Calculating Intrinsic Value

Security Analysis 401: Calculating Intrinsic Value

By Sham Gad 
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.

http://www.fool.com/investing/value/2007/08/23/security-analysis-401-calculating-intrinsic-value.aspx

Intrinsic Value: There are two fatal weaknesses of any DCF model.

Why Stock "Value" Systems Have No Value

John Price, PhD

We regularly get asked how Conscious Investor is different from the countless "value" based software products and books available. The vast majority of "value" approaches are based upon a standard discount cash flow (DCF) model. They all purport to find what is called the intrinsic value or true value of a stock. This is the value the proponents claim that all rational investors should pay for the stock. Many of the authors and investment websites claim to base their intrinsic value approach upon the methods of Warren Buffett. In fact, it is actually very unlikely that he really uses any of these methods in anything vaguely resembling a formal approach. For example, Charlie Munger, the old friend of Buffett and the Vice-Chairman of Berkshire Hathaway, says that he has never seen Buffett do any discount value calculations. This is consistent with the answer he gave when asked about intrinsic value at the annual meeting of Berkshire Hathaway in 1996. "There is no formula to figure it out." He replied. "You have to know the business." Until recently, Buffett had never used a computer for anything, let alone for implementing any value models. Now he only uses it to play bridge on-line. When people write about Buffett I usually agree with most of the general observations made about his approach. The one area where Conscious Investor differs from the majority of Buffett followers (but quite likely not with Buffett himself) is in relation to the "valuation" model used. There are large numbers of DCF models. Stable growth models, two-stage models, three stage models and so on. Each of these models calculate the intrinsic value of the stock by discounting back to present time the stream of "cash" that is generated by the business. All I can say is that it is hard to believe that such simplistic and unreliable material is still taught in universities and promoted by stock analysts. The main problem is that people think that just because they can put some numbers into a formula they have found a useful and realistic model. Here we are talking about all the academics and writers who have limited understanding of the interface between mathematics and the real world. Two Fatal Weaknesses There are two fatal weaknesses of any DCF model. The first is that DCF models are unstable — small changes in the input values can lead to such large changes in the output that almost any number can be obtained. Here is a simple example showing just how unstable intrinsic value calculations are. The model uses the standard two-stage approach. We assume that the company spends ten years in the initial stage during which the cash per share (generally the free cash flow) that it generates grows by the rate given in the second column. After the initial stage comes the steady state period. During this period the cash is assumed to grow at the rate described in the third column. Finally, everything is discounted back to present time using the rate given in the fourth column. With small changes in the input variables, the output can shift from $23 to $58. I can't help getting the image in my mind of the host of an old television show saying, "Would the real intrinsic value please stand up?" Current Cash Initial Growth Rate Final Growth Rate Discount Rate Intrinsic Value $1.00 10% 4% 11% $23.09 $1.00 11% 5% 10% $33.50 $1.00 12% 6% 9% $58.00 And then you have to do the same estimate for the discount rate. If a model with this level of instability was proposed in a science class, it would be thrown out of the window. The second fatal weakness is that just because some model says it is generating something called intrinsic value does not mean that it is providing anything that really is "intrinsic value". And it certainly does not mean that it is giving something useful for investors. For example, just because a stock is undervalued (by some model or other) does not mean that it won't stay undervalued. This is quite different from saying that if a company has a strong economic performance, then eventually the market will acknowledge this by increased stock prices. Another weakness The instability described above is compounded by the fact that it is impossible to confirm the accuracy of two of the input variables. For example, the entry for the final growth rate requires that you estimate the growth rate of the cash not for another ten years, or even twenty years, but out to infinity! This is despite large studies showing that analyst forecasts for earnings over five years are no better than random. In contrast, in Conscious Investor we don't try to calculate the mythical concept of intrinsic value. We don't talk about whether a stock is undervalued or overvalued, whatever that may mean. Rather we define value in terms of the return you will get on an investment. Instead of intrinsic value, we talk about investment value or investment return. This is calculated using the proprietary tools STRETTM and STRETD®. STRET is a calculation of the annualized percentage profit or rate of return from owning the stock. STRETD is similar except that it assumes that dividends are reinvested. By calculating the actual return you can anticipate on your purchases, you get practical criteria whether it is worthwhile buying stock in a particular company or not. So in a nutshell, if you were to compare the stocks selected by Conscious Investor with other "value" models freely available on investor websites, you are unlikely to find much overlap between the selections. Despite the best intentions of would-be intrinsic value systems, the way that DCF models work either provide you with more or less random stocks or with stocks that you like and you (unconsciously) manipulate the data to make them appear undervalued. The Conscious Investor for more details ... The book The Conscious Investor: Profiting from the Timeless Value Approach by Dr John Price covers over 30 valuation methods including their assumptions, and their strengths and weaknesses.

