In the previous post we learnt about the pitfalls of using P/E ratios and the limitations of using DCF. Buffett owners earnings fixed most of the shortcomings. In this post we will learn about valuing a company using residual earnings.
1. Residual Earnings
The fictitious Company A given below has a book value per share of $100,000 on 31-Dec-2014. Earnings per share (EPS) and Book value per share (BPS) from 2015 to 2017 are estimates. Also your opportunity cost aka cost-of-capital is 10%. With this information can you calculate the intrinsic value for company A on 31-Dec-2014?
Intrinsic value has two components to it. One of them is book value which is known and can be obtained from the balance sheet. In this case it is $100,000. The other component deals with future book value and future earnings on that book value. Since future is unknown we call this component as speculative. In this case the items under 2015E to 2017E deals with future and hence speculative.
Intrinsic value per share = Book value per share + Speculative value per share
Let us calculate the speculative value for the year 2015. We know that the book value for 2014 is $100,000 and the cost of capital is 10%. This means that we expect a minimum return of $10,000 ($100,000 * 0.1). In 2015 the expected EPS is $20,000. This represents a return on common equity (ROCE) of 20%. So the company exceeded expectations by 10% or $10,000 which is the residual earnings. In the book Accounting for Value Stephen Penman writes
Residual earnings is sometimes referred to as excess earnings or abnormal earnings and is alternatively (but equivalently) calculated as Earningst − (r × Bt−1), that is, earnings less a charge against book value to cover the investor’s required return (or the “cost-of-capital”).
For the year 2016 the company earned $18,000 on a book value of $120,000. Its ROCE comes to 15%. After 10% cost-of-capital the residual earnings comes to $6000. For the year 2017 the company earned $13,800 on a book value of $138,000. Its ROCE comes to 10%. After 10% cost-of-capital there is zero residual earnings. Take a look at the calculations given below and spend some time to understand it.
Book value per share = $100,000 Speculative value per share = Discounted Residual Earnings2015 + Discounted Residual Earnings2016 + Discounted Residual Earnings2017 Speculative value per share = ($10,000 / 1.1) + ($6,000 / 1.12) + $0 Speculative value per share = $9,090.91 + $4,958.68 + $0 Speculative value per share = $14,049.59 Intrinsic value per share = Book value per share + Speculative value per share Intrinsic value per share = $100,000 + $14,049.59 Intrinsic value per share = $114,049.59
Since company A had positive residual earnings its intrinsic value $114,059.59 is greater than the book value $100,000. This is one of the key ideas that needs to be remembered forever. Let me use an analogy to make this concept stick. You are an employee working in a software company and your manager has assigned you a task. He expects you to complete the task in two weeks.
In 1994 letter to shareholders Buffett explained the difference between book value and intrinsic value using college education. This is by far the best explanation that you can ever read. The lines marked in bold is what we did with Company A.
You can gain some insight into the differences between book value and intrinsic value by looking at one form of investment, a college education. Think of the education’s cost as its “book value.” If this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college rather than a job.
For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted , at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education.
Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn’t get his money’s worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.
2. Residual Earnings with continuing value
Company A had zero residual earnings from the year 2017. But companies with durable competitive advantage can generate positive residual earnings for a very long time into the future. How do we value them? Penman supplies us with the formula which is given below. Let us look at some examples to understand this formula.
Company B given below is similar to company A. The only difference is that company B has a positive residual earnings for the year 2017. Also let us assume that the residual earnings beyond the year 2017 is going to be constant. How much would you pay for company B on 31-Dec-2014?
The calculations should be familiar to you except the continuing value part which I have worked out below.
Book value per share = $100,000 Speculative value per share = Discounted Residual Earnings2015 + Discounted Residual Earnings2016 + Discounted Residual Earnings2017 + Discounted Continuing value Speculative value per share = ($10,000 / 1.1) + ($6,000 / 1.12) + ($6,003/ 1.13) + Discounted Continuing value Speculative value per share = $9,090.91 + $4,958.68 + $4,510.14 + Discounted Continuing value Speculative value per share = $18,559.73 + Discounted Continuing value Continuing value = Residual Earnings2017 / expected rate of return Continuing value = $6,003 / 0.1 Continuing value = $60,030 Discounted Continuing value = Continuing value / 1.13 Discounted Continuing value = $60,030 / 1.13 Discounted Continuing value = $45,101.43 Speculative value per share = $18,559.73 + Discounted Continuing value Speculative value per share = $18,559.73 + $45,101.43 Speculative value per share = $63,661.16 Intrinsic value per share = Book value per share + Speculative value per share Intrinsic value per share = $100,000 + $63,661.16 Intrinsic value per share = $163,661.16
Company C given below is similar to company B. The only difference is that the residual earnings from 2017 is growing at 3.5% every year for a very long time. How much would you pay for company C on 31-Dec-2014?
The calculations are similar except the part that calculates continuing value accounts for 3.5% growth.
