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I’ve been focusing a lot of my time for the past 3 weeks dissecting and reverse engineering Bruce Greenwald’s earnings power value EPV method and it’s time I performed a stock value calculation based on EPV.
Microsoft (MSFT) will serve as a fine example since you know the history of the company and what it does. I’ll then compare the EPV valuation price with a DCF value calculation and Benjamin Graham’s formula. I’ll try to add as much information for those that haven’t read Greenwald’s EPV book.
The valuation technique of earnings power value requires the investor to consider 3 things.
In respect to no.1 let’s say a company is currently in the business of selling inkjets for printers. The company has a market value of $1m but when we analyze the assets we find out the company assets are worth around $500k. This means that if I was able to reproduce the same assets for $500k, I should be able to create a company that is valued at $1m in the market.
Applying this idea to Microsoft, the first step is to adjust the balance sheet. My initial mistake with this step was to look at discounting most of the items such as inventory and intangibles, but that isn’t the purpose of the asset reproduction. We are trying to get to a figure that a competitor will have to realistically pay up in order to enter the market. This is why I’ve left mostly everything in tact because for another software company to compete with Microsoft’s Windows operating system, office suites and increasing Bing market share, a company will have to fork out money for intangibles and goodwill in order to acquire technology and other company’s intelligence.
The only adjustment I made was to reduce goodwill by 50% because I know that Microsoft haven’t made the best of decisions regarding prices paid for acquisitions and the current balance sheet does not reflect Microsoft’s stake in Yahoo yet.
So the new adjusted asset value is $68,916 million.
Step two. The next step is to realize that for a company like Microsoft, there is going to be value added to the company coming from its marketing and R&D. No competitor will be able to compete if they do not try to spend money to increase brand awareness and on R&D efforts.
Some companies will spend very little for both aspects and it can be ignored but to ignore for MSFT would be a mistake.
The amount of marketing added back to the asset value above is calculated by
Taking the average of marketing, general, administration (MGA) as a % of sales for the most recent 5 years and then multiple the % to the current sales figure.
We do the same thing with R&D except for a company such as MSFT, R&D will be a very valuation asset.
The book describes a few ways of going about it but I just simply
take the sum of the past 3 years of R&D and then take 80%.
The number that I use can be understating the reproduction cost as the competitor could need more than 5 years of R&D in order to be competitive but that’s up to you to consider.
Finally, add the marketing and R&D value of $17,631m and $17,495m respectively to $68,916m we got in step one to get $104,403m.
Something else to remember is that although off balance sheet liabilities are liabilities, a significant part of that will also have to be reproduced by a new entrant in order to start business.
E.g. VVTV may be just another home shopping company but for a new competitor to enter the market, they will have to spend money on carriage licenses and other network equipment and licenses that will sometimes not appear on the balance sheet. It may be a liability when valuing the business as a standalone, but when considering what a competitor will have to pay, it should be included.
The final step to calculate the net reproduction cost is to subtract non interest bearing debt and the cash not required to run the business.
Non interest bearing debt is really spontaneous liabilities. Total liabilities isn’t used because it could also include items that are not related to the business such as liabilities for damages, something a new entrant won’t have to pay for.
The formula I use for “cash not required for operations” is
cash and cash equivalents – 2% of sales
Greenwald mentions a couple of times that in general, 1% of sales is the amount required for a company to continue running operations. I’ve used 2% for good measure for this item.
Subtract non interesting bearing debt and excess cash from the $104,403 figure to get the net reproduction cost of $41,181m which is equal to $4.63 per share.
This means that a new potential competitor will have to spend around $41billion in order to compete with Microsoft.
But you don’t just finish off with a net reproduction cost, you now have to calculate the EPV and compare it to the reproduction cost to determine the company’s competitive advantage.
In the asset valuation section, you had to make adjustments to the balance sheet and now we’ll have to make adjustments to the income statement to come up with an adjusted income.
The concept is very similar. Start off with EBIT, and start working through items and decide whether to add it back or ignore it.
(click to enlarge)
First step. Start off with operating earnings, i.e. EBIT. Find out if there are any one time charges and add it back. I haven’t bothered to go back to the reports with this analysis.
In the image above, you see that the EBIT margin from 2005 to 2008 is around 40% while 2009 is at 33.9%. You can adjust this to say that Microsoft is likely to have an EBIT margin of 40% based on regular business conditions and enter 40% into the yellow box on the right side under user input, or you can just continue along with the current numbers.
I’ll just continue.
Second step is to add a certain percentage of SG&A and R&D back to earnings. I prefer to keep things simply by adding back 25% for both. This now leaves you with what we call Adjusted EBIT. Compare the adjusted EBIT percentage margin to the stated EBIT margin.
Third step is to apply a tax rate to the adjusted EBIT. Since EBIT is earnings before interest and taxes, if we pay taxes on EBIT, it now simply becomes earnings. Which is represented by the Adjusted Earnings After Tax line in the image above.
Fourth step you add back in a certain amount of depreciation and amortization. The best thing is to be familiar with the business and industry to accurately assess the equipment needed and how fast it loses value etc. The easy way would be to add back 20% of D&A as I do.
When you do all those steps, you finally come up with an Income as Adjusted number. What I do, along with all of the other valuation techniques, I smooth out the data by taking multiple year snapshots and then taking the median of these timeframes. This way I come up with a normalized adjusted income to ignore business cycles and the occasional overly bad or good year.
So with the normalized adjusted income you subtract maintenance capital expenditures and divide by the discount rate. I used a simple 9% in this example. I don’t bother with WACC as it is seriously flawed due to its dependence on beta.
The result is the EPV, which is the value of the company based on current earnings and ignoring growth. But there is one last step.
Lastly, add to the EPV value Cash-debt because operating earnings ignore the interest on cash balances so you have to add the surplus cash to the EPV.
So the EPV of Microsoft is $24.36 and the reproduction value is $4.63.
What does this mean?
It means that the $19.73 difference is the competitive advantage enjoyed by Microsoft. Refer to slide 18 of Greenwald’s EPV lecture slide.
According to the DCF calculator, using the same 9% discount rate with the along with the default calculation of 9.2% growth gives an intrinsic value of $27.91.
Remember that I haven’t bothered making any changes to any of the inputs throughout this entire analysis. Everything is just based off automatic calculations so you could fine tune your results if desired.
In this case, the normlized earnings (EPS) growth by Microsoft over the past 10 years has been at 13.8% with normalized earnings at $1.01. Applying Benjamin Graham’s formula, the intrinsic value comes out to $30.04.
Reproduction value of $4.63 shows that Microsoft has a big competitive advantage.
EPV of $24.63 is the stock value based on current financial results.
DCF valuation of $27.91
Benjamin Graham valuation of $30.04
Seems like all three match up well and I can confidently say that Microsoft is fairly valued between $24 and $30. The company is currently trading at $25.26 which places it smack into the fair value range.
EPV is a great valuation technique but shouldn’t be used just on its own. Compare it with other valuation methods and it’s a great addition to any investors knowledge base.
And just before people start asking about when they can receive the updated spreadsheet, all premium buyers will be receiving it in October. If you don’t have it yet, get it before October when I raise prices. More on this later.
View the pdf below or download the file from scribd.
Microsoft MSFT Stock Valuation Calculator Spreadsheet