The Berkshire Cow model (shown above) is a pictorial representation of the Economic-Value Creation (EVC) metrics of a business over its last 10-years.
- This is a proprietary model at KIP Capital. It was inspired by an enlightening discussion of See’s Candies presented by Warren Buffett.
- The economic value of a business to its owners is approximately the sum of its ‘BV in place’ + ‘potential earnings-power in the future’.
- The model’s key metric is ‘Economic-Value Creation per share’. It measures the Change in BV + Total Cash-Returned (Dividends+Buybacks) over the span of 10 years. We believe this metric closely tracks and is the nearest proxy of the precise economic-value creation measure of a given business.
- The model measures historical value-creation and does NOT incorporate any future earnings power.
The visuals: The smaller-sized cow represents the company’s shareholder’s equity or book-value (BV) in Year -1 (say, year-end 2006). The larger cow represents the company’s BV in Year -10 (say, year-end 2016). Value-creating businesses typically grow their BV (and BV per sh.) over time. This is represented by the growth in the size of the cow. This, of course, does not always have to be the case. We can find value-destroying businesses which grow their BV/share and vice-versa.
Key features of the model
- All numbers are cumulative for the 10-year period. BV and BV/sh in Year-1, BV and BV/sh in Year-10, and the underlying ‘change’ figures that represent differences.
- Rev/sh, ROIC and Invested Capital/sh (IC/sh) figures of Years 1 and 10 show the Re-investment Dynamics & the Quality of Value-Creation.
- We begin with NOPAT and deduct all Re-investments which include Changes in Non-Cash Working Capital + Growth CapEx + Acquisitions. For simplicity, we assume that Maintainence CapEx requirements are equal to the D&A.
- We then compute Free-Cash-Flow to Equity holders (FCFE) by adjusting for Net Changes in Debt and deducting Debt Service Charges (i.e. After-Tax Interest payments).
- FCFE – represents the cash that could be potentially be returned to equity owners. This is done via Dividends and/or Share-Buybacks.
- Economic-Value created is then computed as the Change in Book Value + cumulative Cash-Returned to owners. It is computed both on an absolute basis (in $mm) and on a per-share basis ($ per sh).
- At the bottom right we show the growth of $1 of equity invested in Year-1 to its economic-value (EVC) after 10-years. The equivalent CAGR% is also shown. We have seen great businesses generate EVC in the range of $2-$15 for each $1 of equity. Poor businesses often result in an EVC less than $1 – meaning a destruction of value.
Disclaimer: We acknowledge that this model omits the fundamental investing notion of Intrinsic Value (IV) – that is, the discounted value all future cash flows. For the record, IV is at the core of every business valuation we undertake. We only refrain from mentioning it in our model due to IV’s subjective nature – making a pictorial representation tedious. Even so, a full appreciation of IV is paramount to successful investing – and we fully accept that the model above is far from perfect. Nevertheless, upon applying it to hundreds of stocks, we find it frequently suffices as an (imperfect) picture of a trend in value-creation/destruction.
Polaris Industries Inc. (PII)