Grey Value Management

As indicated by the title of this web page, the Investment Analysis section of this website focuses on the analysis of investments, not rational speculations, as defined in the Philosophy section. Rational speculations are by definition short-term profit opportunities that often turn on one or two isolated factors and entail very different analysis and reaction time than investments as defined herein. For examples of these more transient opportunities, look to the Trade Archive section. The trades there highlight the short-term nature and limited aspect of that category of investment.

Because it is the bedrock of intelligent investing, the analysis of value is a critical component of the investment process. Talent for forecasting probable outcomes is useless without the underlying financial projections being accurate to begin with. Doing one's own valuation is also critical because it's the basis of investor confidence. No investor can have the courage of someone else's convictions. And to have faith in one's own valuation it must be grounded in actual analysis, not superficial opinion. It's about numbers, not notions.

Each investment is very different, so it may seem improbable that there could be a common methodology applicable to all situations. We would in the alternative hope that, much like Justice Potter Stewart's observation regarding pornography, the investor would recognize thorough analysis when he sees it. Failing that, there are a number of very simple methods for establishing whether one's analysis has been fundamentally adequate.

In questioning how much I know about an investment situation - particularly when it comes to the purchase of securities as a long-term investment in a business - the first question I ask myself is how many hours I have dedicated to analyzing the situation. If I haven't spent at least 30 hours analyzing the company's and competitors' financials, industry, etc., I am certain that I know very little of worth.

spent at least 30 hours analyzing the company, its industry and competitors,

Some might assert that spending even 30 hours analyzing an investment simply isn't practical. The usual protest is "I don't have that kind of time." But I'm not making an argument based on how an investor should plan his or her weekly schedule; whether one has or doesn't have the time is irrelevant to the question of how much time is required. In my opinion, it is simply objectively impossible to have virtually anything relevant to say about a given investment scenario without investing at least 30 hours. I personally read corporate reports and generate spreadsheets and projections as fast as anyone I know, and I take a lot longer than 30 hours just to develop a familiarity. Reading 5 years' worth of filings and creating spreadsheets based on that research will alone consume most of 2 days.

The 30-hour landmark may also seem arbitrary, and the number itself is to some degree (why not 29?). But the point is to have a common sense benchmark. Investing is often a very solitary exercise intellectually, and it's important to have objective bases for maintaining self-honesty. Investors often convince themselves they understand a situation very well, and without a devil's advocate actively questioning their grasp of the details, it's easy to begin to believe one's knowledge and understanding run deeper than they actually do. For most of the major positions I held over the past several years, I typically committed a minimum of 150 hours of work.

Without the proper amount of dedicated research and resulting knowledge, running a portfolio of concentrated positions is suicidal. It's yet another reason why most managers run overly-diversified portfolios - they're trying to diversify their way out of the danger that they know their lack of knowledge about their positions creates.

The hard-copy culmination of all of my investment analysis takes the form of what I refer to as a monograph. Merriam-Webster defines a monograph as "a learned treatise on a small area of learning; also : a written account of a single thing." Practically speaking, as one check on the soundness of my own analysis, I force myself to assemble that analysis into a coherent narrative containing everything I need to know about the industry, the company, the competition, the financials, and everything else that's relevant. These monographs can run more than 50 pages, but they're extremely useful in reviewing the rigor of one's investment thesis - all of the pertinent information is immediately at hand, and if it doesn't make sense as a narrative, it won't as an investment, either.

The discipline of actually putting one's analysis to print and reducing it to a coherent argument inevitably forces the gaps and shortfalls in reasoning to the surface. Balancing all of the information and analysis in one's head leaves enormous room for error, but when the reasons for pursuing an investment are laid out in written form, there's no place to hide. Unfounded assumptions assume an almost glaring quality.