http://www.conscious-investor.com/articles/articles/ar04value.asp

Interview With Mr Market

by THE GRAHAM INVESTOR on OCTOBER 3, 2011

Exclusive! The Graham Investor has staged an amazing interview with Mr Market. Never before has anyone managed to interview this elusive fellow. The interview gives us a new insight into what goes on in the mind of one of the most enigmatic figures of history. Still going strong, and still beguiling investors, traders, and journalists, Mr Market pulls no punches in this amazing interview.

TGI: Thank you for agreeing to this interview. Benjamin Graham once attempted to explain your behavior in a nutshell, suggesting that you came along each day and set a ridiculously high price or a ridiculously low price for an equity or a group of equities, and that the average investor would be well-placed to ignore you and seek his own counsel regarding valuations. What do you feel about that?

Mr Market:  Yes, I heard about that. I can’t speak for Mr Graham – he is dead, after all – but I am still going strong. I’ve been doing this for a few centuries now….I mean, back in 1637 when people were pretty much gambling on tulip bulbs, they were trying to pin it on me even back then. It has been ever thus: every time some bubble/bust or other comes along, they say Mr Market is up to his usual crazy tricks again, setting ridiculous prices. I tell you, one of these days I need to get myself a teflon coat.

TGI: But you do appear to be the one setting prices. Are you denying this?

Read more here:

http://www.grahaminvestor.com/2011/10/03/interview-with-mr-market/

Calculating a Stock's Intrinsic Value (Actual Value)

You've found a great company, possibly the best investment opportunity in your lifetime...

Not only that, you understand the Basic Principle of Investor Return which says, "the price you pay determines your rate of return."

So all you have to do is take advantage of your expert knowledge and buy a great company at a great price.

Right?

Well, almost.

You've still got one problem left...

How do know a company's selling for a great price?

Easy...

You calculate its intrinsic value.

What's Intrinsic Value?

In his 1938 publication "The Theory of Investment Value," John Burr Williams first articulated the idea of calculating a stock's intrinsic value.

His idea essentially adds all of the expected future cash flows produced by a company and assigns them a present value. This present value represents the price you should pay.

So, in financial circles, "intrinsic value" is defined as the present value of all expected future net cash flows to the company.

Find that sentence a little hard to follow?

So do I.

That's why I prefer a definition that doesn't require a dictionary for interpretation.

Here it is...

Intrinsic value is the actual value of a company as opposed to its current market price.

That definition makes a lot more sense, doesn't it?

So why is intrinsic value important?

Because if you can calculate the actual value of a company, then...

You can compare it to the current market price.

If the current market price is higher, then you know the company is overvalued.

But if the current market price is lower, then you know the company is undervalued.

Knowing what's overvalued and what's undervalued is what separates successful stock market investors from the rest of the crowd.

Why?

Because if you know a company is undervalued, then...

You can buy low!

And buying low is the key to successful investing. Right?

Absolutely.

How Do You Calculate Intrinsic Value?

Sounds great, doesn't it?

But we still haven't tackled the problem...

How do you calculate a company's intrinsic value?

Well, first you need current information regarding your company's...

• Stock price
• Average return on equity
• Dividend payout ratio
• Equity per share (also known as book value per share)
• Earnings per share
• Average P/E ratio

Does all that information look intimidating?

Don't worry. We'll address how to easily find each piece of information soon. Fortunately, it's all on the Internet!

Once you have all this information at your fingertips, you can easily calculate your company's intrinsic value by estimating its earnings for the next ten years.

The following chart uses The Coca-Cola Company as an example to illustrate how easy this is...

We'll address how to use this chart in moment.

