Ben GrahamInvestment PhilosophyWarren Buffett

The Simple Concept of Intrinsic Value

“The newer approach to security analysis attempts to value a common stock independently of its market price. If the value found is substantially above or below the current price, the analyst concludes that the issue should be bought or disposed of. This independent value has a variety of names, the most familiar of which is “intrinsic value”.

Ben Graham, Security Analysis (1951 Edition)

Graham went on to say this about the definition of intrinsic value:

“A general definition of intrinsic value would be that value which is justified by the facts—e.g. assets, earnings, dividends, definite prospects. In the usual case, the most important single factor determining value is now held to be the indicated average future earning power. Intrinsic value would then be found by first estimating this earning power, and then multiplying that estimate by an appropriate ‘capitalization factor’”.

Graham was a very eloquent speaker and writer, but Joel Greenblatt I think does a great job at summarizing the crux of the issue when he says:

“Value investing is figuring out what something is worth and paying a lot less for it.”

When I’ve referenced intrinsic value in the past, I’ve received questions like: yes, but how do you figure out what something is worth? In other words, how do you determine intrinsic value?

This post will just have some of my comments that I’ve compiled on the topic of intrinsic value. For those hoping for a spreadsheet or a formula, you will be disappointed. But hopefully this post will provide some general ideas you might find helpful with understanding and grasping the concept of intrinsic value, which at the core is very simple.

Determining Intrinsic Value is an Art Form

The process of determining the intrinsic value of a business is an art form. There are no rigid rules that you can use to plug data into a spreadsheet and hope that it spits out the value for you. I’ve looked at a lot of different models over the years, including many DCF’s, and I’m usually skeptical of most of these types of models. On page 4 of his owner’s manual, Buffett simply defines intrinsic value:

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”  

This implies that a DCF model is the proper method of determining value. However, he goes on to say on page 5 that:

“The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure… two people looking at the same set of facts… will almost inevitably come up with at least slightly different intrinsic value figures.”

Buffett implies that valuation is an art form. Determining the present value of all the future cash flows of a business involves looking at all different aspects of a business’s DNA including its historical financials, its profitability, the stability of its operating history, its balance sheet, evaluating its competitive position, critically thinking about its future prospects, and evaluating its management team, among other factors–all weighted and compared to the current price.

So it’s an art form, and it takes practice.

Buffett was asked about intrinsic value at the annual meeting, and he basically said that it’s really the concept of private owner value. What is the price that a private buyer would pay for the entire business and its future stream of cash?

This is a simple concept, and it makes sense… the question I’ve been getting is how can we determine that?

What is the Earning Power, and What is that Worth?

To me, the concept of a business’ intrinsic value is very simple. It’s based on earning power. Take a look at that Graham quote above one more time… it’s interesting to note that Graham is saying that future earning power is the “most important single factor determining value”.

I can boil down Graham’s words into my own simple definition of intrinsic value by asking two questions:

  1. How much does the business earn in a normal year?
  2. What is that earnings stream worth to me?

So the real question you’re trying to answer is what is the business’s normal earning power? In other words, if I am a private buyer, how much cash will this business put in my pocket each year after paying for capital expenditures required to maintain my competitive position? (What are the normal owner earnings that I can expect from this business)?

In Security Analysis, Graham—contrary to popular belief—actually spends a lot of time discussing future earnings, as that is really what we’re after…. Not what the business earned in the past, but what we can expect the business to earn each year on average in the future.

So think of earning power when you’re thinking about a business’s intrinsic value. Try to determine the stream of cash that you could expect to get from the business over time in the future. If you think a business can earn $3 per share, how much is that $3 worth to you? If you think the business, by retaining and reinvesting a portion of its earnings, can grow its earning power at 10% per year, maybe that $3 is worth more to you than a business that earns a consistent $3 that pays it all out in dividends but can’t retain and reinvest anything (i.e. it’s not growing).

Focus on Predictable Businesses

It’s important to note that not all securities can be valued by everyone. Each investor has a circle of competence. You can’t possibly know everything about everything all the time. You just need to know a little bit about something some of the time.

It helps to also know that some businesses are just easier to value than other businesses. Predictability of cash flows is a very important thing to consider. Graham talked about this as well when he said that the security analyst must:

use good judgment in distinguishing between securities and situations that are better suited and those that are worse suited to value analysis. Its working assumption is that the past record affords at least a rough guide to the future. The more questionable this assumption, the less valuable is the analysis.”

In other words, it’s easier to value a business with stable operations and cash flows than one with a wide variation in cash flows from year to year.

