Earning power of financial companies
The earning power of a financial company has to be viewed differently from a non-financial company as discretionary free cash flow for a financial company does not make much sense. Instead we consider an adjusted and normalised level of return on equity (ROE) over a business cycle as the key measure. Apart from this we apply the same considerations as to any other company in our analysis.
Why we look at earning power and not just liquidation values or growth
The value of a business consists of 3 components: asset values, earning power, and growth. We consider all three but are willing to only pay for the first two.
Asset Values. Historically, the value of the assets of a company was the most certain and reliable factor. The favorite investment situation of classical value investors like Benjamin Graham was the famous "net-net" situations. Graham looked for companies whose stocks were so lowly priced that they traded at a substantial discount to the money that could be raised in a fire sale of these businesses. He was unwilling to consider even the value of certain fixed assets like buildings and excluded valuing accounts receivables and inventories at their full value. Graham defined the net-net value of a business as (cash + short term investments + 0.75 x accounts receivable + 0.5 x inventory) - total liabilities. In today's world, these net-net situations have become extremely rare. At the time when Graham developed his approach the global economy was dominated by manufacturing companies which are normally more asset intensive than today's economy which is more dominated by service companies. Considering exclusively asset values in the valuation of a business one assumes the company to be liquidated and does not consider the business as a going concern, which is our preferred way to look at a business in today's world.
Earning Power. While economic earnings are less certain than asset values, it is the only way to capture the franchise value of a going concern. For more than 10 years we have followed our due diligence process to analyse and evaluate the earning power and sustainability of the franchise of the businesses in which we invest. A franchise is that sustainable competitive advantage which elevates and protects the business from its competitors and results in superior returns. A competitive advantage can take the form of intellectual property, cost, regulatory or legal, advantageous access or captivity of the customers or economies of scale. True sustainable competitive advantages are, however, not common at all and takes work and due diligence to uncover.
Growth. Growth is the least certain of the three components and notoriously difficult to forecast, or predict if you like, and therefore not a part we are willing to include in our valuation. Growth adds value only in the presence of a franchise. To grow the business, most companies have to be supported by larger assets (receivables, inventory, plant and equipment). This on the other hand has to be financed by earnings that could otherwise be distributed to the owners of the business whether retained earnings, borrowings or sale of additional shares. Only companies that enjoy a sustainable competitive advantage that enables them to earn a return sufficiently above the cost of the new investment add value by growing. Companies that do not achieve excess returns will in fact destroy value by growing the business. |
