Saturday, November 30, 2013

Valuation thoughts: Terminal Value

An oft repeated mantra is that something is worth more than it's selling for now, but it's exact full value is unknown.  It's as Benjamin Graham said, you don't need to know a man's exact weight to know that he's fat.  Along these lines I've been thinking a lot about a concept I will call terminal value.  I believe each company has a maximum, or terminal value that is the most it could be worth.

A company's terminal value is what they would be worth if their assets could be put to their highest and most productive use.  Another way to define terminal value is what a company might be worth if the world's best capital allocator with expertise in a company's given sector were in control of the company and made perfect decisions.

I came to think about the concept of terminal value after thinking about valuing companies at a micro level.  As an example think about a bank branch.  Bank branches are everywhere, on some street corners all four corners are inhabited by branches of different banks.  The location of all four branches is the same yet each might have different levels of profitability, why?  Why can one branch across the street from another one differ so much in profitability?  Why is it that an underperforming branch can suddenly become profitable when the bank is acquired, a new logo hung outside, and new processes and procedures implemented?

At a micro level it should be possible to model the perfect bank branch.  We could take the best processes and procedures from any bank in the US and apply those theoretically to our example branch.  Then we could take into account location and geographic details.  All of these inputs would give us the maximum a perfect branch could produce given a certain level of deposits.  If this exercise were extended to all of a bank's branches in theory we could create the maximum value of a bank.

The sum of these maximum branch values, plus an ideal lending program could be considered a bank's terminal value.  Our model creates the most this bank could possibly be worth in an ideal environment.  If an investor is expecting a bank to be worth more than a terminal value their expectations are too lofty.  Conversely if a non-perfect management team, or non-ideal environment exist then the bank's intrinsic value should be much less than its terminal value.

I used the example of a bank and bank branches because branches are easy to understand, and somewhat fungible.  But the concept of terminal value isn't limited to banks, I would say in many ways it's more applicable to other business types.

Take an example of a real estate company that owns an apartment building.  If the company were to attempt to rent their apartments for double the rent of any nearby building they'd have a vacant building.  So it's reasonable to assume that there is some value of rent that minimizes vacancies and maximizes revenue at the building.  If the company were to keep the building in this ideal state forever that cash flow might represent terminal value.  For this real estate company they can't be worth more than this value unless something unusual happens.

It seems like many investors build investment thesis on the premise that something unusual needs to happen for an investment to work out.  A company with an entrenched management team needs a change of heart.  A previously unsalable asset suddenly becomes liquid, an underperforming division suddenly wildly profitable.  Something unusual is different than a reversion to the mean.  A company can't underperform, or outperform forever, eventually competitive dynamics will either hurt or help the company and push them towards the middle (the mean).  The something unusual thesis is expecting that something external to the company, which is unpredictable, and unknowable will unlock value for investors.

Unusual things to happen to companies, they are nice surprises that everyone can celebrate.  Maybe the real estate company owns a property in a depressed area that suddenly experiences revitalization.  While it's nice to experience an external event that unlocks value, it is speculative to base an investment thesis on something unknown and unknowable.

What's the practical application of the terminal value concept?  I don't expect any investor to build a giant model of the highest and best use for each property a company owns.  I think terminal value is a great framework that provides a double check on investment assumptions.  If a thesis assumes Warren Buffett's expertise, but instead has Barney Fife as management it's time to scale back expectations of intrinsic value.  This framework can also help clarify where we think ultimate value will be derived from.  Will it be better utilization of current assets, or something external to the company?

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