Modern Value Investing: What Would a Private Owner Pay?

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- By Robert Abbott

Privately owned businesses do not experience the volatility of public companies since they are not exposed to the psychology of investors, or what Benjamin Graham called Mr. Market. That is the focus of another pair of Sven Carlin's points in "Modern Value Investing: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment."


Tool 5: What would the value be if this were a private company?

According to Carlin, private businesses generally trade at an average industry valuation in relation to their cost of capital and their return on capital. In addition, the price is further affected by other factors, including brand values and risks. It is helpful to know what prices similar businesses have sold for, but, for greater accuracy, a look at the details is necessary. Two companies may have the same amount of revenue, for example, but one may have no debt while the other has no equity and, as a result, will be valued differently.

The author also reported that Walter Schloss, another of Graham's students, outperformed the market by more than five points per year between 1955 and 2002 using a similar approach. He sought out good businesses selling for less than a private owner would pay, and then waited for someone to buy them at a premium.

Such transactions become more common in the late period of an economic cycle, wrote Carlin, because companies have built up strong cash balances and become desperate for growth. Thus, smaller companies can expect to be approached multiple times over a decade, especially if there are good synergies. The safety of such strategies, from the takeover candidate's perspective, increases when an investor compares the current stock price with a potential takeover offer.

Takeover pricing varies from sector to sector, as Carlin showed in these examples:

  • Amazon (AMZN) shelled out $13.4 billion for Whole Foods, which had $15.7 billion in sales and net income of $500 million in 2017.

  • Facebook (FB) spent $22 billion to buy WhatsApp, which had $10 billion in revenue in 2013.



To execute on this idea, Carlin recommended finding five key metrics for the sector and then comparing the target company with acquisitions in the same sector. With that information, it is possible to estimate a buyout value.

Intrinsic value

In discussing intrinsic value, Carlin takes his cues from Warren Buffett (Trades, Portfolio); that starts with a definition from the Berkshire Hathaway (BRK-A)(BRK-B) annual report of 2013: "the discounted value of the cash that can be taken out of a business during its remaining life." Carlin noted that intrinsic value could be considered the equivalent of net present value, to a certain extent. He went on to argue that when an idea comes from Buffett, it will be more about philosophy than technique and, as a result, intrinsic value should be recognized as a separate tool, one that offers precision in business valuation and enjoys a broader reach than net present value.

Even if intrinsic value cannot be precisely estimated, the process of trying to calculate the value will help investors better understand the risks and rewards inherent in a specific stock. By using the same methodology when evaluating various stocks, investors will benefit by making decisions.

Carlin went on to note that an investor who thinks like an owner will focus on changes in book value, calculated by subtracting eventual dividends from current year earnings. He added that the yearly change in book value is more stable than the irrational valuations of the markets.

Tool 6: How to measure intrinsic value

Another way to define intrinsic value is as the discounted value of cash that can be harvested from the business in the future. This might also be called the "cash available for distribution."

It can be calculated this way:

  • Cash available for distribution = (reported earnings + non-cash charges, including depreciation) - (capital spending + additional working capital needed).



Still, the author says the only proper measurement is the change in the book value of a company, after adjusting for dividends and other capital transactions. And the way to arrive at book value is to combine three factors:

  1. Value of past investments: This will be shown in the book value of a company and based strictly on cash and assets that can be converted into cash quickly. This means figuring out discounted cash values for both tangible and intangible assets. Carlin went on to explain the difference between intrinsic value and book value. "Book value is easy to calculate and gives a limited perspective on the company as it doesn't tell anything about its future," he wrote. "But the change in book value in one year tells you how much the intrinsic value of the business has changed in the current year as the current change isn't discounted."

  2. Earnings: An increase (or decrease) in earnings is the driver of change in book value and "the only objective indicator of intrinsic value." To assess earnings, use past averages and adjust to compensate for growth and cyclicality.

  3. Returns expected in the future: This refers to the expected future returns on retained earnings, and the most subjective part of the combination. Carlin offered a "good approximation," which is past returns on invested capital. In this, he joins Buffett and Charlie Munger (Trades, Portfolio) in calling return on invested capital a crucial metric.



(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

Read more here:

  • Modern Value Investing: Liquidation Value and More

  • Modern Value Investing: The Art of Business Valuation

  • Modern Value Investing: Adding to the Value Investing Toolbox


This article first appeared on GuruFocus.


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