overview of vi

8/4/2019 Overview of VI

1/241

Value Investing the Approach

Value

Review

Manage Risk

Search(Look systematically for undervaluation)


2/242

Review

Key Issues -- EPV BUY (Growth Buy)

Franchise

Asset Buy

Management

Collateral Evidence Insiders, Other Investors

Personal Biases


3/243

Earning Power and Entry - Exit

Asset Value EP Value

Case B: Free Entry

Industry

Balance

Case A:


Value Lost to Poor

Management

and/or Industry

Decline


Case C: Consequence of

Comp. Advantage

and/or SuperiorManagement

Sustainability depends on Continuing Barriers-to-Entry


4/244

Summary of ValuationStrategic vs. Traditional Approach

Market Size Estimate

Market Share

Operation Margin

Investment

Cost of Capital

Value

Traditional

Revenue

Oper Income

(EBIT)

Cash Flow

NVP

National Income,

Growth, Consumer

Trends

Competitive

Responses;Entry/Exit

Technology,

Costs;

Prices; Input

Costs

Technology,

Growth

Financial

Market

Conditions;Risks

Strategic: Is this the South Bronx of the Investment World?


5/245

Basic Strategy FrameworkPorter Five Forces Probability Determinants

Four Forces too many

Substitutes

CustomerSuppliers

Entrants

IndustryCompetition


6/246

Strategic Investment Forces

Entry-Expansion Barriers-to-Entry

Incumbent Competitive Advantage

Does this company enjoy competitive advantage that is

significant?

Yes Being industry creates value

No Efficient Operation may create value

Others enjoy advantage stay out. (Being in industry

destroys value)

What about entrant advantages? No good after entry you become incumbent.

Existing Competitor Dynamics Degree ofCompetition (Phillip Morris)

Share the Wealth (Workers, Customers) ValueChain Dynamics


7/247

Consequences of Free EntryCommodity Markets (Steel)

$/Q

QFirm Position

Price

ACEconomic Profit

ROE (20%) > Costof Capital

Entry/Expansion

Supply Up, PriceDown

$/Q

QFirm Position

Price

AC

(Efficient Producers)

ROE = 12%

No Entry

No Profit


8/248

Consequences of Free EntryDifferentiated Markets (Luxury Cars)

$/Q

QFirm Position

Demand Curve

ACEconomic Profit

ROE (20%) > Costof Capital

Entry/Expansion

Demand for Firmshifts left (Fewersales at eachPrice)

$/Q

QFirm Position

DemandCurve

AC

ROE = 12%

No Entry

No Profit


9/249

Barriers to EntryIncumbent Cost Advantage

Entrant Incumbent Sources

No EconomicProfit

ROE = 12%No Entry

Economic Profit

ROE = 20%

Proprietary Tech(Patent, Process)

Learning CurveSpecial Resources

Not Access to Capital

Not Just Smarter

$/Q

QFirm Position

Demand (Entrant, Incumbent)

ACEntrant

ACIncumbent


10/2410

Barriers to Entry

Incumbent Demand Advantage

Entrant Incumbent Sources

o Economic Profit

OE = 12%

o Entry

Higher Profit, Sales

ROE = 20%

Habit (Coca-Cola)

High FrequencyPurchase

Search Cost (MDs)

High ComplexQuality

Switching Cost (BanksComputer Systems)

Broad EmbeddedApplications

DemandIncumbent

DemandEntrant

AC (Entrant, Incumben$/Q

Firm Position Q


11/2411

Barriers to Entry

Economies of Scale

Require Significant Fixed Cost(Internet)

Require Temporary DemandAdvantage

Not the Same as Large Size(Auto + Health Care Co)

Q

Firm PositionEntrant Incumbent

Q

AC

Demand

Firm Position Q

AC

Demand (Entrant, Incumben$/Q

No advantageNo advantage


12/2412

Barriers to Entry

Economies of Scale

Advantages are Dynamic and Must be Defended

Fixed Costs By:

Geographic Region (Coors, Nebraska Furniture Mart,

Wal-Mart) Product Line (Eye Surgery, HMOs)

National (Oreos, Coke, Nike, Autos)

Global (Boeing, Intel, Microsoft)

Q

$/Q

AC

Price (Both)

SalesEntrant

SalesIncumbent

D-Entrant

Profit

D-Incumbent

Loss


13/2413

Barriers to Entry - Sustainability

Static Demand Advantages

Tied Customers

Exploitation

Pricing, focus on Own Customer

No advantage with Virgincustomers

Shrinkage over time as basechanges

Cost efficiency in Own technolog

No advantage with virgintechnology

Shrinkage with technology change

Static Cost Advantages

Economies-of-Scale + Dynamic Demand Advantage

Principal sustainable advantage

Constant vigilance


14/2414

Sources of Franchises

Proprietary Technologies/ Learning Japanese as the future RCA

DuPont

Cisco

Pharmaceuticals

Bubble Wrap (Sealed Air)

Captive Customers Mercedes-Benz

IBM

Coors

Phillip Morris (Marlboro)

Coca Cola

Tide

Microsoft

Amazon

Local Doctor

Economies-of-scale Nebraska Furniture Mart

Oxford (HMO)

Winn-Dixie

Kmart

Wal-Mart

Microsoft

Dell

Boeing

Intel


15/2415

Other Barriers-to-Entry

Government, Regulatory, Public

(Lead based Gas Additives; Cigarettes)

Informational (Who Knows What)

(Banks, Financial Services, HMOs)


16/2416

Performing Strategic Analysis

Industry Map

Do barriersExist?

