Business Analysis: Working Paper

One of the questions I have frequently been asked lately is: “How do you analyze businesses?”

I usually respond by noting that determining a company's intrinsic value is a subjective operation.
It is nearly impossible to determine a company's precise value but it is not hard to determine its
approximate value and that is the aim, to be approximately right and not precisely wrong.

With that in mind, I think the following will be helpful to anyone that is interested in learning how
to properly analyze potential investments from a value perspective.

Definition

Value investing in the manner initially defined by Benjamin Graham & David Dodd entails the
strategy of purchasing securities only when their market prices are significantly below the calculated
intrinsic value.

This difference between value and price is thought of as buying with a “margin of safety”

The objective is to purchase a proverbial dollar for 50 cents or less.

While the objective is simple the actual task is anything but. The goal of this paper is to show one
how they can assess with reasonable certainty the approximate intrinsic value of potential investment
targets.

Here are a few of the simplest and most accurate methods which I have personally utilized for the past
five and half years to get one started in determining a company's intrinsic value:

Asset Based Valuation

NCAV (Net Cash Asset Value)

This shows how to calculate the classic “Net-Net” as utilized by the father of value investing
Benjamin Graham himself.

Current Assets-Total Liabilities = NCAV

This is both the simplest and most conservative estimate of a company's intrinsic asset value. As a
rule, Benjamin Graham only looked to purchase company's which were valued at a discount to their
net cash asset value by 33% or more.

Today, value investors are hard pressed to find company's valued at such a significant discount and
would be happy to pay 100% net cash asset value for a company and acquire both its earnings and any
potential growth for free. This equates to essentially paying only liquidation value for a company and
nothing more.
Reproduction Costs

This type of analysis requires much more specialized knowledge about both the business and the
industry in which it participates.

In this instance we attempt to assign a value to each asset on the company's balance sheet in an
attempt to determine what the inherent reproduction cost of all the assets is.

Example:

Assets $ Reproduction Value Value Assigned

Cash & Cash 1,112,000 1,112,000 100%
Equivalents
Accounts Receivable 1,967,000 983,500 50%*
Inventory 52,080,000 34,372,800 66.00%
Capital Assets (Real 22,368,000 3,355,200 15.00%
Estate, Machinery,
Equip)
Intangible Assets 1,545,000 154,500 10.00%
Future Income Tax 108,000 108,000 100.00%
Credit
Prepaid Expenses 3,303,000 3,303,000 100.00%
Forex Contracts (Used 70,000 0 0.00%
for hedges)
Total 82,553,000 43,389,000

*Retail installment accounts are typically valued for liquidation at this rate. Avg. about 50%

As one can plainly see from the example above, the liquidation value or reproduction costs of assets
is usually far below what is stated on a corporate balance sheet. It is from the reproduction value
figure that investors must deduct all liabilities to ascertain a company's true asset value.

Again, when it comes to asserting reproduction values to assets the better one understands the
company and the industry in which it operates the better (and more accurate) the estimate they can
place on its assets.

Earnings Based Valuation

EPV (Earnings Power Value)

The most conservative earnings based valuation and hence why I utilize it as it falls in line with my
foremost investment objective which is to maintain the safety of my principal.

Adjusted Earnings x 1/Cost of Capital = EPV

Earnings Power Value is what I believe to be the second most reliable measure of asserting a firm's
intrinsic value, behind estimates based on assets.

The simple goal of EPV is to accurately estimate the currently distributable cash flow of the company.
To do this we analyze the earnings data and make adjustments where necessary. For example:

Figures Original Adjusted

Net Sales 98,176 98,176
Cost of Goods Sold 51,963 31,177
Gross Profit 46,213 66,999
Operating Expenses
Selling, General & Admin. 39,349 31,479
Depreciation & Amortization 843 674
Operating Income 6,201 34,846
Interest Expense 464 464
Income Before Taxes 5,557 34,382
Net Income 2,601 22,348
Earnings Per Common Share 0.04 0.34

After making adequate adjustments to the cost of goods sold, selling, general & admin. As well as
depreciation & amortization which takes into account amounts actually spent on increasing sales and
brand awareness while determining actual business expenses and costs more accurately we arrive at
the above stated figures.

After making these necessary adjustments and arriving at a more accurate earnings figure all that
remains to be done is simply assume that these cash flow figures will be sustained and experience no
growth whatsoever. We then divide this figure by a reasonably determined cost of capital (rate of
interest at which the company can reasonably borrow money) to arrive at our EPV for the firm and
thus its earnings based valuation.

By dealing only in current facts and figures and not relying whatsoever on future growth or cost of
capital projections like a discounted cash flow analysis or the like would we arrive at a much safer
valuation figure.

Growth Based Valuation

Like any value investor I would advise not paying anything for even the rosiest projections of future
growth unless they have some basis in current and past figures.

If one does see stable growth then they must first, determine if the growth is taking place within
the franchise and if the firm does indeed enjoy a competitive advantage in the marketplace. If this is
found to be the case only then can a growth based valuation be estimated. One such method is:

Benjamin Graham Valuation

EPS x 7 + 1.5G x 4.4/4.60 = V

EPS is the trailing 12 month's earnings per share, 7 is the PE ratio of a stock with zero growth, G is
the estimated growth rate for the next 5 years, 4.4 is the minimum required rate of return when
investing, 4.60 is the current 20 year AAA corporate bond yield, V is the intrinsic value of
the company.

This is the original growth valuation formula employed by Graham as described in Security Analysis.

However, be forewarned as this method of valuation is much riskier than both an asset or current
earnings based valuation simply because of the fact that we are making projections about the future
which are always extremely imprecise.

Summary

As always there is much more to be said about business analysis than contained in a brief paper such
as this, many more things to be considered and much more expertise to be imparted by those with
much greater knowledge than myself.

However, I would like to add a few further words for consideration. Namely, that many insights can
be gleaned from performing and then comparing asset, earnings and growth based valuations to one
another. Doing this will enable one to better understand certain qualitative aspects of the business in
question, such as if the reproduction cost of the assets is greater than the EPV then in all likelihood
that implies that current management is not earning an adequate return on its current assets or it can
also be that the industry in which the business is involved in is operating with excess capacity. Further
analysis can determine which of these scenarios is factual.

Another very important thing to remember is to always perform a follow up analysis on companies
held in your portfolio to ascertain if the initial reason you made your purchase is still valid. I usually
do this on a half yearly basis.
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10 Grow th Value
Earnings Value
8 Asset Value

0
Asset Value Accuracy Earnings Value Accuracy Grow th Value Accuracy

Sources: Security Analysis 1934 Edition By Benjamin Graham & David Dodd | The Intelligent Investor By Benjamin
Graham | Value Investing By Bruce Greenwald