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. 2008. Berkshire Hathaway Shareholder Letter, p. 5. berkshirehathaway.com.
2 Business Value Drivers Discount Rate Assuming a company has no debt in its capital structure, the discount rate is the company s cost of equity capital. The discount rate is a risk measure, reflecting the volatility of the earnings and cash flows generated by a business. A company s cost of equity capital is essentially the return it must provide equity investors to entice them to purchase and hold the company s stock. Volatile businesses should have higher discount rates than more stable businesses because investors demand higher returns to compensate for greater levels of risk. A company s cost of capital is used to discount future cash flows back to the present in order to estimate value. If a company takes steps to lower the volatility inherent in its business, its cost of capital declines. This lowers the denominator in the constant growth formula shown above and increases the value of the business. Companies can lower volatility in a variety of ways, some of which include eliminating excess capacity, disposing of volatile business units, improving the quality of management, lowering costs, etc. Return on Capital All else equal, if a company s Return on Equity (ROE) increases, the value of its equity will rise as shown in the example in Exhibit 1 below. In this case, ROE moves from 15.00% to 17.00%, boosting the value of the company s equity from $1,200 to $1,304. Because net income growth is a function of the company s ROE and retention ratio (ie g = ROE * RR), the increase in ROE causes the growth rate to improve from 3.75% to 4.25%. The higher growth rate lowers the denominator in the constant growth formula, which, in turn, raises the value of the company s equity. Exhibit 1 Return on Equity (ROE) 15.00 % Net Income Growth (g) 3.75 % value of equity $1,200 Higher ROE Cost of Equity (k) 10.00% Return on Equity (ROE) 17.00 % Net Income Growth (g) 4.25 % value of equity $ 1,304 The example in Exhibit 1 highlights the importance of return on capital in value creation. Companies that increase returns for a given level of capital deployed in the business drive value higher. Price hikes, efficiency gains, cost reductions, volume increases and the introduction of higher margin products can all lead to improvements in return on capital and higher business values. Reinvestment Rates As long as a company s return on equity exceeds its capital costs, value is enhanced by reinvesting a larger portion of net income back into the business. Retaining a higher portion of net income in the business can lead to an increase in value as shown below in Exhibit 2. Similar to the example shown in Exhibit 1, the value of the company s equity moves up due to an increase in its growth rate. Unlike the example in Exhibit 1, however, the growth rate in Exhibit 2 is driven higher by a change in the retention ratio, not an increase in ROE. Exhibit 2 Return on Equity (ROE) 15.00 % Net Income Growth (g) 3.75 % value of equity $1,200 Higher Retention Ration (RR) Return on Equity (ROE) 15.00% Retention Ratio (RR) 30.00% Net Income Growth (g) 4.25% value of equity $1,273 Competitive Advantages and Barriers to Entry As discussed above, companies create value when their returns on capital exceed their capital costs. Generating excess returns over an extended time period, however, is very difficult for most companies according to various economic studies. 2 These studies indicate that businesses and industries producing high returns on capital attract competitors, and the increase in competiton eventually drives returns down to the cost of capital. 3 Simply put, capital returns revert to the mean over time for most companies. Studies have also shown that a relatively small number of firms are able to maintain high returns on capital for extended periods of time. 4 Our own proprietary research indicates that there s a high probability that companies with an ROE of 15% or greater for ten consecutive years will generate an ROE of 15% or more in subsequent years. 5 What is it about these companies that enables them to produce excess returns over relatively long time periods? In our minds, durable competitive advantages and solid entry barriers can delay the inevitable entrance of new competitors into highly profitable industries, allowing existing 2. Mauboussin, Michael. 2006. Common Errors in DCF Models. Research Paper, p. 3. Legg Mason Capital Management. 3. Mauboussin, Michael. 2006. Common Errors in DCF Models. Research Paper, p. 3. Legg Mason Capital Management. 4. Mauboussin, Michael. 2007. Death, Taxes and Reversion to the Mean. Research Paper, p. 5-6. Legg Mason Capital Management. 5. Jensen Investment Management. 2011. Understanding the Investment Process at Jensen Investment Management, Step One: Return on Equity. White Paper, p. 12. Jensen Investment Management.
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) 25.00 % 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) 35.00 % 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 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 51 6. Buffett, Warren. 1984. Berkshire Hathaway Shareholder Letter, p. 3. berkshirehathaway.com.
5 Business Value Drivers Conclusion As indicated in the introduction, stock valuation follows fundamental company research in Jensen s investment process. In our minds, a thorough understanding of a company s underlying fundamentals is required before investors can make a reasonable estimate of the value of the business. Due diligence at Jensen involves spending a significant amount of time researching and studying companies strategies, competitive advantages, management team, financial statements and the barriers to entry and competitive dynamics of the markets in which they compete. Analyzing these fundamentals is critical to understanding the factors that drive business value over time. Only after gaining a detailed understanding of how a company s fundamentals impact those factors do we then feel confident in building a valuation model that guides our buy and sell decisions. This paper describes the various ways in which businesses create or destroy value over time. Multiple tools exist for business leaders to boost a company s value. As portfolio managers and analysts, it is our job to assess a company s ability to use those tools to drive business value well into the future. All factual information contained in this paper is derived from sources which Jensen believes are reliable, but Jensen cannot guarantee complete accuracy. Any charts, graphics, or formulas contained in this piece are only for the purpose of illustration. The views of Jensen Investment Management expressed herein are not intended to be a forecast of future events, a guarantee of future results, nor investment advice. Holdings and sector weightings are subject to change without notice. Past performance does not guarantee future results. The Quality Growth accounts managed by Jensen (including the Fund) are nondiversified, meaning that they may concentrate their assets in fewer individual holdings than a diversified product, and therefore are more exposed to individual stock volatility than a diversified product. Investing involves risks; loss of principal is possible. Current and future portfolio holdings are subject to risk. Earnings growth is not a measure or forecast of an account s (including the Fund s) future performance. Cash Flow: The sum of the after-tax profit of a business plus depreciation and other noncash charges. Return on Capital: Indicates the efficiency and profitability of a company s capital investments. Return on Equity (ROE): Is equal to a company s after-tax earnings (excluding non-recurring items) divided by its average stockholder equity for the year. Earnings Per Share: The net income of a company divided by the total number of shares it has outstanding. The Price to Earnings (P/E) Ratio: Is a common tool for comparing the prices of different common stocks and is calculated by dividing the current market price of a stock by the earnings per share. 5300 Meadows Road, Suite 250 Lake Oswego, OR 97035 800.221.4384 The Jensen Quality Growth Fund investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus contains this and other important information about the investment company, and it may be obtained by calling 1.800.992.4144, or by visiting jenseninvestment.com. Read it carefully before investing. Quasar Distributors, LLC Distributor jenseninvestment.com 2013 Jensen Investment Management. The Jensen Quality Universe is a trademark of Jensen Investment Management. All rights reserved.