Bruce Greenwald on Valuing a Franchise: Pt. 5

So, what was missing from our equation? If you guessed margin of safety, you guessed correctly. Value investors want to buy $1 bills for 50 cents, not for 89 cents.

To incorporate a margin of safety we want to include a term that is:

Probability of Something Going Wrong x Impact If It Does

Now, before Greenwald would have even begun forming the expected return equation he would have not only read the 10-K, he would have computed the firm’s asset reproduction value (ARV) and earnings power value (EPV). Part of the verification that we’re working with a franchise is to look for a company earning far more than just cost of capital on the assets they’re employing.

If a firm that previously had a competitive advantage loses it, what happens? Theoretically, EPV collapses to ARV. I haven’t computed ARV and EPV and it would probably take another 5 posts or so to properly attempt that. So again I’m going to take a shortcut Greenwald probably never would and say, if IBM has a competitive advantage now, and loses it later, I’d expect its P/B to drop from the current 10 to 2.5 (a 75% drop).

And I’m going to say there’s a chance of that happening sometime in the next 15 years. There are concerns that management might not be re-investing enough back into the company to set it up for long-term success. I’ve even heard their Roadmap 2015 plan referred to as Roadkill 2015! So I’m going to assign an MOS factor of:

(1 in 15) x (-75%) = -5%

Updating our equation…

valuation_eq_6

Our expected return is now 12% and includes an allowance for something possibly going wrong. Greenwald says that Glenn Greenberg’s hurdle here is 15%, while Buffett’s is 13%. Magically (or not! if this is indeed Buffett’s approach) we’re estimating a 12% return with the stock trading near the upper range of where Buffett started buying it in 2011.

But the true magic of this whole process to me is in how the equation guides our research. How many times have you read 10-Ks of companies, not really knowing what you’re looking for, but knowing that great investors supposedly spend a lot of time reading 10-Ks?! Guilty as charged.

But if you’re tempted by the 12%, think about how you’d investigate IBM now. Dividends and buybacks are hugely important to what return we’re estimating. We’d begin by looking for any and all guidance the company has issued about what they plan to do here going forward. Have they ever discontinued or cut a dividend in the past? Have they been funding the buybacks unsustainably with debt?

And how about organic growth? Does IBM have a competitive advantage we can put our finger on to insure we get that 5% GDP tailwind? Is there evidence of that recently? Incidentally this where I personally ran into issues with the company that I couldn’t give it a pass on. Shrinking revenue in constant currency the last few quarters despite acquisitions.

The bad news about the process is that it’s very company-specific in terms of what you have to research to fill out your equation with accurate numbers. You have to gather evidence and use your own introspection to draw conclusions. It’s not just pulling ROC numbers from Morningstar and making assumptions of P/B falling from 10 to 2.5 as I’ve done. The good news is that because of this, you can’t be replaced by a computer – and you have an edge over someone else who’s just lazily crunching numbers.