Intrinsic Value: A Big Deal?

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Intrinsic Value: A Big Deal? via Safal Niveshak

Here is an email I received from a tribesman yesterday…

I agree that evaluating and buying great businesses at the correct price (i.e. prices below the intrinsic value) is of utmost importance.

However, while I think I am getting better in evaluating the growth of businesses, their durable moats and creating my own check list of investing, my biggest challenge is in calculating the range of the “intrinsic value”.

I am still not able to calculate the risk associated with the stock and that is prohibiting me from confidently buying a stock which I believe is a value buy.

May I request you to please share any pointers, books, frameworks which can help me estimate the risk and/or this intrinsic value?

I believe this – calculating intrinsic value – is one big issue most investors face, and thus I thought of replying to this email via a post.

Well, the concept of intrinsic value is indeed tricky.

But it’s not tricky because it involves math, but because most of us work on intrinsic values while keeping an eye on stock prices.

So, we start with the assumption that calculating intrinsic value of a stock is difficult, then we see the stock’s price jumping up and down, then we try to connect the intrinsic value with this stock’s price, and then we think how in the world we can ever calculate intrinsic value of something with certainty whose ‘price’ is so uncertain.

Another thing that makes us look at intrinsic value calculation as a complicated concept is because most of us have the inherent fear of going wrong with our estimates and thus losing our money when the stock falls even after we bought it thinking it was cheap.

So again, we are relating the value to the stock’s (future) price.

Now, let me settle the dust for you.

Say this to yourself at least 10 times, and loudly so that you can hear yourself – “A stock’s price is different than its intrinsic value. A stock’s price is different than its intrinsic value. A stock’s price is different…”

The reason you must remember this is because…

  • Stock price works on a “voting machine” concept where thousands of stock market participants, behaving in a funny way, move it (price) based on how they are feeling that day.
  • Intrinsic value – or the underlying business value – works on a “weighing machine” concept where it (value) changes not due to the CEO’s changing moods, but because of the way the business moves.

Of course, a stock price is very important for you to consider in relation to its value before making an investment decision, but to remember the fact that it is different than intrinsic value will make the task of calculating the latter relatively easier.

Why Intrinsic Value is Important?
Here is something the legendary investor Howard Marks wrote in his book The Most Important Thing

The oldest rule in investing is also the simplest: “Buy low; sell high.” Seems blindingly obvious: Who would want to do anything else? But what does that rule actually mean?

…it means that you should buy something at a low price and sell it at a high price. But what, in turn, does that mean? What’s high, and what’s low?

On a superficial level, you can take it to mean that the goal is to buy something for less than you sell it for. But since your sale will take place well down the road, that’s not much help in figuring out the proper price at which to buy today.

There has to be some objective standard for “high” and “low,” and most usefully that standard is the asset’s intrinsic value. Now the meaning of the saying becomes clear: buy at a price below intrinsic value, and sell at a higher price.

Of course, to do that, you’d better have a good idea what intrinsic value is.

Now, I will not go into describing what intrinsic value is all about, because it’s all explained in my earlier post – Intrinsic Value: The Holy Grail of Value Investing.

However, one important thing I will like to mention here is that calculating a stock’s “exact” intrinsic value is not just a difficult task, but it’s impossible!

Like, for calculating intrinsic value using the DCF method, you need to predict the company’s cash flows, say, ten years into the future…and then discount them to the present value using an appropriate discount rate. That’s the way a bond’s price is calculated.

But businesses, unlike bonds, do not have contractual or certain cash flows. And thus, they cannot be as precisely valued as bonds.

Ben Graham, the father of Value Investing, knew how hard it is to pinpoint the value of businesses and thus of stocks that represent fractional ownership of those businesses.

In his seminal book, Security Analysis, which he first wrote in 1934 along with David, he discussed the concept of a range of value. He wrote…

The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate – e.g., to protect a bond or to justify a stock purchase – or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.

Indeed, Graham frequently performed a calculation known as net working capital per share (also known as “net-net”), a back-of-the-envelope estimate of a company’s liquidation value. His use of this rough approximation was a tacit admission that he was often unable to ascertain a company’s value more precisely.

Now, while the net-net method cannot be used in current times as stocks generally don’t trade at a price lower than the company’s net working capital (Current Assets minus Current Liabilities minusBorrowings), the important thing to note is that it is not possible to determine the intrinsic value of a business with exact precision. It is usually a range of values.

If you can establish this range – which this excel spreadsheet can help you do – you can then determine if the stock is undervalued, overvalued, or fairly valued.

This lack of precision need not be a problem, if you can buy the stock cheap enough i.e., after a 30-40% margin of safety to your estimate.

By analogy, Graham says it is quite possible to determine that a man is obese even if we do not know his precise weight, or that a woman is old enough to vote even if we do not know her precise age.

Intrinsic Value Process
When it comes to stocks, if you can understand the underlying business well, it will become quite possible for you to determine whether the stock is ‘obviously cheap’ or ‘obviously expensive’.

So the most important things to do with respect to calculating intrinsic value of a stock are…

  1. Understand the business well whose intrinsic value you are trying to calculate. This can only happen when you stay within your circle of competence and study businesses you understand. Simply exclude everything that you can’t understand in 30 minutes.
  2. Write down your initial view on the business – what you like and not like about it – even before you start your analysis. This should help you in dealing with the “I love this company” bias.
  3. Run your analysis through your investment checklist. A checklist saves life…during surgery and in investing.
  4. Avoid “analysis paralysis”. Trying to increase your confidence by doing complicated analysis or gathering information on the business that is supposedly unknown to most others really only makes you more comfortable with your investment decisions, not better at them, and is generally an unproductive use of your limited time.
  5. All this while, as you are building your understanding on the business, ignore the stock price.
  6. After understanding the business, and after assessing whether it is really good to warrant an intrinsic value calculation, proceed with the actual calculations of value ‘estimates’.
  7. Calculate your intrinsic values ‘estimates’ using simple models (like I have enumerated in this excel spreadsheet), and avoid using too many input variables. In fact, use the simplest model that you can while valuing a stock. If you can value a stock with three inputs, don’t use five. Remember, less is more.
  8. Use the most important concept in value investing – ‘margin of safety’. Without this, any valuation calculation you perform will be useless.

If the stock passes the business quality, valuation, and margin of safety tests, go and invest in it.

Remember, there are not many that pass all these tests, so you must have faith in your assessment after having made one.

Now, even after all this, could you go wrong?

Yes, you will be wrong sometimes. But you see, success in investing comes not from being right but from being wrong less often than everyone else.

So, get going on understanding businesses first, and then valuing stocks.

And please remember, don’t have one eye on the business and other on its stock price, because then you would equate a rising price with a good business, and a falling price with a bad business. Both of these are dangerous assumptions that can spoil your investment returns.

Intrinsic value is not a big deal, if you believe it is not a big deal. But it surely is very-very important.

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