Dr John Price

# The Myth of Intrinsic Value

Is a share of Costco Wholesale Corporation (NASDAQ:COST) worth \$16.04 … or … \$67.07 … or … \$154.02? Actually all of these are mathematically correct according to standard valuation methods and tables used by professional analysts through to DIY investors. Of course, even though they are mathematically correct, the results are no use for anyone considering buying or selling shares in Costco. These contradictory valuation results arise because of three fundamental weaknesses with the standard intrinsic valuation methods.

The first weakness is that there are actually dozens of methods that purport to calculate the true value of a stock providing a bewildering range of outcomes. In some cases one method will show a stock is highly undervalued, others that seem just as reasonable will show that it is completely overvalued.

On top of this variation between the methods, the second weakness is that most of the methods show even more variation within their calculations. Changes of a few percentage points in the inputs give results that differ by two or three hundred percent. A common outcome is that investors and analysts unwittingly manipulate the results to support their prior opinions. While appearing to be objective, the outcome is really highly subjective.

The third weakness with the standard value formulas is that they do not have a time component. Even if we could know that a stock is 50 percent undervalued, there is a world of difference between the price moving to the intrinsic value within a year or as long as a decade. In the first case it would be a wonderful investment, in the second probably not much more than a bank rate.

Finally, all these weaknesses are made worse by what I call mathematical intimidation. This is the use of opaque mathematics, computer programs or tables (which are often quoted second-hand to begin with) without understanding the assumptions and logic behind them.

Fortunately, none of this is necessary for sensible, rational investing. In fact, in this article I will show how a careful analysis of one intrinsic value method brings us back to what we could have been doing all along, finding companies with confident growth in earnings trading at prices that will lead them to be Wealth Winners®.

Over the past 15 years I have personally programmed, examined, tested and compared every method that I could find. In my recent book The Conscious Investor (Wiley, 2011) I closely examine and describe the most well-known of these methods.

The methods range from balance sheet methods (particularly those developed by Benjamin Graham), to discounted cash flow methods (where the outcome is usually referred to as intrinsic value), to dividend discount methods (while still an intrinsic value method, includes many variations such as return on equity, residual income valuation, and abnormal earnings growth), payback methods (that estimate the time for dividends to pay back the price of the share), and expected return methods (that estimate the expected average return of an investment). I also look at various filtering methods such as magic formula investing by Joel Greenblatt, CANSLIM by William O’Neil and factor models by Robert Haugen.

In each case I look at their assumptions followed by their strengths and weaknesses. Some of the assumptions are fairly innocent and open such as working with the entries in the balance sheet. Others require making forecasts over shortish time periods. But the most problematic assumptions require making forecasts for an infinite number of years.

## Dividend Discount Valuation

Instead of looking at the standard discounted cash flow method, consider the dividend discount method. It asserts that the true or intrinsic value is the sum of the discounted values of the dividends over the entire life of the company which is assumed to be infinite. This is the same as the discounted cash flow method except that free cash flows are replaced by dividends.

To get around the problem of forecasting dividends out to infinity, sometimes this method is recast in terms of return on equity and the payout ratio. It also uses an assumption called the clean surplus relationship which asserts that book value (equity per share) at the end of a period is equal to the book value at the start plus earnings less dividends paid.

The simplest variation assumes that ROE and the payout ratio remain constant. Next, if you know the initial book value, it is easy to calculate the earnings and dividends for the first year. Now use the clean surplus relationship to calculate the book value at the end the year. Repeating this process allows you to calculate the dividends out to infinity. Finally discount these dividends and add them up using the mathematical theory of infinite series to get the intrinsic value.

Consider Costco. (NASDAQ:COST) Over the past ten years its ROE has been as low as 10.8 percent and as high as 14.0 percent. Its average has been around 12.0 percent so we will use this as our input into the formula. (There is a difference when calculating ROE whether you use the equity at the start of the period, the end of the period, or an average of the two. For simplicity in the calculations we will suppose that the equity we are assuming is at the start of each financial year. Also, for simplicity the amounts will be written using two decimal places whereas they are carried to full accuracy.)

