GPIC has been in the news recently. There is a group of activist investors owning about 6% of the outstanding shares interested in getting someone better suited to be on the board. The investors, Enclave Asset Management et al, has claimed that GPIC has not had the business owner’s best interest in mind. The claims include not utilizing the cash hoard, self-dealing, and not implementing a strategy to fully exploit GPIC’s proprietary technology.
These types of things are all too common with small cap “value” stocks. The key is to separate the value stocks from the value traps.
I can only spot the glaringly obvious misallocation of capital. I couldn’t tell you if management has fully exploited their proprietary technology. I can tell you that there is way too much cash on the balance sheet.
I thought now might be a good time to review my position in GPIC as well as share one of my valuation metrics.
What I am really doing is finding out the fair price of the business and adding that to what I figure is excess capital. The most obvious excess capital being cash, but it can be really any asset.
This is based on the Bruce Greenwald book “Value Investing” and . I’m sure everyone has heard of it.
You start with adjusting tangible book value. The idea is to turn the balance sheet from a cost form of accounting to a replacement value. It sounds pretty easy, but is quite difficult in practice. You should be taking out intangible assets and goodwill, and replacing them with some multiple of what the company spends on development and brand maintenance. The tough part is how to determine what multiple (usually in number of years) to use. I try using something between 0-3 years. I also use some operating metrics to determine. You can also capitalize the expenses, but again how many years and at what rate?
We can see that the CCC and ebitda margins have been stable, while ROC has been moving up. Another point is to attempt to determine what cash is not needed in the business. Different companies have different working capital requirements and may keep substantial amounts of cash idle on the balance sheet.
When you read the book, Greenwald goes through many more adjustments. For GPIC they are almost immaterial, so I ignored them.
For GPIC, I simply multiplied the marketing expense by 0.50 and added it to tangible book value.
At this time I will normalize earnings for the business. I normalize ebitda margins and sometimes revenue if it has moved too quickly in one direction or another.
Once this is done I remove the run rate D+A to get to EBIT. Another adjustment that needs to be done is to adjust SG+A to back out any growth expenses. The idea with EPV is that it is a no-growth scenario. For GPIC, I removed 20% of SG+A.
Then you take off taxes at the appropriate rate to get a ballpark net income. Now you need to adjust for capital expenses. You need to be aware of companies that require much more than D+A to maintain their position in the industry. You need to add back D+A and only remove what the business requires to maintain its position, again talking no-growth. For GPIC I only subtracted 80% of the stated capex for maintenance.
Moving on to the multiplier. Which is really dividing by what you estimate as the cost of capital. I have tried using WACC and adding a certain amount of basis points to the overnight lending rate, but haven’t settled on anything. For small companies my cost of equity is always 15% and my cost of debt is what the company paid recently or what competitors are paying.
Once you have the business value down you add in any excess capital and minus debt.
Here is where I get off the bus. I never use the growth value. I have a very tough time determining when growth will be accretive in the long run.
Putting it all together
Here is what the EPV value looks like for GPIC. Determining when to buy and sell is another issue. Some buy at NAV and sell at EPV. Some buy at a discount to one or the other. My conservative EPV is $8.20, with NAV being $5.40. I will hold for now as some other valuations give a fair value of well over $10.
To be honest I am using this valuation metric less and less. It has a few shortcomings that I feel lead to people like me buying value traps.
- There is zero assurance that you will see that excess capital, so the market may simply value this as a business.
- There are many inputs that leads to GIGO (garbage in garbage out)
- Like any quantitative measurement, we are looking backward in time. But all of our money is riding on the future.
- We haven’t even talked about a catalyst to unlock value.
Lately I have been looking at companies that have been growing earnings and trying to spot a catalyst. I also don’t want a ton of cash sitting idle. You still have to really think about portfolio construction.
I only use EPV as a blunt object. I don’t have the industry knowledge to determine the precise value. I always use it in conjunction with other metrics and use EPV as a canary in the coal mine.
I would love to hear anyone’s thoughts on EPV and its practicality.
Disclosure: Long GPIC