Don’t Overcomplicate Things

Investing is simple. Weigh things against each other, and think in simple terms. Simple decision trees… How much is the cash flow, what will the cash flow look like in normal times going forward, and what is that worth to me?

If you can’t figure out what the normal earnings will look like 5 years down the road, don’t buy the stock and move onto something where the earning power is more predictable. Most business won’t be able to be valued with any sort of accuracy. If you can’t figure out normal earning power, it will be difficult to figure out what the business is worth.

People tend to make things far too complicated. Intrinsic value is simply what the future stream of cash flow is worth. I think a lot of new investors are searching for a formula or some specific number, and it doesn’t really work that way. As Buffett says, he and Charlie would come up with two different intrinsic values for Berkshire Hathaway if they were forced to write down what they thought it was worth (it would be close, but it wouldn’t be exactly the same).

You don’t have to be precise either. Remember, you don’t need a scale to know that a 350 pound man is fat. Don’t try to sweat over whether the business will earn $3 or $3.25. Just try to focus on finding the big gaps between the current price and the value you’ve placed on future earning power. Remember, Buffett thought PetroChina was worth $100 billion and he could buy it at $35 billion. You could do all sorts of elaborate analysis, but Buffett basically boils down everything to what will the business look like in 5 to 10 years (i.e. what will the business, and all of its assets, be able to produce in owner earnings over time, and how much are those owner earnings worth to a rational buyer).

Simple Logic of Intrinsic Value

If I’m looking at a duplex that I think can earn $10,000 per year, how much am I willing to pay for that duplex? Each situation is different. If the duplex sits in a stable neighborhood with very modest growth and development, I might be willing to pay $80,000 or $90,000. If the duplex sits in a growing part of town with a rapidly developing landscape, maybe those earnings will grow and are worth more to me. If the duplex has a plot of land in the back that can be developed into two more units that will double the cash flow, the overall investment has significantly more future earning power and I might be willing to pay more still.

The level of capitalization I put on those earnings depends on my overall analysis of the situation including what I expect the future earnings to be, but the basic two questions I’m always asking myself when it comes to the concept of intrinsic value are:

  • What can the business earn? And,
  • How much is that worth to me?

Keep things simple. I’ve never bought a stock because of numbers that a spreadsheet gave me based on specific future projections for growth, cost of capital, etc… I spend most of my time reading and thinking, and I try to keep the math very simple. And I try to give myself a large margin of safety in case my assessment of the situation is wrong. But I don’t want to invest in a situation where heroics are needed to reach a certain earnings level or a complicated model is needed to justify a purchase price.

I don’t think Graham ever used a model, and I don’t think Buffett ever did either. I’m not saying models are completely useless, I just prefer not to use them. I think more often than not they provide a false sense of precision, and the real world just isn’t that precise. The world is a dynamic, ever changing landscape, and investing and valuation are—in large part—art forms.

I hope this discussion is somewhat useful, and Happy New Year to all!

22 thoughts on “The Simple Concept of Intrinsic Value

  1. Hi John,

    Great post. I don’t have a finance background, but have been teaching myself accounting and valuation over the past year and it’s taken me a little while to wrap my head around some things, and I wish this post had come out months ago.

    For people just starting to calculate the intrinsic value of a company, I think they often get lost in the weeds of WACC, CAPM, DCF, beta, regressions, etc. Knowing what I know now, I would recommend the first thing everyone reads when starting out is the John Burr Williams quote:

    “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.”

    I think the main question for a lot of beginners is “what does it mean to discount, and what rate should I use?” You get a lot of noise around these two questions which can be rather overwhelming, especially if you’re not a rocket scientist. Then you get into DCFs that give a false sense of precision, but after reading and thinking more and more on the subject, I feel comfortable using a much simpler approach that combines the following:

    – Do they have a healthy balance sheet?
    – Are cash flows sustainable?
    – Any non-operating income I should adjust for?
    – What are the growth prospects?
    – What, if any, is the “moat”
    – Are cash flows sustainable
    – Can money be reinvested at a high rate of return
    – Read through the 10ks to get a better feel for the company, financials, and management
    – Ignore most of the accepted finance theory of ways to determine discount rate, and simply use my desired return rate as the rate I use

    My guess is most people don’t really understand the last piece around discount rate, so while it is commonly said that there is no “magic formula”, which for all intents and purposes is true, I do think showing a very simple calculation of company using a discount rate would go a long way.

