Panning for Gold
Christopher Volk
“I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that” -Warren Buffett to Business Insider, 1999
A Background to My Story
The absolute size of the Berkshire Hathaway investment portfolio created a denominator effect for Warren Buffett. The sheer size of his investment portfolio, achieved through decades of massive outperformance, made it impossible to move the needle with the many, smaller opportunities he once found attractive. But were he able to scour through the 20,000 pages of the Moody’s Manual as he had, looking for hidden gems, he was convinced he could deliver a 50% annual return on a $1 million investment.
Value investors like Warren Buffett provide evidence that, contrary to what you may have learned in business school, markets are not fully efficient. There are any number of reasons for this, not the least of which is that, as behavioral economics pioneers Amos Tversky and Daniel Kahneman would show, investors often do not make rational choices.
But outperforming equity markets requires legwork. Value investing is akin to arduously panning for gold. And, as a devotee of corporate business models and founder and leader of multiple outperforming public companies, this is right up my alley. My central thesis when it comes to investing or leading a business is that business model fundamentals matter because they collectively deliver investor returns.
Business models don’t create themselves. They are generally purposely designed by company founders and leaders looking to repeat the corporate alchemy of return delivery year after year. What this means is that business models tend to have less volatility than the overall stock market. This observation is a cornerstone of value investing and one I personally experienced.
Our share prices generally went up as our cash flow per share rose. But there were times when our share prices and cash flow valuation multiples would fall, often for reasons having little to do with us. It was during one of these periods, in May 2017, when I sold Warren Buffett’s Berkshire Hathaway almost 10% of our last company. The result of their timely buy? They achieved returns that exceeded what our basic repeatable business model was designed to deliver. That’s what value investors do.
Our stock, like all stocks, had daily volatility resulting in share price and cash flow multiple changes. Meanwhile, our business model chugged right along, proving more durable. The relationship between share price and market volatility against comparative business model stability is value investor elixir.
DuPont and the Beginning of Business Model Dynamics
The DuPont Company, founded in 1802 as a manufacturer of gunpowder and blasting powder, became a multi-generational success, growing to become the largest explosives manufacturer in the United States by the end of the 19th century. By then, the privately held company had expanded into broader chemical manufacturing and, with three Dupont cousins guiding multiple divisions, became an early leader in modern business management.
In 1914 a young DuPont engineer‑turned‑analyst, F. Donaldson Brown, invented the decomposition of Return on Investment (ROI), which would eventually become known as the DuPont Formula. The formula was conceived to help DuPont’s leaders manage their performance, represented an advance in management accounting and has since been continuously taught and conveyed through business classes and textbooks.
Five years after Brown developed his formula, DuPont would gain control over troubled General Motors as its largest shareholder. GM had been a meaningful DuPont customer, but became distressed as a result of rapid expansion, overleverage and weak financial controls. Pierre DuPont became Chairman of General Motors and would later bring Donaldson Brown in to repair GM’s financial systems, working closely with Alfred Sloan to guide GM’s turnaround. As GM’s long-time CEO, Sloan would go on to gain a reputation as the architect of modern corporate management, but Brown was instrumental in making this happen through standardized accounting, monthly reporting and ROI driven business decisions aided by his formula.
So, what was the basic DuPont Formula? Here it is:
As initially conceived, the formula was designed to illustrate asset efficiency, evaluating the return on DuPont’s investment in plant, equipment and working capital. Later, the formula would be adjusted to focus on equity returns by adding an equity multiplier variable. The authorship of the change is not attributed and presumably was influenced by Graham and Dodd’s iconic Security Analysis (1934), which popularized the importance of ROE.
There is a lot to like about the DuPont formula, starting with its simplicity. Business leaders could easily see the financial fundamentals and levers at their disposal to maximize returns on investment, starting with optimizing profit margins, maximizing sales and minimizing assets. The later conversion of the model to solve for equity returns is reflective of how I came to see the primary objective of business leaders.
The DuPont Formula has always had a drawback in that current ROI’s or ROE’s are not the same as total ROI’s or ROE’s. The formula makes plain the financial levers at the disposal of management, but total returns are elusive because the formula was not integrated into a complete operational business model. The formula has another drawback: it’s a creation cost value formula, rather than an enterprise value formula. That’s useful from a managerial accounting perspective, but far less useful from the perspective of a prospective shareholder, where the share price deviates from creation cost. And that’s virtually always.
The Value Equation
At the time Donaldson Brown crafted what would become the DuPont Formula, there was no such thing as GAAP (generally accepted accounting principles), with accounting more on a cash basis. There was no standard notion of depreciation and GAAP concepts like share based compensation, right to use assets, straight-lined rents, other comprehensive income, asset impairments, mark to market accounting and much more simply did not exist. In Brown’s era, accounting looked a lot more like finance, with reported net worth a function of proceeds from share issuances and retained cash flow. But accounting and finance would come to increasingly diverge, rendering the DuPont Formula effectively irrelevant. As a result, I have not personally witnessed any businesses that harness this once innovative formula over forty years of providing financial services to thousands of companies.
To retool the concept of the DuPont Formula, I devised The Value Equation in 1999, subsequently using the formula in my management of three outperforming public companies through 2021. At the time, the notion of Economic Value Added was also in vogue but my view was that Brown’s relative approach to returns was simpler and more potent when it came to illustrating equity custodianship efficiency and the impact of equity returns on corporate value creation.
I wrote a book about the Value Equation in 2022 and later devised a means to integrate the formula into a universal business model. To make this happen, the variables in the formula needed to be tightly defined, because the formula represented a finance, rather than an accounting, construct. With corporate financial statements increasingly useless on their face, the aim was to transform them into transparent financial constructs that render business model dynamics comparable and visible to all. That’s what the seven variable Value Equation was designed to do.
The Value Equation:
The Value Equation uses different language than the DuPont Formula to emphasize its accounting independence. The notion of assets is replaced with the concept of Business Investment, which is essentially reported assets at cost, less non-cash accounting conventions, less free money used in the business. The latter includes such items as trade payables, accruals, customer deposits and deferred taxes.
The Value Equation uses Operating Profit, rather than Net Income, which enables it to illustrate the impact of borrowing and lease proceeds. So, Operating Profit is defined to be before rent, interest, taxes deprecation, and other non-cash conventions.
Rather than talk about borrowings, the Value Equation uses the term OPM (or Other People’s Money) to include both borrowings and estimated lease proceeds. The complementary idea is that Business Investment, which also includes estimated lease proceeds, is the amount funded by OPM and Equity, or the capital stack having a cost.
Finally, rather than assuming GAAP depreciation conventions fully reflect actual maintenance capital expenses, the Value Equation looks to more accurately define this commitment. As a former real estate investment trust CEO, the depreciation we reported was massive and at odds with having generally sold off real estate at gains to our original cost. Or consider companies like Walmart, which rents about half its locations, meaning the company reports depreciation expense for the half it owns, while having to maintain all its locations.
One more thing? Where does one include losses on closed locations or failed acquisitions? The Value Equation construct seeks to also incorporate this number into maintenance CapEx. Accountants will seek to exclude the impact of such losses from cash flows because they pertain to investments made in prior periods. Finance people don’t think like that. A loss is a loss irrespective of the investment timing and is often integral to corporate operating risks.
The Results
Through the Value Equation, Donaldson Brown’s groundbreaking management construct, becomes useful again. By focusing on operating profitability and not net income, the Value Equation expands Brown’s original construct to enable business leaders to look to the three efficiencies at their command: Operating Efficiency, Asset Efficiency and Capital Efficiency.
The Value Equation starts with numbers but becomes more potent when the numbers are simply converted into relationships. So, Sales/Business Investment simply becomes a ratio. Same with annual Maintenance CapEx/Business Investment. In this way, companies can be directly compared for relative business model efficiency.
Like its DuPont Formula predecessor, The Value Equation computes current creation equity returns. But with market equity values known, an Equity Valuation Multiplier (EVM) can be created, which is the number of times equity value is worth more than its cost. And, with an EVM, the Value Equation can be converted into an enterprise equation, rather than a creation cost equation.
Finally, with its relative variables, the Value Equation can be transformed into the core of a universal business model to compute estimated total equity returns. Completing the model entails nine added variables:
Dividend Payout Ratio
Same Store/Same Business Line Sales Growth
New Share Issuance Dilution %
The Cost of New Share Issuance
Incremental OPM Cost
Incremental Sales/Business Investment Ratio
% of Free Cash Flow Reinvested in Expansion
Share Count Adjustment for Share Buybacks or Employee Grants
Impact of Cash Flow Cycle on Cash Flow
The universal model output includes the four main drivers of return:
Dividend yield
Cash flow per share growth from same store/same business line sales growth
Cash flow per share growth from cash reinvested into growth
Cash flow per share growth from new equity issuance invested in expansion
As a long-time CEO, I understood that our company had control over the four main drivers of returns. So, we paid a great deal of attention to the business model fundamentals that enabled these four return sources. But there is a noted fifth return source that lies at the heart of the greatest fortunes ever assembled. That’s cash flow multiple arbitrage, which is to create a company at one cash flow multiple and later have it valued at a higher cash flow multiple. Our EVM was about 1.4X, meaning we delivered returns to investors sufficiently high that our equity value exceeded its cost by 40%. The best companies become worth more than the cost of their parts, benefitting from cash flow multiple arbitrage.
Panning for Gold
There are a lot of reasons it makes sense for everyone to have a basic understanding of business model dynamics. For aspiring entrepreneurs, such knowledge can help guide them to craft more valuable businesses. For business leaders, such knowledge can help them constantly improve their companies. For prospective employees, having a knowledge of business model fundamentals can help them make better employment choices. And for value investors, such knowledge can help them think like owners and not simply shareholders.
A cornerstone of value investing is the notion that quality business models tend to be more durable than share prices or traded cash flow multiples. So, knowing how to transform reported financial results into business model fundamentals is more than just useful. It’s important because it makes you think like an owner by giving you an understanding of how returns are delivered.
“Shares are not mere pieces of paper. They represent part ownership of a business. So, when contemplating an investment, think like a prospective owner.”
– Warren Buffett
Can The Value Equation framework help you to achieve the 50% annual return Warren Buffett promises he could deliver? I won’t make that claim. But I know the framework can make you a better and far more informed investor. The legwork entails applying the framework to many companies and then choosing from the best few.
In the coming months, I’ll prepare case studies with recommendations on existing public companies using their annual financial statements. Annual statements tend to be more detailed, which is helpful in peeling back business models. To the extent I refer to quarterly numbers, it will be to highlight any evident business model changes.
The aim of the value investor is to seek out companies having repeatable and understood business models that are reasonably priced with a likelihood of cash flow multiple growth. I look forward to helping you do this with a nod to the building blocks of business model dynamics first laid out over a century ago by F. Donaldson Brown.