Value Investing India Report

Applying Value Investing Principles to the Indian Equity Market

Inside this Issue

IBM from a Modern Graham and Dodd Perspective

Value investing is fundamentally about identifying the intrinsic value of a security and determining whether the current price of the security reflects its underlying value. The difficulty involved with value investing is calculating intrinsic value. Virtually all undergraduate and graduate business students are taught that the intrinsic value of a security is simply the discounted value of its future cash flows. However, if youve ever done a DCF (discounted cash flow) valuation you know that small changes in assumptions can lead to large changes in the value of a security. Although most equity analysts use DCF as the basis of their valuation analysis, modern value analysis investors with a begin their companys

from the tangible to the intangible. The first step of the valuation process is a net asset value analysis. The second step of the analysis is the earnings power valuation (EPV) and the final and most subjective valuation is the growth analysis. For this special report, Ive decided to value IBM using the modern Graham and Dodd approach to provide an example of the types of reports that I will begin producing for Indian stocks via my monthly subscription service. thought Furthermore, it would I be

Volume 1, Issue 1

Investment Analysis: IBM Following Warren Buffetts investment in IBM in November, 2011 we analyze his investment from a modern value investor perspective as taught by Professor Bruce Greenwald at Columbia Business School. Given Mr. Buffetts historical aversion to the technology sector we identify the key components of IBMs competitive positioning and determine intrinsic value using a Net Asset Value (NAV), Earnings Power Value (EPV) and Growth Value (GV) valuation methodology.

interesting to value IBM from a value investor standpoint given Warren Buffetts recent investment in the stock. The purpose of this analysis is to highlight how the most celebrated investor in the world would most likely approach the valuation of a stock.

balance sheet and its asset value. In his book, Value Investing from Graham to Buffett and Beyond, Bruce Greenwald provides the framework valuation. for the modern value Graham and Dodd approach to Modern investing follows a continuum

Calculating Net Asset Value

The first stage of the analysis involves calculating the net asset value (NAV) of IBM. Ill www.valueinvestingindiareport.com 1

begin the analysis by making adjustments to both the asset and liability side of the balance sheet to calculate the net worth or shareholders equity per share for IBM. We can see from Exhibit 1 below that we begin the analysis by adjusting the balance sheet to reflect current market value. Value investors begin their analysis with the balance sheet because its a tangible representation of the current worth of a company. Exhibit 1: Net Asset Value

As we work down the balance sheet we must also make a number of adjustments to reflect current market values of assets and liabilities as opposed to accounting or book value. The first decision that must be made is to determine whether net asset value should be calculated based on liquidation value or a reproduction basis. Given our view that IBM isnt in terminal decline, we should value the balance sheet on a reproduction

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basis. The purpose of this analysis is to determine how much it would cost for a competitor to replicate IBMs business and enter the IT services industry. The main adjustment that Ive made to current assets is to add back the bad debt allowance. The principle behind this adjustment is that a competitor would most likely have a higher rate of uncollectible receivables than IBM. Thus, in order to replicate the net amount of receivables on IBMs balance sheet we would need to add back the bad debt allowance. As we move down the balance sheet, the subjectivity of the analysis increases. The greatest adjustment and source of error relates to how goodwill is measured. However, before we move on to goodwill, the next step in the analysis is to adjust inventory balances. We can see that from Exhibit 2, average days to sell inventory has remained remarkably stable over the past four years. Thus, its unlikely the company would have to write down its inventory and as a result we dont need to make an adjustment. The only other major adjustment made to current assets is to calculate the present value of the deferred tax asset. Moving on from current assets we arrive at PP&E. Ideally, we would like to determine the true Exhibit 2: Inventory Turnover Analysis

market value of non-depreciable assets such as land. Many value investors will hire specialized assessors to determine the true market value of land, plant and equipment. For the purpose of this analysis, Ive simplified the adjustment by adding back 50% of depreciation costs. In comparison, net PP&E of USD 13,883 mn as of 2011 was slightly below total capex outlays of USD 15,862 mn over the past four years. Unless you believe a competitor could replicate the entire production and research facilities of IBM by spending less than four years of capex the net PP&E number is not overstated relative to market value. Furthermore, in most instances the value of land and buildings will be worth substantially more than the depreciated value reported on the balance sheet. Thus, my adjustment appears reasonable. The final and most subjective current the valuation adjustment to our reproduction balance sheet involves goodwill. accounting rules, Based on goodwill represents

premium paid by a company to acquire another firm relative to the tangible assets of the acquired company. Clearly, there are a number of intangible assets such as brand identity, a loyal customer base and industry specific knowledge that also need to be valued. R&D is currently

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Exhibit 3: R&D and SG&A adjustments

expensed

from

an

accounting

perspective.

to replicate IBMs business. Ive made no modifications to the liabilities on IBMs books as there is no justification from an analytical perspective. To arrive at our net asset value we simply subtract the value of total liabilities from our adjusted total assets. Based on Exhibit 1, we can see that our adjusted NAV is USD 51.3 per share. Given Buffetts reported purchase price of USD 170, its clear that he paid a significant premium to NAV. Thus, we move on to the next stage of the analysis which is to calculate the earnings power value of the company.