WhatCompetitive

Advantages?

Future Strategy,Profitability

(1)

(2)

(3)

(4)

Identify Industry

Industry History

Demand? Cost?

Economies-of-

Scale?


17/2417

Performing Strategic AnalysisApple Computer - Industry Map

ndustry:

Identify SegmentsStep 1:

For Apple Segment Are:

Chips

Hardware Software

Step 2:

Step 3:

Chips

Components

Hardware Software Networks

Intel, AMD,Motorola,Apple

Dell, HP,Gateway,IBM, Compaq,Apple

Microsoft,Apple,Oracle,Netscape

AOL

Power SupplyCo.s, etc.

Identify firms in each segments

If firms are the same, treatsegments as Single Industry

If firms are different, treat segments

as Separate industry

If in doubt, treat segments asseparate industries


18/2418


Do Barriers/Competitive Advantage Exist?

Profitability Above Cost of Capital (12%) for sustainedperiods Especially for dominant firms

Chips: Intel (Y)

Hardware: Compaq, Dell, Gateway, IBM (Maybe)

Software: Microsoft (Y)

Share Stability Do market shares change hands?

Does Dominant competitor change?

Is there significant entry?

Year: 1990 Share 1998 Share Change

Compaq 28 39 30 39 0

IBM 18 25 12 16 9

Apple 22 31 14 18 13

Dell 4 6 20 26 20

Total 72 100 76 100 10.5

Chips, Software

Hardware

Software, Chips

High Stability, Low Entry

Low Barriers

High Barriers


19/2419


Nature of Barriers-to-Entry Competitive Advantage

Chips (Strong) Hardware(Weak)

Software(Strong)

Demand Yes No Yes (Very Strong)

Cost Yes/Maybe No No

Economies-of-Scale

Yes Maybe Yes

Apple Disadvantage Level (?) Disadvantage(Some

advantage)

Where is Apple Going?

Is integrated Strategy

Appropriate? Is Steve Jobs going to save

Apple in the Long run?


20/2420

Other Strategic Considerations

Cooperation within BarriersCoke Pepsi

Cigarette Makers

Division of Spoils in Value Chain

Strategic alliances

You can not take home, if you dont bring

(NuKote)

Employee Power (unions, Prof. Servicesfirms)


21/2421

Summary of Strategic Investment

Without Competitive Advantage no Value in Franchise

Competitive Advantage must be

identifiable and sustainable

In particular, Are existingCompetitive Advantages

Sustainable or are they likely toerode?

If in doubt, do not pay for

franchise

Ideally look for hidden franchise

Unused pricing power (Coke, Cereals)

Poorly performing divisions


22/2422

Franchise Value Calculation

A1) Cost of Capital = 10%

A2) Asset Value AV = 1200MA3) Earnings Power Value = 2400M = 240M X (1 / 10%)

Earnings

Competitive Free Entry Earnings = 120M

= Cost of Cap. X Asset V

= 10% x 1200

Franchise Earnings = Earnings Free Entry Earnings

= 240 - 120

= 120

A4) Sales = 2000M (Tax Rate = 40%) Power Value = 2400M= 240M X (1 / 10%)

Franchise Margin = 120M 2000M = 6% after tax

Franchise Margin (pre-tax) = 10%

= (10% - 40% X 10% = 6%)

Tax

EP Value Implies Sustainable 10% Cost and/or PricingAdvantage


23/2423

Summary of Basic Valuation

Compute: Asset Value (Most reliable)

EP Value (Second most reliable)

Case A: Asset Value EP Value Value = EP Value(500M) (300M) + Catalyst Value

Case B: Asset Value = EP Value Value = 500M

(500M) (500M)

Case C: Asset Value EP Value Value = Asset Value

(500M) (1000M) + Sustainable

Fraction

of Franchise Value

(1000M-500M)


24/24

Real Earning Power Value

Real Earnings = Earnings Inflation driven Investment

Real Cost of Capital = WACC Inflation Rate

Inflation Driven Adjustment = Net Assets (Not includinggoodwill items) * Rate of Inflation

Example:

(A1) EP Value = 2400M = 240M * 10%

(A2) Net Assets (not including goodwill) =

Cash + AR + Inv. + PPE A/P AL AT = 800M(A3) Inflation rate = 2%

Inflation Driven Adjustment = 2% * 800M = 16M

Real Earnings = 240M 16M = 224M

Real Earnings Power = 224 = 224 = 2800M10% - 2% 8%

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