Similarly over the past five years the dividend payout ratio has ranged from 21 percent to 28 percent. However, in the last two years is has been 26 percent and 28 percent so we will assume that it is going to be 27 percent in the future.

Currently the book value of Costco (NASDAQ:COST) is \$25.67. It is a simple matter to bundle these facts together to calculate the earnings and dividends of Costco running out into the future. As a start, since the book value is \$25.67 and ROE is 12.0 percent, the earnings per share during the first year must be 12 percent of \$25.67 which is \$3.08. Taking the payout ratio as 27 percent means that the dividends must be 27 percent of \$3.08 or \$0.83.

The next step is to apply the clean surplus relationship to calculate the book value at the end of the first year. In this case, the required book value is \$25.67 + \$3.08 - \$0.83 or \$27.92. Now repeat this step for year 2 and so on.

One more thing. We need to include a discount rate. Basically this is the rate that we would like to earn to compensate for the risks associated with investing in Costco. Assume that it is 10 percent.

The table shows the results when we do this for 10 years. I have also included years 20 and 100. People who use these methods actually implement mathematical formulas, or use tables calculated from these formulas, which calculate the result for an infinite number of years. In this case, the result is \$67.07. This means that if we kept doing the calculations year after year, eventually the sum of the discounted dividends would converge to \$67.07.

Notice in the table that earnings, dividends and book value are all growing at the rate of 8.76 percent per year. This is a consequence of the initial assumptions on ROE and the payout ratio.

 Year Book Value at Start of Year Earnings per Share Dividends per Share Book Value at End of Year Discounted Dividends Running Total 1 \$25.67 \$3.08 \$0.83 \$27.92 \$0.76 \$0.76 2 \$27.92 \$3.35 \$0.90 \$30.36 \$0.75 \$1.50 3 \$30.36 \$3.64 \$0.98 \$33.02 \$0.74 \$2.24 4 \$33.02 \$3.96 \$1.07 \$35.92 \$0.73 \$2.97 5 \$35.92 \$4.31 \$1.16 \$39.06 \$0.72 \$3.70 6 \$39.06 \$4.69 \$1.27 \$42.49 \$0.71 \$4.41 7 \$42.49 \$5.10 \$1.38 \$46.21 \$0.71 \$5.12 8 \$46.21 \$5.54 \$1.50 \$50.26 \$0.70 \$5.82 9 \$50.26 \$6.03 \$1.63 \$54.66 \$0.69 \$6.51 10 \$54.66 \$6.56 \$1.77 \$59.45 \$0.68 \$7.19 … … … … … … … 20 \$126.57 \$15.19 \$4.10 \$137.66 \$0.61 \$13.61 … … … … … … … 100 \$104,683 \$12,562 \$3,392 \$113,853 \$0.25 \$45.49

Table: Return on Equity Valuation

Often the year by year convergence to the final value is painfully slow. For example, after 10 years the result is \$7.19, giving a huge error of 89 percent compared to the true value of \$46.60. After 20 years the table value is \$13.61, giving a sizeable error of 80 percent. Even after 100 years the table gives \$45.49, so the error is still approximately 32 percent. What this shows is that the accuracy of the ROE formula for intrinsic value relies on forecasts decades, and even centuries, into the future.

Unfortunately it gets worse. Suppose you are worried about the impact of the US economy on Costco and increasing competition from other membership-based wholesale companies. You think that for the next 10 years the ROE will be 10 percent and after that it will be 8 percent. These are still excellent levels way above the majority of companies. But even with these slight changes, the intrinsic value drops to \$16.04.

But wait. You believe that Costco will have increasing success overseas and that it moves into China. You reckon that the ROE will be maintained but the board will lower the payout ratio to level it was four years ago, 20 percent, to free up more money for further overseas expansion. Now the intrinsic value jumps to \$154.02.

