My last post garnered quite a discussion in the comments, I'd encourage you to read them if you get a chance. The main question that kept coming back again and again is whether it's possible to separate assets from earning power.
It seems a popular line of thinking is that assets without earnings are worthless. This is clearly the market view as well, the market doesn't care about assets, only earnings. It doesn't care about the quality of earnings, or cash flow, just that earnings, and hopefully high earnings exist.
I want to take a step back and think about assets and earnings with my "real world" glasses on. Let's simplify things and consider a small business, a gas station in a prime location. Presume this gas station is given to me by my grandfather (family business) and I don't have much interest in it. I am happy with the small amount of earnings it throws off, but I don't keep up with it and I let the gas station fall into disrepair. Eventually my gas station's earnings gravitate towards zero and possibly to a slight loss. For me as a disinterested owner the gas station has become quite a drag, it's taking up my time and it's close to losing money. I'd rather cut my losses and go do something I enjoy.
According to the market view this business is worthless. I know that seems like a crazy statement, but it generates no earnings, and if assets that don't generate earnings are worthless, my gas station is worthless. The problem is this simply isn't true, my gas station is ideally situated and at a minimum the real estate is valuable. I already have tanks in the ground and working pumps. A buyer can come along and for considerably less expense than starting new take over where I left off. Maybe they reinvest and develop a car wash or mini-mart and earnings soar. The base assets are the same, but in the hands of a capable manager they're used to generate earnings.
Earnings are great if they can be extracted from the business. In the comments "red." pointed out that my example of a company with earnings that require constant re-investment is a business that doesn't earn their cost of capital. This is true, a business that doesn't earn, or barely earns their cost of capital has to constantly reinvest to stay above water. An investor wants to own a business that earns above their cost of capital; the excess cash can be used to pay out dividends, or grow the business.
I want to dispel another myth that appeared in the comments on the last post, that assets should be considered through the lens of reproduction value. This line of thinking believes that a business should be worth what it would cost to start one new today. I think this is clearly faulty for the following reasons.
Many businesses in heavy industry have locations and permits granted that enable them to do business in a way that a new business never could today. In the Rust Belt there are numerous steel mills and heavy industrial companies (with considerable book value!) very close to urban areas. Imagine trying to build a steel mill right next to the 'burbs in San Francisco, it would be impossible, not metaphorically impossible, literally impossible. Even a city like Cleveland or Buffalo would shy away from such a development. Yet existing businesses with ideal locations exist, they can be purchased instead of built from the ground up.
Many existing businesses have already occupied the ideal locations. Think about trying to locate a car dealer in your local area, where would it go? There's probably already a section of road packed end to end with dealers. Areas like this are a destination for car shoppers, where would a budding dealer operator locate if the strip has no more room? Maybe across town? Why start fresh with a subprime location, when an ideal location with all of the existing infrastructure, and possibly a name brand exists?
In the White Sharks of Wall Street there is a section where the author discusses why Tom Evans engaged in takeovers instead of building divisions from scratch. His line of thinking was why start fresh when a fully functioning company with clients already exists? This is why I don't think reproduction value is worth calculating, why figure out how much it costs to build a business from scratch when one already exists.
Talk to Nate