CFA Digest June 2014 Volume 44 Issue 6

A Novel Equity Valuation and Capital Allocation Model for

Use by Long-Term Value-Investors (Digest Summary)

Myuran RajaratnamBala RajaratnamKanshukan Rajaratnam Journal of Banking & Finance

Summarized by Isaac T. Tabner

Abstract
To capture the investment wisdom and stock-selection approach of Benjamin Graham and Warren
Buffett, the authors derive a valuation model. Their model is distinguished from other valuation models
by its treatment of the expected competitive advantage period (ECAP). Each year, the ECAP is
assigned a subjective probability of termination that is independent of the business cycle.

What’s Inside?
Through their valuation model, the authors provide a structure for analyzing the success of long-term
value investment strategies applied by Warren Buffett and Benjamin Graham in a two-asset setting that
includes cash and stocks. Assumptions underpinning the efficient market hypothesis (EMH) and the
capital asset pricing model (CAPM) are relaxed, and the authors aim to reconcile the wisdom of
Graham and Buffett with mainstream financial economics. Tiger Brands and Campbell Soup Company
are used to illustrate the model, and a comparison between Apple and Coke illustrates the rationale for
allocating different expected competitive advantage periods (ECAPs) when valuing these two firms.

How Is This Research Useful to Practitioners?

Determining a sustainable level, growth rate, and lifespan of competitive advantage is challenging
when valuing growth companies. The authors present a useful—albeit subjective—framework for
determining this valuation by incorporating an ECAP into their model and illustrating how the ECAP
might arguably differ between such different categories of firms as Coke in branded goods and Apple in
consumer technology. As with other absolute valuation models, application of the authors’ approach
does not require the existence of a market; thus, it is suitable for many kinds of enterprise, including
private firms.
The authors’ findings emphasize that value and growth should be viewed synonymously, rather than as
the discrete and diametrically opposed strategies implicit in such settings as the Fama–French three-
factor model. Furthermore, the authors argue (1) that Benjamin Graham’s margin of safety is the only
tool that works when investors are faced with Knightian uncertainty, where the probability distribution
of outcomes, or even the existence of some possible outcomes, is not known; (2) that valuation
techniques are most useful when used to produce range estimates (i.e., probability distributions) rather
than point estimates of value; and (3) that contrary to the assumptions of the EMH, value gained does
not always coincide with the price paid.
When judging the ECAP, the authors argue that it is best to think in terms of the business moat, its
durability, and the extent to which management efforts of the investee firm can be productively used to
reinforce it. Finally, they argue that successful evaluation of the margin of safety—and hence,
mitigation of Knightian uncertainty—requires identification of resilient business moats and that
investors are most likely to achieve this result when remaining within their spheres of competence.
Overall, the greatest benefit to practitioners lies in the provision of a disciplined framework within
which to formulate inputs to conventional valuation models.

How Did the Authors Conduct This Research?

This article is theoretical rather than empirical, and only four companies are used to illustrate the
arguments underpinning the authors’ approach. Their intuition and contribution are supported by
citations from Buffett and Graham as well as by mainstream financial economics. The valuation model
is then developed together with a list of assumptions and conditions, followed by the model’s formal
derivation from a standard present value model.
The relationship between model value and ECAP is illustrated using the South African firm Tiger
Brands as an example. Tiger Brands and Campbell’s Soup Company are then used to demonstrate the
evolution of model outputs for each firm over the periods of September 2006–September 2013 and July
2004–July 2013, respectively, and the authors highlight sustained periods of under- and overvaluation.
A trading strategy composed of concentrated portfolios invested in stocks during periods of
undervaluation and of an all-cash allocation during periods of overvaluation is suggested. No empirical
tests, however, are provided for this strategy.

Abstractor’s Viewpoint
The authors provide a helpful framework within which to judge the plausibility of assumptions required
for analysis and valuation. It is one of only a few articles that seek to reconcile growth and value
investing by developing the insights of Graham and Buffett within a rigorous theoretical framework.
Further research could be directed at empirical tests of the model. As in all models, overapplication will
result in excess returns being arbitraged away, although the necessity of holding only cash for extended
periods may delay this process in cases with a prevailing institutional focus on short-term results.

About the Author(s)

Isaac T. Tabner
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Additional Information

Published by CFA Institute

https://doi.org/10.2469/dig.v44.n6.6

ISSN: 0046-9777

Original Publication
RajaratnamMRajaratnamBRajaratnamK 2014 A Novel Equity Valuation and Capital Allocation Model

for Use by Long-Term Value-Investors Journal of Banking & Finance 01 Feb February 

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