Book value per share = $100,000 Speculative value per share = Discounted Residual Earnings2015 + Discounted Residual Earnings2016 + Discounted Residual Earnings2017 + Discounted Continuing value Speculative value per share = ($10,000 / 1.1) + ($6,000 / 1.12) + ($6,210/ 1.13) + Discounted Continuing value Speculative value per share = $9,090.91 + $4,958.68 + $4,665.66 + Discounted Continuing value Speculative value per share = $18,715.25 + Discounted Continuing value Continuing value = Residual Earnings2017 * growth rate / (expected rate of return - growth rate) Continuing value = $6,210 * 1.035 / (1.1 - 1.035) Continuing value = $6,427.35 / (1.1 - 1.035) Continuing value = $6,427.35 / 0.065 Continuing value = $98,882.31 Discounted Continuing value = Continuing value / 1.13 Discounted Continuing value = $98,882.31 / 1.13 Discounted Continuing value = $74,291.74 Speculative value per share = $18,715.25 + Discounted Continuing value Speculative value per share = $18,715.25 + $74,291.74 Speculative value per share = $93,006.99 Intrinsic value per share = Book value per share + Speculative value per share Intrinsic value per share = $100,000 + $93,006.99 Intrinsic value per share = $193,006.99
Even though Company A, B, and C have the same book value their intrinsic values are different. Companies that can grow its residual earnings for a very long time into the future will have intrinsic value that is much greater than its book value. Since Company C is growing its residual earnings at 3.5% every year its intrinsic value is higher than the other two companies.
To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns. – Buffet, 2007 shareholders letter
3. Valuing Hawkins Cookers
Using the residual earnings method let us value a real company. Hawkins Cookers designs, manufactures, and sells high quality pressure cookers and cookwares throughout India. You can read about its business here. Given below are its per share earnings and book value for the last three years. The company earns around 70% return on equity after tax. Its product quality, brand, distribution and service networks make this above average return possible. Also the company returns most of its earnings as dividends and require very little capital to grow its earnings. This is the reason why earnings per share grew faster than book value per share. Clearly the intrinsic value of the business should be greater than its book value. Let us find out the intrinsic value of the company.
1. Anchor on book value: To calculate intrinsic value we need to start with something that we know is true. The book value per share in FY2014 is 105.75 rupees.
2. Estimate residual earnings for next year: An asset is worth more than its book if it earns more than cost-of-capital. We know that the residual earnings for FY2014 is 62.04 rupees and it grew by 13% compared to FY2013. From this data, I am assuming that in FY2015 the residual earnings will grew by 15%. This assumption is conservative as the company came out of supply side issues from the prior years. Also it introduced a new pressure cooker model called HEVIBASE. Take a look what the management told about recent sales and profits. Residual earnings in FY2015 will be 71.35 rupees (62.04 * 1.15). Since this earnings is going to happen only in next year we need to discount it by an opportunity cost of 10%. The discounted residual earnings comes to 64.86 rupees (71.35 / 1.1).
3. Find out the continuing value with no growth: Pressure cookers and cookwares are going to be there for a long time. Also the moat of Hawkins is very strong and hence it will be able to generate residual value for a long time into the future. Capitalizing the discounted residual earnings of 64.86 rupees we get 648.64 rupees ( 64.86 / (0.1 – g) ). Here g is the growth rate of residual earnings and I have set it to zero.
4. Compare it with the market price: Adding step 1 to 3 we get the intrinsic value of Hawkins as 819.25 rupees (105.75 + 64.86 + 648.64). As of this writing the market price of Hawkins is 3315.85 rupees. Our intrinsic value accounts only for 24.70% (819.25 / 3315.85) of the market price. What explains the remaining 75% of the market price? Remember while calculating the continuing value for Company C we assumed that the residual earnings will grow at 3.5% forever. In the case of Hawkins we assumed zero growth. This is the reason why intrinsic value differs so much from the market price. The remaining 75% of the market price is being paid for the growth in residual earnings.
5. Invert and negotiate with the market: Coming up with a long term residual earnings growth rate is like playing with the mirrors. If you love the company then you will justify infinite growth and end up paying too much for growth. We need to avoid this. So instead of estimating growth rates we will invert the problem and find out how much growth is already reflected in the current market price. Supply various values for g and repeat step 3 and 4 until the intrinsic value matches the market price. To justify the current market price Hawkins residual earnings should grow at 8% for a very long time. Your job as an investor is to negotiate with Mr Market. If you believe that Hawkins can grow its residual earnings faster than 8% then you should buy. If not you should wait. I believe that the valuations are stretched.
Residual earnings method fixed all the limitations of DCF. Some of the advantages with this method are (1) By anchoring on book value we are providing a solid foundation for valuation (2) By estimating forward earnings for only one year we are shunning speculation (3) By setting growth rate to zero for calculating continuing value we are finding out value without any growth assumptions (4) By inverting we are finding out how much growth is already reflected in the current market price and then answering if the market expectations are too much or too little. As Buffett once said – After all, you need not know a man’s precise age to know that he is old enough to vote nor know his exact weight to recognize his need to diet.
We have come to the end of this post. But we are not done yet. There are few limitations with residual earnings method. Some of them are (1) Return on equity can be boasted by leveraging the balance sheet (2) Accrual earnings can be fudged (3) Expenses like Advertising and R & D can create durable competitive advantage and they should not be expensed but instead kept it in the balance sheet and amortized over time. In the next post we will learn how to avoid overpaying for leverage induced growth.