How you answer the question in the title of this article probably says a great deal about what sort of investor you are. The old-school value hounds among you probably said something along the lines of "zero." Those readers who made a killing buying into the IPO of Google (Nasdaq: GOOG) or First Solar (Nasdaq: FSLR) no doubt have a different take.
Across the value-growth spectrum, everyone wants the same end result: a higher share price. This results from either a narrowing of the price-to-value gap, or an increase in value, or both.
For me, the "both" approach is most compelling. This is the one taken by Marty Whitman, of Third Avenue Management. Whitman's principles of "safe and cheap" investing are pretty well known, but what gets less attention is his desire that portfolio companies, purchased at a discount to net asset value (NAV), be able to grow that NAV by 10% per year. In other words, he wants growth without paying for it.
N-A-Who?
If you're not familiar with the concept of net asset value, think of it as "book value meets the real world." Book value takes the accounting value of assets and subtracts liabilities. This measure of net worth has a certain beauty in its simplicity, but in many cases, that beauty is only skin deep. All sorts of real assets and liabilities (i.e., sources of future cash inflows and outflows) lie off the balance sheet. By capitalizing all of these items, net asset value attempts to reconcile the accounting with reality.
You'll most often see NAV used in cases where a company has lots of discrete, tangible assets that throw off cash. Think Simon Property Group's shopping malls or Freeport McMoRan's (NYSE: FCX) copper mines. These sorts of assets best lend themselves to the sum-of-the-parts valuation that NAV analysis affords.
I should also point out that this approach requires significant human judgment, which has its downsides, but also makes it somewhat less likely that you'll be competing with Goldman Sachs (NYSE: GS) trading algorithms in your hunt for value.
Two false dichotomies
The NAV approach that I've outlined is not terribly different from discounted cash flow analysis, the gold standard of valuation techniques. I would actually argue that these are two sides to the same coin, in that DCF turns assets and liabilities into cash flows and NAV does the opposite. The resulting present value calculation should be the same.
I'd like to suggest that the NAV approach (and by extension, DCF analysis) is the bridge between value investing and growth investing. To explain this, I'll look at a specific application.
NAV in the oil patch
As you may know, I spend most of my time focusing on oil and gas companies. In this sector, price-to-earnings ratios are pretty useless, as accounting earnings are frequently distorted by large non-cash charges. For example, Devon Energy (NYSE: DVN) reported a loss of $2.5 billion in 2009, while generating $4.7 billion in operating cash flow. Cash flow is what ultimately matters in any business, and earnings are a particularly poor proxy for cash flow in this industry.
There are several ways to value an oil stock. One method employed on Wall Street is to project year-ahead cash flows per share, and slap a multiple on that projection, as you would with an earnings forecast. Canaccord Adams recently used this method to devise their price target of $26 for ATP Oil & Gas.
A more comprehensive process is to calculate net asset value. To arrive at this measure, you take the present value of proved reserves (i.e., future net cash flows discounted at 10%, or "PV-10"), add working capital and other assets, and subtract debt. Add the net present value of probable/potential reserves, and you've got NAV. The latter component is obviously the most subjective, and generally the greatest source of differences between analyst estimates.
A glance at an early 2010 roundup of small-cap oil and gas valuations by JPMorgan Chase (NYSE: JPM) analysts reveals a huge variance between firms in the relative contribution of proved and potential reserves to estimated NAV. In the case of Swift Energy, proved reserves dominate the valuation. For Mariner Energy (NYSE: ME), proved reserves are literally only half the story. In extreme circumstances, debt exceeds the value of proved reserves, leaving potential reserves to account for over 100% of a firm's NAV.
While the stocks that are all potential represent pure bets on future growth, the ones that offer a blend of proved and potential value are harder to pin down. Mariner is trading at a premium to JP Morgan's estimate of proved NAV, but at a discount if you include potential NAV. So is Mariner a growth stock or a value stock?
Both!
When you take the NAV approach, the distinction between growth and value begins to melt away. I should emphasize, though, that the discipline of buying substantially below intrinsic value, as embraced by our Motley Fool Inside Value team, remains in full effect. The discount to NAV is your margin of safety.
I'm curious to hear what readers of all experience levels have to say about this approach to investing. Is attempting to quantify future potential an exercise in wishful thinking, or is it a Foolish pursuit? While aware of the risks, I tend to believe that the latter is the case.