In addition to the basic financial analysis of a company, the monograph forces one to have a very clear conception of what is driving the creation of value. There's a term in investing called a "value trap" which is used to describe a company that seems inexpensive compared to similar assets but for some reason never appreciates in price such that the discount to its peers diminishes. A company can be a "good value" but never rise in price because even if the assets are inexpensive, there's no additional value being created in the business.

Even if the investor feels he has a clear grasp of the value of the assets as well as what it is in the business model that's driving the creation of value, there has to be a reason, a catalyst, for the share price to rise. In the process of isolating the defining characteristics of the business and determining what that catalyst might be, I always construct a Decision Matrix. The table below comprises the partial decision matrix for an actual investment I made.

Issue	Positives	Negatives
$4.50 per share, ~ $75 mil. cash & securities, NO DEBT	$75 mil. = $3.30 cash/share = approx. downside of $1.20, given no cash burn by company and value of real estate holdings	Given the contractual constraints, distribution of the $3.30 in cash is very unlikely, and the Co. is exploring a credit line w/ an interest in future acquisitions ($50 mil. against property March 10Q)
Inside Ownership: 2 insiders control ~ 50% of the equity	Management’s fate is firmly tied to the shareholders’	Management has also paid itself extremely well, and just because they own half the co. doesn’t mean they won’t drive it into the ground
Property holdings of $125 mil. = $5 per share in real estate	3 properties comprise relatively stable asset values. One mall is over 90% capacity.	Very unlikely that any of the properties will be monetized

The table above is incomplete, but it effectively conveys what the end product should look like. The goal is to isolate all of the important issues and define the positive and negative aspects attached to each. Taking all of that analysis into account and reducing it to a binary decision is an imperfect calculus, but by at least going through the process, the odds of losing money for lack of being thorough decrease. There are always reasons why one's judgment might be less than perfect, but there's never an excuse for sloppy analysis.

What makes an investment "attractive"? For the answer to that question we turn to Linda Evangelista, supermodel of the 80s, who understood value investing better than 90% of the portfolio managers out there. She once famously stated, "I don't get out of bed for less than $10,000 dollars." Just like Warren Buffet and all the other truly great investors cited herein, Ms. Evangelista never took action unless the opportunity was truly worth it - and in deciding what was worth her time, she set the bar very high.

What defines attractive when it comes to financial assets? As indicated elsewhere in this website, I look for a return of at least 30%. Because there aren't many investments that pay a 30% dividend, the investor has to find a financial asset with underlying fundamentals sufficiently attractive that it's reasonable to expect that the price will appreciate 30% in response to those fundamentals (eventually). This entails:

It's an involved process, but not as difficult as it sounds. Beyond understanding what it is that the company actually does, there are a handful of accounting items that provide critical guidance.

The above discussion and decision matrix illustrate how the important issues are effectively organized and weighed, but we still haven't addressed the mechanics of determining value in terms of how a company is performing. Remember, you're ultimately interested in being an owner of the company, so think like an owner. When someone buys a publicly-traded company, they are in effect taking a public company private, and the price they are willing to pay is logically called private market value (PMV).

In buying the entire company and taking it private, one buys not only all of the equity, but also all of the debt. This is because when the company is purchased from the owners (the stock holders), but the debt holders typically have the right to be paid as well if the company changes hands. Thus, in the example of Company X:

Company X	Amount	Price	Cost
Equity (Shares)	1,000,000 shares outstanding	$10 per share	$10,000,000 (total market capitalization)
Debt (Bonds)	$1,000,000 face value	$1,000,000 total	$1,000,000
Cash	$500,000	$500,000	$500,000
		Total	$10,500,000

Every corporate balance sheet is comprised of 3 components: Assets, liabilities, and owners' equity. Equity is on the liability side of the balance sheet because it represents money raised by selling stock to the public. Thus, the purchaser of the company takes rightful ownership of whatever assets are present - in this case $500,000 in cash - but has to pay whatever liabilities exist in the form of owner's equity and debt. Thus, the cost of the company = Liabilities (debt + equity) - Assets, or in this case, $10.5 mil.

