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1 Business Value Drivers by Kurt Havnaer, CFA, Business Analyst white paper A Series of Reports on Quality Growth Investing jenseninvestment.com Price is what you pay, value is what you get. 1 Introduction -Warren Buffett The quote above from Warren Buffet underscores our primary goal at Jensen when it comes to valuation. After concluding that a business is a good fundamental fit for our portfolios, the next step in our investment process is to determine the value of the company s stock. We do this by constructing a discounted cash flow (DCF) model that estimates the current value of the company s expected future cash flows. This value is then compared to the current stock price to assess whether or not the stock is attractively priced. Our goal is to purchase stocks trading below value. When companies improve operations and grow profitably over time, the value of their stock should increase. Eventually, we expect the market to recognize the value being created by the business, leading to increased demand for the stock and a reduction in the gap between price and value. In our recent white paper entitled DCF vs Multiples, we briefly discussed some of the drivers of business value and argued that strict reliance upon multiples for valuation purposes results in a failure to explicitly consider those factors that cause value to change. This current paper goes into more detail on each of these factors in order to provide a more robust understanding of how they impact business value. For illustrative purposes, we use a hypothetical company and make the following assumptions in the examples in Exhibits 1-3 below: The company has no debt in its capital structure. This allows us to use the company s cost of equity as the discount rate, which is defined below. The company is mature and its earnings grow at a constant rate. This allows us to use the constant growth formula outlined below to calculate value. Constant Growth Formula Used to Calculate Intrinsic Value IV 0 = NI 1 * (1 RR)/(k g) g = ROE * RR IV 0 = NI 1 * (1 RR)/(k (ROE * RR)) Where IV 0 = value of the company s stock today NI 1 = net income one year from now RR = retention ratio = portion of the company s net income reinvested in the business k = cost of equity or discount rate g = growth rate in earnings = ROE * RR ROE = return on equity 1. Buffett, Warren Berkshire Hathaway Shareholder Letter, p. 5. berkshirehathaway.com.

3 3 Business Value Drivers players to post high returns on capital over time. Strong brand names, differentiated products, unique manufacturing processes, technical knowhow, patent protection and economies of scale can make it difficult for potential competitors to enter and compete effectively in new markets. This enables existing competitors to post excess returns, creating value well into the future. Earnings Growth: There s More to the Story Most investors probably believe that earnings growth is always a positive characteristic. A cursory review of the constant growth formula,on page 1, tells us that if earnings grow, the denominator declines and value increases. Additionally, the amount of time spent by investors each quarter analyzing companies year over year changes in revenues and earnings reinforces the importance the investment community places on tracking growth. But what if there was more to the story? Is it possible that earnings growth could actually be a negative? Is there such a thing as good growth and bad growth? Surprisingly, in certain instances, earnings growth can actually destroy business value as shown in Exhibit 3 below. In this example, the company s return on capital (ROE) is less than its cost of capital. The company increases its net income growth from 2.00% to 2.80% by reinvesting more of its earnings back into the business. Despite the greater earnings growth, the value of the business declines from \$938 to \$903 because the company s return on equity is below its cost of equity of 10.00%. This example indicates that earnings growth is a positive if a company s return on capital exceeds its cost of capital. On the other hand, earnings growth can destroy value if it is accompanied by capital returns that are lower than a company s cost of capital. Exhibit 3 Return on Equity (ROE) 8.00% Retention Ratio (RR) % Net Income Growth (g) 2.00% value of equity \$ 938 Growth, but ROE is Less then the Cost of Equity Cost of Equity (k) 10.00% Return on Equity (ROE) 8.00% Retention Ratio (RR) % Net Income Growth (g) 2.80% value of equity \$ 903 Share Repurchases: There s More to the Story Logic tells us that an increase in earnings per share brought about by share repurchases will increase a company s share price if its Price to Earnings (P/E) ratio stays the same. The math supporting this logic is irrefutable. But what if a company repurchases shares at a price in excess of value? Investors certainly attempt to avoid purchasing shares for more than what they re worth. Shouldn t companies do the same when buying back stock? The example below in Exhibit 4 shows that share repurchases can actually destroy business value when stock is repurchased at prices that exceed the shares value. In this example, the company spends \$100 to repurchase one share of stock that s actually worth \$50. Because the company pays too much, the value of the shares held by the remaining shareholders declines from \$50 per share to \$47 per share. Exhibit 4 Before Share Repurchase Cash 200 Other 800 Total 1,000 Equity 1,000 Total 1,000 Value of the equity on the balance sheet = value of the equity. Shares outstanding = 20 Calculation of Intrinsic Value Per Share Before Repurchase Equity Value 1,000 Number of Shares 20 Intrinsic Value Per Share Before Share Repurchase 50 Post Share Repurchase: Purchase Price > Intrinsic Value Per Share Cash 100 Other 800 Total 900 Equity 900 Total 900 Value of the equity on the balance sheet = value of the equity. Company paid \$100 to repurchase one share even though value = 50 Shares outstanding = 19 Calculation of Intrinsic Value Per Share After Repurchase Equity Value 900 Number of Shares 19 Intrinsic Value Per Share After Share Repurchase 47

4 4 Business Value Drivers While paying too much to repurchase shares destroys value, the opposite is also true. Companies can boost business value by repurchasing shares at a price that s lower than value as shown in Exhibit 5. In this case, the company spends \$25 to repurchase one share that s worth \$50. The value of the remaining shares outstanding increases from \$50 to \$51. Exhibit 5 Before Share Repurchase Cash 200 Other 800 Total 1,000 Equity 1,000 Total 1,000 Value of the equity on the balance sheet = value of the equity. Shares outstanding = 20 Calculation of Intrinsic Value Per Share Before Repurchase Equity Value 1,000 Number of Shares 20 Intrinsic Value Per Share Before Share Repurchase 50 As it relates to the value creation potential of repurchasing shares at a price below value, Warren Buffet wrote the following in Berkshire Hathaway s 1984 Shareholder Letter: When companies with outstanding businesses and comfortable financial positions find their shares selling far below value in the marketplace, no alternative action can benefit shareholders as surely as repurchases. 6 Post Share Repurchase: Purchase Price < Intrinsic Value Per Share Cash 175 Other 800 Total 975 Equity 975 Total 975 Value of the equity on the balance sheet = value of the equity. Company paid \$25 to repurchase one share even though value = 50 Shares outstanding = 19 Calculation of Intrinsic Value Per Share After Repurchase Equity Value 975 Number of Shares 19 Intrinsic Value Per Share After Share Repurchase Buffett, Warren Berkshire Hathaway Shareholder Letter, p. 3. berkshirehathaway.com.

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