Matt Franz : Zealous For Knowledge

Arriving At Intrinsic Value, Part 2

Businesses use assets to produce earnings. Sometimes these are tangible assets, like factories and trucks. Other times these are intangible assets, like intellectual property and trademarks.

One method of arriving at intrinsic value is to normalize earnings and capitalize them at the appropriate rate. I wrote about that in part one.

Another method is to value the assets that produce the earnings. This works when the assets are readily comparable across an industry.

Consider a small community bank with $10 million of equity that earns $500,000 (a 5% ROE). The market might value the bank at 10x earnings for a $5 million market cap and a 50% price to book ratio.

Assume a larger, regional bank operating in the same area has a 10% ROE due to economies of scale. The regional bank can use the community bank’s assets more efficiently and can profitably pay more than 0.5x for its assets.

As a going concern, the community bank’s intrinsic value is $5 million or 10x earnings. But in a private transaction it’s probably worth at least 1.0x, or $10 million.

When a business with fungible assets is under-earning versus its peers, investors can value the assets in anticipation of a sale or turnaround. This is a way of normalizing the earnings in anticipation of a more productive use or user.

A bank is no different than any other business. It’s how much cash you’re going to get between now and judgement day, discounted and comparing it to other investments.

So there’s no special trick in the valuation. There can be a problem figuring out what’s inside the bank, particularly with non-U.S. banks. But otherwise I’m looking at it like it’s Coca-Cola or American Express.

Warren Buffett

Warren Buffett reminds us that intrinsic value is always the present value of future cash flows. When assets are used inefficiently, earnings are low and intrinsic value is depressed. Owners have an incentive to either bring in new managers that can increase productivity or sell the assets to a business which can make better use of them.

The asset based investor sees that the assets are capable of producing more income than they do currently and values them based on their potential, not their reality.

In fact, asset based investing is no different than any other type of investing. It’s simply a more extreme approach to normalizing earnings, which I wrote about in part one.

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