Investment Philosophy

Simple Concept of Intrinsic Value Part 2

I wrote a post recently on intrinsic value, and I received some comments and questions that made me think a lot of readers are still looking for a formula to calculate a stock’s value precisely. I really don’t think this is the case. I think the best result that an investor can hope to achieve when it comes to appraising business values is to come up with a fairly sizable range of values, and then wait for the market to offer you a price that is significantly below the lower end of the range—which gives you both a margin of safety in the event your analysis is wrong and high returns on your investment if you’re right.

Investing should be simple. The concept of intrinsic value is simple. The value of a business is simply the present value of the cash that you can pull out of it over time. Graham and Buffett both agreed that this is the intrinsic value of a security—either a bond or a stock. But it’s hard to determine the precise level of future cash flows of a business. I think both Graham and Buffett would agree that instead of trying to crunch numbers into a spreadsheet and using DCF’s to value businesses, they thought of intrinsic value in terms of private owner value. Essentially, what is the normal future earning power of this business and what is that earning power worth to a rational private buyer? This is just a more practical way to think about what something is worth. What will a rational buyer pay for this business?

This, to me, is the simplest way to think about value and it’s how I think about intrinsic value.

I like to think of each investment as a separate business that I am about to buy. And with each business, I want to consider the sum of cash flows that I’ll be able to take from the business each year on average in the future. Then, given all of the other qualitative/quantitative factors that go with each individual business, I will decide how much I’m willing to pay to acquire that stream of earnings.

Each business is different. $10 of earnings from Costco is obviously worth more to me than $10 of earnings from Sears. So you have to look at each business’ earning power along with the future prospects of the business to decide how much you’re willing to pay to acquire that business’s future cash flows.

So keep in mind the two questions I referenced in a previous post:

  • How much does the business earn?
  • What is that worth to me?

Remember, you want “normal” earning power of a business. You’re not looking at the P/E ratio or the EPS from the last twelve months. You’re trying to understand the business to make a judgment on what their earning power will look like over the long term (over the next 3-5 years, or even longer perhaps). This is an art. You’re not trying to predict down to the penny what EPS will be in 2017. You’re just trying to understand the business to make an informed estimate on what the cash earnings will look like in a normal year going forward.

I sometimes use a simple real estate investment as an example, and I referenced this example in the last post. Imagine you own a duplex that rents for $900 on each side ($1800 per month of gross rent). This duplex has a gross potential rent of $21,600 per year. Of course, in any given year, a smart duplex owner understands that he might sustain a vacancy in one of the units, so maybe you’d take 8% off of that potential rent to arrive at a gross effective rent of just under $20,000. Then you have taxes, insurance, utilities, property management fees, and routine maintenance. Let’s say after paying all of these expenses, you’re left with $12,000 of annual net operating income from your duplex (NOI is a real estate term, but this is technically a pretax number, as we aren’t factoring in personal income taxes that you’ll owe on your duplex earnings, and we’ll assume for simplicity that there is no mortgage).

In this example, the duplex earns about $12,000 per year of pretax cash flow before depreciation, but since you’re a smart duplex owner, you’ll set aside around $2,000 per year for maintenance capital expenditures (larger outlays of capital for non-recurring items such as a new roof or a new air conditioner, etc…). These are maintenance capital expenditures—real expenses that are required of an owner of a duplex to maintain the current competitive position of this duplex (i.e. without a functioning roof, it will be hard to attract tenants).

So let’s say the pretax owner earnings are around $10,000 per year.

Once you know this, you can then decide how much that is worth to you. If this duplex is in a slow growth, average neighborhood that hasn’t changed much over time and won’t likely experience any abnormal appreciation, maybe you’d be willing to pay $80,000 to $90,000 for the property. If the duplex is newer and is located in a great part of town that is growing rapidly, you might be willing to pay $110,000 to $120,000. If the duplex sits in town on a half-acre lot across the street from a piece of land that is getting developed into luxury condominiums and land is trading at $300,000 per acre, maybe you’d be willing to pay more still to get this same $10,000 of earning power.