However, a competitor wanting to replicate the breadth and depth of IBMs service offering would need to replicate this R&D outlay. Our adjusted goodwill balance attempts to capture this R&D outlay by treating R&D expense as a depreciable asset. Each years R&D expense is added to the balance sheet less accumulated depreciation on a 5-year straight line basis. Thus, R&D expense in 2010 would be equal to 80% of its original value in 2011. Using this method, Ive calculated that IBMs R&D is worth USD 18,336 mn at the end of 2011. Similarly, a company wanting to enter the market would also need to spend a significant amount on marketing expenses to be on an even playing field with IBM. In order to calculate how much a company would have to spend, we use the 5-year average ratio of SG&A to revenue and apply it to 2011s revenue. We then multiply this number by three based on the assumption it would take three years of expenditure to match IBMs brand value. Finally, we divide the number by two, assuming that 50% of total SG&A costs are associated with marketing expense. Thus, we calculate it would cost a competitor USD 35,510 mn to replicate the marketing and brand presence of IBM. Clearly, weve made a number of assumptions that can be challenged. The goal of this analysis is to determine a reasonable estimate of the reproduction costs a challenger would face trying

Earnings Power Value

Following Net Asset Value, the second most reliable measure of intrinsic value is Earnings Power Value (EPV). Essentially, adjustments are made to the most recent annual operating earnings to derive distributable cash flow. The EPV calculation also assumes that the cash flow continues on into perpetuity, which makes it similar to a terminal value calculation in a traditional DCF. However, in an EPV calculation no assumptions are made for growth. Although EPV shares a number of similarities with DCF based valuations, its inherently more conservative because the analysis is based on historical levels of earnings and distributable cash flows as opposed to forecasts. Basically, the analysis begins with operating earnings defined as EBIT and then adjustments are made for 4

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Exhibit 4: IBM Adjusted EBIT from 2007-2011

depreciation

and amortization

to arrive at

and add back excess cash. Using a conservative required return of 14% results in an EPV per share of USD 118, which is below Warren Buffetts USD 170 purchase price. Thus, we must now move on to the final step in the modern Graham and Dodd valuation approach, which is to factor in the value of growth.

distributable cash flow. Since no growth is assumed there is no need to make adjustments for working capital. We begin our adjustments of 2011 EBIT by adding back 25% of both R&D and SG&A costs, under the assumption that this proportion of both line items is not needed in a no growth scenario. After deriving adjusted EBIT, we subtract taxes to arrive at Net Operating Profit After Tax (NOPAT). The final adjustment we make to NOPAT is to adjust for both depreciation and amortization which are non-cash expenditures. Instead of adding back both D&A and then subtracting maintenance capex, Ive made the simplifying assumption of adding back 25% of D&A. As a result, Im assuming that the remaining 75% of the D&A charge will cover maintenance capex. From Exhibit 4, we can see that adjusted earnings in 2011 equal USD 22,562 mn. The next step is to calculate EPV by dividing our adjusted earnings by our required return. Exhibit 5, outlines our EPV per share calculation based on different discount rates. Furthermore, we are calculating returns to shareholders and as a result must subtract total interest bearing debt Exhibit 5: IBM EPV Analysis

The Value of Growth

Before delving into the growth analysis, I need to emphasize that not all growth is created equal. A company must be able to produce a return above its cost of capital for it to add value from an investor perspective. Due to the competitive pressures within a market economy only companies with durable competitive advantages will be able to provide returns in excess of their cost of capital. A firm such as IBM benefits from high switching costs as it provides hardware, software and IT services for large corporate clients. The ability of the company to provide a wide array of services, also results in economies of scale. IBM has benefitted in the explosive growth of computing demand and data that was ushered in by personal computers. The company

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Exhibit 6: IBM ROIC Calculation

has also made the switch from commoditized products to higher margin business such as software, services and integration projects. Given the companys strong ROIC generation, highlighted in Exhibit 6, its clear that a growth valuation can be applied. The main question that

my ultimate growth value per share is USD 237. Its estimated that Warren Buffetts purchase price for his stake in IBM was USD 170. Thus, using our growth value per share as a measure of intrinsic value wouldve resulted in approximately a 28% margin of safety. Its clear that Warren Buffett has

Exhibit 7: IBM Growth Value Multiple and per share value

needs to be answered is whether a growth valuation would provide a sufficient margin of safety for arguably the worlds greatest value investor. The growth multiple applied to our EPV per share calculation is determined by the combination of ROIC, the discount rate and the growth rate. For the growth rate, Im assuming that IBMs long-term growth is equivalent to long-term GDP growth in developed markets of 3%. Exhibit 7 contains sensitivity tables that show how different combinations of forecasted ROIC and discount rates would impact the growth multiple and growth value share price. Im going to use an ROIC of 25% and a discount rate of 14% as my base case. We can see from the exhibit that by adding a growth valuation, my EPV per share value would increase by a multiple of 2.0x. Thus,

assumed continued growth at IBM in order to provide an adequate margin of safety for his investment. With IBM currently trading at approximately USD 190, Mr. Buffett already has a short-term gain. However, the true measure of success of this investment will be determined over a much a longer time-frame. Exhibit 8: NAV, EPV and Growth Value per share

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About the Author
Ankur Shah is the founder and editor of the Value Investing India Report (VIIR). Ankur has been involved in global investing since 2004 and began his investing career at Security Global Investors, a San Francisco based global long/short equity fund. Prior to founding VIIR, Ankur was a Director of Equity Research at Arqaam Capital, where he was responsible for covering the MENA banking sector and building out the firms equity research platform. Ankur earned his MBA from Harvard Business School and his BA cum laude in Economics from Pomona College.

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