In other words, with fairly small changes in the assumptions that go into the ROE method the intrinsic value can swing from a low of \$16.04 to a high of over \$150. We really have no idea whether Costco is undervalued or overvalued, whether we should buy, sell, or do nothing.

## Where does price fit in?

Another confusion concerns the role of price and P/E ratios in making investment decisions. While the theory may be interesting to an academic, even if we could calculate (or approximate) intrinsic value, on its own it is useless to an investor. It needs to be compared to price to make a decision whether the stock is undervalued enough to buy or overvalued enough to sell.

But since price is involved in the final decision, it makes no logical difference whether it is included at the end or included as part of the calculations right from the start. In fact, often more insight is gained by bringing price into the calculations right at the start.

Even more surprising is the fact any decisions using the ROE method implicitly hinge on opinions whether the P/E ratio is high or low.

Consider the earlier calculations for Costco. Suppose that you accept that the intrinsic value is \$67.07 and that you believe that a bargain price for Costco is a 40 percent discount or \$40.24. Since the earnings are growing by 8.76 percent per year, they must have been \$2.83 for the previous year. (In fact they were \$2.92.) This gives a P/E ratio of 14.2. In other words, all these assumptions and calculations regarding Costco are a roundabout way of coming to a conclusion that we could have arrived at right at the outset. In round numbers, Costco is a buying opportunity if earnings grow by at least 9 percent per year, dividends are around 27 percent of earnings, and the P/E ratio is less than 14.

So instead of having a method that we believe avoids such things as price, P/E ratios and dividend yields, in reality the use of formulas or tables has simply obscured their use.

## Discounted Cash Flow Methods

The same extreme variations apply to discounted cash flow methods. Small variations in the input variables give outputs that vary by many multiples. It is impossible to tell whether a company is undervalued or overvalued.

Another flaw of all these methods involving infinite sums is that it is impossible to verify the accuracy of the input variables. For example, if one person says that the company will grow by 10 percent in its final stage and another sys that it will grow by 11 percent, then it is impossible to determine who is more correct. Yet, the difference between 10 percent and 11 percent may give a value that differs by 50 to 100 percent.

## What to do?

Applying mathematics formulas to valuation methods can be fun, but not if it leads to overconfidence and misleading results. The problem is that hidden inside the calculations are absurd assumptions and impractical requirements. Unsuspectingly we have been led astray by mathematical intimidation. I have been through it all: Writing high level code for the hedging operations of international companies through to designing new foreign exchange option strategies.

But the more I see, the simpler I want any method I use. Warren Buffett, the record-breaking chairman and CEO of Berkshire Hathaway, wrote in 1997:

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.”

This seems like a good starting point: find companies with virtually certain significant growth in their earnings. Buffett explains the result of finding such companies:

“Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value.”

Finally he tells us this is what he does:

“Though it's seldom recognized, this is the exact approach that has produced gains for Berkshire shareholders.”

It’s hard to get anything clearer than this. To see how it works in practice, consider Expeditors International and FacstSet Research Systems. The table shows that over the past ten years, the earnings and price of Expeditors have both grown by approximately the same amount, around 16 percent per year. Similarly, the earnings and price of FactSet have also grown by approximately the same amount, approximately 19 percent per year. This reinforces Buffett’s injunction to seek out companies that will grow their earnings because that will drive the price.

 10 Years Ago Today Growth Ratio Growth Per Year ExpeditorsInternational EPS \$0.38 \$1.46 3.84 16.13% Price \$14.00 \$53 3.79 15.94% FactSetResearchSystems EPS \$0.64 \$3.27 5.11 19.87% Price \$19.00 \$96.10 5.06 19.73%

Of course, not all companies will work out as close as this. Consider Wal-Mart over the past ten years. Its earnings have grown by around 12 percent per year but the price is much the same as it was ten years ago. This is because the P/E ratio was around 40 but now it is approximately 14.

