My last post garnered quite a discussion in the comments, I'd encourage you to read them if you get a chance. The main question that kept coming back again and again is whether it's possible to separate assets from earning power.
It seems a popular line of thinking is that assets without earnings are worthless. This is clearly the market view as well, the market doesn't care about assets, only earnings. It doesn't care about the quality of earnings, or cash flow, just that earnings, and hopefully high earnings exist.
I want to take a step back and think about assets and earnings with my "real world" glasses on. Let's simplify things and consider a small business, a gas station in a prime location. Presume this gas station is given to me by my grandfather (family business) and I don't have much interest in it. I am happy with the small amount of earnings it throws off, but I don't keep up with it and I let the gas station fall into disrepair. Eventually my gas station's earnings gravitate towards zero and possibly to a slight loss. For me as a disinterested owner the gas station has become quite a drag, it's taking up my time and it's close to losing money. I'd rather cut my losses and go do something I enjoy.
According to the market view this business is worthless. I know that seems like a crazy statement, but it generates no earnings, and if assets that don't generate earnings are worthless, my gas station is worthless. The problem is this simply isn't true, my gas station is ideally situated and at a minimum the real estate is valuable. I already have tanks in the ground and working pumps. A buyer can come along and for considerably less expense than starting new take over where I left off. Maybe they reinvest and develop a car wash or mini-mart and earnings soar. The base assets are the same, but in the hands of a capable manager they're used to generate earnings.
Earnings are great if they can be extracted from the business. In the comments "red." pointed out that my example of a company with earnings that require constant re-investment is a business that doesn't earn their cost of capital. This is true, a business that doesn't earn, or barely earns their cost of capital has to constantly reinvest to stay above water. An investor wants to own a business that earns above their cost of capital; the excess cash can be used to pay out dividends, or grow the business.
I want to dispel another myth that appeared in the comments on the last post, that assets should be considered through the lens of reproduction value. This line of thinking believes that a business should be worth what it would cost to start one new today. I think this is clearly faulty for the following reasons.
Many businesses in heavy industry have locations and permits granted that enable them to do business in a way that a new business never could today. In the Rust Belt there are numerous steel mills and heavy industrial companies (with considerable book value!) very close to urban areas. Imagine trying to build a steel mill right next to the 'burbs in San Francisco, it would be impossible, not metaphorically impossible, literally impossible. Even a city like Cleveland or Buffalo would shy away from such a development. Yet existing businesses with ideal locations exist, they can be purchased instead of built from the ground up.
Many existing businesses have already occupied the ideal locations. Think about trying to locate a car dealer in your local area, where would it go? There's probably already a section of road packed end to end with dealers. Areas like this are a destination for car shoppers, where would a budding dealer operator locate if the strip has no more room? Maybe across town? Why start fresh with a subprime location, when an ideal location with all of the existing infrastructure, and possibly a name brand exists?
In the White Sharks of Wall Street there is a section where the author discusses why Tom Evans engaged in takeovers instead of building divisions from scratch. His line of thinking was why start fresh when a fully functioning company with clients already exists? This is why I don't think reproduction value is worth calculating, why figure out how much it costs to build a business from scratch when one already exists.
Talk to Nate
Looking for value in the overlooked margins of the market.
Interesting post Nate -- good thoughts.
ReplyDeleteYou made a good observation that I'm not sure you even noticed.
You said that an asset generating zero FCF earnings can have value (I'll use FCF in place of "earnings" because people tend to get their panties in a twist about non-cash elements in GAAP earnings, etc.).
*But* you framed it by saying that the asset had value because another party COULD generate FCF from it -- either by generating revenues or avoiding costs.
Could there be certain assets with no hope of ever being used to generate positive FCF by any party still have value? Quirky paintings by no-name artists? Deviant abstract sculptures? Sports teams?
Hmmm... More I think about it, the more I think we start realizing that investment assets look a lot like the economist's definition of money (i.e. store of value, means of exchange, unit of account).
This is a really good point, I think yes, there are certainly assets that have no value.
DeleteThink about something like a restaurant located on a quiet road, as the city expands it becomes an eight lane monster with semi-limited access. The restaurant could become worthless. I would go as far as saying look around in blighted areas, this has already happened.
The worst is some assets have value in the eye of the owner, but not much, or no value for anyone else.
I think some quirky assets probably do have a market, but it's extremely limited, to that limited subset there's value, but not anyone else. I think about that American Pickers show, those guys buy all sorts of rusty crap that I'd throw away, then they go on to sell it to someone for hundreds of dollars.