    Widget Co Discounted at 5%
    Year Cash Flows PV
    1 $1.00 $0.95
    2 $1.10 $1.00
    3 $1.21 $1.05
    4 $1.33 $1.10
    5 $1.46 $1.15
    6 $1.61 $1.20
    7 $1.77 $1.26
    8 $1.95 $1.32
    9 $2.14 $1.38
    10 $2.36 $1.45

    Total $15.94 $11.85

    If the market is offering this at $3 per share, you know it’s likely a screaming buy. If it’s at $10 per share, it may not be worth the effort, and if it’s selling for $40 per share, then you don’t touch it with a 10 foot pole. Once I understood this very simple concept (and very basic “formula”), things really became crystal clear for me. Prior to that, I was kind of shooting blind.

    We may take this for granted that people understand the concept of a discount rate, but I actually wouldn’t be so sure. Great post though, and happy new year.

    Best,
    Jared

    1. Hi Innerscorecard, I’m not familiar with the post you’re referring to, and no I haven’t read it and this isn’t a response to anything in particular… just some thoughts I had on the topic.

  2. Fortunately, over a sufficiently long time period, valuation isn’t very important. It can provide a headwind or tailwind, but it isn’t the main factor in determining whether an investment is successful. So we do not need to be too precise in estimating it. I’m always wary of people who claim to have skill in the area of equity valuation.

  3. It’s always worth reviewing fundamentals, and this is a simple and well-expressed review, so, thank you. I would add that thinking in this way demonstrates why Buffett, for one, thinks so much about the long-term durability of a company’s level of profitability, because that’s where most of the value resides. He tries to guess what could go wrong, along the lines of the well-known adage, “Take care of the downside and the upside will take care of itself.” The less could go wrong, the lower a margin of safety needs to be.

  4. John —

    Nice post. I also tend to use normalized earnings and normalized multiples a fair amount.

    One trick I often use for valuation is to consider all the different lower and upper bounds that could be at play. In other words suppose all we care about is that someone is obese (the “intrinsic value”), but we cannot measure directly their weight. Then we might start asking other questions about their lifestyle, diet, medical readouts, spouse’s diet, etc.

    I think it is also useful to think about these ideas in the language of statistics and machine learning. The intrinsic value would be called a “hidden variable,” empirically observed facts about companies are called “observable variables,” and finding the intrinsic value is called “inference.” In mathematics inference is in general difficult. I think one of the key points Ben Graham was trying to make, in modern language, is that the inference process should be logically valid, robust, and only based on actually observed data. By insisting on such a logical process, this counteracts the natural tendency of people to make wild guesses or participate in unreliable emotional games.

    Computer scientists have heavily studied inference problems in the area of machine learning. One of the interesting findings is an algorithm called belief propagation which solves certain inference problems involving lots of variables. This topic is fairly technical, so I won’t discuss it in much depth. However an interesting conceptual property that this algorithm has is that it repeatedly updates “beliefs” for each of the hidden variables by pushing information from other known and hidden variables. In particular, it pushes more confident beliefs when information is more reliable, or an inference is more sound.

    In my experience, valuing companies is not so conceptually different.

    You have some things you know, some things you don’t know, and you would like to only push valid information along paths that permit reliable or robust inference.

    For example, suppose stock dilution and the industry’s future imply a low valuation, but insider incentives, growth estimates, and historical earnings imply high valuation. It may not be reasonable to assign a high valuation for such a company, unless one can find a reliable chain of facts on which to perform a robust inference. For example, we might find that a buyout firm has a 10% position in the company, and that the management and the buyout firm have similar views due to incentives, and the management’s actions have been consistent with their statements in the past. Now we could perform an inference along a consistent pathway of observed facts to justify a high valuation (the hidden variable).

  5. Hi John,

    That’s a great post and very useful. Unfortunately, the finance industry doesn’t think this way and the most common requirement you see for an Investment Analyst job nowadays is VBA and advanced modelling. While these are a plus, I don’t think they are relevant assess the economics of a business and its viability. Buffett, who doesn’t use a computer and makes a decision in 5 minutes, is a good example. There are so many assumptions involved in building a model and valuing a company, which amplifies the margin of error. As you said, it should be simple.

  6. I’m curious of your take on sector and industry diversification. I am interested in concentrated portfolios (7 to 10 stocks) but note that Munger seems to put little value in industry diversification (see DJCO portfolio’s bank concentration) whereas Pabrai is careful to diversify his 7 to 10 stocks by choosing only 1 stock from each industry. Thoughts and comments to educate me on this topic are appreciated.

