Circle of Competence

We use heuristics in our everyday lives.  “It’s about an hour away.”  “That beer is $30/case so I’m guessing it’s better than the Busch Light for $13/case.”  A heuristic is a shortcut, basically. Heuristics give us some easy measurements to quickly size up a situation. Guesses, estimates, guesstimates, approximations, whatever you’d like to call them, heuristics are easy.

Investing has no lack of heuristics: P/E ratios, EV/EBITDA ratios, relative valuation ratios, price to book value ratios. These are shortcuts to longer and more complex calculations of the value of an ongoing business enterprise. Price to book is a heuristic on the value of a firm’s assets after deducting what it owes. Price to free cash is a heuristic to discounted cash flow methodology. P/E is a heuristic to DCF, except using an accounting number called earnings. As you can imagine, heuristics, being shortcuts, are full of limitations and errors.

As a corollary, some heuristics are more useful than others.   If you went through and constructed a detailed discounted cash flow model for every company you came across, you’d have little time for any other analysis, so we need something easier to quickly compare investments.

Let’s look at some bad heuristics and some better ones.

Bad Heuristic One

Let us take the book value ratio as case study #1 in poor heuristics.

Book value is an accounting number; the sum of a firm’s assets minus its liabilities; Accounting 101. However, in security analysis, book value is often used as a basis for value.

Widget Company X (WCX) is selling for book value and thus is being undervalued by the market. We are upgrading WCX because we believe a proper multiple to be 1.5x book value.

Literally, whole valuations and brokerage firm ratings can be based on this number created by the accountants.  I’m not making this up.

Book value is merely the “leftover” after deducting liabilities from assets. Seems simple enough. However, sharp readers (which I assume you all are) will know that “Assets” can be almost anything, and “Liabilities” may not be owed after all.

I’ll give you one example to illustrate:

Pick up your favorite company’s recent 10-k and look at their balance sheet. See that number, Goodwill? It’s not worth anything. It might as well be called “Air.” Goodwill is, most often, an account created to allocate the excess of a purchase price over the net assets being acquired.

If WCX acquires Widget Company Y (WCY), the goodwill account will be set up. Say WCY has a simple balance sheet that looks like this, before acquisition:

Cash	$100,00		Debt	$300,000
Factories/Land	$200,000
Inventory	$150,000		Net Assets	$150,000

So, WCX announces they are purchasing WCY for $200,000 in cash, and the deal closes a few months later. In their next financial report, WCX must account for these assets being purchased. However, WCY only had net assets of $150,000! Where are we going to say that extra $50,000 went? Goodwill.

So, in their financial report, WCX will have a footnote that shows the WCY purchase price allocation.  These numbers are now imbedded into the balance sheet of WCX:

Cash	$100,00		Debt	$300,000
Factories/Land	$200,000
Inventory	$150,000
Goodwill	$50,000		Net Assets	$200,000

So What?

OK, so you already know what goodwill is, What the heck is my point?

In the above example, since WCX parted with $200,000 in cash, there has to be $200,000 on their new balance sheet somewhere else. We’ve seen that they had to create an “air” account called goodwill to allocate that cash to something. But you can’t sell Goodwill at a tag sale, folks. If WCX was to liquidate assets tomorrow, they could sell off their tangible assets; the factories, inventory, even the receivables, but not Goodwill!

Yet, analysts often refer to book value, $50,000 of which is pure nothingness for WCX, and treat it as if it was an all-important number that could be used to value a firm.  Really? You’re willing to pay for air? 1.5x the value of that air, mind you? It’s absolute silliness.

Better Heuristic One

What’s a better number to use?  Liquidation value.  You can go through rather quickly and decide what each asset might be worth if sold today, subtract out all the obligations the company currently owes, and come up with a quick, useful number.  Of course, a complete valuation would take much longer, but for a fast look, liquidation value does the trick where book value fails.

So let’s say our balance sheet remains:

Cash	$100,00		Debt	$300,000
Factories/Land	$200,000
Inventory	$150,000
Goodwill	$50,000		Net Assets	$200,000

As a smart investor, you can go through, line by line, and say:

OK, this cash is worth its stated value,  the factories and land are understated, I could sell them for $300,000, the inventory is a little shaky, so it’s only worth $50,000, and good will is worth zero.  I owe $300,000, so the liquidation value of WCY is $250,000.

With that simple exercise, you’ve now trumped the simplistic, and often wrong, heuristic called book value, and come up with something useful.  Unless we’re talking about a financial company with readily salable assets on the balance sheet at their market value, Primus Guaranty (PRS) is a good example of this, liquidation value will often be radically different than book value.

Bad Heuristic Two

Here’s another fun, and meaningless, heuristic. The ever famous price to earnings ratio. What the heck are earnings? Earnings, once again, is a number created and used by accountants to record the supposed amount of money left over after taking cash in the door and subtracting all kinds of costs, real or imagined, that the company has accrued or incurred during the fiscal year. Tired?

For an example of the potential meaninglessness of earnings, let’s return to our favorite Widget Selling Company, WCX. (By the way, someone e-mail me or leave a comment and let me know what WCX makes, exactly).

