What You Will Learn
- How to use the EPV and improve your investing
- How you can calculate the EPV to value stocks better
- What the disadvantages of EPV are
It took me a year or so to purchase the book and then another month or so until I finally got around to reading it but Value Investing: From Graham to Buffett and Beyond is definitely a great addition to the serious investor. Rather than a “book review” it’s more of a discussion on Greenwald’s valuation methods.
If you are new to investing or lack confidence in reading the financial statements and making adjustments to the numbers, then skip this one for now and try looking into either F Wall Street or Five Rules for Successful Stock Investing.
The book is broken down into 3 parts.
- Part 1: Introduction to value investing
- Part 2: 3 Sources of Value
- Part 3: Profile of 8 value investors
After reading a few sentences of part 1 and part 3, I immediately skipped over it. Nothing new to add to the already vast quantity of books defining value investing, the pros and cons of DCF, and some background info on value investing greats.
The sole reason I bought the book was for part 2 alone so let me get on with it.
Part II: Three Sources of Value
The section starts off with why DCF valuation is unreliable, and then goes over a 3 step valuation technique to mitigate the risk of making too many predictions associated with discounted cash flow analysis.
The three described are:
Benjamin Graham’s asset valuation.
Basically the same as Graham’s Net Net Working Capital asset valuation except Greenwald includes some adjustments to the balance sheet to include other assets such as property and goodwill in special cases.
Greenwald also refers to this as the Reproduction Value.
It is called reproduction because it is the amount a competitor would have to pay to obtain all of the required assets in order to be able to compete.
e.g. (Just using any wild number as an example) If I was to go through the balance sheet of Coca Cola and came up with an adjusted (reproduction) asset value of $100 with a market value of $300, an upcoming Pepsi will see that he only has to invest $100 to create an enterprise with a market value of $300. Just a crude example but I hope you get the point.
Earnings Power Value
The formula for Earnings Power Value is based off Graham and Dodd’s earnings assumptions that current earnings correspond to sustainable levels of distributable cash flows and earnings level remains constant. You will see that the formula also ignores growth. There is no variable for growth.
EPV = Adjusted Earnings x 1/R
EPV provides an intrinsic value by smoothing out earnings to ignore one time charges, resolve discrepancies between depreciation and amortization and capital expenditures, making adjustments based on the business cycle and other details which involves more hands on work.
Sounds simple enough, but you’ll have to work through the income statement to get a proper number for earnings.
When you arrive at an EPV for a company and if the value is lower than the reproduction value, you know that management is doing a bad job of using its assets to produce the level of earnings it should.
The second case is when EPV = asset value. This will occur in industries where there are no competitive advantages.
Lastly, if EPV exceeds asset value, you’ve likely found a company that has competitive advantages.
Take KO as an example again. Above I mentioned that the asset value was $100 but the market value was $300. The difference of $200 is the competitive advantage it has over the competition. Pepsi may think it can reproduce the same type of results but the advantage KO has on the industry makes it virtually impossible to topple it off the top.
Value of Growth
Growth as a variable isn’t emphasized in the book as it leads to a lot of uncertainty but he goes on to discuss how growth can lead to economic destruction or added value.
This is because growth has to be supported by additional assets and to get those additional assets, you have to use the distributable cash which will reduce the value of the firm. If the company doesn’t have the competitive advantage, then the returns off the new investment will only be enough to offset the cost, effectively making it a zero gain.
Disadvantage of EPV
I like the fact that EPV doesn’t consider growth or too many variables but the one problem that I see with Earnings Power Value is that it uses earnings. While DCF has many variables, using the free cash flow numbers in my opinion will always be better than earnings.
e.g. Enron had great earnings all the way up to its collapse but FCF foretold the troubles long before the scandal surfaced.
But since the whole purpose of the book is to first go through the assets, followed by the EPV and then considering whether growth adds value, I would say it’s a solid stock valuation method.
Great Book to Study
The characteristic of great investing books is determined by the clarity of the examples and how well it leads the readers through the examples.
Value Investing: From Graham to Buffett and Beyond does a great job.
It goes through the 3 step valuation process for WD-40 and Intel in a very detailed step by step process. Definitely not a book you can read just once or without a pen and paper. It’s more like a mini-text book or a study guide to value investing but work through the book taking notes and highlighting key points and you’ll be on your way to mastering another great valuation method.
Also a good idea would be to go through the book with Bruce Greenwald’s EPV lecture notes on the topic. The diagrams and point form will help out in the understanding.