Assessing the Intrinsic Value of Firms
Earnings Power and Asset-based valuation tools to help investors assess the intrinsic value of firms taking into account the business cycle
Earnings Power-based segmented valuation approach to provide a better assessment of value by separating more certain sources of value (assets and current sustainable earnings power) from more uncertain sources of value (i.e. from future growth)
Sensitivity Parameters and Scenarios to help investors consider the likely range of outcomes for intelligent investing
Valuation is not an exact science. Given the inherent uncertainties in a business, we need to consider the likely range of the firm's intrinsic value taking into account its performance across the business cycle.
Our approach to valuation can be summarized as helping remind ourselves and our users to remember the following insightful quotes:
And this is the reason why:
1. we are upfront that the base quantitative valuation should be used as a starting point to be refined with human judgment
2. present key assumptions driving valuation in their historic context
3. try hard not to convey a false sense of precision with any of the key drivers, and
4. depict intrinsic value as a range and not a singular number.
As such, we provide multiple valuation models along with heuristically selected parameters as starting points for conducting valuation assessment. Broadly speaking, we provide two sets of valuation models:
• Asset-based valuation models: to help assess the intrinsic value of firms that are in decline or have unpredictable earnings or do not have much in terms of earnings power
• Earnings power-based valuation models: to help assess the intrinsic value of firms that have reasonably predictable earnings power as well as adequate financial history to make educated assumptions about their future prospects
Earnings Power-based Valuation (EPV):
As our objective is to help investors discover and assess high-quality companies with strong balance sheets and robust business models, let's first look at the Earnings Power-based valuation approach popularized by Dr. Bruce Greenwald (as high-quality companies tend to have more predictable earnings).
Much of the EPV based approaches available elsewhere focuses on valuation without the growth component. We have combined Dr. Greenwald's EPV (no-growth) model with a two-stage growth model. We recommend this approach as it provides investors a segmented perspective on the drivers and sources of value across assets, (current) sustainable earnings, and (expected) future growth which by definition is uncertain. Let's consider the following likely scenario for GOOGL (Alphabet Inc):
The platform provides historical context around the various value drivers (sustainable revenue, operating margin, tax rate, etc. as seen on left side of picture above) for GOOGL across its business cycle - so the user can get a sense of the scenarios that may arise. The platform handles the calculation mechanics so users can invest their time to consider the firm's historical record and more importantly its future prospects and value drivers.
However, the scenario presented above is only one of the likely scenarios and we need to carefully consider a range of likely outcomes prior to investing - including the fact that GOOGL despite its phenomenal growth across the past decade, still derives most of its revenues (> 80%) from advertising which is a cyclical industry. Our platform presents an initial set of scenarios for the investor to carefully consider and calibrate as shown below:
As you can see from above, this segmented approach provides a better assessment of value because it separates the more certain sources of value (namely, assets - which are most certain, followed by value derived from current estimate of sustainable earnings) from the more uncertain sources of value (i.e. those expected to be derived from future growth).
Patient preparation and disciplined investing in high-quality companies when they are available closer to their more certain sources of intrinsic value can be very profitable.
For instance, investing in GOOGL earlier in the year (when it was around $1000) would have been a very good investment - as it would have meant paying very little for its future growth across most scenarios.
Let's take another example, CRTO (Criteo SA) - a technology company specializing in digital performance marketing that has had a good run but is facing significant uncertainty regarding its future because of multiple privacy-related developments. In the case of CRTO, the uncertainty is not just about future growth but also includes anticipated decline in its sustainable earnings power. Let's consider a rather pessimistic scenario for CRTO as shown below:
What is interesting is that, irrespective of what you think/thought of the future prospects of CRTO - there was a period of time earlier in the year, when CRTO despite generating positive FCF (and with FCF/Sales above 10%) was selling below $6.65 (i.e. below its Liquid Assets net of Debt per share) and as recently as a few weeks back at a good discount to the Earnings Power Value (without any growth) in the above scenario.
Now, this is not to say that companies do not misuse and/or deplete their asset base - we all know of companies that have burned through cash because of their misadventures and/or disruptive changes in their business environment.
Our primary focus is on high-quality companies with predictable earnings power. However, we provide asset-based valuation models as they are useful in considering intrinsic value of firms that do not have predictable earning power.
Asset Liquidation Value model can be useful for assessing the intrinsic value of firms in unsustainable/declining industries. Asset Reproduction Value model can be useful for assessing the intrinsic value of firms that are undergoing temporary (or intractable) challenges but are nevertheless in stable industries.
The platform provides a set of scenarios with pre-defined factors set for various asset classes. These factors can be calibrated with human judgment based on the peculiarities of the firm and the industry in which it operates.
For e.g. inventory liquidation within retail will almost always be at a significant discount as compared to that of a firm in mining. Similarly, even within an industry, say technology, the discounts (or in rare cases premium) to book value of Goodwill & Intangible Assets can differ widely based on the utility/value of a firm's patent portfolio.
As an example let's take DRQ (Dril-Quip Inc), one of the (few) very well-capitalized firms in the Oil & Gas Equipment & Services industry. Its earnings power has declined steeply over the past few years and applying asset-reproduction valuation can give us a sense of its intrinsic value (as its strong balance sheet makes bankruptcy/liquidation highly unlikely). Also, given its strong balance sheet, we can make some educated assumptions on its EPV taking into account the business cycle.
However, to be upfront, we do not engage ourselves in determining when a commodity cycle would turn - and rather prefer to invest in more predictable high-quality companies.
As a final note, this blog was primarily about introducing the valuation capabilities in the Cognitive Quant platform and as such, much of the article earlier was purely focused on valuation without much consideration about anything else. However, in practice, valuation has to be considered in conjunction with business risk and opportunities before determining a price point that provides a sufficient margin of safety.
Invest in high-quality companies with strong balance sheets and robust business models when they become available closer to their more certain sources of intrinsic value.
Please note that none of the discussion above should be construed as a recommendation to buy, sell, or hold any of the securities discussed in this article.
You can read more about our platform and philosophy in an earlier post. Please reach out to us with your questions / comments / inputs below or using contact us form on our website.