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John Emerson
John Emerson
Articles (106) 

Bruce Greenwald Investment Series – Introduction to Intrinsic Value Theory

November 08, 2011 | About:

"If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume." — Benjamin Graham

Value investing has been described as the practice of buying a dollar bill for fifty cents. In reality, the role of the value investor is to assess the intrinsic or underlying value of a stock while comparing that value to the current trading price of the equity. If a gap exists which is sufficient to provide the investor with a adequate margin of safety against a miscalculation, then the investor has likely spotted an outstanding bargain. Of course the period of time which it takes for the market to recognize the pricing discrepancy is nearly as important as uncovering the mispricing; however, I will leave that discussion for another day.

Value investors attempt to record gains over the long term by implementing a three-part procedure:

1) Identifying stocks trading well under their intrinsic value with an adequate margin of safety

2) Purchasing the stocks

3) Holding the stocks until they reach their intrinsic value

The process appears deceptively simple; however, countless investors can testify to the extreme difficulty of successfully executing this seemingly elementary procedure.

The key concept in the aforementioned procedure is the ability of the investor to establish the intrinsic value of an equity. While no investor can expect to be 100 percent accurate in ascertaining the underlying value of a stock, the ability of the investor to establish a value which roughly corresponds with reality is instrumental.

After an investor establishes the approximate intrinsic value of a stock, he/she must then apply a sufficient adjustment which value investor's refer to as a margin of safety. If the equity still appears significantly undervalued, after a sufficient margin of safety has been applied, it is likely that the investor has uncovered a value proposition.

On the other hand, a value proposition may not exist if the investor materially over estimates the underlying value of the equity. In other words, the investor should never rely so heavily on their own subjective value analysis that a significant miscalculation could result in substantial future losses. Instead, the value investor should seek out equities so attractive that even a sizable error in the calculation of the intrinsic value of an equity is unlikely to result in material investment losses down the road.

Of course all this conjecture is meaningless if one does not possess the ability or theoretical framework to roughly calculate the intrinsic value of an equity. The subject of today's article is a discussion of Bruce Greenwald's framework which provides investors with a primary guide to establishing the intrinsic value of a business.

Greenwald's Three Elements of Intrinsic Value

Bruce Greenwald discussed the theoretical framework for establishing the intrinsic value of a stock in his 2001 investment classic "Value Investing: From Graham to Buffett and Beyond." The three components consist of the value of the assets of a company (liquidation or replacement value), the earnings power value (EPV = franchise value), and the value of growth (organic growth in companies with a competitive advantage).

Greenwald contends that the sum of these three components determines the true underlying value of a business. Of course determining the summation of the three elements is extremely difficult and highly subject to error if the investor is not privy to the industry costs as well as the micro economic and macro economic trends for the industry.

Additionally, to determine the EPV of a business and its potential growth with any degree of veracity, the investor must possess extreme insight in regard to the business model of a company as well as successfully ascertaining the duration of its competitive advantage. If the company's moat is penetrated then its franchise value is quickly destroyed and all future growth is rendered worthless. Such are the hidden dangers of projecting durable competitive advantage and the future growth of a business.

Still it is clear that many businesses are worth much more than the sum of their tangible assets; a value which Warren Buffett describes as economic goodwill. For an in-depth discussion of economic goodwill and the hidden value of intangible assets, read my past article.

As Greenwald suggests, an investor must include the "franchise value" and the possibility of future growth if one hopes to come within a "country mile" of estimating the intrinsic value of an investment. Certainly if one assumes that all businesses are merely worth the sum of their tangible assets or the replacement cost of their assets, then one will probably never invest in a truly outstanding business.

Only in extremely rare cases do outstanding businesses drop in value to the point that their market price is less or equivalent to the sum of their tangible assets. Such was the case with Wells Fargo (NYSE:WFC) during the credit crisis of late 2008 and early 2009. During March of 2009, Wells Fargo briefly dropped to less than $10 per share, prompting the following quote from Buffett: "If I had to put all of my net worth into one stock, that would be the stock."

At it lowest point WFC was trading well below the value of its tangible assets. In other words, the market was assigning the stock with a negative EPV. The market had been spooked by the credit crisis and had become unduly pessimistic about the future earnings power of the bank as well as its ongoing liquidity.

It took little time for Buffett's position to become vindicated; although market pundits were extremely skeptical about his comments at the time they were released. In reality, Buffett had spotted a rare opportunity to buy an outstanding business franchise at a price which was significantly lower than the sum of its tangible assets. Such opportunities rarely present themselves during typical markets, as a rule they only become temporarily available during periods of extreme market turmoil.

