Boring Portfolio

"Inpounding" Value

By Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (June 23, 1999) -- One of the tenets Alex Schay and I put together for the Boring Portfolio is that we don't buy or sell a company without attempting to do valuation work on it. An interesting thing has happened now. It has become an accepted maxim that you can't put a value on an Internet company and therefore the Boring Port should not consider any Internet companies for investment. In a recent Fortune piece, CS First Boston analyst Lise Buyer pointed to a passage of Security Analysis that reinforces the thought, straight from one of the gospels, that you can't put a value on unseasoned companies:

"Unseasoned companies in new fields of activity... provide no sound basis for the determination of intrinsic value.... Analysts serve their discipline best by identifying such companies as highly speculative and not attempting to value them.... The buyer of such securities is not making an investment, but a bet on a new technology, a new market, a new service.... Winning bets on such situations can produce very rich rewards, but they are in an odds-setting rather than a valuation process."

And voila, straight from Ben Graham, one of the intellectual giants of the investing world, the teacher and mentor of Warren Buffett, we have a very easy out on trying to put a value on something like Net.B@nk (Nasdaq: NTBK). I am not on board with Ben Graham's conclusion here, heretic that I am. And I'm not on board with those analysts that say that you can't put a value on such companies. I do believe, however, that coming up with a single-point intrinsic value is not useful whatsoever, unless that's the midpoint or highest-confidence point among a spread of different values.

One of the ways you can do this is to "inpound" (which I consider the opposite of "compound") a set of financial and operating assumptions into a price that equals the share price today and then examine that set of assumptions. Do the income statement and balance sheet assumptions make sense to you? Can the company's new projects be financed and will the company get the returns on those new investments such that the net present value of the company is at least as high, or higher than, today's share price?

If you're looking at something like Net.B@nk, you want to examine a number of assumptions, such as how leveraged the company will be in the future, what the net interest margins will be, what the company's asset composition choices might look like and what sorts of credit costs will go along with those, how much noninterest income the company can generate from different lines of business, how much leverage the company can get over its customer service overhead, etc., etc., until you're blue in the face with the banking analysis. You can DCF (discounted cash flow) it to death. There's value in doing that, as you're thinking of the company like an acquirer would, not as someone buying readily-tradable shares of a hot Internet stock.

You can also go about looking at a company's present base of business and then analyze the real options available to it. That is, you can look at the value of the current business plus the present value of options to invest in and create value out of opportunities that it can come up with down the road. This is why I will be paying very close attention to the customer service issues at Net.B@nk on an ongoing basis. Its portfolio of options is enhanced, certainly, if it can retain customers and if customers rave about their experience.

In my estimation, the probabilities that the company will get to scale, the speed with which it does that, and the churn rate of customers (which has implications for customer acquisition cost outlays) all play a large part in the value of the real options available to the company. This is exactly why I've been such a big supporter of (Nasdaq: AMZN) for a long while. The company's customer acquisition costs and its fanatical customer service (experienced on both a firsthand basis and in talking with many customers) abilities made me believe long ago that it could scale up to a size necessary to take advantage of some real options. David Gardner and Jeff Fisher have been saying this, not quite in these exact terms, since the day they invested in the company in the Rule Breaker Portfolio.

For more on real options, check out Michael Mauboussin at CS First Boston also just came out with a report on real options

In my recent series on Net.B@nk, I put its intrinsic value between $22 15/16 and $53 13/16 per share, assuming a 15% discount rate on equity throughout the calculations. The point there is that I'm developing a range of values that I believe will generate my hurdle rate of 15% per year over five years. At the low end of that range, I'm most confident in the ability to get a return and I'm least confident at the high end. But all the way through that range, I have come up with realistic business performance and business model assumptions that would yield those present company values. At the low end of the range, I have what I believe is a better margin of safety than at the high end of the range. At the midpoint, you've got the high $30s, which is exactly where the company's been recently.

A good way to go about valuing a company like this is to take it from a number of different assumptions, just as the market does. In the complex, adaptive system that is the market, you get new bids and asks all day long, some of which reflect considered analysis, some of which reflect speculators looking at fund flows and whatever else, and some of it reflects God knows what. But out of that seemingly chaotic short-term activity, over the long term you get a pretty orderly process that reflects the intrinsic value of the company. If over the long term, the market is efficient in reflecting the value of the company, then certainly over the short term you also have the occasional flashes of efficiency in setting the price of the company correctly.

I really think Ben Graham is a giant, but I also really think that he didn't have that much respect for the beauty and efficiency of the market over the short-term. Sure, over the short term, the market is a voting machine and over the long term, it's a weighing machine. You have to figure some of that long-term efficiency seeps into the short term, as well.

So, the valuation exercise on Net.B@nk reflects a spread of probabilities that range from when the company starts to generate economic profits, how long it will maintain those economic profits, how much capital it can invest, what its margins and asset turns will look like, and what its underwriting standards and practices will be, among other things. The valuation doesn't take one case and discount that and it certainly isn't the product of "it's got this much book value, so we're slapping a 5x on it and calling it a day." That's borderline moronic.

Have a good Monday night.

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06/23/99 Close
Stock Change   Bid
APCC  +1 1/8   21.13
BRKb  +16      2263.00
CSL   +1 1/4   49.44
GTW   -  1/4   64.50

                  Day     Month   Year  History
        BORING   +1.33%   1.44%   6.03%  42.37%
        S&P:     -0.21%   2.40%   9.03% 122.31%
        NASDAQ:  +0.69%   5.17%  18.49% 149.59%

    Rec'd   #  Security     In At       Now    Change
  8/13/96  200 Carlisle C    26.32     49.44    87.80%
  4/20/99  460 American P    14.48     21.13    45.92%
 12/31/98   12 Berkshire   2276.17   2263.00    -0.58%
   2/9/99  100 Gateway 20    72.38     64.50   -10.88%

    Rec'd   #  Security     In At     Value    Change
  8/13/96  200 Carlisle C  5264.99   9887.50  $4622.51
  4/20/99  460 American P  6659.25   9717.50  $3058.25
 12/31/98   12 Berkshire  27314.00  27156.00  -$158.00
   2/9/99  100 Gateway 20  7237.50   6450.00  -$787.50

                             CASH  $17972.40
                            TOTAL  $71183.40