Every investor in common stocks is faced with the challenge of knowing when to buy, sell or hold. Additionally, this challenge will be approached differently by the true investor than it would by a speculator. But since I know very little about speculation (trading or market timing), this article will be focused on assisting true investors desirous of a sound and reliable method that they can trust and implement when attempting to make these important buy, sell or hold investing decisions.
Furthermore, it logically follows that true investing requires a diligent focus and comprehensive understanding of the true worth of any business under consideration. This last notion logically extends to a second notion implying that true investors are also value investors, at least on some level. Consequently, it further highlights the importance of having at least a reasonable idea of what any business you own, or are contemplating owning in the future, is worth in order to successfully invest over the long term.
However, there is an additional layer of complexity that applies to the concept of identifying the true worth of a business. Within the jargon of Wall Street there are many expressions of true worth that are bantered about that are often vague and imprecisely thrown about. For example, when attempting to quantify the value of a business, the four most common expressions will be intrinsic value, fair value, fundamental value and true worth. In truth, these are not synonyms, but often utilized as if they were. Nevertheless, all four share a common objective.
Whether you call it intrinsic value, fair value, fundamental value or true worth, the idea is to quantify optimum prices (valuation levels), which make the most sense regarding making sound decisions to buy, sell or hold a given stock. And even though they are not exact synonyms, they are all close enough to be of practical value. In other words, all four of these expressions of valuation are focused on calculating and knowing what the business you own is actually worth (within a reasonable range), so that your decisions can be sound and beneficial to your long-term performance. Therefore, semantics aside, it all comes down to having an intelligent framework in order to accurately make sound long-term investing decisions.
Therefore, even though I believe it is both useful and important to attempt to try and apply some precision to the definitions regarding true worth, intrinsic value, fundamental value or fair value, investing need not be a game of perfect. Consequently, at their essence, and in regards to making successful investing decisions, they are all concepts that can be used to identify the value of a business. However, there are differences and even nuances that each imply in its own right. On the other hand, the real test supporting any of them is whether or not they can be utilized in real-world applications. I will cover this last point more extensively later in the article.
In my opinion, one of the mistakes that many investors make when attempting to calculate intrinsic value is that they are too strict or rigid with the application of the various mathematical formulas suggested. The following table calculates the intrinsic value of 10 Standard & Poor’s Dividend Aristocrats with the highest premium of current price versus the formulaic calculation of intrinsic value.
These calculations were made using a popular intrinsic value calculator that will remain unidentified. The point I am attempting to make with this table is that relying on the strictest use of the mathematical formula (Ben Graham’s formula) embraced by many, provides an intrinsic value number that is completely impractical in real world applications.
My point being that none of these Dividend Aristocrats could ever be purchased at the calculated intrinsic value price. More simply stated, if you rigidly waited for intrinsic value to manifest on this basis, you would never own any of these names.
Ben Graham’s Formulas For Calculating Intrinsic Value
The concept of intrinsic value is most often associated with the legendary and widely considered father of value investing, Ben Graham. In addition to referencing the term “intrinsic value” numerous times in his seminal work The Intelligent Investor, Ben Graham is also credited with proposing his famous Ben Graham formula for calculating intrinsic value. The formula described by Ben Graham in the 1962 edition of Security Analysis is as follows:
V = Intrinsic Value
EPS = Trailing Twelve Months Earnings Per Share
8.5 = P/E base for a no-growth company
g = reasonably expected 7 to 10 year growth rate
In 1974, Ben Graham revised his formula in order to more accurately account for changes in interest rates. What’s important to recognize here, is that Ben Graham’s approach to calculating intrinsic value evolved, as his knowledge and experience also evolved. Ben’s revised (1974 ) intrinsic value formula is as follows:
V: Intrinsic Value
EPS: the company’s last 12-month earnings per share
8.5: the constant represents the appropriate P-E ratio for a no-growth company as proposed by Graham
g: the company’s long-term (five years) earnings growth estimate
4.4: the average yield of high-grade corporate bonds in 1962, when this model was introduced
Y: the current yield on AAA corporate bonds
on February 11, 2011 provides my first real-world evidence of Ben Graham’s formula at work. (Note that the
Ben Graham’s View of the P/E Ratio 15
Of course, there was a lot more behind Ben Graham’s work than relying on a formula. Ben believed in and practiced comprehensive fundamental research analysis. Moreover, he shared his concepts and beliefs extensively through his books, the most famous of which is The Intelligent Investor.
The following excerpt found on pages 337 and 338 summarizes his 7 recommendations to what he referred to as the defensive investor. However, it is also important to recognize two important points. Number one, these were offered as recommendations to conservative (defensive) investors, but not as absolutes. Point number two, the reader should also consider that Ben Graham developed these recommendations when America was primarily an industrial economy prior to evolving into today’s more prevalent service-based economy. Ben’s 7 recommendations are as follows:
“These will be developed in the next chapter, but we summarize them as follows:
1. Adequate size.
2. A sufficiently strong financial condition.
3. Continued dividends for at least the past 20 years.
4. No earnings deficit in the past ten years.
5. Ten-year growth of at least one-third in per-share earnings.
(*Note: my calculations suggest that this implies a minimum of approximately 3% earnings growth.)
6. Price of stock no more than 1 1?2 times net asset value.
7. Price no more than 15 times average earnings of the past three years.” (Emphasis mine.)
Consequently, most of the businesses that Ben Graham was originally evaluating were rich in tangible assets. Therefore, his recommendation number 6 was more appropriate for tangible assets-based corporations, but less so for companies operating in today’s service-based economy where many companies’ balance sheets also include significant levels of intangible assets. (Note: this is one reason that the above intrinsic value calculator table produced such impractical intrinsic value results.)
Applying a precise calculation of the value of intangible assets such as intellectual property and goodwill is much more challenging than valuing a building or piece of equipment, etc. However, I feel it’s important to interject here that a business derives its value from the amount of cash flow it is capable of generating on behalf of its stakeholders. Intangible assets, like tangible assets, can and do produce significant cash flows for many service and technologically-based companies. Therefore, even though they are more difficult to accurately value, they do produce true economic value.
The point I’m trying to make is that I believe Ben Graham laid a solid foundation for rational approaches to valuing a business. However, I also recognize and believe that it is incumbent upon his devotees and followers to build upon the foundation that Ben laid. His most famous student, Warren Buffett, provides some perspective on this hypothesis as follows:
“You can have a full and rewarding life without ever thinking about goodwill and it’s amortization. But students of investment and management should understand the nuances of the subject. My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic goodwill. This bias caused me to make many important business mistakes of omission although relatively few of commission. Keynes identified my problem ‘The difficulty lies not in the new ideas but in escaping from the old ones.’ My escape was long delayed, in part because most of what I had been taught by the same teacher had been (and continues to be) so extraordinarily valuable. Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring goodwill and that utilize a minimum