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# Assets based on reproduction costs

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Hello All,

I have been reading the notes of Bruce greenwald methods of  estimating the assets based on reproduction costs ,How does one calculate it??  when I ask How to calculate I mean How does one get to X  when it is Y specifically I am looking for information sources or  tips.

Thanks

Mani

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I have a rant on this that I'll save you from.

Just step back and think about buying a company for a second.  The company has x% of their inventory marked down and x% of their receivables as non-collectable.  If you were going to "reproduce" this business from scratch suddenly those accounts are full value at their reproduction value.  Yet those aren't true values.  Extend this thinking through the rest of the balance sheet and I think you'll be able to fill in the blanks for my view on this.

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I have a rant on this that I'll save you from.

Just step back and think about buying a company for a second.  The company has x% of their inventory marked down and x% of their receivables as non-collectable.  If you were going to "reproduce" this business from scratch suddenly those accounts are full value at their reproduction value.  Yet those aren't true values.  Extend this thinking through the rest of the balance sheet and I think you'll be able to fill in the blanks for my view on this.

+1  That's exactly my problems with it too.  This is where academia meets up with the real world and pretends it knows better.

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I have a rant on this that I'll save you from.

Just step back and think about buying a company for a second.  The company has x% of their inventory marked down and x% of their receivables as non-collectable.  If you were going to "reproduce" this business from scratch suddenly those accounts are full value at their reproduction value.  Yet those aren't true values.  Extend this thinking through the rest of the balance sheet and I think you'll be able to fill in the blanks for my view on this.

+1  That's exactly my problems with it too.  This is where academia meets up with the real world and pretends it knows better.

+2.  Assets need to earn something eventually.  End of story.

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I have a rant on this that I'll save you from.

Just step back and think about buying a company for a second.  The company has x% of their inventory marked down and x% of their receivables as non-collectable.  If you were going to "reproduce" this business from scratch suddenly those accounts are full value at their reproduction value.  Yet those aren't true values.  Extend this thinking through the rest of the balance sheet and I think you'll be able to fill in the blanks for my view on this.

+1  That's exactly my problems with it too.  This is where academia meets up with the real world and pretends it knows better.

+2.  Assets need to earn something eventually.  End of story.

+3. Just because.

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I think about it more on a competitive basis. The company might have some machine sitting in the factory which they don't use. I'm not going to buy that machine if I were to go into business and compete with them.

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I have a rant on this that I'll save you from.

Just step back and think about buying a company for a second.  The company has x% of their inventory marked down and x% of their receivables as non-collectable.  If you were going to "reproduce" this business from scratch suddenly those accounts are full value at their reproduction value.  Yet those aren't true values.  Extend this thinking through the rest of the balance sheet and I think you'll be able to fill in the blanks for my view on this.

+1  That's exactly my problems with it too.  This is where academia meets up with the real world and pretends it knows better.

+2.  Assets need to earn something eventually.  End of story.

+3. Just because.

+1 million trillion gazillion.

First time signing in on CBF in many days and I just landed on this. Thanks Universe, I really needed to rant about something after a bad argument I just got into with some #*@&\$# (insert any not very flattering word used to describe a fellow human being).

So, if Nate is OK with it I'll rant on his behalf.

Bruce Greenwald's method is garbage.

I'll tell you guys a little story, a few years ago I was burnt out from working flat out for a few years, at that time I had made quite a lot of money investing for a few years thanks in a big way to one morning my boss came into the office and handed me his copy of "The Intelligent Investor" and said read this and we'll resume our discussions after. The reason he did that was probably because he was growing tired of this kid he had hired straight from college and who thought he knew everything because he had degrees in accounting and finance and would talk confidently about betas and others. Needless to say that man changed my life, that morning denotes a clear inflection point in my life I can point to and I have him to thank.

Anyways, I was burnt out and getting depressive and decided I had had enough of it and it was time to go do my MBA and it didn't matter how much money or stock options they offered me to stay because by then I was the only one they went to for questions about stuff like FAS 123R and other things my boss (who was now gone to work somewhere else) had taught me and they didn't want to see me leave.

So I wanted to go to Columbia because of Greenwald's value investing program but I was too late to apply so I thought, why not that Prem Watsa school in London, ON. I like Prem so why not give it a shot. So I applied to it and the person who reviewed my application must have liked my potential because they immediately called me to accept me and gave me a kick ass scholarship to attend.