This means that we need to add one more requirement for earnings. It is important not to pay too much for them. If we can be confident about the future growth of earnings and we do not pay too much for these earnings, we are going to do well. If we can top this up with a healthy stream of dividends, all the better.

Confidence in the growth of earnings comes from a proper analysis of areas such as debt, the stability of earnings and sales growth, and the company’s economic moat. It also comes from knowing that management is honest, rational and acting in the best interests of shareholders. Knowing what constitutes a reasonable price to pay for the earnings comes from applying six strict rules. These ideas are explained in detail in Chapter 11 of The Conscious Investor.

Finally, no discussion of finding real value in the share market would be complete without talking about of margins of safety. Before making any investment decision we need to stress test or apply practical margins of safety to assumptions or forecasts we make in three areas: future business performance, market opinion and board dividend policy. Even better, as discussed in my book, is to do this in an automated way to remove any prejudicial biases. Putting these steps together is the best way that I know to achieve consistent success in the stock market.

Dr John Price has published over 60 papers in mathematics, theoretical physics and finance.

He has personally programmed, tested, and compared over 30 different stock valuation methods in his search for the best approaches. This led to the development of investment software called Conscious Investor®. It also led to his recent book The Conscious Investor: Profiting from the Timeless Value Approach (Wiley, 2011) in which he describes the assumptions along with the strengths and weaknesses of these methods.

 Currently 4.45/512345 Rating: 4.4/5 (49 votes) Voters:

Alex Morris - 6 years ago    Report SPAM
"Applying mathematics formulas to valuation methods can be fun, but not if it leads to overconfidence and misleading results. The problem is that hidden inside the calculations are absurd assumptions and impractical requirements. Unsuspectingly we have been led astray by mathematical intimidation."

Spot on Dr. Price. Thank you for a wonderful article that should be read by all investors.
WIBruin - 6 years ago    Report SPAM
The Buffett quote is actually from the 1996 letter.
AlbertaSunwapta - 6 years ago    Report SPAM
The best short discussion of intrinsic value I've ever read. Thank you.

Buffett may have "actually" written the comment in 1997. :-)

Valuenow - 6 years ago    Report SPAM

You are right, WIBruin. But since the 1996 letter was published in 1997 I assumed that it was written in 1997.
Hbains - 6 years ago
I agree with Buffet's quote, but it leaves one question unanswered - What is a "rationale price"? It is this question that the various mathematical models are trying to address (albiet with mixed results).
AlbertaSunwapta - 6 years ago    Report SPAM
In the title, I don't know if "myth" was an appropriate choice of words. Every company will have an intrinsic value, changing with everyday of its existence. Unfortunately, it's like estimating one's own 'intrinsic' lifespan or remaining life. Consequently, intrinsic value, just like your remaining life are not mythical values but very real. Moreover, every company's remaining life is just one variable in estimating current intrinsic value.

However, with corporations intrinsic value could further be affected by buyouts, mergers and numerous other events that have less mathematical underpinnings. For instance, a buyout could come at a price well below any otherwise reasonable estimate of intrinsic value thus setting a final real terminal intrinsic value below any 'intellligent' investors's margin of safety. Hence there is no rational price - a condition addressed through ownership of, as Buffett said; "a portfolio of companies."
Dunga - 6 years ago    Report SPAM
This article is a load of nonsense. What matters in terms of alpha generation (the true benchmark of a good investment) is how the future growth in earnings plays out relative to the expectations embedded in price at the time of purchase. If a stock was correctly priced in terms of its expected earnings growth then its price will still appreciate over time at the required rate of return for that investment, ie the stock was fairly priced at purchase or selling for its intrinsic value. If the earnings that unfold are ahead of the expectations in the price at the time of purchase then the realised return will be higher than the required return, ie the stock was purchased cheaply or for less than intrinsic value, which is a value investors objective. If the earnings path turns out to be lower (but still growing) than was built into the price at the time of purchase the stock might still appreciate but the realised return will be less than the required rate of return for holding that investment, ie. the stock was expensive when purchased. Earnings growth might deliver share price appreciation over time but it doesn't necessarily guarantee an adequate rate of return for the risk that is borne.
Dr. Paul Price - 6 years ago

This would have had a lot more impact if the author had actually finished his discussion of COST with a clear estimated 'fair value' for COST as a result of his calculations.

