I’ve seen some confusion on online forums about what Reproduction Cost (RC) is and why it is relevant. The way I think of it is that RC is the cost you would incur if you started from scratch and tried to reproduce the profit-generating (or potentially profit generating) parts of the business today. By comparison, the book value (BV) of the business as shown on the balance sheet is the historical cost of creating all of the assets and liabilities that the company has today. A third value we could calculate is the liquidation value of the assets but this is only relevant if we are considering the possibility that the business may be liquidated.
In calculating RC we are trying to arrive at a cost figure which is not distorted by the capital structure of the business so that we can:
- Compare the RC with the Earnings Power in order to gain clues as to the competitive situation of the business.
- Divide the Earnings Power by the RC to arrive at a return on incremental capital figure that we can expect for investments in growth that the business may make.
- We are also trying to reveal any ‘hidden’ assets or liabilities which have a distorted value due to things like historical cost accounting.
The basic adjustments can be made as follows:
|Item||Balance Sheet Treatment||RC Treatment||Reason for the Difference|
|Current Assets||Cash||Balance held by the company.||Only include the cash needed for operations.||Non-operational cash is considered later when considering capital structure.|
|Receivables||Expected amount that can be recovered.||Balance sheet amount plus bad debt allowance.||Bad debts are a real cost, especially if the business is new.|
|Inventory||Balance held by the company.||Correct for Last In First Out (LIFO) valuation, if used.||If the price of the company’s products has risen, LIFO accounting will undervalue the inventory.|
|Tax assets||Historical amount.||Balance sheet amount discounted to present value.||The cost of creating the same asset today will have changed due to inflation.|
|Pre-payments||Historical amount.||Balance sheet amount.||Usually these payments are recent so they don’t need to be adjusted.|
|Non-Current Assets||Property, Plant & Equipment||Usually historical cost less depreciation and impairment.||Increase or decrease historical cost according to rules of thumb.||Depreciation, impairment and changes in technology or real estate values distort the balance sheet figure.|
|Goodwill||Usually a reflection of merger premiums paid or capitalised IP spend.||Delete and replace with a multiple of SG&A and/or R&D.||Learning, customer relationships and intellectual property need to be created to reproduce the business.|
|Current Liabilities||Accounts Payable||Historical amount.||Balance sheet amount.|
|Provisions||Historical amount.||Balance sheet amount.|
|Tax liabilities||Historical amount.||Delete.||A new business would not necessarily incur these taxes.|
|Employee benefits||Historical amount.||Check if defined benefit pension involved, otherwise use balance sheet amount.|
|Derivative contracts||Historical amount.||Balance sheet amount.|
|Adverse legal settlements||Historical amount.||Delete.||A new business would not necessarily incur lawsuits.|
|Non-Current Liabilities||Borrowings||Historical amount.||Consider later as part of the EPV calculation.||Debt is not necessary to reproduce the business. It is instead a capital structure matter.|
|Employee options||Not shown.||Number of options x exercise price.||Options are a real cost that will dilute other shareholders once exercised.|
|Long-term leases||Contracted amount.||Balance sheet amount.|
One key point to make about the RC method is that it requires industry knowledge to do correctly. For example, in adding multiples of R&D to the assets one must consider the product life cycle of the company. An industry where the product life cycle is long such as airliners will need to add, say 15 years’ worth of R&D to reproduce the range of products (aircraft) which it currently sells. A faster-moving industry such as software may only require one to three years’ worth of R&D to develop the current product suite.
A further implication of this is that the addition of R&D and SG&A charges can result in a large RC in comparison to book value for companies that don’t require a lot of PP&E type assets to run. In these cases the RC is very sensitive to the SG&A/R&D multiple applied so it’s best to look carefully at the product lifecycle in order to arrive at a result which can later be used to evaluate competitive position and returns on capital. Just slapping a multiple on can be dangerous in these cases.
If you have questions or comments please write to Warwick at firstname.lastname@example.org. I answer every email that I receive. You may also want to check out our first article in this series on Bruce Greenwald’s methods here.
Disclosure: 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.