But first, let's get those figures...

How to Find the Numbers You Need

Before you can calculate a stock's intrinsic value, you need to know several pieces of information about the company and its stock.

Here's how to find each piece of information...

Current Stock Price - This one's easy. Just go to Yahoo! Finance or Google Finance or dozens of other places on the web where you can get real-time stock quotes. Plug in your company's stock ticker, and you've got it.

Average Return on Equity - While most online services like Yahoo! Finance provide a figure for return-on-equity, it most likely represents the current year only. To get a more accurate number for your intrinsic value calculation, go to Google Finance, type in your company's ticker symbol, and find the text link titled "More ratios from Thomson Reuters."

Follow that link, and you'll find a category titled "Management Effectiveness." Find the figure for "Return on Equity -5 yr. Avg."

It's best to use a company's five- or ten-year average return on equity as opposed to a single year when calculating intrinsic value.

Why?

Because a dramatically higher or lower one-year return on equity can throw off your entire calculation. So if you want the most accurate calculation possible, use a long-term average return on equity.

In my opinion, The Value Line Investment Survey offers the best return on equity figures. Visit your local library, and you can find a company's return on equity every year for the last ten years as well as Value Line's projections for the company's ROE over the next five years.

For best results, use Value Line figures for your intrinsic value calculations.

Current Dividend Payout Ratio - Again, go to Google Finance, type in your company's ticker symbol, and find the text link titled "More ratios from Thomson Reuters."

Follow that link, and you'll find a category titled "Dividends." Find the figure for "Payout Ratio (TTM)." That's the percentage of earnings your company pays out in dividends.

Current Equity Per Share - Go to Yahoo! Finance, type in your company's ticker symbol, and find the text link titled "Key Statistics." Find the category titled "Balance Sheet," and find the figure for "Book Value per Share." This is the current equity per share, also known as book value.

Current Earnings Per Share - Go to Yahoo! Finance, type in your company's ticker symbol, and find the figure for EPS. This is the earnings per share.

However, keep in mind that Yahoo! Finance and most online services report a company's last four quarterly earnings figures as the EPS, so this figure might be distorted by a one-time expense or charge-off due to otherwise favorable long-term investments by the company.

So make sure you perform due diligence when searching for an accurate earnings per share figure for your intrinsic value calculation. Again, The Value Line Investment Surveyprovides the most accurate figures.

Average P/E Ratio - This isn't a ratio I?ve run across on Yahoo! Finance or Google Finance, so I performed a Google search to find a good site. A site called ADVFN popped up. If you follow this link to their site, and scroll down to the category "Valuation Ratios," you'll find a figure titled "5-Y Average P/E Ratio." This is the company's five-year average P/E ratio.

But again, you can find a far more accurate ten-year P/E ratio by visiting your local library and consulting The Value Line Investment Survey. The figure they provide is the one I personally use.

Using Excel to Calculate Intrinsic Value

Once you've gathered all the necessary information, you can use Excel to calculate a stock's intrinsic value.

The previous image, using The Coca-Cola Company (KO), is a good example of this...

Do all those spreadsheet formulas and calculations look confusing?

Fortunately, I've already set them up for you!

All you have to do is plug in the customized numbers for your company...

And you can use the exact same Excel spreadsheet I use for calculating a company's intrinsic value.

Download Britt's Intrinsic Value Spreadsheet >>>

Just replace the numbers in the yellow-highlighted cells with your company's numbers, and the spreadsheet will calculate a value titled "Multiple" on line 29.

Line 29 is the calculation you're looking for.

If your great company has a number above 5.00, it's currently undervalued.

If it's below 5.00, then the stock is currently overvalued...

Why 5.00?

Because a multiple of 5.00 means you'll make a 5-fold return on your investment in the next ten years if you buy the company at its current price.

A 5-fold return in ten years is a 17.46% annual compounding rate of return.

Also, five is a nice round number, and I like nice round numbers.

No kidding...

Think that's a silly reason for picking 5.00?

It's really not.

Always keep in mind, calculating intrinsic value is an art, not an exact science.

The spreadsheet's calculations act as a guide, not a precise road map.

As Warren Buffett says...

"It's better to be approximately right than precisely wrong."

