no-growth scenario. I then reduce this number to account for effective corporate taxes, and divide it by a reasonable Cost of Capital. If I take for this rate 6%, and assume an effective corporate tax rate of 40%, I conclude that firms trading at EV/EBIT ratios lower than 10 are attractive investment opportunities and worth a closer look.
In particular, I would further investigate whether the company’s cashflows are economically sustainable and defended by what Warren Buffett calls defensive “moats”. To do this we need to analyze their equity story and their comparative advantages vis-à-vis clients, suppliers and competitors, and make sure their corporate governance is in order. More about that in the next blog.