Bookworm: Even simplistic valuation methods are far from simple

Welcome to the next edition of Bookworm, my weekly column where I explore ideas and methods from investing books and letters. Today’s edition was inspired by a reader who emailed in and asked me to write on the topic of valuation.

Today’s insight

The insight we will explore comes from Robert Hagstrom’s book, The Warren Buffett Way. More specifically, we are going to walk through a simple valuation method that Hagstrom used to gauge some of Buffett’s most notable stock purchases.

Before I walk you through the method with an Aussie example, a quick warning: do not be fooled by its apparent simplicity. As with any valuation method, you need to make a lot of assumptions and guesstimates for each and every part of the ‘formula’. Every assumption has the potential to be wrong.

I’d also say that this method has most promise for a specific kind of company. More specifically, it appears suitable for companies that deliver relatively consistent earnings rather than erratic ones, and earnings that are growing slowly rather than quickly. We will see why later.

Introducing our example company

I will walk through my interpretation of this valuation method using GWA Group (ASX: GWA) as an example. GWA Group owns Caroma, Methven and a host of other toilet, sink and bathroom component brands. I decided to use GWA as our example for several reasons:

It has delivered a rather stable level of profit over the last several years
It doesn’t have an extreme level of debt, which would complicate things
It is not currently in our ASX coverage

My goal here isn’t to provide an estimated value for GWA. Rather it is to introduce you to the three main inputs of the valuation method used in Hagstrom’s book and show you how tweaking your assumptions for these inputs will affect the results of using this method.

The basic formula is as follows: Equity value = Owner earnings divided by a discount rate.

Input #1: Owner earnings

Owner earnings is a phrase coined by Buffett. It is supposed to represent the amount of cash thrown off by the business in a typical year, over and above the investments needed to keep the business operating at its current level.

To calculate owner earnings for a given year, you start with net income, add back the non-cash depreciation and amortisation charges, and subtract capital expenditure.

My interpretation of this was to try and assess a level of owner earnings that seems sustainable in a normal year, as opposed to just using what the number was last year. For example, capital expenditure usually happens in lumps.

Given GWA Group’s relatively stable earnings profile, I decided to use rough averages for net income, capex and depreciation over the past several years, as shown in the ‘financial summary’ from GWA Group’s annual reports.

Figure 1: GWA Group financial summary. Source: Annual report

I looked back ten years in total but it’s important to note that I based my expectations for capex on the numbers from 2018 onwards. This is because GWA shifted its strategy to importing rather than making all of its products, leading to a fall in capital intensity.

I used $39m for net income, $6m per year in capex and $20m in D+A in a 'normal year'. This gave me $53 million of what I see as sustainable owner earnings based on past data. It is better to use a range rather than exact amounts, so let’s call it $50-55 million.

As the stock’s value depends on what will happen in the future, you would also need to consider what earnings are likely to look like in future years. We will come back to this later but first, let’s talk discount rates.

Input 2: Discount rate

A discount rate is how you account for the difference in value between a certain dollar today and a less certain dollar predicted to arrive in the future. It also accounts for the fact that today's dollar can be saved or invested with a rate of return, while the future one cannot.

The less certain dollar is worth less to us today than the certain one. So its future value must be discounted to reflect this. The less certain you are that the future dollar will arrive, or the higher return you can get on your dollar today, the higher the discount rate should be.

Hagstrom mentions several potential methods for arriving at a discount rate.

One is to use the return you could (or would hope to get) elsewhere. This represents the opportunity cost of choosing this investment over others.

Another is to use the risk-free interest rate available on government bonds. Hagstrom says that Buffett does not add a ‘risk premium’ to this to account for equities being riskier than bonds, but many investors do.

Another is to use something called the weighted average cost of capital. This is the weighted average of how much a company's equity and debt funding costs.

I generally target a 10% annual return from equities, so I opted for that as my opportunity cost of capital. As for using a risk-free rate, the 10-year Australian bond currently yields 4.44%. Adding a risk premium of 5% (an arbitrary figure that seemed reasonable based on historical levels) gets you to 9.44%. Now for the weighted average cost of capital.

For this, I started by calculating how much of GWA’s balance sheet was funded by equity as opposed to debt. I found that it was roughly 70% equity and 30% debt. I used my 10% required return hurdle as the cost of equity and found GWA’s average cost of debt by dividing its interest payments in fiscal 2024 over average debt during the year.

Calculating the weighted avaerage of these two numbers left me with a weighted average cost of capital of 8.2%. This concept can seem a bit abstract and it is also highly subjective because the number you get depends on which method you use for the cost of equity.

Either way, using these three methods suggests that a discount rate of between 8% and 10% seems reasonable.

