Asset light vs. asset heavy businesses and the effect of inflation….
I deserve absolutely no credit for the ideas discussed below and all credit goes to my 87 year old teacher who lives in Omaha, Nebraska. I have just reproduced my understanding of some of his teachings. He is not only the best investor in the world, he is by far the best teacher that I have ever learnt from. I only wish I could be introduced to his teachings when I was a teenager…that is exactly what I am trying to do with my son. It’s now his to lose…
I have mentioned in my earlier post (can be accessed here) that we prefer asset light businesses i.e. businesses which do not require to invest a lot of capital (be it long term physical assets like Property, plant and equipment or short term assets that is required to run the business viz. working capital. The benefits of asset light business can be understood intuitively, but there is one aspect which we often ignore while thinking about businesses….and that is the effect of inflation. We often hear statements like ‘investing in stocks is a good way of protecting ourselves against inflation’ or investing in physical assets is a good way of hedging against inflation’…..The first statement kind of implies that all businesses would be able to pass on the effects of inflation to the customers in form of a price increase and hence the investors would be protected….one would infer from the second statement that businesses that own a lot of physical assets, in turn would be ‘inflation hedged’…..in reality these are dangerous (wealth-destroying) sweeping statements and the actual scenario could look very different.
However before we can get into the depth of this topic, let us refresh some basic rules of business valuation (or for that matter valuation of any asset). I have outlined some of these basic concepts in a simplified manner in this appendix that can be accessed here.
Now that we got the valuation principles out of the way, let’s take a dive into the two different business scenarios
A – An asset light business requiring less capital
B – An asset heavy business requiring lot of capital
Let’s take a simple privately owned business (A) the does not have much intangible assets on the balance sheet. The business is fully funded by equity (has no debt on the balance sheet). The book value of tangible assets of the business (working capital, Property Plant and Equipment, Cash) = $8M and the business is generating $2M after tax income for the owners. To keep things simple, let us assume that the owner earnings (cash that the owners can take out of the business without hurting the earning power of the business) is also ~ $2M*. We will also assume that the business is being able to maintain the same sales volumes year on year (no growth assumed)
*This means the business A is spending an amount of Maintenance Capex which is about the same as the depreciation figure and there is no year-on-year change in Working Capital (Owner earnings will be discussed in detail in subsequent posts)
Assuming that the market rate of return (opportunity cost of capital) ~ 9%….for anyone wishing to buy this business on a negotiated basis, this business would be valued at around $2M / (9%) ~ $22M (the detailed discussion on the concept of valuation using a discount rate is provided <here>)
Now in this case the market rate of return for the 8M of tangible assets = $8M X 9% = $720,000
However the business is earning $2M after tax, so the business is earning an ‘excess return’ (over and above the market rate of return) of $1,280,000
Fig. 1 – Business A generating Excess Return over and above the market rate of return
Fig. 2 – The capitalized value of this excess return is the Economic Goodwill
As Buffett explained beautifully in the letter to his shareholders in 1983: “businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return…….It was not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.”…(that produced the excess return)
This economic goodwill is different from the accounting goodwill and doesn’t reduce over time ,assuming the business is able to maintain it’s earning power. Hence there is no requirement for amortizing this economic goodwill. Instead the economic goodwill tends to increase over time (discussed in the next section)
Considering that the business A is generating a Return of Capital of 25% ($2M over $8M of Assets) and maintains its earnings power, a negotiated sale of Business A could probably fetch a price a fair bit higher than $22M.
Let’s now look at an asset heavy business (B), which is generating the same after tax income of $2M but has total tangible assets of $18M. Just like A, we will also assume that the business is being able to maintain the same sales volumes year on year (no growth assumed).
In this case the business is generating a Return on Invested Capital of $2M over $18M or ~11%, which is much closer to the Market rate of return on the tangible assets (as compared to A). Hence the business B would possess very little economic goodwill over and above it’s tangible assets. Excess return generated by B = 2M – (18M x 9%) = $0.38M…so economic goodwill for B = $0.38M/(9%) = $4.2M (as compared to $14.2M for A)
Valuing the business in a ‘lazy way’ of just looking at the earnings of $2M and simply using a comparable the P/E ratio of Business A, would also value the business ~ $22M. However there is a serious flaw in this kind of valuation. The two businesses are NOT alike even though they are generating the same after tax earnings.
The Effect of Inflation:
“True economic goodwill tends to rise in nominal value proportionally with inflation”.
Let us look at the two businesses in an inflationary environment. To explain the effect of inflation clearly we will exaggerate the numbers a bit. Let us assume that both the businesses have maintained their profitability but over the years due to inflation the price levels have gone up by 50%.
Now both businesses managed to pass on the price increase to their customers while maintaining the same sales volumes. So both the businesses generate an after tax income of $3M ($2M X 1.5)…however to be able to support the enhanced revenue & income, both the businesses would need to put in additional capital into the businesses.
The working capital (= Inventories + Receivables – Trade Payables) needed by the businesses would also go up by 50% as each component of the W/C would have gone up by 50% due to inflation. The Fixed assets of the business would be slow to reflect the effect of inflation, but will slowly catch up as the PP&E come up for replacement…with higher maintenance capex needed (up by 50%) to at least keep pace with the depreciation.
In a steady state, business A would now need an additional capital of $4M (50% of the initial $8M) to support the extra $1M of net income. However for Business B that additional capital would be $9M for the same purpose.
Both businesses maintained their profitability levels after inflation….even if we are generous towards business B and assume similar discount rates (which would be inappropriate as business B has higher inflation risk), the new ‘Lazy’ valuation of the businesses would be 50% higher ~ $33M…..so Business A needed an additional capital of $4M to generate an additional value of $11M….however in case of Business B, an additional value of $11M was created by investing additional capital of $9M……so Business B was barely able to generate $1 of value from an additional dollar of capital, which is not too different from what you would get from a savings bank account…
…..Whereas in case of Business A, almost ~3X value was generated for each additional $ of capital invested due to inflationary forces……hence in reality this advantage should get reflected in the higher market multiples for the asset light business (A), and A should command a relatively higher valuation than B for the same level of earnings….which means the discount rates* used to capitalise B’s owner earnings should be higher than A, leading to a lower valuation for B.
*A higher discount rate (which is the denominator while capitalising) is corresponding to a lower P/E multiple…..they are two sides of the same coin.
So next time you would do yourself a huge favour by resisting the temptation of taking the short-cut method of just looking at the earnings figure and applying a multiple on it….instead of looking at the amount of capital that went into generating the earnings…..and evaluating wealth destroying factors like inflation carefully.
Let me know what you think and if there are some aspects that I may have missed out. I would love to hear from you so please leave a comment below now.