Growth in profits have LITTLE role in determining intrinsic value.

 

Growth in profits have LITTLE role in determining intrinsic value.

https://myinvestingnotes.blogspot.com/2010/04/growth-in-profits-have-little-role-in.html

Growth in profits have LITTLE role in determining intrinsic value.  It is the amount of capital used that will determine value.  The lower the capital used to achieve a certain level of growth, the higher the intrinsic value.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor."

If understood in their entirety, the above paragraph will surely make the reader a much better investor.

Growth in profits will have little role in determining value. It is the amount of capital used that will mostly determine value. Lower the capital used to achieve a certain level of growth, higher the intrinsic value.

There have been industries where the growth has been very good but the capital consumed has been so huge, that the net effect on value has been negative. Example - US airlines.

Hence, steer clear of sectors and companies where profits grow at fast clip but the return on capital employed are not enough to even cover the cost of capital.

=====:

 It captures a fundamental, yet often misunderstood, principle of value investing. Let's break it down, discuss its implications, and summarize.

Core Thesis: Growth is Not a Free Good

The central argument is a direct challenge to conventional market thinking, which often equates "growth" with "value." The passage asserts that growth in profits is not inherently valuable. It only becomes valuable under a specific condition: when the capital required to generate that growth earns a return above the company's cost of capital.

• Growth that Destroys Value: If a company (or an entire industry) must invest massive amounts of capital at low returns (e.g., 4%) to grow profits, but its cost of capital is 8%, it is destroying shareholder wealth with every new dollar invested. The profit number goes up, but the economic value per share goes down.

• Growth that Creates Value: A company that can grow profits by reinvesting minimal capital at high returns (e.g., 25% on capital) is a value-creating machine. Software companies, certain branded consumer goods firms, and platforms with network effects often exemplify this.

Key Concepts Explained

1. "The amount of capital used will determine value."

   • This refers to the Return on Invested Capital (ROIC). Value is a function of cash flows, and high ROIC means the business generates more cash flow per dollar of capital locked up in the business. A business with a 30% ROIC is far more valuable than one with a 10% ROIC, even with identical current profits, because its future profit growth will require less dilution or debt.

2. "Each dollar used to finance the growth creates over a dollar of long-term market value."

   • This is the value creation test. The "dollar of long-term market value" is the present value of all future cash flows that dollar of investment will generate. If that present value exceeds $1, management has created value. This is directly linked to investing at a spread above the cost of capital.

3. The Example of US Airlines:

   • This is a classic case. The industry has seen consistent growth in passenger traffic and, at times, profits. However, it is fiercely competitive, requires enormous ongoing capital expenditures (planes, maintenance, gates), and has historically earned returns below its cost of capital. The net effect over decades has been wealth destruction for equity investors, despite being a vital and growing service.

Commentary and Nuance

• Echoes of Great Investors: This philosophy is pure Warren Buffett (inspired by his mentors Ben Graham and Charlie Munger) and Michael Mauboussin. Buffett famously said, "The best business is one that can employ large amounts of incremental capital at very high rates of return." He also warned about "the institutional imperative" that pushes managers to pursue growth at any cost, even value-destructive growth.

• Link to "Economic Moats": A business's ability to reinvest at high rates over time is protected by its competitive advantage or "moat." Wide-moat businesses (strong brands, patents, network effects) can sustain high ROIC as they grow. No moat means competition will quickly drive returns down toward the cost of capital.

• The Investor's Practical Takeaway: The passage instructs investors to look beyond the headline "profit growth" figure.

  1. Primary Metric: Focus on Return on Capital Employed (ROCE) or ROIC.

  2. Compare: Weigh the ROIC against the company's estimated Weighted Average Cost of Capital (WACC).

  3. The Rule: Seek companies where ROIC > WACC, and where this spread is sustainable. Be deeply skeptical of high-growth companies with low or declining ROIC.

  4. Sector Selection: As advised, be wary of sectors prone to value-destructive growth cycles—airlines, traditional telecom, capital-intensive manufacturing—unless there is a clear, structural shift toward discipline and higher returns.

Summary

In essence, the passage makes a critical distinction:

• Naive View: Growth in Profits → Higher Intrinsic Value.

• Sophisticated View: Growth in Profits at High Returns on Capital → Higher Intrinsic Value. Growth in Profits at Low Returns on Capital → Can Actually Destroy Intrinsic Value.

The ultimate determinant of value is not growth itself, but the quality of that growth as measured by the return on the capital required to achieve it. An investor who internalizes this shifts their focus from the top-line growth story to the economics of the business model, thereby avoiding value traps disguised as growth stories and identifying truly exceptional compounding machines. This is, indeed, what makes a "much better investor."

Buffett (1980): The true value is determined by the intrinsic value of the company and not the dividends.

Wednesday, 31 March 2010

Buffett (1980): The true value is determined by the intrinsic value of the company and not the dividends.

https://myinvestingnotes.blogspot.com/2010/03/buffett-true-value-is-determined-by.html

Warren Buffett in his 1980 letter to the shareholders of Berks

hire Hathaway:

"The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20% or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage."

======

Buffett’s thinking from that 1980 letter.

Let’s break down and expand upon the key ideas you’ve highlighted:

---

1. Intrinsic Value vs. Dividends in Accounting

Buffett was criticizing the accounting convention that focused on dividends received from partially owned companies as the measure of value for the owning company.
He argued that the real worth to Berkshire wasn’t the dividend payout, but the proportionate share of the underlying business’s intrinsic value — regardless of whether those earnings were paid out or retained.