Input 3: Growth rate?

Buffett morphed from buying merely cheap businesses to those that had the potential to reliably grow their earnings over time. As growth potential is a key component of a company’s value, he needed a way to add this into his valuation method when relevant.

Hagstrom suggests that this could be done by subtracting the annual earnings growth you expect from the discount rate you use. For example, if I was banking on 4% annual growth in earnings, I could subtract this from my initial discount rate of 10% and get a new overall discount rate of 6%.

“When a company is able to grow owner earnings without the need for additional capital, it is appropriate to discount owner earnings by the difference between the risk-free rate of return and the expected growth of owner earnings” Hagstrom in the Warren Buffett Way

As we will see in a moment, this small tweak to the discount rate can bring about big changes in the value served up by this formula. So if you are going to price in growth that way, you need to be pretty sure it will happen.

You will also notice another potential problem: what if the expected growth rate is higher than your initial discount rate? In this case, a more thorough cash flow calculation might be needed rather than this rather shorthand version.

My growth assumption for GWA

In GWA’s case, my base assumption was that earnings will fluctuate around current levels rather than consistently growing. As a result, I did not use a long-term growth rate to reduce the discount rate used in my valuation.

I based this mostly on the company’s historic results. Obviously you would also want to consider factors regarding the future, such as:

The outlook for construction activity in GWA’s main regions and markets
Likely differentials in growth rate between different segments or regions
GWA’s competitive position and potential to expand or lose market share
GWA’s potential to keep more revenue as profit by increasing prices or cutting costs

I would think very carefully before blindly adding management targets into your growth assumption. I would want to see proof that they are obtainable first, noting that GWA has fallen short of the ‘5-10% annual EPS growth’ target mentioned in past presentations.

Assumptions, assumptions, assumptions

Even with a rather simple method like this, and even before asking tougher questions about the company’s competitive position and future, you can already see how many assumptions are built into our valuation. These include:

What levels of net income, capex and therefore owner earnings are ‘normal’?
What long term growth rate to factor in, if any?
Which discount rate method to use?
What equity risk premium to use, if using that method?

Small changes in any one of these inputs can have a big impact on the valuation that comes out. And that’s before you consider the combined impact of changes in multiple inputs.

With that in mind, let’s see how much this method (and my assumptions) suggests GWA might be worth.

Pulling it all together

The base assumptions I arrived at for GWA Group were as follows:

“Sustainable” owner earnings in a normal year of $50-55 million
A discount rate of between 8.2% and 10%
No consistent earnings growth

Here are the equity values suggested by the formula at different discount rates:

Figure 2: Implied equity values for GWA (not an official estimate). Source: Author

This method suggests that GWA Group’s equity might be worth somewhere between $500 million and $670 million. That is if my base assumptions were reasonable. And that is, of course, a huge assumption.

There are a couple of ways you could account for this. First, you should aim to use a range of reasonable assumptions and arrive at a range of potential valuations. As opposed to going all in on one set of numbers and falling victim to false precision.

Second, you should aim to buy at a price significantly below your range of possible valuations. This adds a cushion in case you are wrong in one or several of your assumptions. You will often hear investors referring to this as a margin of safety.

GWA’s market cap when I wrote this was $662m, which doesn’t appear crazily cheap or crazily expensive versus the range of values thrown out by my no-growth assumption. Given that my assumptions may have appeared reasonable for the last few years, you can see why a market cap below $450m in 2023 may have looked too cheap.

Just for fun, here is what happens if we were to add some assumed growth into the mix by subtracting it from our various starting discount rates. The numbers are based on my original owner earnings estimate of $53 million per year.

Figure 3: Impact of growth assumptions. Source: Author

Look how much assumed growth impacts the kind of numbers that come out! This could go some way to explaining Buffett’s remark that Berkshire often comes up with higher valuations for truly high quality businesses than other investors.

An important note

I started this article with a couple of warnings about this method. One was not to be fooled by its simplicity. The other was that it only seems suitable for a specific kind of company, a point that Hagstrom also makes very clear in the book.

If the company you are studying does not provide ‘bond like’ cash flows of the kind Buffett found in Coke and instead swing around wildly, it will be a lot harder to arrive at a level of owner earnings you can rely on in the future.

This method also depends on a company's staying power. If a company isn’t a) still around and b) still earning at a similar or better rate in several years time, you may find yourself paying up for several years of “sustainable” future earnings that don’t eventuate.

More than anything, using even a straightforward method like this shows that valuation is far more an art than it is a science. And it definitely isn’t simple.

For a deeper dive into what you might consider when valuing a company, consider watching the webinar below by Mark LaMonica.

Previously on Bookworm: