Underneath the umbrella of value investing lies a variety of techniques that aim to identify mispriced assets. At Prospector, we heavily utilize two approaches in the value investor toolkit that we believe can add value in any market environment: private market valuation (PMV) and free cash flow yield analysis (FCF). The type of analysis we choose to emphasize depends on the stock and the industry under consideration, and we’re especially attracted to situations where we can evaluate a stock using both PMV and FCF. Here we’ll take a closer look at how private market valuation, which in effect values business units or entire companies as though they are privately owned, informs our decision making.
Private market valuation can often mean different things to different people. Two ways our team engages PMV include:
- Converting GAAP balance sheets into statements of net asset value (NAV)
- Sum-of-the-parts analysis (SOTP)
How We Construct a Statement of NAV
In transforming a GAAP balance sheet into a statement of net asset value, we're essentially marking a balance sheet to market using our own proprietary research methodology. In our view, this is a crucial technique for analyzing balance sheet-driven companies (for example financial institutions) where up to half of the balance sheet may be what we call a “blind pool.” By that we mean that the stated values on the balance sheet for a loan portfolio, or loss reserves are management estimates. As value investors, we savor situations where management teams can grade their own exams, so to speak. Historically, we’ve been able to take advantage of identifying companies whose estimates are consistently either conservative or optimistic.
Another example where we utilize this methodology comes into play when we value real estate companies. Instead of simply utilizing price to FFO (funds from operations) or a similar metric, calculating an estimated intrinsic value sometimes requires emplying different private market value techniques. Take for example a company which owns a combination of undeveloped land as well as properties at different stages of development and in different regions of the country. In these circumstances, we will attempt to value these segments using recent transactions for land in their respective regions and operating assets based on NOI (net operating income) at current cap rates. We feel the resulting NAV obtained from this analysis is a more meaningful representation of what an buyer of the entire company would be willing to pay than a more simplistic metric.
Now let’s turn to the second example of how we incorporate PMV into our research process.
Sum-of-the-parts: A Brief Overview and Case Study
One way to understand a company’s intrinsic value is to evaluate what its business units would be worth in aggregate if they were acquired by another company. A SOTP analysis can be particularly useful for companies with divisions operating in different industries with unique valuation characteristics. Our typical approach in determining the PMV of a business unit is to construct a precedent transaction analysis, which allows us to compare the unit in question to similar businesses that have recently been acquired in the same industry. While considering prior M&A transactions is usually the most reliable indicator of value, from time to time we also may incorporate either a comparable company analysis, which would consider relative P/E, P/B, EV/EBITDA ratios and the like, or a discounted cash flow approach, in our process of arriving at a PMV of a business segment.
In practice, we’ve developed a proprietary SOTP model for Berkshire Hathaway (BRK-A/B), developed over the course of many years, to measure whether the stock is selling at a discount or premium to the SOTP analysis. At its foundation, our model calculates the required capital for Berkshire’s insurance units assuming each is a standalone business. This is important because most of the company’s equities are held at the statutory insurance entities. Therefore, in a scenario where the company is broken up, it is our view that Berkshire would likely only be able to spin out an amount equal to, or less than, what is considered excess capital. From there, we attribute a private market value to Berkshire’s other, non-insurance subsidiaries, while also taking into consideration parent-company debt.
This involved approach is enhanced by our extensive experience analyzing insurance companies and has historically signaled buy and sell points for the stock.
Although the underperformance of value stocks relative to growth stocks has been a feature of markets for over a decade, largely driven by flows into passive investment vehicles and the exceptional performance of a handful of technology stocks, the tools of value investing remain the most consistent and reliable way to uncover undervalued securities. It’s impossible to predict when value will return to fashion, but one thing we can say with confidence is that there’s a reversion to the mean aspect to investor behavior in the long run that we believe will ultimately reward a prudent, rigorous and disciplined approach to security selection in today’s market.