WCX now owns WCY in full. They bought factories, inventory, cash, and goodwill air:

Here is what WCX’s income statement looks like in 2008, the first year after they bought WCY:

Sales $500,000

Cost of Goods Sold $200,000

Operating Expenses $100,000

Depreciation/Amortization $50,000

Taxes $50,000

Net Income: $100,000

Now, a bunch of smart analysts will look at this and say things like:

WCX, with a 20% profit margin, above the industry average, and top line growth of 8% year over year, deserves a multiple of 15x. We put a valuation of $1,500,000 on WCX, or $15/share with 100,000 shares outstanding. With a current price of $17, we see it as an overvalued stock.

Here’s the problem. That $50,000 charge is for deprecation of the factories and the land they sit on.  Mind you, no cash has left WCX’s pockets, but net income has been reduced because the accountants said so.

How do they choose the amount? Well, it’s usually, again, out of thin air. One company might depreciate their factories over 15 years, another 20. It’s an educated guess.

As such, WCX is going to see their precious factory written down on their income statement, year after year, whether they’ve spent another penny or not! What if the factory is holding up better? What if WCX has decided that they don’t need the darn factory any more to maintain their current level of sales? They’ll keep on depreciating the asset, year after year, taking a standardized hit to earnings every year. Or maybe not. They can change the estimated useful life, increase the estimated residual value….

What if, instead of a factory, that was software WCX’s built in-house? Do we capitalize the research and amortize it yearly? We did spend money here, so do we expense it? There are rules outlined by FASB that tell us, but, in the end, it’s not always based on cash in the door and cash out the door every year. It’s mostly educated guesswork.

The point is, this income statement guesswork can be manipulated. Useful lives, residual values, capitalized expenditures vs. expensed items; all can be used to game WCX’s income statement to show a different earnings number. A system of accruals is used to portray an economic reality.

But the price earnings ratio doesn’t care, frankly. Mr. P/E goes along, day after day, an unassuming fellow telling us what our company is worth. He’s a bit dim-witted, though. He doesn’t care if what the useful life on our factories is. He’s oblivious to our pension accounting. But he’s always there, and he’s a popular fellow that Wall Street likes to talk about. He enjoys the spotlight.

In reality, this earnings number has no basis as a good heuristic. Why place a value on an easy to manipulate accounting number? Because it’s easy. It’s the bottom line, a nicely placed figure with two lines under it, underscoring its importance. But, as Bruce Berkowitz likes to say, the only thing you can spend is cash. Earnings are not cash.

If we can agree that the value of an asset is the sum of its cash inflows and outflows from now until kingdom come, discounted properly, then where do earnings come into play here? Where does book value come in to play? Earnings are not cash. Book value is not liquidation value. Don’t rely on them, except in very limited cases.  4x sustainable earnings is cheap no matter how their pension accounting works.  But outside of extreme, extreme valuations, relying on price/earnings is a act in futility.

Better Heuristic Two

Are there any useful heuristics out there to replace P/E? Here’s one: Enterprise Value to Free Cash Flow. I’ll tell you why.

A firm’s free cash flow (FCF) is the cash left in the till after adding up all of the cash that came in the door and subtracting all of the cash that went out. COGS, operating expenses, interest, taxes, capital expenditures, additions to working capital, all of them enter that equation. Notice I didn’t say depreciation or amortization.

If the above definition holds, that the value of an asset is the sum of its cash inflows and outflows from now until kingdom come, discounted properly, then an accurate discounted cash flow model starting with the firm’s FCF would capture the value of that company accurately.

You can go ahead and do that DCF model every time, if you like, to determine the approximate value of a company undergoing your analysis.  However, a DCF takes serious time and effort, and at some point you’ll want a quicker way to compare two companies whose basic characteristics you are familiar with before delving deeper. Here’s where price to free cash flow comes in.

The first step is accurately determining what “free cash flow” is for a given enterprise.  That may be a little tough.  Basically, though, you’re taking that accounting number, net income, and adding back any non-cash charges, then subtracting capital expenditures necessary to maintain operations and additions to working capital.  It’s not a simple, easy, bottom line, but as Warren says, it’s better to be approximately right then exactly wrong.

Second, enterprise value.  The enterprise value of a firm is simply it’s market value, plus the market value of the interest-bearing debt on its balance sheet, minus excess capital, like cash.

If you took the yearly free cash flow of a firm, assumed no growth, and discounted the resulting free cash at 10% per year, the company would be worth exactly 10X that free cash flow number. There’s a baseline to start with. If you assume the company will grow at 5% for the next 10 years, then slow down to 1% for its remaining life, value becomes about 15.8X 14.08X FCF. Change the discount rate upwards, the value goes down. Adjust the discount rate downwards, and value goes up!

You can go through the whole exercise yourself with a basic spreadsheet, but the point here is that you can use free cash flow multiples to quickly compare the embedded assumptions the market is using to value the enterprise.

That’s a useful heuristic to me.  Unlike earnings or book value, free cash flow is a real number used to compute the value of a firm.  When KKR wants to buy a company, they don’t care about earnings.  Earnings can’t cover debt, can’t pay workers, can’t pay their limited partners.  Cash can.

I’m all for using heuristics to approximate intrinsic value. But if you’re going to be quick and dirty, do it right.