A Reader’s Question on Greenwald’s Valuation Slides


A Reader’s Question

Hey John,
Thanks for sharing and giving advice on my previous query. I am interning in a fund that practices value investing philosophy now and learning at a much faster pace than as a retail investor. Institutional investors certainly have more firepower when it comes to gathering more information. Had me pointlessly worrying why my knowledge of industries was so shallow as a retail investor ha ha  ha. But no excuses for not read up broadly and extensively! 
Came across these slides.
One of them is on Jae Jun’s site. Not sure whether you have came across it. The reunion presentation slides contained some workings which I think is Greenwald’s? (Downloaded it off Columbia’s site)
I believe they could shed some light on how Prof. Greenwald measures business returns. (You audited his classes before, maybe you would know better)
Some questions that I have:
From EPV slide:
1) Slide 35& 42: I don’t quite really understand the steps. For slide 42, I think this might be the workings for slide 35. Don’t quite really understand them either. How did he get cash and the growth rate. And what is option.
2) Slide 36: Why does he use 2 methods to calculate the expected return for each respective market?
From the reunion presentation slides: It is largely similar to the EPV slides except the last few slides that are handwritten. For Gannett, I can’t decipher the workings without any context. No idea how to get distribution, organic growth or reinvestment. Needless to say, clueless for the Walmart and Amex returns as well.
I think a more quantitative approach to calculate the expected rate of return would be more useful in determining intrinsic value and Greenwald presents us his way of doing it.
How I would value a company is for instance, Company W earns $50million for FY 2012. By determining the expected return (X), we can take 50/X to determine the value of the business. Reading the way how Buffett valued Mid Continent Tab, he seems to approach valuation this way. But of course, he has a deep understanding of the industry such that he is able to project an accurate return. 
Not sure if you or your readers could help out. 
My reply: Ok, CSInvesting readers are the smartest in the world, so I will let them have first crack at your questions before I chime in. …I will be back later to answer. 
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15 responses to “A Reader’s Question on Greenwald’s Valuation Slides

  1. Interested in what industry sources he’s referring to, apart from the ususal sell-side analysts

  2. Industry magazines like oil and gas, Best’s Review, and other industrial periodicals. Also, reading merger proxies is another way to glean industry data.

    AVOID sell side research reports.

  3. Sell side analysts have years of experience in the industry. I believe we can still learn from them about the industry but their valuations and forecast must be taken with a pinch of salt.

    • Point well taken, Industry reports can be useful, but the most successful investors Buffett and Greenberg never use up their time reading them. Better to read primary sources and do your own thinking in my opinion.

  4. Mohammed Al-Alwan

    Basically the slide you are referring for are the way greenwald value franchise companies. However, he is approaching them from IRR point of view rather than $ value. This makes sense if you want to compare investment opportunities on standardized basis.
    If take Gordon growth model of DCF and assume you are in equilibrium where price=value. Then Price=V=Dividend/Required Return- Growth.
    If you re arrange the equation and solve for required rate of return. You get
    Required Return=D/P+Growth
    Required Return=Dividend Yield which is named cash in the slide+growth+the reinvestment return (RE) which is basically your RoIC divided by your cost of capital multiplied by your retention rate. The last component is basically how much you are returned you earned on retained earnings RE.

    So the source of value is dividend yield (CASH) +reinvestment on retained earnings (RE) +Growth in the industry you are operating in which might be higher or lower than GDP growth.
    So, what greenwald did is that he is looking for normalized version of dividend yield which is basically 1 divided by normalized PE. This would give you normalized Earning yield. Then, you multiply it by your average payout ratio which will be equal to your normalized dividend yield.

    So, greenwald wants to say that don’t be fooled by PE ratio high or low. in case of Gannet although PE is low but the expected IRR from the stock is way below the required rate of return which means that stock is not cheap as it appears. The opposite is true with Amex, where it sounds expensive on a PE ratio but the expected IRR is 15% which is above the cost of capital or required rate of return.

  5. Mohammed Al-Alwan

    Please be careful as this valuation methodology is only applicable to franchise companies, so if your assessment is wrong with regard to franchise then you will have impairment of capital from day one.

  6. Hi Al-Alwan,

    Thanks for the thorough explanation. I understand it better now. Could I clarify a few points:

    1) Let’s take Gannett’s example. How do you compute the reinvestment return? Reinvestment return= ROIC (8%)/your cost of capital (10%) multiplied by retention rate (2.5%?). May I know how to get the retention rate. Isn’t the retention rate: 1- Dividend payout rate? Which gives me 20%…That doesn’t seem right. And, I noticed that he does it differently for Amex.

    2) For Walmart, how does he compute the organic growth? Is it GDP+ Income CAGR Growth + Goods/services for Amex (? Don’t get this)

    3) And why does this valuation only apply to franchise companies? Is it because for companies without a franchise, reinvestment returns and organic growth will be declining year after year. Hence, a value trap.

  7. Mohammed Al-Alwan

    Hi Wes
    Yes your correct reinvestment is basically 1-dividend payout multiplied by RoIC/WACC (normalized not the latest one).

    Gannett’s last 10 years average dvd payout ratio is around 22%. Retention rate is (1-.22) which is around 78%.Now look at the average RoIC over the last 10 years you get average RoIC of 12% divided by WACC of 10% you get a spread of 1.2 you then multiply it by your retention ratio of 78% and you get 1%

    Goods industries are going to grow lower than GDP due to diminishing marginal return on capital. Developed countries like US where capital to labor ratio is very high benefit less from such investment in these industries compared to china where the capital to labor ratio is very low. However, service industries are likely to grow much faster than GDP because demand for such industries is higher in developed countries and as result they will have higher organic growth rate. So; News Company like Gannett operates in an industry that is likely to grow less than GDP or Service Company like Amex. On the other hand, Wal-Mart is likely growing inline GDP growth rate. So, starting point is GDP growth rate and you put an allowance for the industry growth rate (+/-).

    The reason this mythology applies for Franchise Company is that if there is no barrier to entry (BTE) then, this growth will be competed away and as a result your return on capital will mean revert to the cost of capital over time unless you have an economic moat that prevent this mean reversion process.

    • Okay thanks.

      In the slides, he seem to calculate reinvestment return for Gannett differently. Any idea what does ‘Amount’ refer to? It’s 2.5%, which is very different from the retention rate of earnings of 78%. The retention rate can’t be that low right…

  8. Mohammed Al-Alwan

    you’re welcome 🙂

  9. Thanks Al-Alwan!

  10. can someone explain to me where Greenwald gets his WACC or cost of capital? sometimes it seems he derives this from some equation regarding the percentage of equity financed by debt and the avg tax rate…but other times it looks like he’s just using a number based on “risk”, ie 8-9 for low, 10-11 for mid, and 12-15 for high risk. can anyone clarify this for me?

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