One of the many difficult question to answer in investing is what drives value of business

What makes one business to trade at a premium to other business in eyes of market participants and how does one identify any such business which is out there and still not recognised by Markets

There is an excellent thread on Valuepickr and I keep going to as it does a great job of answering these question

First lets understand they key value drivers, Most of what I am proposing below is based on this excellent paper by Bear Stearns¹ .

Value increases by

1. Growing operating profit and investing in NPV positive opportunities
2. Increasing ROIC (by taking capital out of the business or identifying high return projects)
3. Reducing WACC (Lowering risk)
4. Extending competitive advantage period (CAP)

Let’s give this a fancy name – 4 pillar framework

Can we put above theory in practice lets tackle each of the above components one by one

1. Growing operating profit and investing in NPV positive opportunities – This sounds fairly intuitive, has two parts

How can a company improve its operating profit – By Expanding operations or By expanding margins (EBIT as % of sales) – We will talk about margins first

Look at the break down of operating expense of Page Industries for financial year ending march 2015²

To improve operating margin, Page has to

• Improve sourcing capabilities, It needs to have supply side advantages, This is also what Porter refers as understanding bargaining power of suppliers­­
• Employee and administration expense should not grow linearly with sales

Keep these two points in mind, While we break down the other expenses which form a significant part of operating expense

• The next set of things that would improve operating margin is what often referred as scale advantages as scale of operations increase the percentage operating expense per unit of sale should go down on things like rent, spares and stores , publicity etc.
• Finally operating efficiencies would drive expenses like sub-contracting expense

So there are three primary sources that improve operating margin of any company

• Sourcing capability
• Operating efficiencies – using existing assets at optimum
• Scale advantages – spread of fixed cost over a higher number of sale units

All three can be gauged by numbers but for first two we really to understand company and its Industry

2. Moving to investing in NPV positive opportunities – The first thing is that the company should have reinvesting opportunities and then it should earn excess positive return on capital on those investments

The company basically has four options with its free cash flows

1. Invest in the business itself if the returns are good, this is call reinvestment rate or organic expansion
2. Acquires other company – This is called inorganic expansion
3. Return cash to shareholder via dividends or share buyback
4. Just hold cash and do nothing

A proxy reinvestment rate can be calculated as Excess capital expenditure (Capex – Depreciation) / NOPAT)

The company which has long run way for reinvestment combined with above cost return on capital is often is the one where there is maximum value creation

These is were masters operate see below quotes

“I would look for a business that is able to grow at reasonably high rate for a long period of time by generating consistently high rate of return on invested capital mostly financed through internal accruals” – ValuePickr

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“A high return on capital (not contributed by a very low margin operation where margins could fall) which is sustainable – pricing power, low cost advantage etc. Ability to deploy incremental capital at high rates of returns i.e. growth prospects. Ability to self-fund growth” – Prof Sanjay Bakshi

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“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.” -Warren Buffett, 1992 Chairman’s Letter

In case of Page Industries the reinvestment for current fiscal has gone down from 26% to 18% , however this rate going down is not always a bad sign

Did I confuse you ?

This moves our focus to the second pillar of value driver which states that value is increased by increasing ROIC (by taking capital out of the business or identifying high return projects)

There are only two drivers for Return on Invested Capital

1. Operating Margin – measures how effectively the company converts Revenues to Profits, We covered it above in the first pillar
2. Capital Turnover – measures how effectively the company employs its invested capital. The company can either use its fixed assets more efficiently or take out capital and run on an asset light model

This is reason when I said that reinvestment rate going down is not always bad because company might be on path to adopt an asset light model, However this is not always the case most of the times companies don’t have right opportunities to reinvest capital at attractive rates. In those cases it is prudent that management returns rather than reinvest

As an investor we can compare two things

Growth possible from internal funds generated

Internally Funded Growth = ((operating cash flow- maintenance capex – interest) * Capital turn over )/(Revenue form operations * 100)

Reinvestment rate

(Capex – Depreciation) / NOPAT)

These are my deductions

If reinvestment rate is reasonably higher than growth possible from internal funds, then company would resort to debt to fund expansion. If the rate of return is greater than debt rate – The investor should gain from management decision

If the reinvestment rate is reasonably lower than growth possible from internal funds, then company increases pay out, it also indicates that number of possible cash deployment opportunities are reducing

If the reinvestment is close to growth possible from internal funds, then company is in sweet spot all cash coming out from business is getting reinvested at attractive returns bringing compounding into play

I am deliberately avoiding maths here as it is an important concept to grasp the maths is easy, remember When reinvestment is funded through internal sources and it is growing at a brisk pace year on year then maximum value creation happens

Let’s go to our third pillar, Value is increased when cost of capital to run business reduces

How can a business reduce cost of capital, There are two ways

• Financial Engineering -Keeping the same level of asset but funding assets through cheaper debt – However this will still lead to drop in earnings
• Using Other People’s Money FLOAT (free capital) to run business

Buffet writes in his 1989 letter

“We would owe taxes of more than $1.1 billion were we to sell all of our securities at year-end market values. Is this $1.1 billion liability equal, or even similar, to a $1.1 billion liability payable to a trade creditor 15 days after the end of the year? Obviously not – despite the fact that both items have exactly the same effect on audited net worth, reducing it by $1.1 billion.”

On the other hand, is this liability for deferred taxes a meaningless accounting fiction because its payment can be triggered only by the sale of stocks that, in very large part,we have no intention of selling? Again, the answer is no.

In economic terms, the liability resembles an interest-free loan from the U.S. Treasury that comes due only at our election…”

It is basically what Prof Bakshi has explained in his 16^th lecture in BFBV 2015 – Revolving fund which is costless and Long-enduring,

The more of an asset that you can fund with a free float, the less the need to fund it with expensive debt or equity becomes

Who are these other people who can fund business lowering its cost of capital

• Suppliers providing materials on long credit
• Customers paying advances
• Government providing Tax subsidy, Export Incentive etc.

Therefore a capital structure which is funded by sustainable costless other people money will create more value all other things equal

Our Final Pillar states that value is created by extending competitive advantage period (CAP)

Competitive advantage period is the period where company can earn more than its cost of capital I have written about calculation of MICAP previously here

Theory says below business 1 and 2 should be priced by market same

But will they be ?

Business 1 will always be valued high reason being even if it is able to extend the CAP period by 1 year, the marginal value it will create will have more PV than business 2

As the length of CAP remains unchanged, a year of value creation is added, and the past year of value creation is lopped off. As the investor purchased the shares expecting above-cost-of-capital returns for the implied period, the additional year of value creation represents a “bonus,” or excess returns³

There is no scientific method so say that CAP is for business is 10 years or 20 years or forever. A constant CAP is contrary to economic theory, but it may be achieved through outstanding management (i.e., resource allocation, acquisitions)

So management which can increase or keep constant CAP will create more value all else equal

The above four pillars when put together for a company can provide a peek into future value creation and if you spot this value creation  ahead of market then obviously there is bounty to be made

Share your thoughts on this framework

 

References

1. Primer on the ROIC valuation Framework,August 2004, Bear Stearns
2. Page Industries – 2014-2015 Annual report
3. Competitive Advantage Period “CAP” The Neglected Value Driver, January 14, 1997, Michael Mauboussin
4. Professor Sanjay Bakshi’s various lectures