Graham & Dodd and ModernFinancial Analysis

Joseph Calandro, Jr.PwC & the University of ConnecticutDecember 13, 2011

www.pwc.com

Agenda

• Benjamin Graham

• Warren Buffett’s 1995 GEICO acquisition – DDM

• Modern Graham & Dodd Valuation – Overview

• Warren Buffett’s 1995 GEICO acquisition – Graham & Dodd

• “Critical valuation errors to avoid”

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• Forecast-related errors

• Growth-related errors

• How to avoid errors

• The Graham & Dodd valuation process

• Graham & Dodd and avoiding “Critical valuation errors”

• Recommended reading

• About the presenter

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Benjamin Graham

• Benjamin Graham founded “value investing” in the 1920s-1930s

- Heavily influenced by the “new era” boom of the 20s & the subsequentbust/Great Depression

- Price arbitrage-based strategy: buying firms < liquidation value resultedin a “margin of safety,” which is the cornerstone of the approach, & is

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in a “margin of safety,” which is the cornerstone of the approach, & iswhat differentiates an “investment” from a “speculation” for Graham & hisstudents

- Bottom-up, investment-by-investment approach

- Value investors opposed modern financial economic theory (i.e., efficientmarkets, portfolio theory, capital structure doesn’t matter, asset pricingmodels, option pricing models) from the beginning & thus tend toapproach valuation & investment differently

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Warren Buffett’s 1995 GEICO acquisition – DDM• Below is a DDM valuation based on a popular case study

1995 1996 1997 1998 1999 2000 Terminal value

Current dividend $1.00

Expected dividend (low) $1.16 $1.25 $1.34 $1.44 $1.55 (1)

Expected dividend (high) $1.16 $1.34 $1.55 $1.79 $2.07 (1)

Average expected dividend $1.16 $1.30 $1.45 $1.62 $1.81

PV expected dividend $1.04 $1.05 $1.05 $1.06 $1.06 $64.37 (2)

Expected sustainable growth 10.25% (3)

Total present value/share $69.63 (4)

Buffett’s purchase price ~$70.00

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• “This concept of an indefinitely favorable future is dangerous, even if it is true; becauseeven if it is true you can easily overvalue the security, since you make it worth anything you want itto be worth. Beyond this, it is particularly dangerous too, because sometimes your ideas of thefuture turn out to be wrong. Then you have paid an awful lot for a future that isn’t there. Yourposition then is pretty bad.” Benjamin Graham quoted in Timothy Vick, How to Pick Stocks likeWarren Buffett (NY: McGraw-Hill, 2001), p. 163

• “An un-resolvable contradiction exists: to perform present value analysis, you must predict thefuture, yet the future is not reliably predictable.” Seth Klarman, Margin of Safety (NY:Harper, 1991), p. 124

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Stock price $55.75

Price premium 25.6%

Notes

1. Dividend source Robert Bruner, Warren E. Buffett, 1995, Darden case services #UVA-F-1160, 1996, p. 11

2. TV = PV of A(DIV)200o * (1 + Expected sustainable growth) / (Cost of equity - expected sustainable growth)

3. Subjective estimate (or plug) against a discount rate of 11.2%

4. Sum of PVs for 1996 -2000 + the TV

Modern Graham & Dodd Valuation – Overview

• Net Asset Value: reproduction-based,line-by-line

• Earnings Power Value: based on alevel of historical earnings that shouldbe sustainable into perpetuityFranchise

Value

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• Franchise Value: Sustainablecompetitive advantage

• Growth Value: least tangible (& thusmost risky)

• All assumptions are upfront &transparent in each level of value(facilitating due diligence, integrationefforts & value realization)

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Net AssetValue

EarningsPowerValue

GrowthValue

Adapted from: Bruce Greenwald, JuddKahn, Paul Sonkin, & Michael van Biema,Value Investing – From Graham toBuffett & Beyond (NY: Wiley, 2001), p. 44

Warren Buffett’s 1995 GEICO acquisition –Graham & Dodd

• NAV driven by significant “goodwill”

• EPV based on average operating margin

• FV driven by “low-cost” offering to a“safe driver” niche*

$44.15

$69.00

$106.55

$30

$60

$90

$120

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• GV based on “normal” growth earning17.3% against a discount rate of 11.2%

$0NAV EPV GV

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* Significant strategic analysis is involved invalidating a franchise. I profiled this in mybook, but addressed it more thoroughly in asubsequent paper: Joseph Calandro, Jr.,“Growth-Based Franchise Opportunities:Lessons from the Geico Acquisition,”Journal of Private Equity, Spring (2011),pp. 6-17