Hi Nate
ReplyDeleteThe way I think about it is that assets are worth the higher of their current use or their opportunity cost.
Corporate raiders and value investors who look at assets are looking to see where the opportunity cost of the asset's current use is very high, and buying when it is.
Great posts Nate!
ReplyDeleteMost of us private investors do not have enough capital to buy whole companies. Thinking like you could is a useful exercise in the valuation process, but it is also important to keep in mind that you can't make the decisions for the company.
The value of the company to a minor shareholder depends heavily on the actions of the management (E.g: Solitron) and the big shareholders. Buying assets worth of a dollar with 50 cents sounds like a good deal, but a lot depends on when you get that dollar back and do you actually get it back at all.
Unless it is a great company with a great return on the invested capital, the value of the assets depends a lot on the existence of catalysts to realize the value.
Nate
ReplyDeleteI completely agree with what you're saying. The market all too often focusses entirely on what assets are earning now, rather than their actual value on the open market.
There are also many examples of assets in real life with value that give no income, for example jewelry, TV's, i.e. things that give people non-monetary benefits.
But I would say that in the commercial world that most assets are valued based on cash-flow, or rather the maximum cash flow that the asset could generate over its whole range of uses. Things like property are a good example because one business may lose money on it, but there are endless other businesses that can utilise it and generate returns from it, hence it retains value very well.
Highly specialised equipment may be one example of something that wouldn't hold its value, other companies may not be able to integrate it into their operations, hence it is only worth either what cash it generates for its current owner, or as scrap.
Every company is different and its one of those things thats hard to generalise and you need to look at the exact assets of every business and then determine what the true value is to you as a shareholder.
Great post Nate, but I have one question, you said you don't bother to look at reproduction value... but if I can't reproduce an asset and I want to buy one I will have to pay a premium (some price above book value)exactly because I can't reproduce it. Thus, it makes sense to calculate the reproduction costs (for investment purposes).
ReplyDeleteIn Greenwald's book, he mentions that he calculates reproduction value because it gives him a point of reference. He compares reproduction (asset) value with his best guess of an earnings power value. If the earnings value is higher than the reproduction value, it's possible that you're looking at a franchise. If not, it's likely that you're looking at a company that is not well run, or a commodity business like making toasters. Intuitively, a company with EPV > asset value has a high ROIC, which to me is the most important characteristic of a great business. I agree with your point that as a valuation technique, reproduction value is near useless. I wouldn't buy a company because it has a high reproduction value, but it does help us paint the picture.
ReplyDeleteKeep it up, Nate! I enjoy reading your posts.
Up to me to dissent again, eh? :)
ReplyDeleteThere's a difference between being a passive, minority shareholder and being a control investor (whether de jure or via one's ability to organize other minority shareholders). So, we should analyze the gas station example from that perspective.
To the passive outside, passive minority shareholder in that going-concern enterprise, with you as the controlling owner, the gas station is valueless and/or a drag: intrinsic value is what present value of the cash that can be reasonably be expected to be received from the business. You don't seem inclined to sell it and we know already (from the discussion in the prior post) that we're avoiding businesses that are at risk of bankruptcy, so there's not catalyst on the horizon.
What would a value oriented business oriented person pay for that gas station in a private transaction -- if you controlled it and didn't sell it or put it to good use? Nothing. Putting my own real world glasses on, you'ld asking me to lend you money but only if I bear the 10% interest expense and with no deadline as to when you'll pay me back. No, thanks!
What abut the price of a low cost option, just in case something happens one day? Yes, that has some value but it's predicated on ifs and buts (when? how much? etc) and meanwhile you're paying a carry of 10% in opportunity cost. It is the rare circumstance that one knows for sure that the NPV of the maybe one day scenario will trump that hurdle rate. And if one doesn't know, then one is speculating.
Not that there's anything wrong with speculation: rational investing of the "I know what this is worth" variety is tedious in the extreme and all of us, I think, try to spice it up a little bit with some risk, each in our own way: the so-called "hidden asset", the proxy fight, the complicated back story, the confusing accounts, the business model puzzle, the falling knife, the now very famous company that I bought back when it was a penny stock, etc. It's dressed up as risk/reward, of course, to give it some gravitas, but, at bottom, it's just speculation - hopes, maybes, and you-never-knows.