And to make a different point, it’s pretty safe to assume that the duplex has earning power of $10,000. This is a “business” that is pretty easy to understand—it’s easy to estimate the future earning power of this asset. Even if in one year you had to make some renovations and sustained an abnormally high level of vacancy and your duplex only earned $5,000 in the last 12 months, you’d still consider the “normal earning power” of the duplex to be around $10,000.

But in each case, you’d decide on the earning power of the duplex (how much does the business earn?), and then you’d weight the other factors such as age, location, neighborhood, population growth, job market, etc… and you would decide how much you’d be willing to pay to acquire that duplex’s earning power.

So just like the duplex, when you’re looking at the earnings from Costco, you’re going to capitalize that earning power differently than you would for the earnings from Sears.

Like the Concert Pianist, Practice Makes Perfect

Start with the businesses you know how to value. For practice, read a book called Analyzing and Investing in Community Banks and then go out and read a few annual reports of tiny community banks–which are fairly transparent and relatively easy to value. Or pick an industry that you have some expertise in and begin reading some annual reports of businesses in those industries. Pick simple things–I recently read a 10-K on a business that sells hot dogs and has a nice competitive position in that niche. It’s easier to understand–and value–a business that has been selling hot dogs for the past 100 years than it is to value a business that sells pharmaceuticals (at least for me–others might have an advantage with drug companies, or software, or oil and gas, etc…).

So if you’re going to value individual businesses, you have to understand that business. As Joel Greenblatt says, if you don’t understand it, move on to the next one. There are 10,000 stocks in the US, and probably over 50,000 worldwide in developed markets. You only need to find a minuscule percentage of them to fully allocate a portfolio.

Also, value investing comes in many different shapes and sizes, and if you choose not to value individual businesses, there are alternative measures such as quantitative investing in the Graham or Schloss tradition, or even Greenblatt’s “formula”. This quantitative approach values the basket as whole, removing the need to value each individual business. It relies on the law of large numbers, similar to the insurance underwriting business. I personally enjoy reading about those types of strategies, and the results from Schloss are absolutely phenomenal, but I prefer to think of the stocks in my portfolio as fractions of businesses, and thus I endeavor to understand them and value them individually.

Anyhow, valuation is an art form, and it takes practice. Just like practicing the piano, you’ll get better the more you practice. And the best way to practice is to just start reading reports. Over time, you’ll begin to understand the different metrics that are important for each business, and you’ll be less inclined to use hard and fast rules (ROIC above X, P/E below X, etc…) and more inclined to think inquisitively about the business and its operations.

The last thing I’ll mention: over time, as business owners our results are tied to the internal results of the businesses we own. A business that is growing intrinsic value over time will reward us as owners. Over the longer term, quality is the most important determinant of our results as equity owners. A business that can compound value over time at 12-15% annually will create fabulous amounts of wealth for the owners of that business.

So quality is crucial for long term owners. BUT, valuation is the most important determinant (or at least as important) over the shorter term (say 1-3 years). If you overpay–even for great businesses–you’ll have to wait a long time for your investment returns to “catch up” to the internal compounding returns of the business. Conversely, if you buy a great business that compounds value at 12% per year–if you can buy it at a discount to its fair value, then your returns will generally exceed the business’s results in the early years of the investment.

The market is a weighing machine, and over 3-5 years, it tends to weigh things properly. So valuation is an absolutely crucial factor over the near term.

Have a great week!

10 thoughts on “Simple Concept of Intrinsic Value Part 2

  1. Hi John. Great post.
    I have a question.
    Starting with the definition of Buffett according to which intrinsic value “is the discounted value of the cash that can be taken out of a business during its remaining life”.
    Assuming we have two companies which have both normal earning power of 10.000 $ and that increases 10% every year.
    However, the first company pays it all to shareholders through dividends while the second company retains all its earnings. Theoretically the two companies should have the same intrinsic value according to Buffett definition because the cash that can be taken out is the same (even if the second company does not give it to shareholders).
    Where am i wrong?