Where “NAV” equals Net Asset Value,“EPV” equals Earnings Power Value, &“GV” equals Growth Value (FranchiseValue (“FV”), or the positive differencebetween EPV & NAV, is not expresslyillustrated). All calculations are mine

Source: Joseph Calandro, Jr., Applied ValueInvesting (NY: McGraw-Hill, 2009 ), p. 56

“Critical valuation errors to avoid”Prof. Ruback’s “Critical Valuation Errors to Avoid”

Error # 1: Forecasts are aggressive

Error # 2: Cycles are ignored

Error # 3: Forecasts are not consistent

Error # 4: Terminal value timing

Error # 5: Inconsistent assumptions

Error # 6: Long-term growth rates are aggressive

Error # 7: Discount rates are conservative or aggressive

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Error # 7: Discount rates are conservative or aggressive

Error # 8: Changing capital structure is not considered

Error # 9: Control premiums

Error #10: Multiples are inappropriately applied

How to Avoid These Errors

Rule # 1: “Focus on common-sense economics”

Rule # 2: Use more than one valuation approach

Rule # 3: Don’t be mechanical

Source: Richard S. Ruback, Know Your Worth: Critical Valuation Errors to Avoid, HBS Press - Faculty Seminar Series,August 1, 2004, http://hbr.org/product/know-your-worth-critical-valuation-errors-to-avoid/an/6433C-MMC-ENG

Forecast-related errors

Error # 1: Forecasts are aggressive

Error # 2: Cycles are ignored

Error # 3: Forecasts are not consistent

Error # 7: Discount rates are conservative or aggressive

Error # 8: Changing capital structure is not considered

• Heavily skeptical going in. Remember the earlier quote: “An un-resolvablecontradiction exists: to perform present value analysis, you must predict the future, yet

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contradiction exists: to perform present value analysis, you must predict the future, yetthe future is not reliably predictable.” Seth Klarman, Margin of Safety (NY:Harper, 1991), p. 124

• Conservatively-oriented

- Derived a level of past earnings over time (including cycles)

- Expected improvement can be an input if estimated conservatively

- Hard multiple guideline: not > 16-20x

• Margin of Safety is the final control to mitigate forecasting risk

Forecasting errors can nevertheless be relatively common:“The process of valuation, while seemingly mathematical, is in reality

psychological and quite arbitrary.” Benjamin Graham and David Dodd, SecurityAnalysis 6th Ed. (NY: McGraw-Hill, 2009 [1934]), pp. 85-86

Growth-related errors

• VERY skeptical going in. Remember the earlier quote: “This concept of anindefinitely favorable future is dangerous, even if it is true; because even if it istrue you can easily overvalue the security, since you make it worth anything you want itto be worth. Beyond this, it is particularly dangerous too, because sometimes your ideas

Error # 4: Terminal value timing

Error # 5: Inconsistent assumptions

Error # 6: Long-term growth rates are aggressive

Error #10: Multiples are inappropriately applied

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to be worth. Beyond this, it is particularly dangerous too, because sometimes your ideasof the future turn out to be wrong. Then you have paid an awful lot for a future that isn’tthere. Your position then is pretty bad .” Benjamin Graham quoted in Timothy Vick,How to Pick Stocks like Warren Buffett (NY: McGraw-Hill, 2001), p. 163

- Normal growth (more mature firms like GEICO): relates growth to current values

- Super normal growth (explosive growth phase; venture capital)

• Conservatively derived based on NAV & EPV inputs (helps ensure consistency)

- Reinvestment risk assessed in the context of a franchise

• Margin of Safety is the final control to mitigate growth risk

- Using GV as the basis for a margin of safety (paying full EPV so long as growthprovides an acceptable margin)

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How to avoid errors

1. Skepticism, Conservatism, a rigorous valuation process (see the next 2 slides), & theMargin of Safety principle facilitate “common sense” analysis

2. NAV & EPV are different valuations, which most of the time will lead to ~the same

Rule # 1: “Focus on common-sense economics”

Rule # 2: Use more than one valuation approach

Rule # 3: Don’t be mechanical

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2. NAV & EPV are different valuations, which most of the time will lead to ~the samevalue (“base case value”), which helps to control for forecasting risk

- EPV > NAV = potential franchise

- EPV < NAV = potential turnaround opportunity

3. “… value investing is not a paint-by-numbers exercise. Skepticism and judgment arealways required.” Seth Klarman, “The Timeless Wisdom of Graham and Dodd,”Security Analysis 6th Ed. (NY: McGraw-Hill, 2009 [1934]), p. xviii

- Assumptions transparent in each level of the valuation; subject to validation(especially Franchise Value)

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The Graham & Dodd valuation process (a)

