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Hi Hewitt,

What is old was once new.

If I am an enterprising investor who is to say what my angle is. Maybe I am interested in unlocking undervalued assets of the company. In this case I would be very interested in the market value of particular assets the firm owns. However if I am interested in the operations of the firm (which is the portrayal in the book), then market value of assets only has a partial role in measuring value creation. There should be a distinction made between existing sales and the creation of new sales. The Earnings Power Chart focuses on existing sales and how they were created. A valuation in contrast, focuses on future sales (or earnings) and how they will be financed.

From the operational perspective, the enterprising investor is concerned with how to finance future sales. But the firm shouldn't be expected to refinance existing sales. To not give credit to an operation for existing sales on existing capital base measured by historic costs isn't fair. From this viewpoint, firms able to increase their profits through operating leverage are stuck as eternal bridesmaid's to the enterprising investor.

What? Lets look at an unrealistic example which might be worth the exercise - the capitalization of an intangible. The reason to capitalize certain expenses is to recognize that these expenses are rather investments which won't pay off in the current period but over a time horizon. For instance, we would capitalize the research and development expense to develop a block buster drug over several years. If the drug is successful we should see value creation through operating leverage. In otherwords, if the drug sales increase as the capitalized cost is amortized we will see an increase in returns on capital. By assuming that the market value is a better proxy we would never amortize those costs (worse we would add incrementally to the capitalized cost to cope with inflation of cost inputs) and therefore the returns would never materialize. An enterprising investor would fail to recognize the value created by investing in risky projects under this criteria.

Now lets look at a more realistic situation when considering marking invested capital to current market value. Lets us a real world example of this - the LIFO reserve. Inventory in an inflationary period measured as last-in first-out would be understated by the LIFO reserve. The profits of the company would also be understated because the COGS would be overstated. Adjusting the inventory to market value we must also add the change in LIFO reserve back to the profits. The result is higher profits on a greater capital base. It becomes a moot exercise because the two cancel each other out. Copeland says don't bother and Stewart says to make the adjustment. I am confident that either way is fine as long as the analyst is consistent with the treatment. This same procedure would follow for any asset that increases in value over time making the mark to market of tangible assets a questionable activity when valuing the operations. This is not the case for different valuations such as liquidations - but that distinction has been made.

Anyway those are just some of the thoughts I had on the subject. I don't think there is a right or wrong as long as there is consistency. I strongly argue though that knowing why we stick to a particular methodology keeps us consistent when evaluating companies individually and as a universe in total. You have to draw the line somewhere.


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