Security Analysis 401: Calculating Intrinsic Value
August 23, 2007 |
In the previous three articles in this "Security Analysis" series, I discussed the concept ofmargin of safety, explained why you should rely on intrinsic value to make investing decisions, and showed why you want to find great businesses with wide economic moats. Once you've taken those steps and found a business that looks attractive, you next need to determine theintrinsic value of that business, to find out whether a bargain of an investment opportunityexists.
Every business has an intrinsic value. According to John Burr Williams in his 1938 publicationThe Theory of Investment Value, that value is determined by the cash inflows and outflows -- discounted at an appropriate interest rate -- that can be expected to occur during the remaining life of the business.
This definition is painfully simple, but it works. Let's apply it to a couple of businesses so you can see for yourself.
Solid, stable cementCEMEX (NYSE: CX ) is a Mexican producer and distributor of cement. Competing with the likes of LaFarge (NYSE: LR ) , it is one of the largest cement players in the world. It produced free cash flow -- cash from operations less capital expenditures -- of about $2.6 billion in 2005 and around $2.75 billion in 2006. Meanwhile, between 2004 and 2005, it grew free cash flow by around 50%, but that same figure was virtually flat from 2005 to 2006. That may give you an inkling that it makes no sense to try predicting a different rate of cash flowgrowth each year. Instead, when attempting to calculate intrinsic value, you should stick to one or two consistent conservative growth rates, although smaller companies starting with a lower base figure can be assigned higher rates of growth. When calculating intrinsic value, I use a 10-year forecast, because I think that's an adequate time period to provide sufficient data, and I apply a 10% rate discount rate, which is equivalent to the S&P 500's historical return.
Cemex, however, is a huge business, and while it may experience some years in whichcash flows grow abnormally, it's more logical when determining its intrinsic value to use a meaningful conservative figure. Always work with a margin of safety.
In this case, it's reasonable to assume that Cemex can grow its free cash flow by 10% for four years. While this growth rate can continue for a longer period, I like to be extra cautious and predict that free cash flows stabilize at a 3% growth rate thereafter. Cemex is a very well-run company, and there will always be a need for cement in the world, so I think 3% free cash flow growth is very achievable.
Let's look at the calculations. Dollar figures are in billions.
Year | Free Cash Flow | Present Value of FCF |
|---|---|---|
2007 | $3.02 | $2.75 |
2008 | $3.30 | $2.75 |
2009 | $3.70 | $2.75 |
2010 | $4.02 | $2.75 |
2011 | $4.43 | $2.75 |
2012 | $4.56 | $2.57 |
2013 | $4.70 | $2.41 |
2014 | $4.83 | $2.25 |
2015 | $4.98 | $2.11 |
2016 | $5.13 | $1.97 |
The sum of the present value (PV) of the free cash flows comes to about $25 billion.
Next, you need to determine a terminal value for the business. Conservatively, I assume that Cemex would be worth 10 times its 2016 free cash flow, or $51.3 billion, which has apresent value of $19.7 billion. So by adding all of the PV cash flows together, my estimate of intrinsic value for Cemex comes to about $45 billion. With about 790 million shares currently outstanding, Cemex has a per-share intrinsic value, based on my assumptions, of approximately $57 a share, versus the current stock price of $31.
Does this mean you should back up truck and load up on Cemex? No, even though I do think Cemex is a fantastic company selling at an attractive price. For one, the number ofshares outstanding 10 years from now will surely be a different number from what it stands at today. Assume, for example, that the share count rises to 1 billion shares and the intrinsic value comes down to $45 a share. Then you're talking about a whole different set of numbers.
Most importantly, though, you need to know the business inside and out in order to estimate cash flow growth with a high degree of confidence. The ability to assess the quality and competence of management thus becomes critical. Knowing how management spends company dollars tells you a lot about how much cash the company will produce years down the road. In short, do your due diligence ... and when you are done, do it again.
The hard part
Calculating intrinsic value is simple and straightforward. It's having accurate data that's the difficult part. That's why Benjamin Graham remarked: "You are neither right or wrong because the crowd disagrees with you. You are right because your data and reasoning are right." That's also why Warren Buffett, the best investor on the planet, spends a lot of time focusing on businesses with durable competitive advantages, such as the brand value that Coca-Cola(NYSE: KO ) offers, or the monopoly-like industry that American Express (NYSE: AXP ) operates in.It's easy to predict future cash flows with a high degree of certainty for businesses like this -- ones that have wide economic moats insulating them from the threat of competition. That gets back to our last discussion. And it shows how all of our discussions tie together to make you a better investor.
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