• According to Benjamin Graham & David Dodd“A general definition of intrinsic value would be ‘that value which is justified by thefacts—e.g., assets, earnings, dividends, definite prospects’”(Security Analysis 3rd Ed. (NY: McGraw-Hill, 1951 [1934]), p. 16)

- Value is subjective not intrinsic hence the importance of justifying estimates basedon “the facts”

• Seth Klarman noted that

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• Seth Klarman noted that“Value investing, the strategy of buying stocks at an appreciable discount from thevalue of the underlying business, is one strategy that provides a road map tosuccessfully navigate not only through good times but also through turmoil” (MITRemarks, 10/20/07,http://www.designs.valueinvestorinsight.com/bonus/bonuscontent/docs/Seth_Klarman_MIT_Speech.pdf, p. 7)

• As Michael Lewis observed in Moneyball“It’s looking at process rather than outcomes,… Too many people make decisionsbased on outcomes rather than process” (p. 146)

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The Graham & Dodd valuation process (b)

Screening• Quantitative - low market-to-book, low price-to-earnings, high dividend

yield, etc.;• Qualitative - business cycle analysis, franchise-based research, special

situations (such as bankruptcies, spin-offs & restructurings), etc.

Initial Valuation

Net Asset Value(NAV) Adjustments• Appraiser, Auditor; Consultant, Expert input on select balance sheet

“The most common sourceof mistakes in management

[&, I believe, in investment]decisions is the emphasis

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• Appraiser, Auditor; Consultant, Expert input on select balance sheetadjustments

Earnings Power Value (EPV) Analysis• Earnings-based inquiries & investigative items

Franchise Value (FV) Analysis• Financial Strategy-based inquiries, & corresponding questions for

executive management

Growth Value (GV) Analysis• Consistent strategic themes that can support growth initiatives?

Final Valuation

Source: Calandro (2009), p. 203

decisions is the emphasison finding the right answer

rather than the rightquestion.” Peter Drucker, The

Practice of Management(NY: Harper Row, 1954), p. 351

Graham & Dodd and avoiding “Critical valuationerrors”

NAV EPV FV GV

Prof. Ruback’s “Critical Valuation Errors to Avoid” x

Error # 1: Forecasts are aggressive x

Error #2: Cycles are ignored x

Error # 3: Forecasts are not consistent x

Error # 7: Discount rates are conservative or aggressive x

Error # 8: Changing capital structure is not considered x

Error #4: Terminal value timing x x x x

Error # 5: Inconsistent assumptions x x x x

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Error # 5: Inconsistent assumptions x x x x

Error # 6: Long-term growth rates are aggressive x x x x

Error #10: Multiples are inappropriately applied x x x x

Error # 9: Control premium

How to Avoid These Errors

Rule # 1: “Focus on common-sense economics” x x x x

Rule # 2: Use more than one valuation approach x x x x

Rule # 3: Don’t be mechanical x x x x

Used properly, Graham & Dodd can help to mitigate the risk of “CriticalValuation Errors”; however, it cannot eliminate the risk:

“valuation is an art, not a science.” Seth Klarman, “The Timeless Wisdom ofGraham and Dodd,” Security Analysis 6th Ed. (NY: McGraw-Hill, 2009 [1934]), p. xviii

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Recommended reading

• Security Analysis 6th Ed., by Benjamin Graham & David Dodd (edited bySeth A. Klarman)

• Margin of Safety by Seth A. Klarman

• The Intelligent Investor - Revised Ed. by Benjamin Graham (edited byJason Zweig)

• Benjamin Graham: Building a Profession edited by Jason Zweig

• Financial History Magazine by the Museum of American Finance

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• Financial History Magazine by the Museum of American Finance

• Moneyball by Michael Lewis (particularly relevant to those in corporate)

• Value Investing: From Graham to Buffett & Beyond by BruceGreenwald, et al.

• Applied Value Investing by Joseph Calandro, Jr.

• Richard S. Ruback, “Know Your Worth: Critical Valuation Errors to Avoid,”HBS Press - Faculty Seminar Series, August 1, 2004,http://hbr.org/product/know-your-worth-critical-valuation-errors-to-avoid/an/6433C-MMC-ENG

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About the presenter

Joseph Calandro, Jr. is a Managing Director at PwC & a FinanceDepartment faculty member of the University of Connecticut where hedesigned & taught MBA courses on value investing and risk management &insurance

Joe has published widely including the book Applied Value Investing (NY:McGraw-Hill, 2009), & journal articles in the Journal of Private Equity,

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McGraw-Hill, 2009), & journal articles in the Journal of Private Equity,Journal of Alternative Investments, Strategy & Leadership, etc. A listof his publications--some of which are downloadable--is available at the SocialScience Research Network (http://ssrn.com/author=357310). Joe has alsopresented papers at conferences in the U.S., U.K., & Canada

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