If there's a known, definite catalyst on the horizon, however -- a 363 sale, etc -- then, of course, the gas station has value. Potential value becomes actual value and the game is on. Like most (all?) small cap value investors, I have a list of these companies and keep them on a watchlist; they become investable if/when a catalyst appears.
Safe doesn't mean cheap, imo.
On reproduction value: if one cares about earnings power one'll care about what it costs to reproduce the business. If one wants to understand the causes behind hollowing out of the industrial midwest (or "up north", in England), or the death of Circuit City, or what Coke will be earning 10 years from now, a large part of the answer to each is to be found in reproduction cost.
@red:
DeleteI don't think Nate disputes your claim that the gas station is worthless to an OPM. He is arguing it has value to a control investor. This fact is indisputable. The question is: will the current owner sell the company at a reasonable price. The gas station has value, it is simply hidden by a disinterested owner.
Reproduction value is also useful in your car dealership example: imagine the dealers' strip has an available empty lot next to an existing dealership the owner is ready to sell. Then you need to know the reproduction value (net of the lot's cost) to decide whether you buy from the incumbent or start from scratch, because it would be silly to buy the existing dealership if the seller wants to sell it for (much) more than it costs to build your own showroom on the empty lot, get staff and build up a customer base.
ReplyDeleteAlso: reproduction value is not about reproducing the exact same business, but about how much it would cost to reproduce a business producing the same output/product, using the best current methods, people, and location, which may be very different from what the incumbent you're trying to value is doing. This capture your legacy industrial location example, among other things.
ReplyDeleteFrom the perspective of some who think that assets without cashflows are useless, would you ever purchase Berkshire Hathaway stock? (the purchaser of Berkshire in the market has to be bailed out by the market and not by cashflows from the business.) I think there are inconsistencies in that logic.
ReplyDeleteI think reproduction value is a worthwhile valuation metric to use because it is similar to the process that a company will go through in order to decide if they should acquire a company or attempt to create a similar company. Apple just introduced a pandora-esque product. They likely made an analysis of whether or not it would be cheaper to create the pandora-esque system or to acquire pandora.
Warren Buffett did a similar analysis with Coca-cola. If he had more than enough money and the best management in the world could he properly compete with coca-cola, was the kind of analysis he made before he purchased the stock.
Martin Whitman in his latest book explained that he didn't really get why people blast book value but go on to use ROE and other similar ratios. He also stated that book value also gives a good report on the earnings power of a company because there is such a thing as retained earnings. So if you think earnings signify value it is likely that you should think that retained earnings do the same.
Book value may not be worth while in a way because everyone mostly focuses on earnings and cash flow and not necessarily on restructurings. But it can come in handy to certain companies like utilities, banks, investment companies and certain conglomerates from a simple going concern perspective. In many restructurings NAV is a better metric than cash flow analysis. There is likely less of a range of value in NAV than in DCF calculations.
I don't think anyone could deny the credibility of NAV in a situation where a company is trading below NAV with a catalyst for example LMCA trading at an obvious discount before it spun of Starz. Or closed end funds trading at a discount with a catalyst. I remember hearing that Ben Graham advised a family member of his to only invest in closed end funds that were trading at a discount of something like 15-20%. Martin Whitman in his latest book suggests that people view NAV in both the static approach and the dynamic approach. Without a catalyst an investor should probably diversify more heavily.
Ok, you cover a lot of ground in your note. Good post.
ReplyDelete"From the perspective of some who think that assets without cashflows are useless, would you ever purchase Berkshire Hathaway stock? (the purchaser of Berkshire in the market has to be bailed out by the market and not by cashflows from the business.) I think there are inconsistencies in that logic."
This is an interesting point about non-dividend paying stocks in general. Here's how I think about it -- I distinguish assets that CAN generate cashflow vs. assets that WON'T generate cashflow. How do I know the difference? My own personal judgement of the agents' intentions.
If the discount to intrinsic value (I view NAV a little differently because it's a snapshot of today, so can be growing or shrinking depending on RoE) on the asset is sufficiently high, Warren Buffett will buy back Berkshire stock with the cashflow generated by his businesses. For other non-cashflow assets run by Controlling Shareholders who would refuse to *ever* sell the asset to another buyer or refuse to issue dividends / repurchase shares, I would value that asset at _zero_. Yes, I know that seems absurd, but it also seems equally absurd that a Controlling Shareholder would exist that would refuse ANY transaction no matter the price or issue dividends / repurchase share.
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Nothing to add on your other comments. I agree with all of them.
Great post, you make a lot of valid points that I agree with.
ReplyDelete