Without that it simply is an academic exercise.
Investor123 - 6 years ago    Report SPAM
I think it all boils down to what intrinsic value calculation methodology you use and accuracy of your forecast. However, even the best intrinsic value estimate does not guarantee that the stock will actually trade at that level. But, I do not see a better approach to stock investing.

By the way, there is a great site where you can calculate intrinsic value of most U.S. stocks using either the default or your own assumptions: Intrinsic Value of Common Stocks.

AlbertaSunwapta - 6 years ago    Report SPAM

"I think it all boils down to what intrinsic value calculation methodology you use and accuracy of your forecast. However, even the best intrinsic value estimate does not guarantee that the stock will actually trade at that level. But, I do not see a better approach to stock investing." - Investor123

That's pretty obvious and the whole point of Price's discussion is that none of the methodologies and thus the resulting forecasts is all that great. So should we chalk 'success from choice of methodology and accuracy of forecast' down to random luck?

I feel that most people don't think about intrinsic value and what exactly they are estimating and how. RIV, DDM, EV, sum of parts, comparable earnings, private/take-out valuation, etc. all create wildly differing results. Using a single discount rate over the course of a forecast also introduces deviation from what true intrinsic value would be. Choosing a satisfactory Margin of safety (not only in price but in risk to moat, etc.) is thus a critical determinant of adjusting for the inherent error in all the methodologies. The only guarantee available is that future events will, with great certainty, occur that upset any longer term forecast.

Moreover, I'd guess that Price's consideration of CANSLIM, etc. and the factors inherent in their methodologies likely serve to improve his odds that the shares will begin to trade towards intrinsic value sooner rather than later (i.e. react to a catalyst) and so not sit well below intrinsic value for an extended period of time.
Valuenow - 6 years ago    Report SPAM
Thanks for all the feedback. I have started to prepare a more detailed article which I will send to an academic journal. The main theme will be that discount methods for calculating intrinsic value are dogma. Using them requires believing statements that cannot be tested. For example, almost every website that publishes discount cash flow methods assumes that the cash flows grow by 3% out to infinity. But the accuracy of this statement cannot be tested.

I hear stories all the time of analysts asked to come up with a valuation of a private company. If it is not what the buyer (or seller) wants to hear, they are told to go away and redo their numbers. Just by tweaking a few of the inputs, they get the required result -- and the deal goes through.

I realize that most individual investors don't use DCF methods. But they are an integral part of the analysis process for the big end of town.
Taowave - 6 years ago    Report SPAM
Hi all,

New to the world of value investing,but have spent the last 20 years as the head trader of equity derivatives at 2 major investment banks on Wall street.In that time,I have traded and been exposed to every plain vanilla option as well as the most complicated exotics.

If one is competitive in the market place,it would be financial suicide to not employ an option "model".

And if one prefers not to go the way of the dinosuar,they best not fully believe thy are safe from "harm" because they have bought an option less than its fair value or sold one for more than its fair value.

Models,whether based on fundamentals or distributions of prices are only as good as the input.If we take a conservative approach and haircut the assumptions,in all probability we will have a positive expected return.

Financial models are compasses,not GPS/navigation systems.They merely point us in the right direction.

Billspetrino - 6 years ago    Report SPAM
Investing is 50% art and 50% science. Those without instinct like Jeremy Siegel and 90% of the population can not expect to know what a professional investor knows. Those of us who have done this for 20+ years and achieved financial independence clearly have an advanatge
Cm1750 - 6 years ago    Report SPAM

Investing is 50% art and 50% science. Those without instinct like Jeremy Siegel and 90% of the population can not expect to know what a professional investor knows. Those of us who have done this for 20+ years and achieved financial independence clearly have an advanatge

Buffett would entirely disagree with you - he would say it is all science using basic calculations and logic.

