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CHAPTER 1
What Is Intrinsic Value?
Intrinsic value is an elusive concept.
âBenjamin Graham1
Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses.âWarren Buffett2
Valuation methods start with the goal of calculating intrinsic value, the true worth of a stock based on established financial information and clear forecasts about the business. Intrinsic value is, or should be, independent of market opinion and investor sentiment. The basic assumption is that over time the price of the stock will move toward its intrinsic value. This means that knowing the intrinsic value of a stock, if only approximately, provides a firm foundation for all investment decisions, whether to buy, to sell, or to do nothing. In this sense, value comes from putting together and comparing intrinsic value and price. However, as we will soon see, the idea and use of intrinsic value is not as straightforward as it first seems.
Intrinsic Value
The general idea is that the intrinsic value of a unit of stock in a publicly traded company is its
true worth, which may be quite different from its market price. Over 70 years ago Benjamin Graham, often referred to as the dean of Wall Street, gave the following description:
[Intrinsic value] is understood to be that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses.3
Around the same time, John Burr Williams4 wrote about the âreal worthâ of equities and emphasized that it could actually be calculated in a precise manner from data obtained from financial statements coupled with judicious forecasts. Williamsâ methods put particular emphasis on current dividends and forecasts of dividends. The result was the dividend discount method, which is described in Chapter 8.
Intrinsic Value
The theory of intrinsic value is that it is the true worth of a stock based on established financial information and clear forecasts about the business.
When someone starts to look at intrinsic value, often the first characteristic they notice is that there are many ways of calculating it, giving a wide range of results. The second problem is that, even if there is agreement on the method chosen to calculate intrinsic value, there is unlikely to be agreement on the levels of the input parameters in the calculations. This often leads to even wider variations in the calculations. Sensitivity is the size of the variation of the outcome compared to variations in the input. Some methods are very sensitive with just a few percentage points change in the inputs leading to twofold and higher variations in the output. Other models are more stable, meaning that the results do not vary much with changes in the input levels.
Just the same, by having an improved understanding of the assumptions and the parameters that go into the various calculations, we are in a stronger position to make better investment decisions. Without this understanding, we are vulnerable to many of the claims and statements by market participants and investment advisers. The other good news is that all the methods for calculating intrinsic value have different strengths and weaknesses. For example, some may be suited for companies with consistent levels of dividends while others may be better suited to companies that do not pay dividends. Furthermore, all the methods have been developed to meet specific needs and applied to good effect at different times.
Whatever definition of intrinsic value of a company is used, the overall idea is that the financial data from the companyâs current and historical financial statements forms the basis of the calculations. In addition, the calculations usually include forecasts of this data as to what it will be in the future or how it will grow.
The basic assumption is that, over time, the price of a stock will move toward its intrinsic value. If the price is $20 and the intrinsic value is $30, then it would be a good time to buy since the price would be anticipated to rise toward $30. In the opposite direction, if the price is $30 and the intrinsic value is $20, then it is time to sell. Burton Malkiel refers to this as the firm-foundation theory of stock prices. He writes:
The firm-foundation theory argues that each investment instrument, be it a common stock or a piece of real estate, has a firm anchor of something called âintrinsic value,â which can be determined by careful analysis of present conditions and future prospects. When market prices fall below (rise above) this firm foundation of intrinsic value, a buying (selling) opportunity arises, because this fluctuation will eventually be correctedâor so the theory goes.5
Benjamin Graham was questioned about this tendency when he appeared before the Senate Banking Committee in 1955. When asked by J. William Fulbright, the committee chair, why stock prices move up to their intrinsic value, he replied, âThat is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. [But] we know from experience that the market catches up with value.â6 There is actually a second part to this assumption, namely that stocks that are more undervalued will initially rise in price more quickly than those that are less undervalued. In other words, they will have a higher rate of return. Importantly, the research on different valuation methods mentioned throughout the book generally supports the assumption of the firm-foundation theory.
The Basic Assumption of Intrinsic Value
The basic assumption of intrinsic value is that, over time, the price of the stock will move toward its intrinsic value.
As we will see, it is not hard to develop and support calculations for the worth of a stock and to call the result intrinsic value . . . but is there really such a thing, whether in the stock market or anywhere else? Despite all the talk about intrinsic value, is it just a will-oâ-the-wisp with no real substance and not worth trying to track down? Experts in many areas, not just theoretical finance, argue these questions with weighty articles and books.7 To avoid being stuck in existential quicksand, we are going to take a pragmatic approach and skirt around the main philosophical problems.
The core argument against intrinsic value in the stock market is that if it existed and could be properly measured, then everyone would know what it is. Consequently, no one would sell anything for a price less than the per-share intrinsic value and no one would pay more than this amount. There would be either no transactions or very few on any of the stock exchanges. One weakness of this argument is that perhaps intrinsic value exists for equities but the method for calculating it is so complex or abstruse that only a very small number of people can determine what it is. Even among those who can determine it, many may not bother.
