Redefining Value

"... One of the worst things that can happen to value managers is to have investors actually listen to them, and by the looks of things, investors are all ears at the moment."
Ben Inker, Head of Asset Allocation, Grantham, Mayo, Van Otterloo & Co., The Trouble With Value

Individual investors, at least on a macro level, have really bought into "value investing" in the aftermath of the tech bubble. This doesn't bode well for those who continue to seek out value, since the widespread adoption of value investing inherently sows the seeds of its own underperformance. So what have "value" and "value investing" become, and what can they be going forward?

What is value?
Benjamin Graham's classic take on value investing had investors scouring small and/or unloved stocks, screening for those with low P/E and P/B ratios. Yet, today, many value mavens are finding opportunities among well-known giants such as Anheuser-Busch at a P/E of 17 and a P/B of 10 (book value has been diminished because of continued stock buybacks) or Wal-Mart (NYSE: WMT  ) at a P/E of 19 and a P/B of 4 (as evidenced by the raft of third-quarter 13-F filings). Sure, they're fine companies with deep moats throwing off tons of cash, but they're not traditional "values."

Today, more people think of themselves as "value investors" than probably should. The term is too broadly applied -- much like "long-term buy-and-hold." So if value has lost some meaning through its favorable press, then how can we redefine the term? I define it as disciplined stock selection: find a company that is growing steadily and creating tangible value for its shareholders; assess the intrinsic worth of that created value; and determine whether the market is appraising the company at substantially less than its intrinsic value.

Internal value creation
So how do we find firms that are creating value? One way to do this is by comparing the cost of capital (debt and equity) with the returns the company can generate from that capital. Debt providers and equity investors don't fund companies out of the goodness of their hearts; they seek a certain return. That level of return is a cost to the company they are funding -- the weighted average cost of capital (WACC). The company then deploys that capital in the hopes of also earning a return, otherwise known as the return on invested capital (ROIC). True economic value is created when there is a positive spread between ROIC and WACC. Rather than going any further into the mechanics, check out the Fool's School's excellent primer on ROIC.

To quantify the created value, we turn to Stern Stewart's trademarked concept of Economic Value Added (EVA), which is simply the ROIC spread multiplied by the invested capital (IC):


Forecasting and comparing value
Once we find a company that is steadily creating value, we need to then assess the worth of that continued value creation. This is typically done by forecasting free cash flows into the future and then discounting back to the present at an appropriate discount rate. While firm-specific free cash flows are best discounted at that firm's WACC, it's often better (and simpler) to discount at a prudently selected personal hurdle rate. The reason is that the components that make up WACC often change in response to myriad factors such as inflation, interest rates, market fluctuations, changes in capital structure, and company-specific operations. Adhering to a mathematical methodology can lend a perhaps inappropriate air of certainty to what is a process fraught with uncertainty and assumptions.

Once we have assessed the intrinsic value of the company (one easy way is to plug some numbers into the discounted cash flow calculator provided to subscribers of Motley Fool Inside Value), we need to quickly compare our result against what the market is currently paying for that company. We're not exactly value investors if we're paying $1 for a $1 of value. But steady value creators purchased for $0.75 (or even less) on the dollar are the bedrock of successful portfolios.

Direction of value creation
The beauty of this methodology is that any company can be classed as a "value investment" as long as it meets the above criteria. Of course, the devil is in the details. It is very easy to -- even unwittingly -- cook forward valuations by being too optimistic. A common way to do this is to forecast a continued wide spread between ROIC and WACC over the long term, even though the current presence of a large ROIC-WACC spread encourages competitors to enter the market, thereby narrowing the spread across the board.

To that end, it's worthwhile to assess the direction of a firm's ROIC-WACC spread. A slipping firm might have its market value reassessed before the average investor is aware of it. Let's take a look a few examples pulled from recent 52-week-low and 52-week-high lists. Consistently, companies with positive and growing ROIC-WACC spreads have that value creation reflected in higher stock prices. Companies with negative spreads (destroying shareholder value), are seeing share-price depreciation.

New 52-Week Lows 2004
Ford (NYSE: F  ) -6.9% -7.4% -37.1%
Blockbuster (NYSE: BBI  ) -0.7% -10.5% -55.5%
Coca-Cola Bottling Co. (Nasdaq: COKE  ) -2.9% -2.5% -14.3%

New 52-Week Highs 2004
Paychex (Nasdaq: PAYX  ) 0.4%*** 2.6% 12.8%
UnitedHealth (NYSE: UNH  ) 10.2% 15.1% 25.9%
Scientific-Atlanta (NYSE: SFA  ) 17.4% 21.5%*** 26.6%

* End-of-period balance sheet values used for calculation of ROIC and WACC. Beginning or average values might be as, or more appropriate. Either way, consistency is required.
** WACC calculated using the market value of equity and the market value of debt (where available, otherwise assumed that market value of debt approximated book value at the time of measurement). Market value of equity used closing share price on the day following the respective earnings release.
*** FY 2005 data.

The Foolish bottom line
It would be optimal to find a company on the 52-week-low list with a widening ROIC-WACC spread -- although that may be a diamond in the rough. But in your search for value, remain cognizant that forward value is often in the eye of the beholder and it's easy to get an estimate of forward value wrong. But seeking to remain disciplined and on the "right side of the transaction" in any buy or sell should help us garner market-beating returns.

To see where the Fool's own value guru Philip Durell is finding value these days, click here to take a free trial to Motley Fool Inside Value. By searching out value creators at discount prices, he's besting the market by four percentage points in a little more than a year of existence. There is no obligation to subscribe.

Jim Gillies owns no shares in any company mentioned, although he does own Jan. 07 $45 call options on Wal-Mart. Was this article of "value"? Send Jimfeedback! Anheuser-Busch is anInside Valuepick; UnitedHealth is a Motley Fool Stock Advisor recommendation. The Fool has a disclosure policy.

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