Your Indian example — valuing M&M based only on dividends from Tech Mahindra, rather than 20% of Tech Mahindra’s intrinsic value — perfectly illustrates the flawed accounting viewpoint.
If Tech Mahindra reinvests its earnings profitably, the retained earnings compound and increase the intrinsic value of M&M’s stake far beyond the dividends received.
Accounting rules at the time (and to a large extent still today) fail to capture this unless ownership exceeds a certain threshold (e.g., consolidation or equity method with impairment tests, but still not intrinsic-value based).

---

2. Retained Earnings: Value Depends on Use

Buffett’s core point:

“The value of retained earnings is determined by the use to which they are put and the subsequent level of earnings produced.”

This means it’s not retention itself that creates value, but the return on reinvested capital. If a business can reinvest earnings at high rates of return, retaining earnings adds more value than paying dividends.
If it can’t find good reinvestment opportunities, returning capital to shareholders (via dividends or buybacks) is better.

For partial ownership, even if you don’t control the capital allocation decisions, if the investee company reinvests earnings well, your share of its value grows without you receiving cash dividends.
That’s why Berkshire’s holdings in companies like Coca-Cola or See’s Candies were worth far more than the dividends indicated — because retained earnings were deployed into high-return operations.

---

3. Buybacks at a Discount to Intrinsic Value

The second quote contrasts corporate acquisitions (often full-price or overpay in competitive bidding) with stock buybacks in the open market (where shares can sometimes be bought far below intrinsic value).

Key takeaways:

• Acquisition market = auction between corporations → often pays premium to intrinsic value.

• Stock market = sometimes an auction where sellers panic → can buy parts of a business at a discount.

Buffett loves buybacks when:

1. The stock trades below intrinsic value.

2. The company has excess cash and no better investment opportunities.

Buybacks increase per-share intrinsic value by reducing shares outstanding, effectively giving remaining shareholders a larger claim on future earnings at a bargain price.

---

4. Relevance Today

These principles remain central to value investing:

• Look-through earnings: When evaluating holdings, include your share of undistributed earnings of subsidiaries/associates if they are reinvested well.

• Capital allocation priority:

  1. Reinvest in high-return projects.

  2. Acquire other businesses at fair prices.

  3. Buy back stock when cheap.

  4. Pay dividends if no better use.

The accounting standards (e.g., IFRS 9, ASC 323) still don’t fully reflect “look-through” intrinsic value for minority holdings — they focus on dividends, fair value changes, or equity-accounted earnings, but not necessarily the full economic value of retained earnings compounding inside the investee.

---

5. Buffett’s Broader Philosophy

The 1980 letter segment you’re discussing fits into Buffett’s larger framework:

• Own businesses, not stocks → value comes from underlying business performance.

• Mr. Market offers opportunities to buy/sell pieces of businesses at irrational prices.

• Management’s job is to increase per-share intrinsic value over time, not to cater to short-term stock prices.

By ignoring dividends as the sole measure of value from investments and focusing on the growth in intrinsic value, Buffett built Berkshire’s worth far beyond what dividend-based accounting would suggest.

=====

SUMMARY

Here is a summary of the article's key points:

Core Argument

Warren Buffett, in his 1980 letter, argues that the true economic value of a company's stake in another business is not determined by the dividends it receives, but by its share of the intrinsic value of the underlying business. Accounting standards that focus on dividend income are misleading.

Main Points

1. Intrinsic Value Over Dividends:

   • If Company A owns 20% of Company B, the stake should be valued as 20% of Company B's intrinsic value, not just 20% of the dividends paid out. This is because retained earnings reinvested into the business can create far more long-term value.

   • Example: Valuing M&M based only on the dividends from its stake in Tech Mahindra would be incorrect; one must value its 20% ownership of Tech Mahindra itself.

2. Value of Retained Earnings:

   • The worth of retained earnings depends entirely on how effectively they are reinvested. If a business can reinvest earnings at a high rate of return, retaining them creates more value than paying them out as dividends.

3. Buybacks vs. Acquisitions:

   • Acquisitions often occur in a competitive auction, forcing acquirers to pay a "full" or inflated price.

   • Stock Buybacks, however, allow a company to buy parts of its own business in the open market, often at a significant discount to intrinsic value, especially during market panics.

   • Buffett strongly advocates for buybacks when a company's stock is trading below its intrinsic value, as it is the most efficient use of capital to increase per-share value for remaining shareholders.

Conclusion

Buffett’s philosophy centers on economic reality over accounting convention. A value investor should focus on the growth of intrinsic value from reinvested earnings and take advantage of market irrationality to buy ownership stakes at a discount.

Chapter 1 & 2: Scope and Limitations of Security Analysis (Security Analysis 6th Edition)

Chapter 1: Introduction – Scope and Limitations of Security Analysis

Introduction. Scope and limitations of security analysis. 

Every science has its limits. Even the most advanced tools cannot guarantee perfection. Security analysis is no different. It offers investors a way to think clearly about financial decisions, but it cannot eliminate uncertainty.

Benjamin Graham and David Dodd open their classic by warning us. Do not expect analysis to predict the future with certainty. Instead, expect it to create a logical foundation for making decisions. The role of the analyst is not fortunetelling. It is interpretation.  It is careful judgment built on facts, not on wishes. 

The first step is to understand what security analysis is meant to do. 

It studies financial statements, balance sheets, income accounts, and company reports. It searches for the real strength and weaknesses of a business. Its goal is to find the truth behind the numbers. 

