Bruce Greenwald’s Approach to Valuation

In my mind I sort value investing methodologies into the following categories:

  • Quantitative ratios (e.g. P/B, P/FCF, EV/EBITDA). Backtests such as this one by Tweedy, Browne show that it’s possible to outperform by simply selecting stocks according to the cheapest decile as defined by these metrics.
  • Checklists. These usually incorporate simple ratios, measures of financial strength, management quality, business category quality etc. Benjamin Graham is famous for applying these.
  • Financial models. Net present value models are the epitome of this category.  Vitaly Katsenelson’s model as laid out in the Little Book of Sideways Markets is another good example.
  • Sum of the parts valuation. Basically this is any case where a business is separated into parts and valued using one of the above methods’  This is done to identify any individual segments which may be dragging down the share price of a conglomerate and thus causing mispricing.
  • Bruce Greenwald’s work on strategy and valuation.  Whilst it builds on the above items I think it is far superior if one wishes to pick individual stocks.  It’s not for those wishing to use a strictly quant approach.

The reason I like Greenwald’s method is that it’s built the way that an engineer would build a model of a physical problem.  Seeing as he started out as an electrical engineer before moving on to study economics, this is probably not a coincidence.  I also find it’s the method that provides the clearest and most tractable way to understand a business.  Full disclosure – I’m also an engineer.

The key aspects I like about the approach are:

  • Rely on information according to its reliability. Tangible assets which can be appraised by an auditor are pretty reliable.  Future growth projections are not.
  • When comparing items, make sure they are in the same space. By that I mean that you often hear people talk about a company that for example is selling for book value and has a revenue growth rate of 10%.  However book value is in the valuation space; it’s something that can be calculated as a dollar figure.  Earnings per share or enterprise value are other examples of valuation space items.  In comparison, revenue growth is in the return space. It’s expressed as a percentage change in something each year, similar to growth in dividends or share dilution due to capital raisings.  It’s possible to convert from valuation space to return space and vice-versa but great care needs to be taken with this because it involves a DCF calculation (see below).  Better to convert all values into the return space for comparison.
  • Understand the mechanics of each calculation. The conventional discounted cash flow calculation amplifies information which is low in reliability.  Small changes in the growth and discount rates used make a huge difference in the result, even though both of these figures are highly subjective.  Greenwald instead uses the return space to calculate the value of growth without over-amplifying its impact on the calculation.
  • Understand the competitive situation to understand the likely returns the business will earn on its capital.  Greenwald has written a book, Competition Demystified, which distills Porter’s classic work on competition to a usable form.  By providing a solid basis for returns on capital this method allows us to place a value on potential growth and on the existing assets of the company.
  • Consider the business as a whole before diving into per-share valuation. By comparing the earnings power of the business cost of the assets needed to reproduce the business we gain insight into the competitive situation of the market the business is situated in.  Once we’ve established the likelihood of the business to earn its cost of capital we can then divide the returns between the share capital and the debt.  Changing from whole company figures to per share figures is another basis or space change that we need to be clear about.
  • Triangulate data to check for reliability. Quantitative indications of competitive position should be confirmed by investigating qualitative barriers to entry in the company’s markets.  The reproduction cost of the assets, earnings power and cost of capital should gel with the company’s competitive situation.

Overall, I find that Greenwald’s method of appraisal drives at determining a cohesive, robust picture of businesses and their environment.  It doesn’t contradict the other methods mentioned above but I think it provides layers of qualitative safety that add to the quantitative margin of safety that value investors routinely apply.  I intend to flesh out the details of the method in future articles.  You can also find an analysis of WPP AUNZ using the method here.  You can also find a series of Greenwald’s lectures on Youtube although the video quality is not great so it’s not easy to get all of the info from his slides.  There’s also an article over at Valuewalk which might be of interest.

If you have questions or comments please write to Warwick at oceaniavalue@gmail.com.  I answer every email that I receive.

Disclosure: We currently hold WPP.  This is not a recommendation to buy or sell any securities.  All information presented is believed to be reliable and is for information purposes only.  Do your own research before purchasing any security.

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