We have calculated the cost of the company in this instance based on the assumption that the underlying financial performance justifies paying $10 per share, or $10.5 mil. total. To adequately understand that performance, we have to look at some basic financial line items: Revenue, net income, cash flow and free cash flow.

The definitions of revenue, net income, cash flow and free cash flow can become complicated based on the type of company being analyzed and such issues as revenue recognition, etc. But this website is dedicated to a discussion of investing, not accounting, so our focus will remain on the basics.

Keep in mind that much of what the investor is analyzing is accounting artifice, not "real" in any practical sense. And as an investor thinking like an owner, you ultimately want to know how much cash you could literally take home in your pocket and have the company still maintain healthy performance.

Revenue is an easy enough concept to understand; it's the money the company makes before anything else is deducted. It's "sales." Revenue sits at the top of the income statement.

At the other end of the income statement is net income; this is what remains after all other items required to generate the revenue are deducted. Some of these items are cash expenses - cash going out the door, such as employee wages. But some are not. One example is "depreciation", which isn't actually paid by the company in cash, but represents the loss in value of (for example) equipment that the company owns. Another major non-cash expense is amortization (which is similar to depreciation) of the "goodwill" of the company, the value of its brand and reputation in the marketplace.

Thus, net income is an important indication of what is actually left over when all of the costs, cash and non-cash, are deducted from revenue. But notice that it's a creature of accounting - cash is real, but net income is not, and almost everything that distinguishes the two is a judgment call. The owner of a business logically wants to deduct each year some amount representing the loss in value of his equipment. All equipment wears out, and if a given machine has a useful life of 10 years, the logical thing to do would be to plan for the end of that useful life by setting aside enough each year so that when the machine has to be replaced, there are the resources available.

Let's say the machine in question does have a useful life of 10 years, and that each year 1/10th of the value of that machine is deducted. After 5 years, half of the value has been deducted, but imagine that at the beginning of the 6th year it is discovered that the owner of the company is a little shifty, and that the useful life of the machine - a major expense for the company - was only about 5 years. What has happened? Because depreciation is deducted in the calculation of net income, and the depreciation figure was too small, net income was inflated and inaccurate. It was misleading.

Should the investor ignore net income, because it is so vulnerable to manipulation? No. The answer, as with most issues regarding investing, is simply to do more work. Be certain to understand every item that comes between revenue and net income. If they don't pass the common sense test, there's probably something amiss.

As mentioned above, this website is dedicated to investing, not accounting. Cash flow can be a complicated calculation, but there's a conceptual short-cut that one can use during the first stage of analysis that can be a helpful tool.

If net income is an accounting number that's not "real" in terms of actual cash, how does one translate net income into cash flow? If net income includes both cash and non-cash deductions from revenue, the answer is to add back the non-cash items deducted from revenue until all that remains are the deductions that comprised actual cash going out the door. Generally speaking, adding back depreciation and amortization of goodwill is a reasonable proxy for cash flow. It's not entirely reliable, but it's a good place to start as one gets down to the real work of creating full income and cash flow statements and balance sheets.

Again, you're thinking like an owner, and if you own a business - it could be a carwash down the street - your most important concern is how much cash you can take home at the end of the year and still maintain the business.

How much cash the owner of a business can safely take out of a business is determined in part by how much capital (money) is required to maintain that business, thus maintaining those cash flows. Cash flow may describe how much cash the business is generating, but free cash flow is the number that indicates how much cash can safely be extracted from the business. It is calculated by taking cash flow and subtracting from that sum the amount of cash required to maintain the business - hence, the term "maintenance capital expenditure."

Net Income + Depreciation + Amortization - Maintenance Capital Expenditure = Free Cash Flow

A capital expenditure is an investment by the company in the hard assets required to run that business. Maintenance capital expenditure is calculated by evaluating the business, what it has historically required in capital investment, looking at the future and determining how those capital needs might fluctuate, and then choosing a number for maintenance "cap ex" that has an adequate margin of error.