But here comes the limitation. Even the best analysis cannot foresee wars, political revolutions, sudden economic crisis, or natural disasters. These unknowns are beyond the reach of numbers. So the analyst must remain humble. He must remember that markets can surprise anyone. 

Still, analysis has great value.  It allows the investor to avoid blind speculation. It helps in separating companies with solid foundations from those built on illusions. It gives the investor a rational anchor in a sea of market emotions. 

Graham and Dodd emphasize discipline. The analyst cannot be swayed by hope, fear, or market noise. Instead, he must ask, "Is the company truly able to protect the investor's money? Does it have a record of stable earnings? Are its assets real and strong?" If the answer is yes, then the security deserves attention. 

At the same time, analysis must remain flexible. The world changes. Industries rise and fall. Methods that worked in the past may not always work in the future. So the intelligent analyst adapts, but he never abandons the principles of logic, evidence, and caution. 

The authors also point out another important truth. Most mistakes in investing come not from lack of intelligence, but from overconfidence.  People believe they can outsmart the market. They trust predictions that sound certain, but are built on weak foundations. Here security analysis acts as a defense. It keeps the investor grounded in facts rather than fantasies. 

So what should we take from this first chapter? That security analysis is both powerful and limited. It cannot promise wealth but it can prevent disaster. It cannot predict the future but it can prepare us for it. And above all it gives us the discipline to remain rational when others lose control. 

And now comes the natural question.  If analysis is both powerful and limited, how exactly do we define its scope? What areas of finance can it truly master? And where must we admit its boundaries?

Chapter 2: The Scope and Limitations of Security Analysis Continued

The second chapter deepens the discussion of what security analysis can and cannot do. Graham and Dodd remind us that the analyst is not a prophet. He is more like a doctor. A doctor cannot guarantee life, but he can diagnose, prevent, and improve chances of survival. In the same way, an analyst cannot guarantee profits, but he can diagnose weaknesses, avoid risks, and improve chances of success.

The scope of security analysis lies in facts. Numbers do not lie, but they can be misread. The analyst's job is to test those numbers, compare them with reality, and build a logical conclusion.

For example, if a company's earnings cover its interest many times over, that is a strong sign of safety. If assets are greater than debts, that provides protection. These are within the scope of analysis, but there are strict limitations. Analysis cannot account for political revolutions, sudden natural disasters, or unexpected human behavior. It cannot forecast the timing of booms or crashes.

No formula can predict exactly when optimism will turn to panic. Therefore, the wise analyst does not try to predict everything. He accepts uncertainty and builds a margin of safety. 

The authors stress another key point. Security analysis works best when applied to groups of securities rather than single bets. Looking at one company may lead to mistakes, but examining a wide group gives a more reliable picture. Patterns and averages are more dependable than isolated cases. This is why Graham often relied on statistical studies of many companies, not just one. 

Another limitation is human emotion. Even when analysis shows danger, people often ignore it. During market bubbles, investors dismiss logic. They believe this time is different. In truth, no amount of analysis can protect someone who refuses to listen to reason. Yet, despite all these boundaries, analysis remains essential. It is the compass that keeps investors from drifting aimlessly. It cannot guarantee the destination, but it can keep the ship away from rocks. 

So, what is the lesson of this chapter? That security analysis has clear power but only within defined territory. It is like a flashlight. It cannot light the whole forest but it can guide you safely along the path in front of you. With this foundation, Graham and Dodd prepare us for the next step. 

If analysis is about finding the truth of a business, then we need a central guiding star. Something that helps us measure whether a security is really worth buying. That guiding star is the concept of intrinsic value. And it is in chapter 3 that the authors introduce this core idea. The very heart of security analysis. Chapter 3, the concept of intrinsic value.

Warren Buffett's Intrinsic Value Method Exposed

A Range of Value

 A Range of Value

Businesses, unlike debt instruments, do not have contractual
cash flows. As a result, they cannot be as precisely valued as
bonds. 

Benjamin Graham knew how hard it is to pinpoint the
value of businesses and thus of equity securities that represent
fractional ownership of those businesses. In Security Analysis he
and David Dodd discussed the concept of a range of value:

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, 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.

To illustrate the difficulty of accurate business valuation,
investors need only consider the wide range of Wall Street
estimates that typically are offered whenever a company is put
up for sale. 

In 1989, for example, Campeau Corporation
marketed Bloomingdales to prospective buyers; Harcourt Brace
Jovanovich, Inc., held an auction of its Sea World subsidiary;
and Hilton Hotels, Inc., offered itself for sale. In each case Wall
Street’s value estimates ranged widely, with the highest
estimate as much as twice the lowest figure. If expert analysts
with extensive information cannot gauge the value of high 

profile, well-regarded businesses with more certainty than this,
investors should not fool themselves into believing they are
capable of greater precision when buying marketable securities
based only on limited, publicly available information.

Markets exist because of differences of opinion among

investors. If securities could be valued precisely, there would be
many fewer differences of opinion; market prices would
fluctuate less frequently, and trading activity would diminish.
To fundamentally oriented investors, the value of a security to
the buyer must be greater than the price paid, and the value to
the seller must be less, or no transaction would take place. The
discrepancy between the buyer’s and the seller’s perceptions of
value can result from such factors as differences in assumptions
regarding the future, different intended uses for the asset, and
differences in the discount rates applied. Every asset being

bought and sold thus has a possible range of values bounded by
the value to the buyer and the value to the seller; the actual
transaction price will be somewhere in between.

