The Safal Niveshak Mastermind Module 5 | Lesson 40 uo The Safal Niveshak Mastermind Earnings Power Value Module 5 | Lesson 40 Followers of value investing believe that stocks, like all other assets, have an intrinsic value that can be determined by careful analysis. Opportunities for profitable investment emerge when the current market prices of stocks deviate significantly from their intrinsic values. The essential task of value investor is thus to determine intrinsic value with enough accuracy to take advantage of the market’s mis-pricings. In the past two lessons we looked at two such methods — DCF and Residual Earnings Model ~ that can help us assess the intrinsic value of a business, or at least the value implicit in the current stock price. Both these methods, however, required us to predict the future ~ 10 years in case of DCF, and 2-3 years in case of Residual Earnings Model. In this lesson, we look at a third method - EPV or Earnings Power Value - where we do not take into account any future growth in earnings. In the classic “Value Investing — From Graham to Buffett and Beyond”, the authors, Bruce Greenwald, Judd Kahn, Paul Sonkin and Michael Van Biema, write that EPV is a highly reliable measure of a firm’s intrinsic value, as it values a company’s current earnings, properly adjusted. Now, this value — based on current earnings — can be estimated with more certainty than future earnings or cash flows, and it is more relevant to today’s values than are earnings in the past. ‘The traditional Graham and Dodd earnings assumptions are two — 1. Current earnings, properly adjusted, correspond to sustainable levels of distributable cash flow; and 2. This earnings level remains constant for the indefinite future. Using these assumptions, the equation for EPV of a company is — EPV = Adjusted Earnings x 1/R www.safalniveshal.com Page 10f 8The Safal Niveshak Mastermind Module 5 | Lesson 40 In this equation, R is the current cost of capital. Because the cash flow is assumed to be constant, the growth rate G is zero, and thus not included in this equation. Now, how do you calculate “adjusted earnings” of a company, which are different from the report earnings in the Income Statement? Calculating Adjusted Earnings Here is the step-by-step way to calculate the adjusted earnings, which wouldbe used as the numerator in the EPV calculation — 1. Start off with PBIT (profit before interest and tax). To even oiit.the effect of business cycles, calculate the average EBIT margins of a company over the past seven years, and multiply the result by latest year's Net Sales to arrive at adjusted PBIT. 2. Find out if there are any one-time or extraordinary expenses in the current year and add them back. 3. Add a certain percentage of S&M (Sales and Marketing)’expenses and R&D expenses back to earnings, as these expenses help a company grow its earnings in the future. A thumb rule can be to add back 25% of the last 7- years’ average S&M and R&D costs each. Thisynow leaves you with what we call Adjusted PBIT. 4. Fourth step is to apply a tax rate to the adjusted PBIT. You can use the 30% corporate tax rate. Since PBIT is profit before interest and taxes, if we pay taxes on PBIT, it now simply becomes Adjusted Profit after Tax. Then, add back a certain amount of depreciation and amortization, as it is a non-cash expense and one that adds valtie to earnings in the future. Again, as athumb rule, add back 20% of depreciation expense of the latest year. 6. From the resultant earnings number (after adding 20% depreciation), subtract “maintenance capex” ~ a calculated amount the company would need to spend every year just to maintainpits earnings. I have detailed the calculation of “maintenance capex” inthis excel sheet. After completing these six Steps, you finally come up with an Adjusted Earnings, which is the numerator in the ealculation for EPV, and which must be divided by the discount rate (R) to arriveat the EPV of the company. You can use a constant/discount rate of 10% for all companies, as this is the approximate rate.at which Indian companies raise capital. The result is théEPV, which is the value of the company based on current earnings and ignoring growth. But there is one last step. Add to the EPV the value of “net cash” or “cash minus debt” because operating earning ignore the interest on cash balances so you have to add the surplus cash to the EPV.. ‘As/examples, I have calculated the EPV of Hero Motocorp in this excel sheet, alongwith, my explanation. www.safalniveshal.com Page 2 of 8The Safal Niveshak Mastermind Module 5 | Lesson 40 As you can see in the EPV sheet, the value arrived for Hero Motocorp is 21,099 crore or Rs 1,057 per share. EPV Calculation - Hero Motocorp (All figures in Re Crore) Net Sales 25,125 [Latest Avg. PBIT Margin 11.0%| 7-Years Avg. Adjusted PBIT 2773 Add _| Extraordinary Expenses -_|Latesi [Add [25% of SG&A 85 [25% of 7_Years Avg. Add [25% of R&D 9 [25% of 7-Years Avg. Adjusted PBIT 2.667 Less [Tax @ 30% 860 [Latest Tax Raie Adjusted PAT 2,007 Add |20% Depreciation 221 [Latest Less [Maintenance Capex 458 Adjusted Income 4,770. Cost of Capital 10.0% EPV 47,703 Add_|Net Cash 3,396 [Latest Final EPV 21,099 ‘No. of Shares (Cr] 20.0 |Latosi EPViShare 4,057 ‘The goal of using EPV is to arrive at an €8timate of the current distributable cash flow of the company by starting with earnings data and refining them. To repeat, we assume that thisilevel of cash flow can be sustained and that it is NOT growing. Although the resulting earnings power value is somewhat less reliable than the pure asset-based valuation (like we will do below), it is considerably more certain than a full-blown DCE ¢aléulation that assumes a rate of growth in cash flows many years in the future, Using EPV to Identify Moat In his book, Bruce Greenwald and his co-authors write about three key elements of a business's valuation, EPV being one of them. The other two are — 1. Valu@ of assets, and 2.Value of growth Let us take them one by one. Page 3 of 8The Safal Niveshak Mastermind Module 5 | Lesson 40 Value of Assets When valuing a business, investors rely solely or partly on some sort of value of the company’s assets. The net asset value does not rely on any forecasts but rather on the value of the assets that exists in the company today, and it is therefore a more reliable and restrictive approach to valuing a company than most traditional valuation such as a discounted cash flow model. However, the approach requires some strategic judgments as well as judgments about the reliability of the information going into the model, The most important strategic judgment is whether you expect the industry that the firm operates in to be economically viable or not. If the industry is not economically viable, the assets in the company should be valued at their liquidation value. However, if the industry is expected to be economically viablé the assets should be valued at their reproduction cost, i.c., the costs for the company or a competitor of replacing the assets today. This decision is very important/when it comes to estimating the value of assets such as property, plant and equipment, inventory and goodwill although most companies’ assets will be valued at their replacement cost. The most important source of information for the.net asset valuation is the Balance Sheet where the values of the assets are given as they are determined by the accountants. This information is more or less feliable and correct for different kinds of assets, So, here is a table that shows my calculation of Hero Motocorp’s reproduction asset value, after making any adjustments to its actual FY14 asset number Calculation of Asset Reproduction Value Book Value Reproduction Rs Crore (FY14) Adjustment __Asset Value Fixed assets 0.0% Non-current investments 0.0% Doferred tax assets 106 | 0.0% Long-term loans & advances 47 0% Other non-current assets 48 .0% Current investments 3,276 0.0% 3,276 Inventories 670 0.0% | 670 Trade receivables 921 0.0% 921 Cash & cash equivalents 120, 0.0% 120 Short-term loans & advances 550 0.0% 550 Other current assets 22 0.0% 22 Total 10,122 10,422 If you see the above table, I have made no adjustments to any asset figure, and thus I believe that it would take approximately the same amount for a competitor to spend to create an asset base like Hero. www.safalniveshal.com Page 4 of 8The Safal Niveshak Mastermind Module 5 | Lesson 40 The only adjustment 1 would have made to Hero Motocorp’s F¥14 asset numbers would have been if the company had Goodwill on its books. It’s good to use just 50% of Goodwill while calculating the reproduction asset value, because we know that. most companies don’t make the best of decisions regarding prices paid fort acquisitions. You can discount other items like inventory, receivables and intangibles as wéll, but that isn’t the purpose of the asset reproduction. We are trying to get to a figure thaba competitor will have to realistically pay up in order to enter hero Motocorp’s market. That amount, as the above table shows, is Rs 10,122 crore. The next step is to realize that for any business, there is going,to be value added coming from its marketing and R&D. No competitor will be able to\eompete if they do not spend money to increase brand awareness and on R&D efforts, Some companies will spend very little for both aspects, but ignoring these costs completely would be a mistake. The amount of sales and marketing to be added backsto the asset value above can be calculated as — Average S&M Costs as % of Net'Sales for last 5 years x Latest year’s Net Sales In case of R&D, take the sum of the past 3 years of R&D and then take 80% of the same. Finally, by adding the S&M and“R&Divalue of Rs 463 crore and Rs 108 core respectively to Rs 10,122 crore, weget toRs 10,693 crore. The final step to calculate the net reproduction cost is to subtract non-interest bearing debt and the cash notfequired to run the business. Non-interest bearing debt/is)really Trade Payables. As for “cash not required for operations”, calculate itvjas 2% of Net Sales (though Greenwald suggests to use 1% of sales). Subtract non-intéfesting