Essay on Value Investing Approach

    The value investing approach advocated by Ben Graham has three basic tenets:  (1) the value of assets in place, (2) Earnings Power Value and (3) the value of growth.

        The value of assets in place is an approach that advocates assessing the most liquid, and easy to value assets on the balance sheet; namely current assets.  By focusing on those assets that are most liquid, the analyst can gain an understanding of the value of the firm with great precision.  By avoiding fixed assets (e.g., net plant and equipment) or goodwill, the analyst can be more confident in the valuation assigned to the assets.  Graham believed that by subtracting the value of all the firm’s liabilities from current assets, an analyst could determine the “net-net working capital” position of the firm.  If a firm can afford to pay off all its debt with current assets, then presumably the firm is highly liquid and worthy of further consideration for acquisition.  If the firm can be purchased in this condition, the debt can be reconciled and the fixed assets and productive capacity of the firm owned outright.  While there may not be many opportunities to acquire a company in this condition, it is helpful to see how ably the firm could remove all its liability constraints. The value of asset in place determines the present value or fair market of asset using book values, option pricing models or comparable, and absolute valuation model such as the analysis of discounted cash flow. These assets include various investment kinds in marketable securities like bonds, stocks and options; intangible assets like patents, brands, and trademarks; or tangible assets like equipment and buildings (Cordes, Ebel and Gravelle 2005).

            Earnings Power Value (EPV) is another valuation metric promoted by Graham.  Earnings Power Value looks at the value of adjusted earnings, rather than estimating future cash flows.  By focusing on current earnings and making the assumption that if the firm has maintained a certain earnings stream, they have a good possibility of continuing that earnings stream into the future.  Basically EPV considers the current distributable cash flow (after adjustments for depreciation, working capital and year over year investment in capital) as a perpetuity.   Therefore, with proper consideration for the cost of capital, an intrinsic valuation can be determined assuming the present earnings of the firm continue into the foreseeable future. The Earnings Power Value’s formula is based on the assumption that the firms’ current earnings are sustainable under a scenario that there is no growth. Enterprise value is estimated by EPV by dividing the weighted average capital cost and an earnings measure (Greenwald, et al. 2004).

        In the above equation r represents a cost of capital. The adjusted earnings is arrived by adjusting the one-time charges earning, taxation adjustments, capital expenditures, depreciation, and more adjustments that are based on an economic business cycle along with the other details. It can be difficult to find the adjusted earnings.

Earnings Power Value Technique:

The earnings power value’s valuation technique requires the investor to carefully consider the following 3 things.

         The assets’ value a will be required by competitor to have so that the same market value of the incumbent company could be achieved in the industry.

Earnings power value estimated based on current financial status where the business cycles has ignored by resulting intrinsic value.

Either the growth is a factor or not. In this valuation technique, growth is usually ignored, so it is better not to go into the aspect of growth.

Value of growth can be either net value of growth or present value of growth. Present Value of Growth gives a different approach to analysts to equity valuation.

            Graham’s position on growth is that unless the firm has a competitive advantage in its market, growth does not add value.  Graham believed that where an open market, with zero to few barriers to entry exist, growth is essentially a zero sum game.  In order to grow, a firm must make investments in working capital and capital capacity to sustain that growth and in the long run that leaves no additional cash flow available to shareholders.  Thus Graham saw growth as the least reliable factor to consider when valuing a firm.  If a firm does not have a competitive advantage in their market, growth should be completely discounted (Gerstein 2003).