In early 1991, for example, the junk bonds of Tonka
Corporation sold at steep discounts to par value, and the stock
sold for a few dollars per share. The company was offered for
sale by its investment bankers, and Hasbro, Inc., was evidently
willing to pay more for Tonka than any other buyer because of
economies that could be achieved in combining the two
operations. Tonka, in effect, provided appreciably higher cash
flows to Hasbro than it would have generated either as a 

standalone business or to most other buyers. There was a sharp
difference of opinion between the financial markets and Hasbro
regarding the value of Tonka, a disagreement that was resolved
with Hasbro’s acquisition of the company.

Absolute Valuation: Calculating the Intrinsic Value of a Business

Absolute Valuation (calculating Intrinsic Value)

In absolute valuation of a stock, the worth of a business is calculated.  This is the Intrinsic Value.

The Intrinsic Value can be estimated from various ways, the two common ones are::

• from the assets* the company owns, and the other,
• from its expected future cash flows (also known as the discount cash flow analysis).

Relative Valuation

Some common market ratios for valuations of stock are PE, EV/EBIT, EV/EBITA, P/B and P/S.  The problem is these are all based on price; comparing what an investor is paying for a stock to what he is paying for another stock.

Relative valuation does not tell you the Intrinsic Value (IV) of the stock.  Without knowing the IV, at least an estimated one, the investors do not really know what price should be paid for it. 



Absolute Valuation versus Relative Valuation

Comparing ratios across companies and across time can help us understand whether our valuation estimate is close to or far from the mark, but estimating the IV of a company gives us a better understanding of its value and hence the price we are willing to pay for it.

Having an estimated IV also helps us focus more on the value of the business, rather than the price of the stock which changes every minute on the screen.

It gives us a stronger basis for making investment decisions.



Discounted Cash Flow Analysis (DCFA)

Discounted Cash Flow Analysis (DCFA) is a method of valuing the intrinsic value of a company.

DCFA tries to work out the value today, based on projections of all the cash it could make available to investors in the future.  

It is descried as "discounted" cash flow because of the principle of "time value of money" - that is, cash in the future is worth less than cash today.

DCFA starts with the premise that a stock's price should be equal to the sum of its current and future cash flows after taking the time value of money (discounted by an appropriate rate) into account. (John Burr Williams).

Stock Price IV 
= Sum of the Present Value of All Future Free Cash Flow (FCF).



Advantages of DCFA

• It produces the closest thing to an intrinsic value of a stock.
• DCF method is forward looking and depends more on future expectations than historical results.
• This method is based on FCF which is less subject to manipulation than some other figures and ratios calculated out of the financial statements.

Weakness of DCFA

• It is a mechanical valuation tool and is subject to the principle of "garbage in, garbage out."
• In particular, small changes of inputs in cash flows and discount rate can result in large changes n the value of a company.  
• Hence, IV obtained is never absolute and infallible, but rather an approximation.

Reference: 

Page 256 to 265  The Complete VALUE INVESTING Guide That Works! by K C Chong

Also  read:

* Warren Buffett Explains Why Book Value Is No Longer Relevant

http://myinvestingnotes.blogspot.com/2020/03/warren-buffett-explains-why-book-value.html

How to derive the intrinsic value of an asset?

https://myinvestingnotes.blogspot.com/2011/09/how-to-derive-intrinsic-value-of-asset.html

Warren Buffett Explains Why Book Value Is No Longer Relevant

The Oracle of Omaha on why cash flows are more important than book value
March 03, 2020


For decades, value investors have used book value per share as a tool to assess a stock's value potential.

This approach began with Benjamin Graham. Widely considered to be the father of value investing, Graham taught his students that any stocks trading below book value were attractive investments because the companies offered a wide margin of safety and low level of risk. To this day, many value investors rely on book value as a shortcut for calculating value.



Buffett on book value

Warren Buffett (Trades, Portfolio) is perhaps Graham's best-known student. For years, Buffett used book value, among other measures, to asses a business's net worth. He also used book value growth as a yardstick for calculating Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) value creation.

However, as far back as 2000, the Oracle of Omaha started to move away from book value. He explained why at the 2000 annual meeting of Berkshire shareholders. Responding to a shareholder who asked him for his thoughts on using book value to track changes in intrinsic value, Buffett replied:

"The very best businesses, the really wonderful businesses, require no book value. They — and we are — we want to buy businesses, really, that will deliver more and more cash and not need to retain cash, which is what builds up book value over time...

In our case, when we started with Berkshire, intrinsic value was below book value. Our company was not worth book value in early 1965. You could not have sold the assets for that price that they were carried on the books, you could not have — no one could make a calculation, in terms of future cash flows that would indicate that those assets were worth their carrying value. Now it is true that our businesses are worth a great deal more than book value. And that's occurred gradually over time. So obviously, there are a number of years when our intrinsic value grew greater than our book value to get where we are today...

Whether it's The Washington Post or Coca-Cola or Gillette. It's a factor we ignore. We do look at what a company is able to earn on invested assets and what it can earn on incremental invested assets. But the book value, we do not give a thought to."

It is no secret that value as an investing style has underperformed growth over the past decade. There's no obvious explanation as to why this is the case, but one of the explanations could be that the definition of value is out of date. Buffett's comments from the 2000 annual meeting seem to support this conclusion.



No longer a good measure

Book value was an excellent proxy for value when companies relied on large asset bases to produce profits. As the economy has shifted away from asset-intensive businesses and more towards knowledge-intensive companies, book value has become less and less relevant.