bearing debt and excess cash from the Rs 10,693 crore figure to get thenet reproduction cost of Rs 7,900 crore which is equal to Rs 396 per share. This means that a new potential competitor will have to spend around Rs 7,900 crore in orderto compete with Hero Motocorp. But you don't just finish off with a net reproduction cost. When you compare it with ‘the EPV, you can assess whether a company has any competitive advantage in the industry or not. So the EPV of hero Motocorp is Rs 1,057 per share and the reproduction value is Rs ‘396 per share. What does this mean? www.safalniveshal.com Page 5 of 8‘The Safal Niveshak Mastermind Module 5 | Lesson 40 It means that the Rs 661 per share difference is the competitive advantage enjoyed by Hero Motocorp. See this figure, which showeases the three key elements of a company’s valuation. ‘The first slice represents the asset value (Rs 396 that we calculated for_héto Motocorp above). Under conditions of free entry and no competitive advantage, this is all the value there is. Three Slices of Value Value of Growth: > + Only ifthe growth is wnthio the franchise and beneiits from the competitive advantage Earnings Power > Value: npertive advantage AssotValue > Reproduction Cost of Assets » Free Enty ‘= No Competitive Advantage ‘The second slice, which is the difference between the asset value and EPV (Rs 661), represents the “franchise value” of the firm. Superior management may be considered here as a variety of franchise value, though it is probably less durable than a competitive advantage in its pure form. What is more, estimates about the value of this slice (EPV) are less reliable than estimates of asset value. ‘The third andiJast Slice is the difference between the EPV and the full value of growth within the franchise. Of all the estimates, this one is the most difficult to make and therefore thelleast reliable. Value of Growth Here lis what Greenwald writes in his book... --this third and last clement of value is the most difficult to estimate, especially if we re trying to project it for a long period into the future. Uncertainty regarding future growth is usually the main reason why value estimations based on present www.safalniveshal.com Page 6 of 8The Safal Niveshak Mastermind Module 5 | Lesson 40 value calculations are so prone to error. By isolating this element, we can keep it from infecting the more reliable information incorporated into the asset and earnings power valuations. Second, under many commonly encountered strategic situations, growth in sales and even growth in earnings add nothing to a firm’s intrinsic value. Growth in sales that finds its way to the bottom line (net income) would, seemito imply that there is more money available to investors. But growth generallyha8 to be supported by additional assets: more receivables, more inventory; More plant and equipment. These extra assets that are not offset by higher spontaneous liabilities have to be funded by extra investment, whether from retained earnings, new borrowings, or sales of additional shares. That cuts into the amount of cash that ean be distributed and thereby reduces the value of the firm. For firms thatyaré)not protected by barriers to entry and thus do not enjoy sustainable competitive advantages over their rivals, the new investment produces returns that are just enough to offset the costs of the new investment. The net gain is zero. Inall, growth is the most uncertain source of value anthis, therefore, the element of value for which the value investor is least willing to pay full price. Conclusion Overall, here are a few reasons EPV is a good technique: * It ignores growth and future(projections of sales. Growth projections are always faulty and if they materialize it is by sheer luck. * DCF ignores the balance sheet and this one incorporates it as part of the valuation (asset reproduction value). This method is more conservative. It gives us an indication if the management is able to exploit effectively its assets and competitive advantages. Exercise Use this EPV excel template and perform a EPV and asset reproduction value calculations fof two companies — + Relaxo Footwear; and ‘* One company of your choice. Then headyover to the Mastermind Forum u ik and share your thoughts on howefar is your calculated EPV to the current stock price, and whether the company has any franchise value (as seen from the excess of EPV over asset value). www.safalniveshal.com Page 7 of 8The Safal Niveshak Mastermind Module 5 | Lesson 40 Further Reading * Value Investing — From Graham to Buffett and Beyond ~ Bruce Greenwald Dizeluimer: This document is confidential and is supplied to you for information purposes only. 1t should n fret) be reproduced, further distrbuted to any person or published, in whole or in part, for any purpose whatsoever, ‘without the conaent of Skylab Media & Research. This document does not constitute a personal recommendation Or take into ‘account the particular investment objectives, nancial situstions, or needs of individual investors. www.safalniveshal.com Page 8 of 8