Last year, I had the honor and pleasure to attend the Value Investing Class taught by Mr. Chang Jing of Himalaya Capital at Peking University.
A key topic of the class was intrinsic value. During one lecture, Mr. Chang discussed the breakdown of intrinsic value components, i.e., sources of value. He also used a real-life example to illustrate this way of thinking, which I thought was very helpful.
The idea of “sources of value” is detailed in Bruce Greenwald’s classic value investing book "Value Investing: From Graham to Buffett and Beyond." Faced with the shortcomings of DCF-based intrinsic value calculations, Graham and Dodds investors have developed a three-element approach to valuation: assets, earnings power and profitable growth. The advantages of such approach are obvious, according to Greenwald, for the following reasons:
• "It segregates information affecting valuation by reliability class, so that good information is not contaminated by poor information."
• "It puts more emphasis on information about the firm that is solid and certain."
• "It is based on a thorough grasp of the economic situation in which a company finds itself."
• "It values the company’s future prospects with more realism and less optimism than is customary on Wall Street."
• "It refuses to pay anything for even the rosiest prediction that has no current or historic foundation."
When you invest in asset-light companies or high growth companies, the most reliable source of value, i.e., assets value as properly adjusted, is a very small part of the intrinsic value. For these types of companies, profitable growth is the major component of the intrinsic value calculation. Any change in the business’s future prospects would have an outsized impact on intrinsic value.
At other times, your investment decision relates to an asset-based comopany. Asset value as properly adjusted accounts for a much higher percentage of the intrinsic value estimate for these companies, while profitable growth accounts for a much smaller percentage.
Before attending Mr. Chang’s class, I hadn’t incorporated the sources of value analysis in my intrinsic value calculations, but after attending his class, I analyzed my past investment decisions by painstakingly breaking down the components of value at the time of initial purchase. It didn’t surprise me when I found out that the best decisions I made were the ones where the purchase price reflected a much higher percentage of assets value than growth value. The worst decisions are the exact opposite.
Like most things in investing, the “three-element approach” to valuation is a combination of art and science and requires quite a bit of individual judgment. It’s a framework, or a mental model, as opposed to a formula. In practice, many other things need to be considered when applying the three-element approach.
For instance, many modern businesses such as technology companies inherently have asset-light business models. Therefore, their intrinsic values inevitably depend upon earnings power and profitable growth. This might explain from a fundamental level why value investors shy away from technology companies. Intuitively, the weight of each component should vary among different industries, but how should we think about the proper weight of each component for each company we analyze?
But regardless of the practical challenges, on rare occasions Mr. Market does offer opportunities when the market price of the company is below the properly adjusted assets value, and we get the earnings power and profitable growth for free. On less rare but still non-frequent occasions, Mr.Market only prices in asset value and no-growth earnings power, and we get the profitable growth for free. Of course, in both cases the most important thing is to have high conviction that the business is profitable and has growth potential.
Read more here:
- Knowing What You Don't Know
- Notes From Li Lu's Recent Interview - Part III
- Notes From Li Lu's Recent Interview - Part II
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