Tuesday, 19 February 2013

Valuing a Business - Mason Hawkins on Dell

Valuing a business is part art, part science.  Since determining a business's true worth is subtle enough to resist any hard-and-fast formula, it's always useful to learn how successful investors do it.  After all, investors who have outperformed the market over an extended period of time must know how to identify undervalued assets.  The consensus these days is that most of a business's value lies in the free cash flows that it will generate in the future, albeit adding on surplus assets, and subtracting long-term liabilities.  

Warren Buffett pegs the value of a business on the earnings that will be generated "from now to kingdom come," though he's deliberately vague on specifics.  It appears that he doesn't employ any standard discounted cash flow model.  In fact, biographer Alice Schroeder, among the most well-informed and shrewdest of all Buffett-watchers, has suggested that when gauging a business's value he looks forward mostly by looking backward, focusing on a business’s past ability to generate profits as a predictor of future results.  If he's confident that the business has an enduring competitive advantage, and the industry it's operates in is unlikely to undergo major change, he assumes that tomorrow will look much the same as yesterday and today.  

However, there are other valid ways of assessing a company's worth.  One of North America's foremost investors is Mason Hawkins, of Southeastern Asset Management.  He is currently campaigning on behalf of Dell shareholders, maintaining that the proposed leveraged buyout, led by founder Michael Dell, "grossly undervalues" the company.  In fact, he argues in a recent publication that the tech giant is worth nearly twice what's being offered.  Given that Southeastern is the largest outside shareholder, owning 8.5% of Dell's stock, the business world will be watching closely as events unfold.

Happily for investors and students of investing, Hawkins not only makes explicit what he thinks Dell is actually worth - $23.72 per share - he offers details about he arrives at his conclusion.  Essentially, Hawkins breaks Dell down into its constituent parts - no longer merely a purveyor of low-priced desktops, the company now sells servers, software and services, in addition to its financing operation - and attaches a multiple to current operating income.  The multiples applied are different for each business, reflecting the going rate for comparable companies in their respective industries.  He sums up these numbers, adds net cash plus an estimate of the value of recent acquisitions, then subtracts unallocated financing and corporate expenses.  While Hawkins doesn't attempt to quantify it, he notes that Dell's distribution network offers the company a competitive advantage, adding further value.

Number-loving investors will be fascinated by Hawkins' analysis, but the important work is actually qualitative.  Taking apart Dell piece by piece forces Hawkins to carefully consider each of its component businesses, and how they compare to competitors in their respective industries.  While this analysis focuses on today's earnings, rather than attempting to predict what may happen tomorrow, it has one crucially important thing in common with a future cash flow estimate: it places a company's value in its ability to sell products and services to customers.  Hawkins goes on to suggest several scenarios that may unlock latent value, but the value itself resides in the quality of the business.

Source: http://www.longleafpartners.com/downloads/dell-board-letter.pdf

Here is an earlier article on Dell.

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