Case Study: Reproduction Value

“I think one can invest successfully with just a few techniques and simple principles. The main point is to have the right general principles and the character to stick to them.”

- Benjamin Graham

Repro-duc-tion Val-ue: The costs involved to replace the assets of a company or property of the same or equal value.

Finding a good business which falls within one’s particular area of competence and is appraised in the market for below its approximate liquidation value or discounted book value is an ideal.

However, sometimes one may come across a good or better yet great business with easily understandable operations and somewhat stable cash flow. Seldom will such a business be valued at a price such as to make it worth more dead than alive, in such cases we must turn to reasonably assessing how much the business in question is worth as a going concern. One way of going about this is approximating just how much a potential competitor would need to essentially duplicate your business’s current position in its particular industry.

Reproduction Value

The first thing we must attempt to do is determine is what the actual cost of operating the business is, not book value or accounting value as these are simply “theory” but the amount a new entrant in the industry would have to in “reality” expend just to replicate or reproduce the current incumbent’s operations.

Specialized knowledge and experience are invaluable in this analysis, since the more insight one possesses about a particular industry or business the better they will be able understand the day to day aspects of  its operations. However persistently and stringently applying the underlying guidelines which follow can make up for deficiencies in these areas.

We begin with the balance sheet, which for our company looks this:

Adjustments To Current Assets

Looking at the current assets some minor adjustments need to be made as follows:

Exhibit II.

Cash & Cash Equivalents:  Cash is cash and will always be valued at 100% as it is immediately exchangeable into other goods.

Marketable Securities:  Are valued at 100% since they are highly liquid and can readily be converted into cash (most marketable securities listed in Current Assets are Level 1 Securities).

Accounts Receivable: An allowance for doubtful accounts must be factored in, typically about 15% but no more for this analysis since a potential competitor will have to reproduce this level of turnover in order to compete (this can also vary and be helped by one’s particular knowledge of the industry and business in question).

Inventory: Since inventory is always held on a company’s books at either market or cost (whichever is lower) there is no need for an obsolescence or other allowance in this case since a new entrant into the industry would have to go out and purchase these goods or material in the market.

Prepaid Expenses & Other Assets:  
No adjustments needed here either as these assets will invariably need to be reproduced.

Adjustments To Non-Current Assets

Property, Plant & Equipment:  What we must determine in this regard is just what PP&E entails, namely what is its usefulness and function to the business in question and how old it is.

Finding out the function of the property and machinery to the business is very simple if one understands the business and its operations, finding out its useful life may be a bit harder depending upon each individual business’s disclosure.

For example a company may own a particular building (let’s say a warehouse facility) in this instance which they purchased 50 years ago. Since most businesses utilize a Straight-Line depreciation method which writes down the value of a building between anywhere from 10-40 years, we know that this warehouse facility is now being carried on the books at zero since it has been fully depreciated.

Is the value of this warehouse facility in actuality nothing? Of course not, this is why finding out how much the company in question actually paid for the property, how much it has been depreciated and over how long of a time frame is so important. Real Estate Comparables (Comps) also help as they can give us an indication of what other similar properties in a specific area are currently appraised at and selling for in the market.

Moving on to the equipment and machinery, generally speaking the more specialized the equipment is (think nuclear camera units, MRI scanners, die cast machines) the more expensive it is and the more it will require a potential competitor to pay current market prices for.

This requires a bit of digging but it is helpful to know what the approx. replacement cost for your business’s particular equipment is.

As one can see, both of these accounts (property & plant as well as equipment) require some specialized knowledge and accurate info to assess. Whether one discounts or adds back to these accounts will vary on a case by case basis.

Goodwill:This may be the most difficult asset of all to adjust. The reason? Goodwill is by definition intangible. It is trademarks, brands, processes and patents. Placing even an approximate ballpark value on these things is very tough, this is where (once again) business and industry knowledge go a long way.

It really comes down to the individual taking the time to be thorough and applying what he already knows about his business while exercising his best judgement.

Total Balance Sheet Adjustments

The overall adjusted balance sheet will look as such:

Notice that we thoroughly went through the balance sheet line by line and really got to know our company’s assets, just as one would do if they were considering buying an entire business which is the objective.

Adjustments To Current & Total Liabilities

All liabilities are not equal, as Bruce Greenwald illustrates in his book Value Investing: From Graham To Buffett & Beyond

He goes on to say: “Spontaneous liabilities include accrued wages and other things such as accounts payable and accrued expenses that arise from being in business.”

Rather than simply deducting all liabilities we must understand the financial and thereby business ramifications of a liability, namely which liabilities a potential competitor would need to take on to effectively compete with our business and which liabilities are circumstantial (unique to our business) that a competitor would not need to replicate.

Some examples of fixed (spontaneous) liabilities which a competitor would absolutely need to take on are:

- Accounts Payable (They will have vendors and suppliers just as the current industry incumbent does)
- Accrued Expenses (They will have staff and other payroll compensation costs)

Some circumstantial liabilities are:

- Legal Reserves (A brand new business will not have prior pending lawsuits for which they need to allocate reserves)

- Pension Expense (Again, a new business will not have the legacy pension costs that a long-time industry incumbent will)

The second type (circumstantial liabilities) can be written-off as a competitor will not need these to support their assets. The first type (fixed liabilities) must be left whole as any potential competitor into the industry will certainly incur these costs.

Normalized CAPEX

The final step before estimating our company’s reproduction value is to subtract the cash that does not need to be re- invested back into the business just to continue operations. There is no hard or fast rule here since this will be different for every business.

A good company may be able to keep normalized capital expenditures under 1-1.5% of sales, while a not so good business may need to re-invest 5% or more of their annual turnover back into operations just to keep going as a concern. It is up to you to find out what the approximate amount of cash not required to run your business is.

Reproduction Value

Our Net Reproduction Value estimation looks like this:

Adjusted Asset Value – Circumstantial Liabilities – Cash not required in the business = Net Reproduction Value

This final number will usually differ from a company’s stated book and market values and will approximate what a potential competitor would have to spend just to compete with your business.

Appendix

- Value Investing: From Graham To Buffett & Beyond: Bruce C.N. Greenwald, Judd Kahn, Paul D. Sonkin, Michael van Biema

- How To Perform An Asset Reproduction Value Analysis: Jae Jun

- Benjamin Graham: The Father Of Financial Analysis:Irving Kahn, Robert D. Milne

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3 thoughts on “Case Study: Reproduction Value

  1. Pingback: Case Study: Earnings Power Value | Theodor Tonca

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