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Klarman: Concentrate on cash value [ClearOnMoney]
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Klarman: Concentrate on cash value

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Commentary

Klarman: Concentrate on cash value

19 Nov 2011 by Jim Fickett.

Value investing depends, obviously, on assigning a meaningful value to a company/security. Many investors take the shortcut of using the price to earnings ratio, or the price to book value ratio. Klarman sees little value in either of these and instead concentrates on two versions of cash value. One, based on the presumption that the business will continue, is the net present value of future cash flows. The other, on the opposite presumption, is liquidation value. In both cases there is considerable uncertainty, so very conservative assumptions must be used.

Klarman suggests that earnings are too often manipulated to serve as a good measure of value.

Earnings per share has historically been the valuation yardstick most commonly used by investors. Unfortunately, as we shall see, it is an imprecise measure, subject to manipulation and accounting vagaries. …

Corporate managements are generally aware that many investors focus on growth in reported earnings, and a number of them gently massage reported earnings to create a consistent upward trend. A few particularly unscrupulous managements play accounting games to turn deteriorating results into improving ones, losses into profits, and small profits into large ones.

And he argues that book value often has little to do with real value:

What something cost in the past is not necessarily a good measure of its value today. Book value is the historical accounting of shareholders' equity, the residual after liabilities are subtracted from assets. Sometimes historical book value (carrying value) provides an accurate measure of current value, but often it is way off the mark. …

Inflation, technological change, and regulation, among other factors, can affect the value of assets in ways that historical cost accounting cannot capture. Real estate purchased decades ago, for example, and carried on a company's books at historical cost may be worth considerably more. The cost of building a new oil refinery today may be made prohibitively expensive by environmental legislation, endowing older facilities with a scarcity value. Aging integrated steel facilities, by contrast, may be technologically outmoded compared with newly built minimills. As a result, their book value may be significantly overstated.

What does work is cash value:

While a great many methods of business valuation exist, there are only three that I find useful. The first is an analysis of going-concern value, known as net present value (NPV) analysis. NPV is the discounted value of all future cash flows that a business is expected to generate. …

The second method of business valuation analyzes liquidation value, the expected proceeds if a company were to be dismantled and the assets sold off. Breakup value, one variant of liquidation analysis, considers each of the components of a business at its highest valuation, whether as part of a going concern or not. The third method of valuation, stock market value, is an estimate of the price at which a company, or its subsidiaries considered separately, would trade in the stock market. Less reliable than the other two, this method is only occasionally useful as a yardstick of value.

Since valuation is an imprecise exercise, one must always err on the side of conservatism:

Each of these methods of valuation has strengths and weaknesses. None of them provides accurate values all the time. Unfortunately no better methods of valuation exist. Investors have no choice but to consider the values generated by each of them; when they appreciably diverge, investors should generally err on the side of conservatism.