What's more, as Buffett explained in 2000, book value does not necessarily represent intrinsic value. Just because a stock is trading below its book value does not necessarily mean it is worth said book value.

The same is true of companies trading at a premium to book. The intrinsic value of that business could be significantly higher than book value as book value does not tend to reflect intangible assets.

Investing is an art, not a science, and valuing businesses is not a straightforward process. Investors cannot rely on a simple metric or shortcut to assess value. Many factors contribute to intrinsic value and intrinsic value growth, and using book value as a proxy for intrinsic value is an outdated method. Even in Graham's time, it wasn't always correct.


https://www.gurufocus.com/news/1063604/warren-buffett-explains-why-book-value-is-no-longer-relevant

Understand the Intrinsic Value

Intrinsic Value is the "real value" behind a security issues, as contrasted with its market price. 

Generally a rather indefinite concept; but sometimes the balance sheet and earnings record supply dependable evidence that the intrinsic value is substantially higher or lower than the market price.


Benjamin Graham

Warren Buffett and Charlie Munger discuss intrinsic value at the 1997 Berkshire Hathaway annual meeting.

Warren Buffett and Charlie Munger discuss intrinsic value at the 1997 Berkshire Hathaway annual meeting.


@7.00 Charlie Munger advocates the concept of opportunity cost.

@8.30 Compare with Coca Cola. Compare to Gillette. Is it better than buying Coca Cola or Gillette stock? Always compare to your own preexisting stock. Maybe better off buying more of the preexisting stocks.

@9.40 Concept of intrinsic value was easier in the past. Based on liquidation value. Based on asset value. You can see the discount from intrinsic value. Now, you need to get into Warren's type of thinking on valuation.

@12.00 Part of the process of calculating intrinsic value is the ability to: Walk away from anything that doesn't work? Walk away from anything you cannot understand?

Buffett explains Intrinsic Value

Intrinsic Value of a Stock by Warren Buffett

As the Dow tanks, here is Warren Buffett on the biggest puzzle for investors: Intrinsic value of a stock

• Warren Buffett's Berkshire Hathaway recently repurchased close to $1 billion of its own stock, a move made after the billionaire investor changed the trigger he uses for stock buybacks.
• Instead of basing share repurchases on a discount to the company's book value, which Berkshire had been doing for years, Buffett now is using a stock price below "intrinsic value."
• Intrinsic value is a concept that Buffett has talked about a lot over the years, but it is not an easy stock market valuation method for investors to master, though it is important at times of elevated asset prices.

Eric Rosenbaum | @erprose

Published 8:36 AM ET Wed, 5 Dec 2018  Updated 3:54 PM ET Wed, 5 Dec 2018CNBC.com

Eric Francis | Getty Images

Warren Buffett (L) and Berkshire-Hathaway partner Charlie Munger

In May of 2007, as the markets were reaching new records (and moving closer to a bear market precipice and the financial crisis), Warren Buffett and Charlie Munger were discussing intrinsic value at the annual Berkshire Hathaway conference. The decade-long run for the current bull market and widespread concerns about elevated values in U.S. stocks leading to days like Tuesday, when the Dow Jones Industrial Average fell by close to 800 points, are reminders that getting at the true value of corporations is as important as it has ever been.

The concept of intrinsic value came up earlier this year when Buffett made the decision to change his trigger for buying back Berkshire shares from a quantifiable discount to the company's book value (1.2 times book value) to a discount to intrinsic value. In moving back to monitoring intrinsic value, Buffett invoked the method also used by J.P. Morgan CEO Jamie Dimon.

As buybacks across the corporate sector continue to reach new records, it becomes more questionable whether all of these companies are basing their share repurchases on a valuation metric that uncovers a discount in a stock's trading price to intrinsic value — or are just buying back stock to keep shareholders happy and prop up earnings. Jamie Dimon said on Tuesday at a Goldman Sachs conference that buying back stock when market prices are high is not a wise idea, and companies should be reinvesting in the business instead.

Now the issue of valuation isn't limited to buyback analysis. As many sectors within the S&P 500, including one of Buffett's favorites (banking) are in correction, every investor should be questioning the value of what they own in their stock portfolio.

Warren Buffett poured his money into stocks this summer  4:49 PM ET Mon, 5 Nov 2018 | 01:09

Buffett recently bought $4 billion worth of J.P. Morgan, a bank stock that has since entered a correction, and if he performed his analysis right, he might be buying more of it now. So no one should be making rash decisions, and Buffett reminds the fearful that the stock market is there to serve investors, not instruct them (echoing Ben Graham's maxim).

But having conviction in the staying power of your market bets becomes much more difficult when everything stops going up in unison. As Buffett famously wrote in an early '90s annual letter and said at the 1994 shareholder meeting, "You don't find out who has been swimming naked until the tide goes out."

Over the years, in annual Berkshire Hathaway shareholder meeting Q&As and in annual letters, Buffett has made clear — if in a roundabout way — just how difficult a concept intrinsic value is to explain. At the 1998 meeting, Buffett described it as "the present value of the stream of cash that's going to be generated by any financial asset between now and doomsday. And that's easy to say and impossible to figure."

Maybe that is why he has written that "what counts for most people in investing is not how much they know, but rather how realistically they define what they don't know." That may also explain why he added, "An investor needs to do very few things right as long as he or she avoids big mistakes."