So a figure above 5.00 means you're approximately right.

But there's another reason you want a 5-fold investment return and not a 4-fold or a 6-fold return...

Remember, if achieved, a 5-fold return is a 17.46% annual compounding rate of return.

This beats the S&P 500's fifty year track record of 10.85% by more than six points.

Now, in order to make all your time and effort researching stocks a worthwhile endeavor, you need to beat the market by at least a couple of points per year.

Over time, those couple of points will add up to a lot.

And while achieving a 4-fold return over ten years (a 15% annual compounding rate of return) achieves your goal of beating the market by more than a few points...

You need to remember, calculating a stock's intrinsic value is an estimating tool. It's more art than exact science.

So as a precaution, give yourself a little room for error.

Force your potential investment to live up to a higher standard...

Tack an extra 25% onto that 4-fold return, and give yourself a new goal of a 5-fold return.

That way, if you fall short of your goal, you still have a good shot at beating the market averages.

Remember...

"It's better to be approximately right than precisely wrong."

So give yourself a little bit of leeway in case something goes wrong.

In investment circles, this idea is known as the margin of safety.

Providing a Margin of Safety

Benjamin Graham first put forth the idea of a margin of safety in his groundbreaking bookSecurity Analysis (1934), which he co-authored with colleague David Dodd.

According to Graham, margin of safety is the secret to a sound investment philosophy...

"Confronted with a like challenge to distill the secret of sound investment into three words, we venture the following motto, Margin of Safety."

So what's a margin of safety?

It's nothing more than giving yourself a little room for error.

Just ask yourself, "If things fail to go perfectly, will my investment still work out?"

If not, there's no margin of safety.

However, if your company's earnings fall well short of your projections and you can still achieve your desired investment returns...

Then, you have a margin of safety.

By purchasing only those stocks which offer a significant margin of safety, you limit your downside risk and significantly increase your odds of success.

Conclusion

Learn how to calculate a stock's intrinsic value. It's a skill that will prove invaluable over the course of your investing lifetime.

Use the spreadsheet located in the middle of this page. Look for companies with a multiple in excess of 5.00 at the current price.

However, remain mindful of other variables. Some companies look like they're dirt cheap, and they are. These companies will make you a fortune if you're prudent enough to buy them.

But other companies also look like they're dirt cheap, while in reality, they're grossly overvalued...

So how do you tell the difference?

By following all the rules previously outlined for finding a great company...

Also, I can't emphasize this enough - ask question after question about your company's future business prospects and apply your own common sense and good judgment. This will go a long way toward determining your investment success...

After all, if numbers told the entire story, no one would think about their investment decisions at all. We'd all just let computer programs "run the numbers" on our investments. Right?

http://www.your-roth-ira.com/calculating-a-stocks-intrinsic-value.html

Value investing – When to Sell or Hold?

A good discussion on when to sell in another blog.

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12:30 pm
April 10, 2012

matthew

Member
posts 13
9
Yes, I did this on Aeropostale. Approximately a 32% gain I got on that bad boy.
Reasons I sold, it had trouble getting past $21-$22, and then Barclay's raised there price target to $25 so more investors bought and price went up a bit. I took this chance and sold it, and it has now went back down after today -5%. Keep in mind that I sold it early basically because my intrinsic value was around $23 and I figured i'd rather sell now than risk more just for a small additional gain.

If I had not sold it then I would have been stopped out as during the price consilidation period I put in a stop loss @ $21
10:55 am
April 10, 2012

Jae Jun

Admin
posts 1408
8
do any of you sell after a big fast run up even though it is below intrinsic value?
6:29 am
April 1, 2012

nell

Member
posts 88
7
Some reasons to sell..


1. intrinsic value < price -> no margin of safety
2. business quality goes south, management issues etc.
3. better opportunity


One good reason to buy more is when market tanks but intrinsic value of your specific company keeps growing..

Best wishes,
Nell
10:58 am
March 31, 2012

BugMan

New Member
posts 2
6
I'm fairly new to this, and I, too, see selling as the hardest part.