Furthermore, even with armies of analysts, 90%+ of portfolio managers can't beat the market over 10 years.

So where is this "advantage" you speak of?

Billspetrino - 6 years ago    Report SPAM
Buffett may not say he's using instinct,but he does not buy companies strictly by the numbers or he would have never bought COP .I can't explain why most investors can not average 15% annually like professionals can.I can just tell you that those of us who have beaten the averages ALL have this instinct
Grandpagates - 6 years ago    Report SPAM

This is one of the greatest articles I have seen written. Looking back, I have not done a DCF in 20 years, for reasons that I could not articulate until reading this article.

I would like to add some pertinent Buffett quotes from Snowball, page 231, out on books.google.com:

"The right company (with the right prospects, inherent industry conditions, management, etc." means "the price will take care of itself ... This is what causes the cash reigster to really sing. However, it is an infrequent occurrence, as insights usually are, and of course, no insight is required on the quantitative side - the figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on the qualitative decisions."

Somewhere else, if I recall right, Buffett said that it should not take that long to know if a company is good to buy ... it should be kind of obvious. The exact words escape me.

And Munger said words to the effect that when he could see what the profits are doing, they really go in big. This was in reference to Coke, and he said it just before buying BNI. Again, the exact words escape me.

Full disclosure - I am not that good at qualitatives :( My kind of investing is investing for idiots: I had lots of cash, when the dow dropped to 8000 Buffett said buy, so I did. I made money. No DCF needed. Almost impossible to screw it up.

Billspetrino - 6 years ago    Report SPAM
Last post was excellent

Like Buffett says you do not have to know someone's exact height to know they are TALL

Like I said the difference from those of us who do this for a living and the amateur is the INSTINCT part

I have constantly told my readers this and they are finally starting to get it

Great post grandpagates
Pachyderm - 6 years ago    Report SPAM

Stockdocx99 wrote ...

"This would have had a lot more impact if the author had actually finished his discussion of COST with a clear estimated 'fair value' for COST as a result of his calculations.

Without that it simply is an academic exercise."

Fair point - but if you if you were to use John's favoured expected return methods (and Valuesoft equations or Conscious Investor Software) you could go on to both predict the likely annual return over say a 5 year period you will get buying COST at its current price (with a margin of safety built in if you want); or alternatively after specifying the minimum annual % return you want to get over the next 5 years; you could then go on to estimate the maximum price you should pay for the share to get this minimum level of return (again building in a margin of safety if you want). The result for COST at the time of writing is that, with or without adding a margin of safety, the projected annual return over the next five years doesn't warrant buying this share at its current price. The current estimated maximum price you should pay for COST to get at least a 10% annual return over the next 5 years (using Price's approach) is also well below the current share price. Given the company's pretty consistent and reasonable ROE and pretty consistent (albeit small) increases in sales and EPS over the years we also can have more confidence in estimates of likely return at current price. Armed with these estimates one would not invest in this company at this time. These estimates are therefore practically useful and not just academic (provided the company's growth in EPS and sales are sufficiently consistent that one can reasonably attempt to predict the future).

As a scientist who enjoys working with data I like John's reasoned and what seems to me very practical and logical approach. As an amateur investing for my retirement, so far, fortunately it is working for me. Time will tell will tell whether this is a flash in the pan and due more to luck - but I hope it isn't! I enjoyed reading John's latest book Conscious Investor and would recommend it if you want to learn more about value investing approaches and John's approaches. To make up for getting zero financial education at school I have been reading many investing books over the last few years and John's new book is one of the best I have read.

His point about the danger of DCF methods (that one risks falling into the confirmatory bias trap and ending up using input parameters that give DCF results that match our current notions) is a good one.