The classic valuation models

In the classic business text Business Analysis and Valuation, which he wrote with fellow Harvard University professor Paul Healy, Krishna Palepu laid out two primary models for calculation of intrinsic value: the discounted cash-flow model and the accounting earnings-based valuation model.

But Palepu noted in an email to CNBC that even in using these models, getting to an intrinsic value requires the input of some significant assumptions, such as how long a company's outperformance can last: "The key is to start with the company's strategy and current performance and ask how long that performance is likely to be sustainable, given the nature of the industry and competition. Much of the value estimate in DCF lies in terminal value."

Terminal value is the estimated value of a business beyond a reasonable earnings forecast period, which some finance experts put at three to five years. Terminal value can take two paths: assuming that a company will continue to have a normalized growth rate even after its best years are over, or it assigns a takeout price for the firm.

Palepu continued: "The accounting based valuation technique puts some discipline in estimating the terminal value by using the company's current book value, and also its 'advantage horizon' — the time period over which the company's competitive advantage, if any, is sustainable."

Buffett: Apple makes its products indispensable  1:57 PM ET Thu, 30 Aug 2018 | 04:37

The reason why an intrinsic value model can work so well — in terms of making people like Buffett a lot of money — is because so few people can effectively master them. "Since value is about the future, it is obviously based on forecasts. Forecasts have to be based on assumptions," Palepu wrote via email. He added: "The question really is how to make your assumptions sensible and grounded in fundamentals. That is why it is called fundamental analysis. If there is a mechanical way to do this, it won't have much payoff in the investment process, since everyone would have the same information, and it is tough to make money with common information in a market. So assumptions are a double-edged sword. They are subjective, but they are also the source of superior investment returns."

The principles related to intrinsic value can be laid out, but there is no one formula into which an investor can plug the ideas and come out with the same result as Buffett. If nothing more, the attempt to understand the ideas and calculate a publicly traded company's intrinsic value, even done imperfectly, could help an investor avoid the big market blunders before hitting the buy button. Or an investor would be perfectly correct to come away from an attempt to understand intrinsic value and say, "I'd rather just buy an S&P 500 index fund" — Buffett also approves of that antistock-picking strategy.

1. The bad news: There is no magic method, and most companies are too hard to value.

Berkshire Hathaway Vice Chairman Charlie Munger provided one of the most frustrating definitions of intrinsic value ever.

"There is no one easy method that could be simply mechanically applied by, say, a computer and make anybody who could punch the buttons rich. By definition, this is going to be a game which you play with multiple techniques and multiple models, and a lot of experience is very helpful," Munger told Berkshire shareholders at the 2007 annual meeting.

Munger went on to deflate the hopes of any investor who is confident enough to think they have valuation mastered. When it comes to valuation of companies, even he and Buffett draw a blank most of the time. "We throw almost all decisions into the too hard pile, and we just sift for a few decisions that we can make that are easy. And that's a comparative process. And if you're looking for an ability to correctly value all investments at all times, we can't help you."

Buffett's statements about intrinsic value over the years can seem like a labyrinth as well.

When stating Berkshire's new buyback policy in July, Buffett said, "The tough part is coming up with the intrinsic value. There is a lot more to intrinsic value than P/E," and there is no way to work intrinsic value out to four decimal places, "or anything of the sort."

At the 1994 Berkshire annual meeting, Buffett said a corporation's publicly reported financial statements can only help so much. "The numbers in any accounting report mean nothing, per se, as to economic value. They are guidelines to tell you something about how to get at economic value. ... To figure out that answer, you have to understand something about business."

But he went on to say at that meeting, and on other occasions, that when it comes to intrinsic value, "the math is not complicated."

Maybe a bit of an overstatement. But where to begin?

2. Start by breaking a business down to its basics.

Consider an iconic business: the American family farm. That's what Buffett did at the 2007 Berkshire Hathaway annual meeting, when he tried a little harder than Munger to explain the concept in terms that anyone could understand.

Catalog the basic stats:

• The farm can produce 120 bushels of corn per acre.
• It can produce 45 bushels of soybean per acre.
• The price of fertilizer is X.
• The property taxes are Y.
• The farmer's labor is Z.

That simple accounting will lead the investor to a dollar value that can be generated per acre "using fairly conservative assumptions."

But those assumptions are a big part of the riddle.

"Let's just assume that when you get through making those calculations that it turns out to be that you can make $70 an acre. ... Then the question is how much do you pay for the $70? Do you assume that agriculture will get a little bit better over the years so that your yields will be a little higher? Do you assume that prices will work a little higher over time?"

An investor looking for a 7 percent return and predicting the acre's cash value at $70 annually could determine that the acre is worth $1,000. But you wouldn't want to pay that price.

"You know, if farmland is selling for $900, you know you're going to have a buy signal. And if it's selling for $1,200, you're going to look at something else," Buffett explained to Berkshire shareholders. "That's what we do in business. We are trying to figure out what those corporate farms that we're looking at are going to produce. And to do that, we have to understand their competitive position. We have to understand the dynamics of the business."

The most important dynamic of the business may be its cash-generating potential.

3. Place value on cash generation.

Telling investors it is critical to "understand a business' competitive position" and the "dynamics of a business" are the kind of opaque clues that make this valuation concept so fuzzy. Even in the farm example, Buffett noted that the investors need to make assumptions about the future direction in agricultural commodity pricing, and even if reasonable assumptions can be made based on recent pricing trends in a market, they are still assumptions.

At that 2007 meeting, Buffett went even folksier than the farm, invoking Aesop's fables from 600 B.C. as the original source text for "the mathematics of investment":

"A bird in the hand is worth two in the bush."