After sleep walking through most of the useless (IMO) classes you're put through in any academic endeavor, came the time to take George Athanassakos' value investing classes and I was stoked. Finally no more consulting related classes full of "synergies" and other consultant buzzwords that made me want to shoot myself (or someone else) on a daily basis.

The day we received the material for his classes, I went straight home and flipped through everything before the first lecture.

The first realization was that the entire course was pretty much based on Greenwald. All of it. I had read Greenwald's book before so to me that was a disappointment but I wanted to see how it would go since the Ivey MBA program is entirely case based so what mattered would be how we would handle the actual cases and not necessarily the readings and other things we were given.

First lecture, first case. Let's value a company. Oh boy.... Oh my effing God (excuse my French all).

Long story short he walks us through valuing the balance sheet of the company in the case and before our adjustments it had a net worth of roughly \$1 billion. By the time we were done with all those stupid "replacement costs" mark-ups to almost every single line items on the BS the \$1B equity had basically tripled to about \$3B.

Now this is someone who quotes Buffett every 22.5 seconds, so at the end he stands in front of the class and solemnly declares:

"Remember, we value investors are conservative, so what we'll do is take 15% off for margin of safety!!"

I looked up from my book and said to myself "Are you effing kidding me?" You just arbitrarily tripled the BV of this company and then shave off 15% because you have to be conservative... The disappointment I felt could not be described in words, I nearly shed a tear. I had been looking forward to this for a while now. (By the way, George is a great guy etc. etc. He really is. I know many people get butthurt real fast when someone even dares say something about someone close to Prem so please spare me, I am not attacking him. Thanks.)

So I went to see him after class just to chat a bit about this stuff and I gave him an easy example, i.e. his adjustments to "Accounts Receivable" in current assets:

I told him something like this:

"George, just think about this for a sec, when I call a broker and ask him to buy me 100 shares of company X. What I am doing is acquiring whatever proportion 100 shares represents of those exact account receivables that are sitting on company X's books right? Those exact damn receivables. However they were acquired, however they will be collected and turned into cash etc... Those are the receivables I'm buying into right?

Now, in your formulas to get to a Net Asset Value, in the part about A/R you ask us to go look for write-offs for bad debt allowances and other collection allowances write-offs and ADD that back because we have to get to a reproduction cost for A/R, the thinking being that, somehow, that's the money a brand new company would have to spend to get those assets on their books.

Does that make sense?

I am buying the receivables that are there right? Right.

So what if I studied company X over the last 10 years and realized that they suck at collecting money and constantly have to write off 50% of their receivables because they can't turn them into cash, does it make sense to you that I'd go and mark them up when I'm analyzing company X's balance sheet????? Even though I know that they're probably not going to collect more than half of it??? And still you want me to mark them up?? WTF George..."

And then a very instructive moment happened. He just replied, well that's the formula. And then it hit, it hit me like a thousand pounds of bricks falling on you. So I said thanks and then and there decided most of the class would probably be garbage so I just had to deal with it and went back to reading my newspaper.

What hit me you ask?

Well... It's simple, when he said "that's the formula". I immediately understood him and where he was coming from. I had a flashback to the first day of class when he was introducing himself and told us when he was first introduced to value investing, sometime in the mid 90s. You see, by then George had been a PHd in Finance for many many years and was just a straight up academic like Kraven said. He had already published many papers with betas and alphas and blablabla. They just like their formulas because... just because actually. It's who they are. And if you look at Greenwald he is the exact same way. His bio will tell you that he got his PHD in 1978 and by the time he had to try and reinvent himself into a value investor for that Columbia class in the 90s it was probably too late.

And that will result in these notions that they introduce that make absolutely zero sense in the real business world. But still people follow them.

I just went foraging through my George notes and opened his class slides to pick one other example for you guys.

So here you have an example of a random intangible (Hidden Assets he called them) he'd have you add onto the balance sheet to get to a "reproduction cost"

This one was called "CR - Customer Relations"

The thinking being that a new company starting from scratch would have to spend money acquiring those relationships and before you know it you had another formula on your hands that on the surface makes it seem like it is measuring the right stuff when it is just as nonsensical as the other formulas.

Here's what you did:

You look up their marketing expenses if disclosed. If not disclosed like is the case for the vast majority of companies, you take 1/2 of SG&A (Why 1/2 of SG&A? I don't know. It's the formula)

Then you take the average of the ratio of that SGA/2 over sales for a few years and multiply it by current sales.

