Bruce greenwald in his book value investing formula

Benjamin Graham adopted an even more conservative approach to valuing assets. He focused on net-net working capital. This is the difference between current assets and total firm liabilities. Reproduction cost of assets We can also interpret net asset value as the reproduction cost of assets. This is the estimated cost of replicating the company. Determining the reproduction cost is more difficult than just estimating book value or net-net working capital. It requires a deep understanding of the company and its industry.

Greenwald notes that realising mispricing in net asset value tends to require some catalyst as well e. Net asset value adjustments Greenwald notes that the investor may have to make some adjustments to estimate the reproduction or liquidation value of assets fairly. Cash should require little adjustment. We can say the same for marketable securities if it is valued at current market prices, and accounts receivables if allowances for unlikely payments are already made.

However, inventories are trickier to value. It depends on the price trend of items and how fast inventory levels are growing. For example, the balance sheet may understate the reproduction costs of inventory if the company uses the LIFO method while the price of items are rising.

Adjustments for non-current assets may be even more substantial. For example, depreciation rules, inflation and the market value of debt can cause reported asset values to diverge significantly from the reproduction or liquidation value. Goodwill may also diverge from reproduction costs if management had previously overpaid for acquisitions. This may include research and development, operating leases, advertising expenses, and business development costs.

In other words, this is the level of distributable cash flows that the company can achieve if it does not grow. Greenwald suggests that to calculate adjusted earnings, the value investor should also remove one-time charges and adjust for discrepancies between depreciation, amortisation and the actual reinvestment required to maintain current earnings.

Furthermore, the value investor should account for non-normal effects in current earnings such as the business cycle. They should also subtract debt and add excess cash to their estimate of EPV to make it comparable to the market price of equity. Its return on capital will equal its cost of capital. For these companies, growth has no value. The solution here is to improve or change management. The important question here is whether such competitive advantages and barriers to entry are sustainable.

For example, free-entry is not synonymous with commodity-type products. There are many industries with free-entry conditions that compete on differentiated goods. Furthermore, companies may be unable to sustain high franchise margins over time. This could be due to economic shock, corporate mismanagement or new entrants that disrupt the status-quo. The value of growth The final step for the value investor involves estimating the value of profitable growth. This stage is most sensitive to assumptions and error.

Greenwald reminds his readers that growth in sales or earnings does not always create per-share value for owners. This is because growth requires reinvestment and additional liabilities. For companies with zero competitive advantages, and industries with no barriers to entry, gains from new investments will be offset by the cost of capital. Only companies with franchise value can create value through growth. The higher the present value of a company whose cash flows are growing, the higher the margin of safety is for the value investor.

The latter is concerned with earnings that are distributable to shareholders if the company decides not to grow. The former is likely to differ because growth requires additional investment. Valuable growth Two factors determine the value of growth. Put in other words, it is when the profitability of incremental capital employed is large. Secondly, value creation depends on how much capital is used to generate franchise returns. For an even stricter constraint, as described in Narrative and Numbers , Professor Aswath Damodaran highlights that long-run growth rate of companies are unlikely to exceed to the nominal growth rate of the economies in which it operates.

Greenwald highlights that there are very few types of competitive advantages. These are demand advantages, supply advantages and economies of scale. Government protections such as licenses, patents and copyrights can confer such advantages as well. Cost advantages describe processes and know-how that are difficult or costly for competitors to access or replicate over time.

Economies of scale Economies of scale, where the average cost per unit falls with each additional unit produced, is another potential source of competitive advantage. Companies that can combine economies of scale with a demand advantage are more likely to create enduring franchise value. The first is the profitability of the incremental capital employed; the greater the amount by which incremental returns exceed the cost of capital, the greater will be the value created by each dollar invested.

The second factor is the amount of capital that can be employed to earn these franchise returns. That depends on how fast the franchise grows. The limits of sustainable growth are some fraction of the cost of capital. As we said, if growth equaled the cost of capital for any lengthy period, the return on capital would be infinite.

We use 25 percent, 50 percent, and 75 percent as three standardized percentages. Based on more algebra, which we have consigned to the appendix, we offer Table 7.

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Greenwald concedes that his preferred methodologies require, in some instances, in-depth knowledge of the business and industry of the company being examined. The non-professional me! In fact, an adjusted future growth rate derived from a number of industry-knowledgeable analysts may be more generally accurate if imprecise.

It just feels like academia making things overly complicated, while simultaneously missing the essence of the subject. Leave it to the academics to dissect all the reasons why, in time-draining detail. The main knock against the book is the whole second half consisting of eight investor profiles.

If I had wanted a book on famous value investors, I would have picked up something by Kirk Kazanjian. The chapter on Warren Buffett is almost exclusively quotations taken from freely available public reports and Seth Klarman has written his own book on investing. Surely, there could have been something else to write about.

So my advice is to soak in the first half of the book and skip the second half entirely. Dig into an annual report instead and start applying what Greenwald has shown you. This article was written by Followers Follow In classic maven fashion, Davy Bui started off a software engineer, toured nationally as a musician, campaigned in elections as a political hack, only to end up a Wall Street junkie -- in short, a solid base to develop a consilience or latticework approach to investing a la Mauboussin and Munger.

The second factor is the amount of capital that can be employed to earn these franchise returns. That depends on how fast the franchise grows. The limits of sustainable growth are some fraction of the cost of capital. As we said, if growth equaled the cost of capital for any lengthy period, the return on capital would be infinite. We use 25 percent, 50 percent, and 75 percent as three standardized percentages. Based on more algebra, which we have consigned to the appendix, we offer Table 7.

To flesh this out, if the return on incremental capital is 12 percent and the cost of capital is 8 percent, a business that grows 2 percent a year is worth 11 percent more than one with no growth.