Intrinsic value determines whether a stock offers value or not. But it is also one of the most confusing concepts in value investing
31-Mar-2020
Intrinsic value is perhaps one of the most important concepts in value investing as it determines whether a stock offers value or not. But it is also one of the most confounding concepts.
The simplest explanation of intrinsic value is offered by Warren Buffett himself. It is the "discounted value of the cash that can be taken out of a business during its remaining life." The definition alone opens up a Pandora's box. Estimating how much cash the business can generate during its remaining lifetime may be complicated. If you manage to do that successfully, then there is the grey area of using discounting - what rate to use? Buffett has not explicitly mentioned how he calculates intrinsic value, though he has dropped broad hints about how he goes about it. But because there is no clarity about intrinsic value, analysts and investors try very hard to get intrinsic value right and that is where many falter.
Busting the Myth
As Charlie Munger points out, it may not be easy to pin down intrinsic value. He says, "When you're trying to determine intrinsic value and margin of safety, there's no one easy method that can simply be mechanically applied by a computer that will make someone who pushes the buttons rich. You have to apply a lot of models. I don't think you can become a great investor rapidly, no more than you can become a bone-tumor pathologist quickly". (Berkshire Annual Meeting 2007).
Here is an easy explanation by Buffett of intrinsic value. Says Buffett, "Let's say you decide you want to buy a farm and you make calculations that you can make $70/acre as the owner. How much will you pay [per acre for that farm]? Do you assume agriculture will get better so you can increase yields? Do you assume prices will go up? You might decide you wanted a 7 per cent return, so you'd pay $1,000/acre. If it's for sale at $800, you buy, but if it's at $1,200, you don't." (Berkshire Annual Meeting 2007).
Here's another way to look at intrinsic value. "If you were thinking about paying $900,000 or $1.3 million for a McDonald's stand, you'd think about things like whether people will keep eating hamburgers and whether McDonald's could change the franchise agreement. You have to know what you're doing and whether you're within your circle of competence," said Buffett. (Berkshire Annual Meeting 2008).
In his 2010 Annual Letter Buffett described a "Two-Column Valuation Method" to arrive at the Intrinsic value. Using Berkshire as an example he divided his firm into investments and non-insurance business. The first part involved arriving at the per share investments. Next he calculated the pre-tax earnings of his other businesses and applied an appropriate multiple to the earnings. Finally he added this amount to the per share investments to arrive at the intrinsic value.
At best, intrinsic value is an estimate. "Intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised." You don't need to get intrinsic value figures right to the second decimal place. Buffett points out, "If we see someone who weighs 300 or 320 pounds, it doesn't matter - we know they're fat. We look for fat businesses.'' (Berkshire Annual Meeting 2007).
Intrinsic value can sometimes be much lower than the company's stated book value. In the "Owners Manual" dated 1999, Buffet gave the example of Berkshire in 1964. The book value of Berkshire was $19.46/share. According to Buffett, the intrinsic value was far lower because Berkshire was struggling in a low profitability textile business. The textile assets did not have going-concern or liquidation values equal to their carrying values.
In the end, it pays to keep in mind Munger's statement when considering Intrinsic value. "We have no system for estimating the correct value of all businesses. We put almost all in the 'too hard' pile and sift through a few easy ones". (Berkshire Annual Meeting 2007).
This story was published on an earlier date.
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