Over the past ten years, I’ve participated in both the public and private markets, investing in over 50 late-stage private companies, early-stage startups, and pieces of real estate. This is how I’ve learned to evaluate investments.
Successful investing boils down to buying assets at a discount to intrinsic value. The greater the discount, the more likely the investment will perform. Benjamin Graham, the father of value investing, called this “margin of safety.” The concept is simple in theory and extremely challenging in practice, with the valuation process anything but straightforward.
Two highly-educated, emotionally stable, and reasonable people can view the same information and come to very different conclusions. People weight information differently based on their preferences, values, and experiences. Some are comfortable tolerating certain types of risk. Predictions differ and forecasts can be wildly divergent. Those differences create the market. As just one participant in the market, here’s how I evaluate a company’s intrinsic value.
I always start by understanding what I call owner earnings, which I define as:
Owner Earnings = Net Income + Non-Cash Expenses (Depreciation, Amortization, Depletion) + One-Time Charges – (Maintenance Capital Expenditures + Working Capital Needs)
Said another way, owner earnings are the profits left over after necessary expenditures that owners can discretionarily spend, save, or reinvest. Blindly following the formula can easily provide false precision and a false sense of security. It’s merely a simplified starting point.
Depreciation and capital expenditures rarely reconcile easily, due to irregular spending patterns in response to the business cycle. The goal with those two items is to understand what spending is necessary to maintain the capacity and competitive position of the business, and if the company is doing so responsibly. It’s easy to dramatically boost net income by halting necessary reinvestments, the consequences of which won’t be noticed immediately. I see this in the private markets all the time. To the chagrin of sell-side “helpers,” depreciation is a real cost and should be looked at as merely the repayment of prior capital investments. It’s not “free” if you’re just being paid back. Depending on the nature of the assets, depreciation usually represents the average recent capital expenditure rate.
Although frequently grouped with depreciation as a non-cash expense, amortization is a different beast. Hard assets are depreciated. Intangibles are amortized. This distinction is critical in understanding cash returns. A large depreciation rate means the business is likely capital-intensive. High amortization means the business has probably been acquisitive and the difference in tangible book value and purchase price is being amortized. Therefore, amortization can usually be counted on to deliver higher post-tax returns, without necessary re-investment.
Special income/losses require particular scrutiny. If earnings are going to be distorted, this is usually where it happens. It never fails to amaze me how creative some get with what counts as “special.” In my experience, every business has a consistent barrage of non-recurring expenses. The causes behind those expenses may vary, but the total usually remains in a tight range. That range should be deducted from earnings.
Another important consideration is asset intensity, or how much past investment has been made to create the earnings. There are two very different ways to view asset-intensive companies. The first is the possibility that it creates a backstop for valuation. If you buy a company (or a share in it) with a large asset base relative to valuation, the worst-case scenario, failure and liquidation, can be reasonably calculated. The trick is to properly value the assets in a forced-sale situation, which almost always results in a very significant discount.
The downside to an asset-heavy business is re-investment requirements. Most would say that a business consistently netting $10M per year is a “good business,” but that fact alone leaves an incomplete picture. How would your view of the business change if I told you it had $150M of assets? This means that over the course of the business’s history, the owners invested at least $150M to produce that return. That’s a little less than 7 percent return on assets. Not great. What happens to owner earnings if the business grows and the investment rate remains steady? It would require about $30M in additional reinvestment to generate $2M of incremental profits, which isn’t a stellar tradeoff.
But a business’s economic worth goes beyond its assets and should always be centered around the owner’s benefit. Two common metrics are return on equity (ROE) and return on invested capital (ROIC). Both measure the profitability of the company based on the owner’s money it consumed, but in slightly different ways. ROE only takes into account the equity investment, while ROIC includes the total investment made, including debt deployed.
The difference between equity and assets is the use of debt, which is a tricky topic. Employing leverage always amplifies the outcome, good or bad, and the nature of thebusiness determines how intelligently debt can be used. For instance, railroads and banks have a low return on assets, yet are considered by many to have excellent potential based on their abilities to employ debt responsibly. Before you start thinking about writing a sarcastic comment about banks, leverage, and the crisis of 2008, let me explain a little further. Debt can be easily mismanaged and the line between responsibility and recklessness is not always apparent, especially when incentives aren’t properly aligned. With that said, many banks didn’t need to get bailed out in 2008 and remained excellent investments for their owners.
Many investors like to discuss the business’s competitive advantage(s) and a common term to summarize those is “moat.” A business with a moat, especially one with alligators in it, demonstrates its superiority by generating above-average returns on invested capital for an abnormally long time, which drives superior shareholder returns and reduces the risk of competitive destruction. Moats come in a variety of forms and range from branding or process-driven efficiency, to patents or contractual agreements. The trick is to understand why a company can produce profits and estimate the durability of that advantage.
The final quality I look for in a business is that it invests its capital well. The decision-making process around opportunities is called capital allocation, or how the company’s leaders decide to direct resources in the pursuit of returns. There are two big questions about these decisions: 1) How many high-confidence, high-return opportunities exist? 2) What is the company’s track record for making value-creating asset allocation decisions? The first question is what many call “runway,” or the size and time-frame for high-return reinvestment opportunities. The bigger the better. The second question revolves around the confidence and perspective of management. Some companies have long histories of making value-destroying, vanity decisions that boost top line and kill investor returns. Other companies make value-accruing decisions, with the occasional and understandable stumble. The ultimate investment is in a company with a long runway and management that has a history of making consistent, wise decisions. It may sound simple, but it’s incredibly rare. How important is this trait? I’ll let Warren Buffett explain:
“The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.”
The last piece of the valuation puzzle is earnings yield, or the projected cash-on-cash return based on the proposed valuation. For instance, a business bought at a 10X multiple of net income yields a 10% post-tax return in a steady, zero-growth state. Multiples differ depending on the buyer’s assessment of earning quality, growth projections, sustainability, and ultimately opportunity cost. The higher the multiple, the higher the expectations for future growth of owner earnings.
Valuation is a process that is best learned through experience and study. While no two investors share the same method, I hope a peek inside my perspective helps shape your methodology. I’ve included a brief list of resources below that have proven helpful in my journey.
*One area I intentionally glossed over is time-cost, which can range from irrelevant to incredibly important. An investor only has 24 hours in a day. Some investments, like early-stage startups or small late-stage companies, can require massive amounts of time and effort to generate and protect returns. Most public investments don’t give the investor the option for involvement. It’s important not to discount time-cost and factor it into your investment formula.
Memos from Howard Marks: Incredibly thoughtful discussions around risk, financial engineering, and investing.
Berkshire Hathaway Annual Letters: There’s a reason you know him. You should go to the source.
Charlie Munger’s Quotes: Thanks to Tren Griffin, you can read what Buffett’s partner has said over about seventy years of investing.
Writings of Jason Zweig: Jason offers a disciplined and contemporary perspective on the markets, valuations, and how businesses should be run. His Devil’s Financial Dictionary is one of the most amusing and insightful works I’ve ever read.
Articles by Morgan Housel: I find Morgan’s work insightful and precise, which is certainly a rarity in the world of finance.
Written by Brent Beshore, this post originally appeared in Forbes.