Why is free cash flow an important concept? Because analysts and money managers can talk night and day about how "cheap" a company is on the basis of price-to-earnings, price-to-sales, etc., and how based on those multiples a company is a "real bargain" compared to the multiples that competitors are selling for, but cash never lies, and it's the most transparent means for assessing whether a business is truly a good investment. It's no accident that free cash flow is also a key metric that any private market purchaser is going to focus on.

Without knowing anything about investing, the average individual knows that getting 1% interest on their savings account is much less attractive than 18%. Using free cash flow to calculate the return on a potential investment facilitates the same transparent reasoning.

Again, if you're buying stock in a company, the proper mindset is to imagine you're buying the entire company. Consider a stable company in a good, established industry niche which could be purchased in its entirety for $100 mil.

If that business is generating free cash flow ("FCF") of $1 mil. per year, that would be a return of only 1% on your investment ($1 mil. in FCF divided by the $100 mil. total purchase price). However, if that business were generating $20 mil. in FCF per year, that would be a 20% FCF yield. Thus, one could take $20 mil. home each year in return for that $100 mil. investment, effectively earning back the entire investment in 5 years and thereafter earning a magnificent return for zero capital at risk.

Not every investment opportunity will offer that kind of FCF yield, but by the same token you don't have to invest in every opportunity, either. You can let 500 opportunities drift by before you decide to act. Just like Warren Buffet or Linda Evangelista (imagine their offspring!), don't bother doing anything until the opportunity is genuinely too good to pass up. And FCF is a great indicator of what is attractive because regardless of what some price/earnings, price/sales, relative analysis might indicate, the investor always knows what's attractive based on FCF. This is why it's a key metric for people who buy businesses, but not those who speculate in stocks.

FCF has a great common-sense appeal to it, and if one's analysis is truly first-rate and the FCF on an annual basis is very attractive, very often one can safely stop there. If I can make $20 mil. annual cash return on a $100 mil. investment with a very high level of confidence, what more do I need to know?

There's another dimension to the analysis that is revealed in the following question: What are those cash flows worth today? This is the issue addressed by present value, or "PV" for short.

Calculating present value is best understood as compounding in reverse. Interest on savings compounds to a larger value in the future, and one can estimate that sum by calculating the interest and ever increasing principal going forward. In the same fashion a future amount, arrived at via financial forecasting, can be "discounted" back utilizing a "discount rate" - it's just like compounding, but backwards. Discounting effectively removes the element of time from the investing decision, so the amount one is investing today can be compared with the future cash flows presented in today's dollars (i.e., discounted today).

Obviously the key decision in discounting is what rate is chosen as the discount rate. One simple approach is to look at the return one could earn in other immediate investment opportunities and utilize that as the discount rate. For example, if one has no concerns about inflation and can invest in a bond paying 10%, the argument could be made that the discount rate should be at least 10%.

Once the discount rate has been selected, there are "present value tables" that provide the present value interest factors for calculating the PV of a given set of future cash flows. It is by referencing one of these tables that one discounts the future sums as shown below. Note that all of this is also very easily automated by using the NPV function provided in the Microsoft Excel spreadsheet program.

The above illustrates that the next 5 years' free cash flow is worth - discounted to today's dollars at a discount rate of 10% - approx. $76 mil. That is, at a discount rate of 10% the above cash flows are worth $76 mil.

Now that the PV has been calculated, that number must be subtracted from the investment itself to arrive at the Net Present Value ("NPV").

$76 mil. minus $100 mil. is negative $24 mil. If the NPV of the future cash flows after discounting is lower than the current cost, there's no point in making the investment, is there? The answer to that question is generally yes, but there is one piece missing from the above breakdown: What is the value after year 5? This great company doesn't cease to exist after year 5, and may very well be worth more than the $100 mil. we paid for it.