And after that (this is where it gets funny), you introduce a random ass multiplier (thinking being for industries that are CR sensitive the multiplier would be higher and those that aren't it'd be lower) I can't remember but I think the multiplier would be between 1 and 2. I of course asked him why 1? why 2? Annnnnddd... you guessed it.... because it's the formula.

So for an easy example of a company that has 1000 in revenue and spends 200 on SG&A and using the magical multiplier of 1.25, here's what it would look like.

 Customer Relations Yr 1 Yr 2 Yr 3 SGA/2 \$100 \$100 \$100 Sales \$1,000 \$1,000 \$1,000 (SGA/2)/Sales 10.00% 10.00% 10.00% Average 10.00% Current Sales \$1,000 Multiplier 1.25 CR Value \$125

(Sorry for bad formatting)

So you see how before long you're adding stuff onto the balance sheet and you end up with a net worth that is triple what it was to begin with. Garbage. And the thing is if you didn't use his formulas (and there were a bunch like these) he would fail you. And I can't remember a class when he didn't quote WEB by saying "You'd rather be approximately right than precisely wrong", right before going on to calculate a replacement cost for a CR/Hidden Asset  to the penny with a random formula. It was hilarious.

Now with that being said, Greenwald's EPV stuff has some stuff that we all use. Of course learning DCF will just suffice.

Alright folks, end of rant. Thanks all, I needed this.

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AZ_Value, a proverbial tip of the hat to you.  A very nice rant indeed.  What the academics don't appear to understand is that you're not valuing a business that might come along to compete with another business, you're valuing THIS business.  You take your business as you find it.  It isn't about what someone would have to invest in order to come along and compete, it's what someone would pay on a specific business.  I can just imagine back in my negotiating days telling someone that there is \$1 mil of A/R written off because we think it's worthless, but they'll have to pay for it anyway since if they started it from scratch that's what they would need to invest (since of course they would have the exact same percentage of written off A/R).

The Greenwald book is good in some ways.  It's an easy, enjoyable read.  But at the end of the day all it's really good for is the profiles in the back.  Even the profiles are just summaries of other materials already out there, but they're nice to have in one place.

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Great stuff AZ_Value, thanks.

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Thanks all for your replies and suggestions and I am new to this group and learning the investing game.

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Alright folks, end of rant. Thanks all, I needed this.

Not Too Long; Did Read.

+4

+5. Good rant.

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My takeaway from Greenwald's book is quite different. It is not meant to be applied mechanically via a formula. He specifically mentions that this takes skill and industry knowledge to apply this and that it is very difficult to improve upon book value. So if some professor is using it via a formula, shame on him.

The book has a couple of key big ideas that have helped me immensely.

1. If a business does not have competitive advantage, there is no point in valuing growth, since growth does not add any value. So you can try to estimate value via reproduction value using your judgement to correct for things where it makes sense and use book value as the starting point. Or you can estimate it using a no growth valuation via a multiple derived from DCF valuation.

2. Only and only if a business has competitive advantages, you need to consider growth in valuation. Even then you try to first estimate a no growth value and instead of using DCF to model specific growth rates, you can try to estimate roughly how much more growth could be valuation compared to a no growth case.

To take an example, when I looked at Arcos Dorados Holdings, which basically has 2000 McDonalds restaurants in Latin America and an exclusive franchise agreement for that region. Arcos does not have any competitive advantages other than the fact that it got an exclusive agreement and possibly low cost leases. As a franchise owner McDonalds has the competitive advantages and negotiating leverage and hence it is likely to take the majority of the excess returns available. So Arcos would earn just a tad higher return from its investments than average. So reproduction value of its assets would be a good starting point. A McDonalds would take about \$1 million to \$2 million to start up in US. I am not sure about Latin America, but I would be surprised if it is a lot different and more likely it would be at the lower end. So using a \$1 million as the capital needed to start one individual McDonalds outlet, the reproduction value is roughly \$2 billion, since Arcos has debt of \$0.9 billion, equity value would be \$1.1 billion or about \$5 per share on 210 million shares outstanding. This is not the IV for Arcos, but I know with a high level of confidence (assuming that we validate the \$1 million startup cost) that Arcos is worth a minimum of \$5. Its modest advantages means it would be worth at least a little more.

