Sunday, September 1, 2013

INTRINSIC VALUE AGAIN – Part I


Like many investors, this blog writer has struggled how to best evaluate a company and its share price. There are so many ways of doing so and to make matters worse, not all businesses are to be evaluated the same way. Earlier this year we attempted to calculate intrinsic value of a company (or its stock) using investor cash flow (money returned to investors through dividends and share buy-backs/earnings). Companies that return a significant portion of their earnings to shareholders and that require only modest capital investments to stay competitive and to even grow are ‘capital efficient’, shareholder friendly and often stable and profitable. Yet this approach is somewhat contorted and with to many assumptions on future stock pricing.
Today, I will discuss an easier and less interpretive definition of calculating a company’s intrinsic value. Note that both methods are referring to ‘intrinsic value’ but that those values are NOT really the same. Today’s intrinsic value is entirely based on net earnings.  Mind you, not all earnings and companies are the same. Today’s method focusses mostly on manufacturing and service companies, rather than on financials or mining or oil producers.
Take our perpetual example Microsoft.  It makes products and sells them at a profit. So how much is the sold (Revenue) and how much does it cost to make the product (Cost of Goods)?  How much equipment and how many buildings (Capital Expenses) are needed to manufacture these products? What is the wear and tear on the equipment (Depreciation).  Strangely enough, the cost of research is often not included and is treated as a part of production costs rather than as a long term asset.  Rather than reporting the market value of the buildings (real estate) the company owns, these buildings are reported as purchase or construction value.  So accounting does have its idiosyncrasies that makes things less straight forward.
But basically in a manufacturing company one should ask how much profit does the company make and how much capital (debt plus shareholder equity) is required to be able to produce these products.  The value of corporate patents and real estate is often more of a side-show.

When dealing with an oil company, earnings are from production operations. Thus again how much revenue was made (barrels of oil equivalent times the price of oil) and how much did it cost to produce the oil including well operating costs and royalties? Sometimes we call the difference of the revenue per barrel minus the operating costs and royalties the ‘Net back price’ per barrel.
But you know what?  Every time a profit is made assets are used up – the oil company’s main assets are its hydrocarbon reserves that are depleted. If those reserves are not being replaced then the company will run out of ‘assets’. In manufacturing equipment is worn out; this is called ‘Depreciation’. However in the oil industry, we also use up the oil and gas reserves of the company (Depletion). Now here comes the big difference: Oil companies spend capital first to replace its production but secondly to grow. By spending capital on new drilling (Cap-Ex), reserves are replaced and often they are also increased. This is where the ‘finding costs per barrel’ comes in – some companies are replacing and augmenting their reserves much cheaper than others – their ‘finding costs per barrel’ are a lot less than that of their competitors.
Thus an oil company not only makes profits from selling its oil by operating its production facilities efficiently as reported on the income statement; it also makes money (appreciates) by adding to its reserves and thus to the value of its assets on the balance sheet.  This requires an investor to look at an oil company quite differently than at a software maker or service company. 
Banks and insurance companies differ yet again from the two earlier mentioned industry sectors. These companies work with other people’s money: insurance float (which made Warren Buffett so wealthy) or depositor’s money or plain borrowed money.  These financials have typically a very high level of leverage – “other peoples’ money” is sometimes 10 or even 100 times (as in 2008) their shareholder equity.
In our new intrinsic value calculation, we will focus on a classic manufacturer such as Coca Cola, Hershey or for that matter Microsoft. The typical blue-chip company has often a ‘simple’ straight-forward and predictable income statement and balance sheet. Valuing such a company focusses on earnings, asset value and debt. That is the kind of company that Warren Buffett says ‘he can understand’ and whose earnings can be extrapolated with some confidence far into the future. These companies are nearly like government bonds but rather than getting paid interest you’re getting the – hopefully – ever increasing profits.
 
 

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