There are two aspects to this issue which are somewhat related: What is the value of the cash flows after year 5, and what could the business sell for after year 5, given the above cash flows and all other factors? Those questions are related because the value of the business is anchored in its cash flow-producing qualities, but the future cash flows don't comprise the entirety of its future value. Merging the two issues, the question becomes: What is the continuing value ("CV") of the company?

The task of forecasting future cash flows is tricky business. One can argue that accurately forecasting the next 3 years would be difficult enough, but extending the effort 5 years into the future is absurd. On the other hand, one can also argue that the company is being "purchased" to begin with because its financial performance is inherently stable and predictable. But even if that's the case, how far beyond 5 years makes sense before the calculation becomes unreliable to the point of being useless?

In calculating continuing value the investor is surrendering to necessity. The company and cash flows have to be worth something in the future - even if one can't assert with 100% certainty that the company will even exist in 6 years, it has to be assumed.

A popular method for estimating the continuing value of a company is a formula that assumes free cash flow growth in perpetuity. The formula arrives at a CV by taking the FCF for the first year after the forecasted period ("FCF _T+1") and divides it by the difference of the company's Weighted Average Cost of Capital ("WACC", which is the return it must pay to borrow money from the public in the form of debt, stock, or both), minus the expected growth rate of the free cash flow in the future ("g"), or:

Assuming the company's FCF in year 6 would be $20 mil., but that FCF would grow by 4% thereafter and that the company could issue debt at 8% (which we'll use as a proxy for WACC, which also takes into account the expense of issuing equity), we have:

Thus, according to the free-cash-flow-in-perpetuity formula, the company has a continuing value of $500 mil. Add that to the NPV of $76 mil., and the company's total value is $576 mil.

$576 mil. seems like a huge number, and it is, but perpetuity is a long time. Would buying an asset worth $576 mil. for $100 mil. seem like a bargain? Absolutely. Is it unusual for the stock of a company to increase five fold? Yes, but it happens more frequently than one might suspect. The value of even moderately compounding cash flow growth should not be underestimated.

The Dutch bought the island of Manhattan from the native inhabitants for $24 worth of beads in 1624. If $10 trillion would buy all of Manhattan today (by the way, that's the GDP of the entire U.S.), that means that the original $24 earned an annual compounded return of only approximately 7.5%. An asset only has to exhibit moderate growth over an extended period for it to be worth an amount so gigantic the mind struggles to comprehend it.

The rudimentary process above doesn't constitute much. There's an ocean of information left to the intricacies of accounting, financial forecasting, business analysis - the list goes on. In as much as investment analysis is a very ad hoc business and can be quite complicated, thorough analysis is nonetheless possible with only the most rudimentary resources. Consider the process above a modest framework for that analysis.

Although it doesn't require repeating, success is much more function of doing thorough research than anything else. Understanding what constitutes genuinely thorough analysis, as well as how to weave one's way through the most basic aspects of business and financial analysis, can carry the investor very far.

As one example, Enron was a magnificent fraud - and fraud by definition entails deliberate deception. However, it didn't take much inspection of the books to confirm that Enron was cash flow negative for 9 of the 10 trailing years. If a company is cash flow negative, that means that it is dependent upon outside sources of cash in order to stay in business. Is a company being investigated for fraud likely to be able to raise outside money by borrowing from banks or selling stocks (or bonds) to investors that now know the company is being investigated for fraud? The answer is very probably not. Thus, even if no one could have imagined the ultimate depth of the fraudulent activities at Enron, in reality it wasn't very difficult to see that owning Enron stock was a bad idea.

There are myriad mistakes that can be made in the process of investment analysis, which is a great reason why it should be attempted. In the alternative, absent careful research, mistakes are all but guaranteed. As the great poet Rainer Maria Rilke once said, "Trust in what is difficult."