    1. Hi Eddy, Yeah in your example, the company that didn’t pay the dividend would just pile up cash on the balance sheet. I’m not sure how these companies would be valued in theory, but in practice, you’d rather have the cash as presumably you could invest it at a higher rate than the company who lets it pile up can earn on its cash. So to me the company paying it out is worth more. However, this hypothetical example doesn’t take into consideration that each company (in reality) is different and some companies have better uses for their cash than others. So in general, I’m indifferent to dividends just as I’m generally indifferent to retaining cash flow. Each situation is different and I’d analyze each situation that way. Some companies you’ll want the cash, other companies might be able to earn very high returns on capital in which case you’d prefer that they keep it.

      1. Both companies will have the same intrinsic value: PV of future cashflows.

        provided both have no growth. i.e. neither company has any positive NPV projects to engage in.

        If growth exists, the company paying dividends will have a lower valuation than the company holding cash to reinvest.

  2. Hi John,

    Got a question – I couldn’t really come up with a good answer myself.

    I was reading Buffets most recent letter, in it he describes his view of the past 50 years of BH.

    At one point in the letter he says this:

    ”This cheery prediction comes, however, with an important caution: If an investor’s entry point into Berkshire stock is unusually high – at a price, say, approaching double book value, which Berkshire shares have occasionally reached – it may well be many years before the investor can realize a profit. . In otherwords, a sound investment can morph into a rash speculation if it is bought at an elevated price. Berkshire is not exempt from this truth.”

    Of course he is well known for saying that the intrinsic value of a company is ”the discounted value of the cash that can be taken out of a business during its remaining life.”

    So why is he concerned about price to book value? And what relationship if any does this have to future earnings?

    Apologies if this has been discussed before.


    1. Hi Ben,

      Buffett is just using P/B in this example as a simple proxy for valuation levels. He has often referenced book value as a proxy for intrinsic value (book value at BRK is well below intrinsic value, especially in recent decades). To answer your question, the P/B ratio has nothing to do with future earning power. It’s just the valuation that the stock market is giving to the company. And yes, Buffett describes intrinsic value in his letters and his owners manual as the discounted value of the amount of cash that you can pull out of a business from now until judgment day. The P/B ratio is just a simple proxy for valuation, and he’s simply saying in your highlighted example that it is important not to pay too much for even a great business.

  3. Similar to your conclusion, I have always had difficulty with the value of a business today is its present value of cash flows. Typically it just tells me what the price should be TODAY. Sometimes that formula misses on the growth in earnings and the multiple someone is willing to pay for it a year or two from now.

    Random, what were your thoughts on that 100 year old hot dog company? I am actually looking through that company along with an ADT like company.


  4. Hi John! Just a question. When buying a stock lets say @15X, would a good goal be to find stocks that you think could shrink back down to 10X earnings due to earning’s expansion? Using your example of the duplex, if I paid $1,800,000 for $120,000 in earnings per year, if all things held constant I would be paying 15X earnings, but my goal is for the business to grow which would eventually be reflected in a lower PE, (original price/new earnings) unless it kept growing then the P/E would keep expanding as the price bid for the duplex would go up. (In this case I increased earnings to 1200 per month(600 per unit).


    1. Hi Tony, I’m not sure I follow you exactly. The goal wouldn’t really be to have the P/E multiple shrink… the goal is for the business to continue producing attractive returns on capital, continue spitting out cash flow, and then ideally, for the market to continue valuing the company at (or preferably above) the multiple you paid for it.

      1. Hi again John! You answered my question! My question was a little convoluted, lol, sorry! Please keep on writing, your stuff is great! I’m working through this article and the other article. I’m also reading your article on pricing power which I think is an amazing trait. I work at Starbucks and I see pricing power all the time! An extra 10 cents here added onto the price of a cookie adds up across 21,000 stores.

  5. Hi John,

    What do you think about Greenblatt’s simple EV/EBIT valuation on individual stocks? Essentially I look for companies that are priced lower than their peers (>50% discount), have a good ROE history, and have predictable earnings going forward. Then all I ask myself is “do I expect the future earnings to be the same, lower, or higher”. Of course that question takes a lot of analysis going forward. But it is essentially what I do in real estate. Look for a property that is selling cheaper than its peers, understanding if in fact there is nothing really wrong with it, and how confident can I be that another buyer will eventually come along and buy it from me at a higher price. Being patient and a long term investor is the challenge.

    I’ve also think DCFs are academic and your time is better served thinking about the future than making up forecasts.

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