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EPV - Reproduction and earnings power value in practice


tol1
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Hey,

 

Some of you may have come across the EPV method to derive an adjusted NAV and so called earnings power value. Greenwald is one of the advocates of the method. I like the concept, but still struggle with it from a practical point of view:

 

1. Reproduction value: heavily depends on assumptions, ideally done by appraisers

2. EPV: starts off with a 'sustainable' operating profit; simply taking historical averages can skew valuation results heavily and I rather understand how P&L drivers impact the profit in the next 2-3 years instead of relying on historical means

 

What are your thoughts on those 2 points and if so, how do you apply the EPV method?

 

 

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tol1,

 

FWIW, will give you my perspective on this.

 

Somehow, we all have to form our own "proprietary" system to filter and evaluate investments.

Some of this EPV from Mr. Greenwald has made it into my process.

 

On point 1, I suggest that, in some cases, this forces you to think like an insider and to familiarize yourself with competitors and industry dynamics. This scuttlebutt-type work can be helpful to determine perhaps a floor or downside protection. For instance, I remember investing in Fortress Paper (FTP.TO) in 2009 (not necessary to know the company and it changed a lot anyways). There were two components. The first component was a factory printing money (literally). There was potential upside; I thought that in 2009, there was potential for high demand, in terms of money printing :) for this sub. By doing some work (appraisal of land, buildings, equipment, assets (energy) that could be sold), one could come up with a "reproduction" value that was way higher than book value. The other component was a relatively simple and easy to value free cash flow generator (wall paper). I thought that the enterprise value was selling at about 50% of market value only based on that component of the valuation. I submit that thinking about current competitive advantage is a nice step before evaluating the durability of the moat.

 

On point 2, I agree with your statement and previous years earnings can be "normalized" and a relatively consistent operating history may be a pre-requisite. Analyzing the sustainability of underlying drivers may help to make the bridge from EPV to "total value". This is the area that is the most promising but also the most subject to error.

 

 

 

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I usually don't like reproduction value. Like let's say a business makes wallpaper (stealing the example above). Maybe they have 5 factories and ship out from there. So are they worth five factories? Well maybe if you're an entrepreneur and ur going into the wallpaper business maybe you only need 2 factories.

 

What i do like is "put-out-of-business" value. What would it cost for a competitor to put you out of business. I think that's a pretty good idea to have as you triangulate value. It kind of defines the width of the "moat". Oh and maybe that cost isn't to build a competing similar product, maybe it is the cost to develop a new product which makes yours obsolete.

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Cigarbutt,

 

I like Greenwald’s approach overall, especiallly his discussions of scale and growth and how growth often erodes value when there are no economies of scale. It helped me understand the difficulty in assisting my family in the growth or its business.

 

The problem I see which it surrounds the premise of valuing reproduction value and taking it above book value. In my experience:

 

1. In high PPE businesses book value of the assets is often much higher than the OLV of the assets.

 

2. Which leads to a reproduction much higher potentially.

 

As you noted, the reproduction value worked for you on frontier.

 

I did use reproduction value -> EPV when buying CHL. It worked out well, hopefully it does over the longish term.

 

It also makes sense to consider reproduction value when considering high quality companies.

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Thanks all -

 

I concur that the concept is very good (on paper), in particular, the method of deriving a margin of safety.

 

- Do you use appraisers for assessing the reproduction value? In particular, PP&E excluding land and Greenwald's goodwill adjustments by adding a multiple of SG&A are subjective IMO. 

 

- Regarding the EPV I am sceptical as historical earnings, even if they were consistent, do not necessarily apply going forward. Usually, there is a reason why a stock is cheap, and that is that the future ability to achieve the same level of earnings is impaired.

 

 

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I had a go with the excess return and EPV method in a mature, competitive industry. As per excess return method the implied value was in line with the current share price, whereas the EPV showed a value 30% below the current price.

 

To me it seems that the methods only work for businesses with a LT historically stable margin / asset base.

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