One thing i've thought of that makes it easier is compare your current holdings to what else is out there. If are holding onto a good company, and you figure it has the potential to go up 12% per year, but you see other companies out there that have the potential to go up 25% per year, then sell your current stock and buy the other ones. It's not that the old company isn't good — it is — it's just that there are better deals out there.
8:03 am
February 27, 2012

gstyle

Member
posts 4
5
I am fairly new to value investing so I find it good to know other have had similar thoughts to my own!
2:17 am
February 25, 2012

Jae Jun

Admin
posts 1408
4
selling is defnitely harder than buying.
One of my weak points as well. If I had a partner, I'd find someone who was better at selling than buying. It would be a great combination.

But to sell, you would have to re value a company regularly.
If there isn't much upside to intrinsic value, then I'm willing to sell at 10% below intrinsic value rather than hanging on.
Companies like GRVY, I am happy to hold even if I'm up 100%.
8:17 pm
February 22, 2012

jalleninvest
Coronado, CA

Member
posts 22
3
Post edited 8:20 pm – February 22, 2012 by jalleninvest
G.raham came up with the 50% or two years towards the end of his life, in that interview that is bandied around the internet some. I am not at all sure that he practiced that in the Graham Newman closed end fund he ran. In one case, he did not, and that was GEICO which they bought half of in 1947 or 1948. They ended up having to distribute the shares to the shareholders of the fund, and it increased 54,000 per cent or something like that. Many became multimillionaires, quite a feat back then.
Walter Schloss, who died the past weekend at age 95, talked about selling. According to him that was the hardest part of this business, trying to figure out when to sell. He didn't like paying short term income tax rates and tried to hold stocks for a number of years. He commented ruefully several times about buying at $30, selling at $50 and watching the stock go to $200, etc. He recommended a new company to Graham that had wonderful prospects. Graham turned it down, saying it wasn't their kind of deal. It was Xerox, of course, but Schloss said Graham would have sold it at a double anyway and missed out on the big increase.

If it was easy, everybody would do it!
9:23 am
February 21, 2012

Graeme
Austin, Texas

Member
posts 162
2
Yeah, this is always a fun question.

For me what I do is I break up my holdings into different categories. For example, I have holdings that I bought at a good (not great) but good price, but they pay me dividends, and if they keep acting as they have for years, they should be increasing my dividends every year. I get a bit of return on the stock price increase, but a great return over many years with the dividends reinvesting. So my sell thesis on these guys is pretty firm: as in, I wont easily do it.

But then I have holdings that I would consider a deep value: selling at a deep discount to book value, or below NCAV or in a really beat up industry. These are the shares that I have a target price for: as in, I will sell when they hit that specific price. There is not a whole lot that would change my mind and make me hold on to it longer. And sometimes that target price is 50% above my purchase, 100% or even more.

So you need to judge for yourself whether the business you bought shares in is now fairly priced at it's 50% gain or if it still has room to go.
4:33 am
February 21, 2012

gstyle

Member
posts 4
1
Hi,

I was pondering the concepts of selling a value stock or holding it for longer. I understand that Ben Graham had a strict rule of selling after a 50% increase or after two years, whichever came first.

A stock brought at value brings the 50% gain, but if this stock is in a strong company with good prospects for the future, should it still be sold? At this point, do you make a decision to strictly adhere to Ben Grahams teachings or evolve to be more like Buffett in buying a good company at discount and holding it for a long time?

If the company in question was a 'cigar butt' then selling after its gain seems more obvious than for a value stock in a good company.

Thoughts / comments
No Tags
Page: 1

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http://www.oldschoolvalue.com/blog/forum/value-investing/value-investing-sell-or-hold/#p4033

To make sure every $1 investment will generate $2000 in just 30 years ...

Fundamental analysts can have good dreams because they usually sleep well. If you are one of them, you don’t have to be afraid of daily stock price fluctuations. Why care so much for $1 to $2 per day price movements and uncertainties when you can get $100,000 30 years later almost certainly and do nothing? The ‘do nothing’ is what makes you an investor. Don’t you think so? Once you bought the shares, you will only sell them if there are fundamental changes; such as change in management or business model. Otherwise, continue riding on their profits and keep on collecting dividends or bonus issues by ‘doing nothing’.

Doesn’t it sound so peaceful?

"To make sure every $1 investment will generate $2000 in just 30 years, make sure you buy the stock at the lowest price possible."