I do not need to consider a detailed growth rate, currency fluctuations and whole lot of others to come up with a rough value. This happens to be the case in lots of cases and this is where Greenwald's book is of immense help. It simplifies valuation quite a bit if you think in a binary "Does it have a competitive advantage or not?".

Vinod

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It's funny, I read the first 1/2 Greenwald on Saturday for the first time and liked his formalization of the value investing framework. You start with the balance sheet and assess each line item to get an idea of the assets, then assess what those assets are earning, and then attempt to analyze the sources of earnings/quality of business/growth prospects etc. I agree that some of the adjustments are forced and a bit of gobbledygook but I thought the overall framework and the expression of value investing was good.

To me he is much more nuanced than presented here and is not overly formulaic. That professor sounds pretty awful.

Page 45 (at least in my copy)

"Discrepancies between asset value and EPV suggest both an opportunity and a caution. If the gap can be closed because of better management, then the intrinsic value of the firm will increase, which should be reflected in its marker price because earnings will grow (i.e. return to normal). On the other hand, the fact that the assets are not producing  the earnings they should ay indicate that the firm is operating at a competitive disadvantage."

this seems much more reasonable than the capitalizing marketing costs and all that other stuff he does.

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Alright folks, end of rant. Thanks all, I needed this.

Thanks for going into such detail, understandably, this must have been a huge letdown.

The formulas and approach certainly do not make sense.

My takeaway from Greenwald's book is quite different. It is not meant to be applied mechanically via a

formula. He specifically mentions that this takes skill and industry knowledge to apply this and that it is very difficult to improve upon book value. So if some professor is using it via a formula, shame on him.

This is a great discussion.

As Vinod explains, as a framework to think about it can be useful.

There is a reason buying Sees Candy above book made sense. But you will not get there with the approach described.

;)

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Isn't it better to just look at the balance sheet and adjust it for your best guess of fair value? Like marking up land carried at cost, marking down old inventory that should be scrapped, etc.

I don't know, I try to value things but I'm just terrible at it. I think it's better to wait for stuff that just flies in your face, then you don't need to depend on making sharp predictions and what not. You don't look as cool and trendy, but whatever, let's make money instead, you know?

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• 4 weeks later...

I've been a fan of the Greenwald approach, as a beginner it was/is very helpful . His points about comparison between the calculated reproduction cost to the EPV of the company to look for evidence of competitive advantage and his caution about paying for growth only in the case where a franchise exists were very helpful.  There is also a book written by a guy who took his course, Applied Value Investing, which is basically the same stuff, but with explicit instruction on how he works out the values. With that said I tend to rely on the EPV more then the asset/repro value, I always think back to Buffett's mistake with BH, how the looms turned out to be essentially worthless despite being acquired quite cheaply. I quoted the passage from the 1985 letter below, for those who may not have read it.

"  There is an investment postscript in our textile saga.  Some

investors weight book value heavily in their stock-buying

decisions (as I, in my early years, did myself).  And some

economists and academicians believe replacement values are of

considerable importance in calculating an appropriate price level

for the stock market as a whole.  Those of both persuasions would

have received an education at the auction we held in early 1986

to dispose of our textile machinery.

The equipment sold (including some disposed of in the few

months prior to the auction) took up about 750,000 square feet of

factory space in New Bedford and was eminently usable.  It

originally cost us about \$13 million, including \$2 million spent

in 1980-84, and had a current book value of \$866,000 (after

accelerated depreciation).  Though no sane management would have

made the investment, the equipment could have been replaced new

for perhaps \$30-\$50 million.

Gross proceeds from our sale of this equipment came to

\$163,122.  Allowing for necessary pre- and post-sale costs, our

net was less than zero.  Relatively modern looms that we bought

for \$5,000 apiece in 1981 found no takers at \$50.  We finally

sold them for scrap at \$26 each, a sum less than removal costs.

Ponder this: the economic goodwill attributable to two paper

routes in Buffalo - or a single See’s candy store - considerably

exceeds the proceeds we received from this massive collection of

tangible assets that not too many years ago, under different

competitive conditions, was able to employ over 1,000 people."

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• 3 weeks later...

Dear AZ_Value

I am sorry to tell you that the story you told is a bit exaggeration from your side. I attended greenwald class and its completely different than the way you explained it.excuse me I am doubting that you and people who commented  read his book.

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