Bruce Greenwald on Valuing a Franchise: Pt. 2

The first step in the “Greenwald” approach is to remember that there are two ways to go about determining whether a stock is trading at an attractive price. We tend to, by default, think that we have to figure out what price the stock should be (intrinsic value) and compare that to what the stock is currently trading at. But we can also estimate what return we think we’ll get if we purchase at today’s price. It’s sort of net present value (NPV) versus internal rate of return (IRR).

I see Greenwald’s technique as a hybrid between the two, but mostly IRR. We are estimating rate of return, but as you will see, part of that computation requires an NPV calculation. The Good News about this approach though, is that small errors in your best guesses at your inputs only cause small errors in your estimate of expected return. As a bonus, the valuation equation is transparent. You can see how much each part contributes to the whole, so if you’re a little unsure about one of the terms, you can mentally say “if this terms ends up being 0% instead of what I think it is, how does that
change my expected return?”

I’ll give you the equation soon. Then we’ll talk about the terms. First, let me just say that this is not meant to be a mathematically airtight equation for exactly what return you’ll get. It’s more putting a rough equation around common sense – storyboarding – in order to see whether the price is attractive.

4 factors will contribute to what return we get from purchasing a stock:

    (1) the % of earnings the company gives us via dividends

    (2) the % of earnings the company “gives” us via buybacks

    (3) the % earnings grow from the company reinvesting some earnings

    (4) the % earnings grow just due to increases in demand

The first two terms, Greenwald refers to as “cash return”. The last two terms are growth, with one being active (think, opening new stores or developing new product lines) and the other being organic (think, same stores sales growth or selling more of an existing product just due to increases in demand).

Let’s begin to form the equation for our expected return:

E[R] = DividendYield + BuybackYield + ActiveGrowth + OrganicGrowth

As we develop the equation, we’ll add some meat on these bones. And we might as well use real numbers for the analysis, so let’s examine a stock I was recently asked to take a look at. Today (November 13, 2013) IBM is trading at $182 and a forward P/E of 10. It was 20% higher at $215 earlier this year. Is it a bargain?