For the investor, the questions that follow from this approach are:

1. How sure can you be that there are two in the bush?
2. Could there be even more?

(There is one additional question Buffett posed, which we will come to in the next section.)

"We are looking at a whole bunch of businesses, how many birds are they going to give us, when are they going to give them to us, and we try to decide which ones — basically, which bushes — we want to buy out in the future. It's all about evaluating future — the future ability — to distribute cash, or to reinvest cash at high rates if it isn't distributed."

Buffett: Stocks driven by companies reinvesting  4:36 PM ET Mon, 3 Dec 2018 | 01:55

Of course, investors who follow Berkshire know that is has never distributed cash, and even as it has conducted limited buybacks in recent years, Buffett remains against paying a dividend. Berkshire also is sitting on more than $100 billion in cash currently, and that is a balance-sheet figure that Buffett said in 2007 is the underlying basis for the company's value.

Even refusing to part with the cash at any given time, "it's the ability to distribute cash that gives Berkshire its value." Though Buffett also has said in the past at times when Berkshire has more difficulty in figuring out how to invest its cash, it does become more difficult to calculate the intrinsic value. Berkshire ended September with close to $104 billion in cash.

He warned any investor who cannot come to conclusions about future cash flows of businesses in which they invest.

"There are all kinds of businesses that Charlie and I don't think we have the faintest idea what that future stream will look like. And if we don't have the faintest idea what the future stream is going to look like, we don't have the faintest idea what it's worth. ... Now, if you think you know what the price of a stock should be today but you don't think you have any idea what the stream of cash will be over the next 20 years, you've got cognitive dissonance. ... We are looking for things where we feel — fairly high degree of probability — that we can come within a range of looking at those numbers out over a period of time, and then we discount them back. ... We are more concerned with the certainty of those numbers than we are with getting the one that looks absolutely the cheapest."

4. You have to discount the future.

To "discount" the numbers back, as Buffett remarked, is the third question that proceeds from Aesop's original "mathematics of investment":

What's the right discount rate?

That question is the key to evaluating the value of a company's cash generation, and it circles back around to Buffett's example of an investor expecting a farm to generate a 7 percent return, and basing a purchase decision on that return assumption and the current business price. There are essentially two components to the discount rate-based risk modeling: the concept of time value of money, and the additional risk premium for the investment.

The time value of money is typically accounted for using the long-term government rate. It is the way investors contend with the fact that the value of a dollar today will be lower in the future. The additional risk premium, because an investor buying a stock is taking risk versus the purchase of a bond, can be modeled by using a higher, customized discount rate, or by building what Benjamin Graham called a "margin of safety" directly into the cash flows (a concept we will come back to in the next section). For example, an investor believes there is a 90 percent probability of receiving the cash flow, they multiply the cash flow by 90 percent.

In the 1992 Berkshire Hathaway annual shareholder letter, Buffett turned to another writer, and a five-decade old business text, to explain stock value better than he thought he could himself. The text was "The Theory of Investment Value" written by John Burr Williams, a prominent figure in the history of fundamental analysis.

"The value of any stock, bond or business today 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 asset."

The "remaining life of the asset" makes it difficult to specify an exact period of time for this calculation, though in an example laid out by a Berkshire Hathaway shareholder to Buffett in an exchange back in 1999 (and which we will come to later) Buffett did say that the shareholder's model for intrinsic value looking out 20 years into the future was stated well.

Buffett went on to explain a few key differences between a discount rate for bonds and stocks. Bonds have a coupon and maturity rate that define its future cash flows. Stocks, on the other hand, are subject to cash flow estimates that even the best analysts can mess up, and, in addition, the performance of company management.

Buffett has been clear about the discount rate he prefers to use, saying at the 1996 shareholder meeting that he doesn't think he can be very good at predicting interest rates and so he thinks in terms of "the long-term government rate," as long as the business being considered first meets another requirement: it is one that the investor can understand. A higher discount rate is justified for riskier businesses, he said. Pertinent to the current market environment, he added: "And there may be times, when in a very — because we don't think we're any good at predicting interest rates, but probably in times of very — what would seem like very low rates — we might use a little higher rate."

But this doesn't mean Buffett is not also factoring a risk premium into his models. A "margin of safety" is likely built directly into his models so the additional risk premium is not required as a separate discount modeling rate.

5. It is important to act as if you won't get it exactly right.

Buffett added to the definition provided by John Burr Williams in his own 1992 text that, "The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value."

But he made it clear that getting this right is a lot more difficult in practice. If the mathematical calculations required to evaluate equities are not difficult, Buffet still said that experienced and intelligent analysts can "easily go wrong in estimating future 'coupons.'"

Expecting to get things wrong about future cash flow is why Berkshire places so much emphasis on investing in businesses that the buyer understands, and only buying the businesses at prices which are reasonable — low enough to withstand mistakes in the model's assumptions.

"If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success."

The margin of safety is not a single ratio or percentage that can be used across the board. It is a concept — some in the market have referred to it as more of an art than a science — and its methods can vary. It can be evaluated based the difference between the calculation of a company's intrinsic value and its trading price; it could also be evaluated based on the stock's return potential versus the risk-free rate (government bond rate).

6. Don't think in terms of growth stocks vs. value stocks.

One thing is certain: Intrinsic value is not to be confused with the way the word "value" is used to denote an entire class of stocks. In fact, even as many pundits position Buffett as one of the greatest "value" investors of all time, he dismissed the entire stock-picking industry that has been built around choosing between growth and value stocks in his 1992 letter to shareholders.

