Valuing a business: Moats, management and margin of saftety

Greg Hopkins of Alphen Asset Management writes that one sometimes reads about competitive advantages, barriers to entry and the word 'moat' to describe the quality of a company's business model. At Alphen, he says, research focus is on the three M's - 'Moats, Management and Margin of Safety'.

The moat is particularly important to us and is a feature on which we spend a great deal of time. Buying a business is seen as being similar to buying a castle surrounded by a moat - a moat that we would like to be deep and wide to fend off all competition.  This is particularly relevant if one is buying a business with a high return on capital - if the expected growth in the industry is perceived to be attractive then one can expect that there will be competitors knocking on the door. Without a sustainable moat, a good potential investment turns into a value trap, as new competitors enter an industry and the company's returns fall to its cost of capital. If the original margin of safety in the investment case was not sufficient then the risk of permanent capital loss looms for an investor.

How then do we assess the value of these moats when developing an investment case?

One interesting approach which we use internally at PSG Alphen (which emanates in part from Bruce Greenwald* at Columbia University) is to assess the value of a business in three buckets.

The simplest form is to evaluate the replacement cost of a business (bucket 1). In this exercise we try and measure what we estimate it would cost in today's money for  a new entrant to the industry to replicate the assets, distribution channel, customer relationships, brands etc of  the existing player we are evaluating. We simplify the discussion by assuming that there are no barriers to entry for the new entrant - anyone with deep enough pockets will be able to replicate the business we are evaluating. Not an easy task to evaluate one might think. We are, however, not striving for a precise number but the discussion is an interesting one and channels us into hopefully asking the right questions in our research efforts to understand the underlying business. How much research and development spend (R&D) would it take to replicate that key product, how much advertising would be needed to get a similar traction in the market? What would it take to build a similar distribution channel? Unfortunately, the balance sheet of a company is often of only little assistance in this exercise as significant value in the company might exist in its 'off balance sheet' assets - the last few years of R&D expenditure, for example, which is written off through the income statement.

The next step in evaluating a moat's value is to estimate what we think the company is worth on a steady state basis (ex-growth value bucket). In this bucket we attempt to evaluate the 'earnings power 'of the business as it currently stands. We assess sustainable margins and tax rates for example. We do, however, need to make a few simple adjustments. We add back what we estimate the business spends on a daily basis to grow in the future - a portion of their advertising spend, expansionary capital expenditure on new plant, or perhaps a slug of their research and development spend, for example. We are in essence aiming for an ex-growth valuation of the business. We hate paying for future growth, which is very difficult to forecast and often proves to be fleeting in nature. That ex-growth value is calculated by taking our estimate of the earnings power (with adjustments) and capitalising it using a suitable perpetual discount rate. We now have estimated our second bucket of value.

The last step is to assess the value of future growth in the business. If we find ourselves paying for this when buying a share, one needs to be very certain that that growth will materialise, and probably at a lot faster rate than we hopefully anticipate. This is not an enticing prospect. Evaluating this bucket of value does have some merit - we can then assess the true estimated value of the business (ex-growth and with growth) - generating an intrinsic value so to speak. The starting assumption here is that growth is only worth something when a company's growth spend is earning a return greater than its cost of capital. This is relatively simple to demonstrate mathematically. (It's a good question why companies remunerate management on earnings per share growth - perhaps a topic for a future Angle.) Our research here is channelled into understanding the drivers behind a company's return on capital and its potential sustainable growth rate in the future. Our starting point is looking at its past track record, though this is useful only in part. Taking a red pen to first estimates is usually a more successful approach. We pass the two estimates through a simple formula to estimate the value of future growth.

Ok, so we now have an estimated replacement cost, an ex-growth value and a value of future growth for the business.

What do they tell us and how do we use the data?

If the company's market cap is trading at a discount to our estimate of its replacement cost value, then the margin of safety (the last of the 3 M's mentioned above) might be significant. If the company's estimated ex-growth value is significantly above our estimate of the replacement cost, then we can assume there is some moat attributed to the business. This can also be cross-referenced by looking at the company's return on capital history versus its cost of capital (look out for abnormal returns). If the company's market cap is trading at a discount to that ex-growth value, and we feel that the company's moat is potentially sustainable, then we are getting some margin of safety on a quality business and the future growth all for free.

Throughout this exercise outlined above we are continually asking ourselves the questions:  how does this company compete with its peers, what makes this moat so large, and do we really understand the business model? We usually try to answer the question with - 'the beauty of this business model is...'

So for instance for Microsoft, which is currently a holding in our PSG Global Equity Fund, we would say 'the beauty of this business model is that it's very expensive and often poses significant business risks for a company to switch to a new software supplier. In addition, the company has a huge advantage in being able to spread the cost of a new software platform (such as Windows 7) over its billion odd existing customers'. On our estimates, the company is also trading at a discount to its ex-growth value, which means that we can potentially be getting a quality franchise with a hopefully significant margin of safety and future growth (such as an upcoming PC replacement cycle) for free.

This is, of course, just one of the approaches that we use to evaluate a business. The exercise we described above can be done in a few minutes using our internally developed models. The discussions and research conducted into understanding the business model typically takes a lot longer!

*His books are all worth a read - See for example: 'Value Investing: From Graham to Buffett and Beyond' Greenwald, Kahn, Sonkin, van Biema which outlines the above approach more comprehensively.

For more information on PSG Alphen Asset Management, the free Alphen Angle Newsletter or the people behind PSG Alphen Asset Management, please visit  www.AlphenAM.co.za.