Analyst estimates historically have been very innaccurate (and presumably many of these are based on DCF approaches). As a result it seems bonkers that markets so often trash the share price of good companies simply because they fail to meet analyst earnings estimates by a small margin (even when reporting record and big increases in earnings and sales). Still I suppose we should be happy about such market trader irrationality and over-reaction, because this helps create buying opportunities for the rest of us who subscribe to a longer term more Buffet style value investing approach.
Thomascapital - 6 years ago    Report SPAM
Okay, so you don't believe in estimating "a" intrinsic value, and you so eagerly expose the flaws in the commonly used valuation methods. Please explain (in light of what I've copy and pasted below) how you estimate a stock's purchase price.

From The Conscious Investor's website http://conscious-investor.com/:

"How does Conscious Investor Determine the Purchase Price? The interlinking sophisticated algorithms take the financial information from the 10 years of balance sheets and income statements, combines it with the market data for the same period and develops its trademarked answers so you can determine which is the right purchase price and which is the right sale price. Exactly how the program does it can best be described as taking an almost unmanageable amount of data, ratios etc. and quite simply translating all that into the very uncomplicated easy to use set of tools so you can decide which company to buy and at what price. In the end most investors just want to know what company to buy and when to buy and when to sell. Conscious Investor makes it easy!"

LwC - 6 years ago    Report SPAM
So let's see, we have such well known successful investors as Klarman, Buffett, Schloss, Brandes and Graham pointing out that the key to their success is their ability to estimate intrinsic value. Now we have that famous investor John Price…who? Well anyway, that not so well known investor Price stating that intrinsic value is a myth.

Hmmm…who should I believe?

@thomascapital: this is at least the second time that I know of that you have challenged Price to provide some explanation for his assertions about IV, and I suspect that you will not receive an adequate answer this time either; rather just more gobbledygook. His writing smells like spam to me - not a surprise since he now has a book to sell.

Trustamind - 6 years ago    Report SPAM
Very interesting topic and very nice discussion. As a late comer to value investor's world, I'm still learning what is value and how to play with it. I'd speak straight what's in my mind and please help me to polish up.

First of all, I think value comes in two parts: quality and price. You always want good quality and low price. The intrinsic value is merely a concept that helps an investor to quantify the quality. You are expected to pair it up with margin of safety to ensure a low price. If the business is simple, then probably any valuation method is good enough and they probably produce similar numbers. That's why we want to focus on simple business. If the situation is complicated, then probably none of the method would work. But that's OK, we can skip them and still make money on others. There are people that is good at complicated cases, no argument on that. The valuation method is quantitative, but to understand the business and choose a suitable valuation method is fully qualitative. And I think the qualitative part is more important. If one plays numbers only for the sake of numbers, usually it's garbage in, garbage out. That's not going to do any good to us.
Superguru - 6 years ago    Report SPAM
As Ajit Jain aptly put it - Price like beauty is in eye of beholder. (as I recollect from his interview during recent India trip)

So Intrinsic Value is a very personal number (range), for one value investor a stock at certain price may be very cheap and to other it may be very expensive at the same price. It is as much a function of the company as much it is a function of person calculating it.

So there is not much intrinsic about intrinsic value.

IV is best calculated as a range, with stated assumptions on which calculations is based, rather than a single number.

Batbeer2 - 6 years ago
The interlinking sophisticated algorithms take the financial information from the 10 years of balance sheets and income statements

Ehm..... that's not sophisticated, it's redundant. Earnings statements basically state the difference between consecutive balance sheets. With 10 years of balance sheets you won't find anything in the earnings statements that's not already known. The reverse isn't true.

http://searchcio-midmarket.techtarget.com/definition/Ockhams-razor

Occam says you use these algorithms "in vain".

Thomascapital - 6 years ago    Report SPAM
So now I wonder... Should I take the time to read his book with the eventual goal of posting a honest (and very brutal) review on amazon.com, or should I not bother wasting my time?