Buffett said the difference between companies judged to be growing faster than the market even if trading at relatively high prices (growth stocks) and those priced lower than peers based on measures like price to earnings ratio but with strong earnings potential than the market consensus believes (value stocks) is no way to pick stocks.

"Most analysts feel they must choose between two approaches customarily thought to be in opposition: 'value' and 'growth.' ... We view that as fuzzy thinking … Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. ... In addition, we think the very term 'value investing' is redundant. What is 'investing' if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price — should be labeled speculation (which is neither illegal, immoral nor, in our view, financially fattening)."

Buffett added that a low ratio of price to book value, a low price- earnings ratio, or a high dividend yield, "even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments."

7. The Berkshire Hathaway shareholder who (sort of) got it right.

At the 1999 Berkshire annual meeting, a shareholder from Bonita Springs, Florida, took the risk of asking Buffett and Munger whether his attempt to model Berkshire's intrinsic value was on target.

"You've given many clues to investors to help them calculate Berkshire's intrinsic value. I've attempted to calculate the intrinsic value of Berkshire using the discount of present value of its total look-through earnings. I've taken Berkshire's total look-through earnings and adjusted them for normalized earnings at GEICO, the super-cat business, and General Re. Then I've assumed that Berkshire's total look-through earnings will grow at 15 percent per annum on average for 10 years, 10 percent per annum for years 11 through 20. And that earnings stop growing after year 20, resulting in a coupon equaling year 20 earnings from the 21st year onward. Lastly, I've discounted those estimated earnings stream at 10 percent to get an estimate of Berkshire's intrinsic value. My question is, is this a sound method? Is there a risk-free interest rate, such as a 30-year Treasury, which might be the more appropriate rate to use here, given the predictable nature of your consolidated income stream?"

Buffett: S&P 500 a better choice than Treasurys  4:43 PM ET Mon, 3 Dec 2018 | 03:46

Buffett's response: "Investment is the process of putting out money today to get more money back at some point in the future. And the question is, how far in the future, how much money, and what is the appropriate discount rate to take it back to the present day and determine how much you pay? ... And I would say you've stated the approach — I couldn't state it better myself. The exact figures you want to use, whether you want to use 15 percent gains in earnings or 10 percent gains in the second decade, I would — you know, I have no comment on those particular numbers. But you have the right approach."

Buffett stressed again that getting to an intrinsic value that an investor can be comfortable with doesn't ever mean paying that price.

"Now, that doesn't mean we would pay that figure once we use that discount number. But we would use that to establish comparability across investment alternatives. So, if we were looking at 50 companies and making the sort of calculation that you just talked about, we would use a — we would probably use the long-term government rate to discount it back. But we wouldn't pay that number after we discounted it back. We would look for appropriate discounts from that figure. But it doesn't really make any difference whether you use a higher figure and then look across them or use our figure and look for the biggest discount. You've got the right approach. And then all you have to do is stick in the right numbers."

Easier said than done.

The pros and cons of building your own valuation model

Tim Vipond, CEO of the Corporate Finance Institute (CFI), said in an email to CNBC that there are three primary models of valuation it teaches. There is the cost model, which is predicated on the cost to build a business or its replacement cost. Then there are the more common approaches for valuing corporations, which are the relative value and intrinsic value models. Relative value relies on public company comparables and transactions that set a precedent in the market. In order to perform an intrinsic valuation analysis, an investor needs to build a discounted cash flow (DCF) model.

Start by thinking of how you would build a DCF model for a bond. "It would be relatively straightforward. ... You know the timing of when all the cash flows (interest and principle) will be paid, and you know exactly how much they will be (assuming the company doesn't default)," Vipond explained.

That's not the case for equities. "To build a DCF model for an equity investment is the same concept, however, it is much more complicated to estimate how much cash flow there will be for equity investors. How much will revenue grow? What will the expenses be? How much capital investment is required? etc. etc."

CFI does not provide investment advice and would not instruct an investor to give up, or go ahead, with building their own intrinsic value model. But Vipond did offer a note of caution as to a disadvantage most investors might face: "To build a 'good' model may require access to management, the CEO, CFO (interviews, essentially, which institutional investors like Warren Buffett can do, but retail investors cannot."

On the plus side, it also requires access to materials that many investors can get: equity research reports, lots of reading over 10-Ks and other company filings.

Buffett reads voraciously about companies, as many as 500 pages a week during his career, and reading is what he once told Columbia University students — including current Berkshire stock-picker Todd Combs — was his "secret."

From his earliest days as a student investor with Moody's securities manuals, through his married, family life when he would hole up in a home office at night, to his current octogenarian stock-picking, his life has been consumed by that practice.

"Read everything you can," he told shareholders in 2007, and be prepared to feel lucky if only 1 percent of it leads to a great investment idea.

An investor would be wise to start by reading a lot more about intrinsic value, as this barely scratches the surface. Or, if it all seems like too much, stick with an index fund.

For more of Buffett's views, consult CNBC's Warren Buffett Archive , the world's largest collection of Buffett speaking about business, investing, money and life.

Eric RosenbaumEditor, CNBC.com

https://www.cnbc.com/2018/12/05/warren-buffett-on-the-biggest-puzzle-for-investors-intrinsic-value.html?fbclid=IwAR3q-spkCx85_k_V1WuIX00q9fZ9zq05gUkjCbS-YUgAZC_-O8c_-pPVuIY