Analysis of the value of growth presents the most difficult challenge for value investors. The key element which Greenwald notes before factoring the intrinsic value of future growth into his three-part equation is discerning whether the business holds a legitimate and ongoing competitive advantage over its competitors. Without a competitive advantage, growth holds no value and frequently the cost of capital which is required to finance the growth results in negative returns.

Why should a business endeavor to increase it profits by 8% if it costs 10% to finance the growth? Such is frequently the case when a business operates in an area which offers few barriers to entry and holds little in the way of a competitive advantage over its rivals.

In upcoming articles I intend to write in depth about the three elements of intrinsic value as well as writing a post mortem for my own business. The business represented a perfect example of the eventual fate of a business which offered little in the way of barriers to entry and temporarily flourished due to an unusual set of micro and macro economic factors which belied its trailing earnings power. I closed down the business after 16 years this spring. I intend to discuss the intrinsic value of the business using Greenwald's framework.


1) The practice of value investing involves identifying stocks which are trading well below their intrinsic value then holding the equities until they approach their fair value.

2) A margin of safety must always be applied to any analysis of intrinsic value to offset the likelihood of miscalculation.

3) Bruce Greenwald has provided a three-component approach for estimating the intrinsic value of a stock. The components consist of asset value, earning power value (EPV) and the value of growth.

4) Quality businesses are generally worth considerably more than the sum of their tangible assets.

5) Quality businesses rarely trade at or below the sum of their tangible assets. However, during times of economic turmoil an investor can sometimes purchase such an equity at an extreme discount to its intrinsic value.

6) The concept of valuing growth only applies to organic growth and only exists in businesses which contain a legitimate competitive advantage.

Disclosure: no position in WFC

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 3.9/5 (20 votes)


Dealraker - 5 years ago    Report SPAM


Can you give us your expert analysis of the railroad business and repeat how stupid Warren Buffet was to have bought BNI?


Actually, I'll pass on your expertise.

Managing real money is far different than theory or flowy- sellable instructional presentation.

Augustabound - 5 years ago    Report SPAM
dealraker. Those were my thoughts when Bruce Greenwald was "commenting" on Berkshire's BNI purchase. He should have been more constructive with his criticism and less of the school yard name calling..........like any good academic. :)

I'm sorry to hear about your business John. Sixteen years is a long time.
JeanPierreSarti - 5 years ago    Report SPAM
There is so little written about Schloss relative to other persons I would greatly be interested in what you think his philosophy actually is.

thank you.
John Emerson
John Emerson - 5 years ago    Report SPAM
Thank you A,

The business provided me with a wealth of friends and good customers as well as teaching me plenty about business theory and accounting. It also provided us with the lion's share of our money to invest in the market. Now I have the time to write and maybe I can help a few others become better investors by using my business experience as well as financial theory.
John Emerson
John Emerson - 5 years ago    Report SPAM

Hi Jean,

I believe the first time I heard of Walter Schloss was when I first read Greenwald's book many years ago on a jet to Vegas. I wrote an article in the Spring about Schloss which you might find helpful. http://www.gurufocus.com/news/128615/the-investing-philosophy-of-walter-schloss

As you may be aware by reading my columns, I believe that the average investor is much better served by evaluating assets as opposed to evaluating earnings. As Schloss puts it; assets change much slower than earnings. My next article will focus on asset valuation.
Frogghi - 5 years ago    Report SPAM
Is it correct, as stated in the article, that Greenwald measures intrinsic value as the SUM of asset value & earnings power, not one OR the other?

It would seem that I'd buy a business either to sell off the assets (and receive asset value) or keep the assets so that they could produce earnings (and receive earnings value). But I can't do both so I don't understand why intrinsic value would be the sum of both.
Dealraker - 5 years ago    Report SPAM

I can handle Greenwald fine as long as he makes no assumption that he personally could manage money successfully.
John Emerson
John Emerson - 5 years ago    Report SPAM

I believe the value of a business should be compared to the value of a bond. The principle for the bond is consumate to the assets of the business and the interest on the bond is the equivalent of the earnings yield that the business produces.

Therefore, if one buys a business which produces a steady earnings yield for say ten years; the purchaser can still sell the business and reclaim one's original investment. In other words, the true value of the business is the sum of its assets plus its earnings yield, just as the value of a bond is the sum of its principle plus its interest payments.

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