Given the recent ascendancy of behavioural economics and the cult following attached to Warren Buffett, most investors in India now acknowledge the complexity of determining “fair value”. Most methods of valuation are inconsistent—not only are they constrained by the assumptions underpinning the technique, they often fall prey to over-simplification. The only universal truth in this quest for value seems to be that price and value are inversely related!
Benjamin Graham’s contribution to quantifying value remains unsurpassed even though his efforts go back to the 1920s. In The Intelligent Investor, Graham proposed a formula for calculating intrinsic value (V) such that V = EPS times (8.5 + 2g). In effect, he believed that 8.5 was a fair PE multiple in the absence of growth.
Peter Lynch asserted that fairly priced companies should trade at a PE multiple equal to their earnings growth. Interestingly, Lynch’s calculation must always be considerably lower than Graham’s estimate of intrinsic value, provided expected growth is positive. The PEG ratio is obviously meaningless when growth is zero!
Graham felt that the best proxy for g was the average annual growth of EPS expected over the next seven to ten years. Quite apart from the fact that this formula is highly dependent on divining future earnings growth, Graham acknowledged that it failed to take note of changes in the interest rate. Recognising this inadequacy, he refined his methods to arrive at a new formula: V = [EPS times (8.5 + 2g) x 4.4]/Y. Graham explained this as being related to an AAA corporate bond yield of 4.4 percent at the time he originally derived the result and the need to have V vary inversely with changes in the interest rate. Graham was the first to point out that the multiplier failed to account for the company’s financial structure and competitive position. Hence, for his method to work it needs to be restricted to businesses that “meet criteria of financial soundness”. Finally, he added that growth estimates need to be fairly conservative if the method is to confer a margin of safety. Even though the method is rudimentary and there is no justification for the constants, it remains an excellent way to understand the rate of EPS growth being discounted in the current price and the sensitivity to a deteriorating macro-economic environment.
Professor Bruce Greenwald urges investors to use a range of valuation methods instead of depending on a single approach in his book Value Investing: From Graham to Buffett and Beyond. The three techniques that he outlines are the asset method, the earnings power method and the profitable growth method. In effect, the first approach combines three concepts—book value, liquidating value and reproduction value.
Reproduction value is based on guidelines for adjusting each element of the balance sheet to reflect the amount “a competitor would have to pay to replace them today, at the currently most efficient way of producing them”. Rather than whittle down book value, the strength of the reproduction cost idea is that it explicitly adjusts for elements that generate future cash flow, such as R&D and brand building.
The earnings power value method is a single-stage DCF (discounted cash flow) with special emphasis on adjusting the reported earnings in order to arrive at a figure that represents the cash investors can extract from the firm and still leave it functioning as before. The method is highly sensitive to the choice of a “risk-free interest rate” and an assessment of the riskiness of the business in relation to other investment alternatives. In effect, the earning power valuation amounts to EPV = C x R/r where C is capital employed in the business, R is return on capital and r is the cost of capital.
In the third method, the underlying assumption is that the business grows at a fixed rate, g. In addition, this method modifies the earnings by reducing from it an estimate of the investment needed by the company to provide for this growth. So the value using the profitable growth method is PV = [C x (R-g)]/(r-g). If growth were to be absent (zero), then EPV and PV are identical. So the real question to be asked is when does growth add value? In simple terms, the answer provided by the third method is that growth is valuable when the return on capital achieved by growing exceeds the cost of capital required to fund it!