We will take a down-to-earth approach in this book and look at intrinsic value in an operational sense. As a starting point, we define intrinsic value as any of the outcomes of the application of calculations that arrive directly at a dollar amount for the worth of a stock, where the calculations are based on defensible rational logic using two sets of inputs. The first set of inputs comes directly from the financial statements of the company and may include items such as equity and earnings per share. The levels of these input numbers are well defined and usually have a high degree of mutual agreement on their actual values. (But not alwaysâwe will see examples where there can be disagreement over some of the input figures based on such considerations as whether certain items should be expensed or capitalized. In the first case, the cost of the item is fully reported as an expense in the profit and loss statement; in the second case, only the depreciation appears there.) The second set of inputs involves forecasts of key financial parameters such as dividends and earnings per share. Based on opinion, these are much more variable between individuals.
This is the direct approach to intrinsic value. The intrinsic value is obtained directly as a dollar amount. Examples are the book value or equity per share, described in Chapter 6; or the dividend discount method, described in Chapter 8, where the intrinsic value is the discounted value of the dividends generated by the business over its life.
There is a second approach to intrinsic value in which the intrinsic value is calculated indirectly. As an example, in Chapter 11, price ratio methods calculate the expected total average annual return of a stock from particular input financial parameters over specified investment periods. Suppose that, to compensate for the risks associated with a business, a reasonable return is 14 percent per year. The intrinsic value is the price of the stock needed to achieve this return. It is like a reverse engineering exercise. Different prices are tried in the calculation until a price is found that gives the required return. Bingo! This is the intrinsic value according to the price ratio method with the associated input parameters.
Another example is the PEG ratio, defined in Chapter 10 as the ratio of the price-to-earnings ratio divided by the expected growth rate. In this setting, the intrinsic value is the price of the stock that would give a satisfactory level for the index. Suppose you are interested in a company that currently has a PEG ratio of 1.2. However, you believe that the company is trading at a fair price when its PEG ratio is 1.0. You invert the formula to find the price that gives a PEG ratio of 1.0; this price is the intrinsic value according to the PEG ratio method. In this case, the price of the stock exceeds the intrinsic value and so, according to this method, it is not a time to buy.
More generally, suppose we have a method for calculating an index associated with each stock that measures its worth. This could be the expected total average annual return, as just described. Another example is described in Chapter 9: Intrinsic value is the number of years it would take the earnings of the stock to pay back its price. Or it could be a more abstract index such as the PEG ratio described in the previous paragraph. In each case we can calculate a dollar amount as the price of the stock that would give a satisfactory or fair level for the index. This dollar amount is called the intrinsic value of the stock. Comparison with the current price determines what action to take: whether to buy, to sell, or to do nothing. Admittedly, this may seem a little theoretical at this stage but later chapters contain many examples.
In fact, since we can always turn calculations involving measures such as return or other various indexes into an intrinsic value in terms of dollars, it makes sense to expand the definition of intrinsic value. Quite simply, we define intrinsic value as the result of any calculation that evaluates the worth of a stock. In other words, we will talk about measures such as the expected return, the expected payback period, or the PEG ratio as the intrinsic value. We are not going to keep stating that the results of these calculations can always be converted into an actual dollar amount. Of course, as stated earlier for the direct method, to be included as a genuine method we require each method to have a firm, logical foundation with clear assumptions.
Types of Intrinsic Value
Our operational definition of intrinsic value contradicts much of the financial literature, which assumes there is really only one approach, and that is via the discounted cash flow method. Even Warren Buffet explains that âintrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business.â8 (It is often inferred from this statement that this is the method used by Buffett, although this is not what he actually says. Indeed, at the end of Chapter 7 we will see that he probably does not use this method.) Not only is discounted cash flow not a unique method for calculating intrinsic value, but we will see in Chapter 7 that it has many variations, with still more interpretations of these variations, giving a wide range of results. Should we be using free cash flows to the firm or free cash flows to equity for the âcashâ in Buffettâs definition? Or perhaps it is better to use dividends? Does it make sense to use a one-stage model, a two-stage model, or perhaps even a three-stage model?
Suppose we manage to gain agreement at the level of which variation to use. We may still be faced with quite different opinions on the appropriate values of the input variables. Buffett makes this clear when he continues: âTwo people looking at the same set of facts, moreoverâand this would apply even to Charlie and meâwill almost inevitably come up with at least slightly different intrinsic value figures.â (The âCharlieâ to whom Warren Buffett is referring here is Charlie Munger, the vice-chairman of Berkshire and long-term friend of Buffett.) It is actually much worse than this. In Chapter 7 we see that it is uncomfortably easy to come up with widely divergent intrinsic value figures rather than the âslightly differentâ figures referred to by Buffett.
Many Variations of Intrinsic Value
In practice, there are many ways of calculating intrinsic value, giving a wide range of results depending on the method and the input parameters.
On top of the variations of discount methods and the extreme range of possible results, there are actually many other approaches to intrinsic value. The following is an introduction to the main types.
Balance Sheet Calculations of Intrinsic Value
As is explained in detail in Chapter 4, the balance sheet is a snapshot of the financial position of a company...