Between Price's comments and what I've seen of his website, I already have plenty of bones to pick... :)
Valuenow - 6 years ago    Report SPAM
Thanks for all the comments. One of the fascinating things for me about the stock market is the huge range of opinions about how to choose stocks. What is particularly fascinating is the commitment people have to their chosen methods. This understandable because, in many cases, much of their future financial wellbeing depends upon the success of whatever method they use.

At one extreme are traders who believe that stock prices have patterns and periodicities that can be used to forecast future price movements. At the other extreme are those that believe that the market is efficient. Knowledge of past price movements is irrelevant since all information is captured in the stock price. In my book I give some of the evidence for and against these hypotheses.

But the main part of the book is an analysis of about 30 different valuation methods. These include net current asset value, discounted cash flow (DCF), dividend discount, payback, magic formula, residual income, CANSLIM, q-theory, PEG and PEGY ratio, benchmark, option valuation, expected return and many others. As part of looking at these methods I discuss the ideas of Benjamin Graham, John Burr Williams, Warren Buffett, Robert Wiese, Joel Greenblatt, James Tobin, William O'Neill, Maynard Keynes, James Ohlson, Bruce Greenwald, Kenneth Lee, Robert Haugen and others.

Over the years I have programmed all the methods and tested them in many different situations. When I write about them in the book I try to be fair by listing their assumptions followed by a list of their strengths and weaknesses. For example, regarding discounted cash flow (DCF) methods I give 8 strengths and around the same number of weaknesses. The discussion takes about 7 pages. The strengths and weaknesses of dividend discount methods (DDM) amount to around the same number. (In the previous article the focus is on DDMs, but the problems are much the same with DCF methods.)

So in many ways the book is a compendium of a large range of valuation methods. It is up to the reader to choose the method, or combination of methods, that they believe will give them the most success.

As many will know, for me the most rational approach to choosing stocks is described in Chapter 11 “What rate of return can I expect?” and then expanded in Chapter 13 “Forecasting and the three most important words in investing.”. But just as for all the other methods, I talk about its strengths and weaknesses. In a nutshell, the idea is to estimate the eps (using growth) and p/e ratio in, say, 5 years. This gives an estimate of price in 5 years. Now estimate the growth of dividends over the same period. Assuming that the dividends are being reinvested, it is possible to figure the wealth being generated in 5 years by buying a single share.

Now you can estimate the average total shareholder (TSR) you would get over the 5 years assuming that you pay the current price. So instead of focussing on value in dollars and cents, I like to focus on expected TSR.

All this makes most sense in a practical setting when (1) instead of specific estimates, statistical confidence intervals are used, (2) companies are pre-screened for things such as not too much debt, good ROE, and strong and stable growth in earnings and sales, and (3) automatic margins of safety in company performance, market opinion, and board policy. Finally, since investing involves seeking a specified average TSR to compensate for the risks involved (in other words, what extra return do we want above the risk free rate for a particular company), it is possible to turn the calculations into a rational buying price. I call it the target price. But since the target price was constructed using TSR, a time factor is built into it.

Valuenow - 6 years ago    Report SPAM
Warren Buffett and DCF methods

I am only too aware that discounted cash flow (DCF) methods are taught in as the standard valuation method in MBA and finance courses around the world. Over the years I have had numerous discussions with people who teach these courses. In fact, it is this reason why I wrote my book and tried to lay out all the strengths and weaknesses of the DCF methods and all the other methods that I could get my hands on. However, it is not as clear that DCF methods are as widely used as may first appear. For example, here is what I say on page 194:

“Many writers and market commentators state that Warren Buffett uses DCF methods. However, there is consistent evidence that this is not the case. For example, Alice Schroeder, as the author of the biography The Snowball: Warren Buffett and the Business of Life, had unprecedented access to Buffett and his archives and papers. On November 6, 2008, at a “Value Investing Conference” at the Darden School of Business, University of Virginia, she said, “[Warren Buffett] doesn’t do any kind of discounted cash flow models or anything like that.” This is supported by Charlie Munger, Buffett’s friend and partner for many decades, who I heard say at the annual meeting of Berkshire Hathaway."

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