Wednesday, 10 December 2008

Intrinsic value, impossible to pinpoint but essential to estimate

Graham did not invent the term intrinsic value, though he did endow it with greater meaning than it had before he began teaching and writing.

The phrase is known to have been used in relation to the stock market as early as 1848. William Armstrong, an investment writer, described it as the principal determinant in setting the market prices of securities, though not the only factor.

Further groundwork for the intrinsic value concept was laid when Charles H. Dow was the editor and a columnist for The Wall Street Journal. Though Dow is most famous for his study of stock market movements, he repeatedly explained to his turn-of-the century audience that stock prices rise and fall because of investors' perception of the future profitability of a company - in other words, on the stock's intrinsic value.


In the 1940 edition of Security Analysis, Graham and Dodd used a now historic company as an example of one way intrinsic value is determined.

Graham: In 1992, prior to the boom in aviation securities, Wright Aeronautical Corporation stock was selling on the New York Stock Exchange at only $8, although it was paying a dividend of $1, had for some time been earning over $2 a share, and showed more than $8 per share in cash assets in the treasury. In this case analysis would readily have established that the intrinsic value of the issue was substantially above the market price.

Graham looked at Wright Aeronautical again in 1928. By then the company was selling at $280 per share. It was paying a $2 dividend, and earning $8 per share, and the net asset value was $50 per share. Wright was still a sound company, but future prospects in no way justified its market price. The company was, by Graham's reckoning, selling substantially above its intrinsic value.

An Artful Science

In his 1994 Berkshire Hathaway annual report, Warren Buffett spent several pages explaining how he arrives at intrinsic value. Buffett regularly reports per share book value for Berkshire Hathaway, as most investors expect.

"Just as regularly we tell you that what counts is intrinsic value, a number that is impossible to pinpoint but essential to estimate." However, he continues, "we define intrinsic value as the discounted value of the cash that can be taken out of a business during the remaining life." Though Buffett says this is a subjective number that changes as estimates of future cashflow are revised and as interest rates change, it still has enormous meaning.

Warren Buffett used his 1986 Scott Fetzer purchase to illustrate the point.

When it was acquired by Berkshire Hathaway, Scott Fetzer had $172.6 million in book value. Berkshire paid $315.2 million for the company, a premium of $142.6 million. Between 1986 and 1994, Scott Fetzer paid $634 million in dividends to Berkshire. Dividends were higher than earnings because the company held excess cash, or retained earnings, which it turned over to its owner - Berkshire.

As a result, Berkshire (of which Buffett himslef owns more than 60 percent) tripled its investment in 3 years. Berkshire still owned Scott Fetzer, which had virtually the same book value that it did when Buffett bought it. Yet since purchasing the company, Berkshire has earned double the accquistion price in dividends. (1996)


So, what is intrinsic value?
  • Some analysts consider net current asset value to be a measure of intrinsic value.
  • Others focus on price-earnings ratio or other, more fluid factors.
  • Buffet defines intrinsic value as the "discounted value of the cash that can be taken out of a business during the remaining life."
Whatever device investors may use, the goal is to find an estimate of a company's present and future worth."

Almost by definition, a really good business generates far more money (at least after its early years) than it can use internally," explains Buffett. That money can be reinvested to increase the value of the company or paid out to shareholders in dividends. One way or another this additional money will eventually work its way back to the shareholders.

Also read:
"Warren Buffett used the Scott Fetzer acquisition to explain Berkshire’s investing strategy in his 1985 letter to shareholders: Scott Fetzer is a prototype, understandable, large, well-managed, a good earner. The Scott Fetzer purchase illustrates our somewhat haphazard approach to acquisitions. We have no master strategy, no corporate planners delivering us insights about socioeconomic trends, and no staff to investigate a multitude of ideas presented by promoters and intermediaries. Instead, we simply hope that something sensible comes along-- and, when it does, we act.

Buffett went on to outline six acquisition criteria that are still published annually in his famed letters to shareholders:

  • large purchases,
  • consistent earnings,
  • little debt,
  • ongoing management,
  • simple businesses, and
  • an offering price
.....At Berkshire, in contrast, Ralph ran Scott Fetzer for 15 years until his retirement. Under his leadership, the company distributed US$1.03 billion to Berkshire against our net purchase price of $230 million. We used these funds, in turn, to purchase other businesses. All told, Ralph’s contributions to Berkshire’s present value extend well into the billions of dollars.

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