“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:
- How much does the business earn in a normal year?
- 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!