    1. Hi Sean, thanks for the question. I actually think Pabrai is more concentrated than you suggest–if you look at his current holdings, 5 stocks represent the majority of the equity and two bank stocks represent more than a third of his portfolio. He actually gave an interesting talk at Google last summer where he used the example of a real estate billionaire who has made all of his money investing in real estate near Stanford University. His circle of competence is tiny (real estate near Stanford) and his sector diversification was nil–but he still has done incredibly well. I think a lot depends on your own personal situation, your age, your appetite for stock investing (risk tolerance), etc… If you look at most of the people who have made significant amounts of money, they tend to make it being extremely focused and concentrated on one idea–Carlos Slim was virtually 100% concentrated in telecom, John Malone made all of his money in the cable business, Harold Hamm made all of his money in oil & gas, Sam Walton made all of his money not only in one industry (retail)–but one stock (Walmart), the same goes for Bill Gates–one industry (tech), and one stock (Microsoft). Same for Zuckerberg, Brin and Page, Bezos, and the list goes on… Even Buffett… early on–these guys were extremely focused and produced incredibly high rates of compounding. Some of them now are much more diversified, but even now, they mostly maintain the majority of their wealth in one entity, or in some cases just one stock. But when they were building wealth, they did it in a very concentrated manner. I can almost guarantee that not one of those business titans ever once considered industry diversification–or diversification at all. It was the furthest thing on their mind.

      So this is not to say that you should be cavalier about these things–it is a very good question you bring up. I just think that very few investors tend to think like business owners, and most investors think the way large pension funds or endowments tend to think–just trying to not lose. While it’s always smart to consider downside, I think this type of diversification mindset ends up leading to mediocre results over time.

      I think you have to allow for the possibility that you’re wrong, so I’m not suggesting concentrating on one idea, but I do not think that investors need to be overly strict on diversification rules among industries, stocks, etc… I tend to fall more toward the ideas of Charlie Munger when he said you get plenty of diversification if you lived in a small town and owned stakes in the Ford dealership, the best apartment building, the class A office park, and the McDonald’s franchise.

      So I’ve never felt that I’ve been overly concentrated, but I don’t tend to put rules on my portfolio or think in terms of allocating to sectors, attaining adequate diversification among sectors, or anything like that.

      I’m just out trying to find the best value with the lowest risk, wherever that might be…

      Hope that helps. Thanks for reading Sean.

  7. Hi John,

    Your posts are thought provoking and I appreciate them very much. I wonder if you are willing to talk about your weekly habits and what you may have read about the habits of other accomplished value managers when it comes to looking at market prices for current portfolio holdings. How does Graham’s notion of treating shares as ownership in the business manifest specifically in how often one looks at market prices for current holdings? Buffett’s statement on operating such that it wouldn’t matter to him if the market closed for 5 years implies that he could go a long time without market price feedback- but is purposely avoiding periodic check-in of price action an important part of success?. I note the common theme of Buffett and even Alan Mecham being portrayed as spending their days reading and thinking quietly. I further note Pabrai’s afternoon naps- perhaps during trading hours. Additionally, I have seen reference to value investors having high regard for the notion of “insulating” themselves from the emotion of the markets. So, in your practice and in your opinion, does ‘insulating” equate to or at least include not looking at price action on current holdings for days or weeks at a time? Have you read any interesting articles you could point me to about how often the greats look at stock quotes? I have just recently had a thought that perhaps one would be “insulated” from the emotions of the marketplace by looking only at ratios of Price/IV for a list of stocks, trying very hard to never look at the price action. I would love for you to weigh in on this. Thanks!

  8. I found a partial answer to my question. There is a great article in the latest AAII Journal that Guy Spier wrote. The title of the article is “Nine Rules for Smarter Investing”. #1 rule? “Stop checking the stock price so often”. Guy says individual investors should check stock prices of their holdings only once per quarter or even once per year. According to Guy “It’s a wonderful release to see that your portfolio does just fine when you don’t check it.” Guy continues the theme with his #6 (inspired by his friend Mohnish Pabrai) “Never buy or sell stocks when the market is open.”

    Interestingly, I think Guy’s #7 (also borrowed from Pabrai) supports not looking at prices of holdings. #7 is “if a stock tumbles after you buy it, don’t sell it for 2 years.” I think one of the major reasons I watch prices arguably too often is the sense that a move down may alert me to a new development with the company or industry and then I can have more time to think about the new development and its impact. This becomes useless with strict adherence to rule #7, eliminating the need to stay abreast of price quotes.

    Here’s the link if anyone is interested. If anyone else has other articles on how often talented value investors look at prices, please point me to them.

    http://www.aaii.com/journal/article/nine-rules-for-smarter-investing?a=homepagetop&acc=o

  9. Hi again John, this I by far one of my favorite articles! Would you ever consider calculating intrinsic value using a real company(s) for illustrative purposes?

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