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The Real Definition of Intrinsic Value

September 18, 2013 | About:
The Science of Hitting

The Science of Hitting

234 followers
I may be naïve in saying this, but the world of investing baffles me; actually, let me rephrase that – the way that the vast majority of people approach the world of investing baffles me.

One prominent example, and the focus of this article, is intrinsic value. Value investors are intimately familiar with intrinsic value, much like a group of worshipers reciting the Lord’s Prayer. I’ll use the definition from “The Little Book of Valuation”:

“In intrinsic valuation, the value of an asset is estimated based upon its cash flows, growth potential and risk. In its most common form, we use the discounted cash flow approach to estimate intrinsic value, and the present value of the expected cash flows on the asset, discounted back at a rate that reflects the riskiness of these cash flows.”

Those “expected cash flows” discussed cover everything from here to eternity. Considering that the average 24-month analyst forecast error rate in the U.S. and Europe is north of 90% (per a study in James Montier’s “Value Investing”), that leaves a lot of guess-work for any investor looking to employ this approach.

While that may leave things looking quite grim, there’s some solace for the long-term investor: You choose when and if you’d like to play. You can stand at the plate for as long as you’d like, and the umpire won’t bat an eye. With some patience (and the natural vicissitudes of markets), we should eventually wander upon opportunities that are all but a sure thing; in the words of Warren Buffett, “If someone weighed somewhere between 300-350 pounds, I wouldn’t need precision — I would know they were fat.”

But let’s step back for a minute and think about our less patient brethren: How do they approach valuation, or approach the question of future cash flows? I made my opinion on this pretty clear in my recent article, “The Luxury of Thinking Like an Owner” – I don’t think they do. Most of these people (based on the reports I read) are concerned at most with the next few years of earnings, if even that far out. They’ll arbitrarily slap a multiple on their preferred measure of earnings (often just high enough to be at a slight premium to the current market price), and thus conclude that they’ve reached an estimate of “fair value.”

This spits in the face of the definition presented above. If we were going to try and estimate the expected future cash flows of a business, even at the most basic and inexact level, I would point to a few important measures: (1) the expected return of capital to shareholders in the form of dividends and share repurchases, (2) the extent of reinvestment in the business (Capex, M&A, etc.) as well as the source of those funds, and (3) the expected return to be attained on reinvested funds.

I want to make a point clear that I cannot stress enough: The purpose is not exactness. In fact, I would consider any attempt to do so to be an act in futility (again, think of our analyst error rate on a two-year basis). The point of this exercise isn’t to get to a specific number; it is to derive a wide range of values that can be expected to contain intrinsic value under a variety of assumptions (while thinking deeply about the likelihood of those assumptions) – and to then purchase the equity at a material discount to that range of values.

Point number one from above is generally well vocalized by management. Many companies will either have an explicit payout target, or will show some pattern over a period of years. Naturally, the second point is directly related to the first (that which is not paid out is, by definition, retained; if all that is generated is returned, then we must be financing reinvestment some other way).

The third point is where life starts to get interesting. Amazingly, this third step, which is most critical when thinking about future cash flows, is where most of the financial community throws in the towel. Why is this third piece so important? Let’s revisit a recent example:

"I’ve mentioned this quote from Charlie Munger (BRK.B) in the past, and undoubtedly will share it again in the future:

'Over the long term, it's hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with one hell of a result.’

Let’s use Charlie’s figures, and assume two companies will end our 20-year forecast period trading at 15x earnings (and reinvest 100% of earnings every year); if we paid 25x on day one for the business with an 18% ROA – meaning the earnings multiple will contract by 40% over time – what multiple of current earnings would you need to pay for the 6% ROA business to end up with an identical return in 2033?

Think about it for a minute and write down your answer; the correct one might surprise you.

Here’s the math: Our first business earned $0.18 on $1 of assets; we’re paying 25x the $0.18 in earnings, or $4.50 per share. Over 20 years, the impact of compounding takes hold in a big way:

300759498.jpg

In the 20th year, the business earns $4.18 – or 18% – on $23.21 per share in assets. At an earnings multiple of 15x, the stock would be trading at $62.70 per share; in the 20-year period, our shares went from $4.50 to $62.70 – a 20-year CAGR of 14%, and a cumulative return of 1290%.

Now let’s run the numbers for the 6% ROA business:

1648038903.jpg

Our second business earned $0.06 on one dollar in assets; the return on the $0.06 being reinvested back into the business in the second period was also a paltry 6%, adding roughly a third of a penny to the bottom line. We can see that compounding in this example was much less meaningful than it was in the first situation; earnings took 13 years to double, nearly two and a half times as long as in the first example. Assuming that the market would pay a similar 15x for this business in the 20th year, we still need a lot of help to match the 14% annualized return in our first scenario; at 15x the $0.18 per share earned in 2033, the market will pay $2.70 for this business. On day one, you would have needed to pay $0.20 per share – or about 3.5x earnings – to match the returns generated by the first business, which you paid 25x earnings for.

This concept evades market participants who are focused solely on the days and week ahead; they're simply incentivized to avoid (or face the risk of) any recommendations that accept short-term weakness for long-term benefit (as Tom Russo likes to call it, 'the capacity to suffer').

I’ve never read an analyst report that discussed this potent combination of solid fundamentals and time; it doesn’t mesh well with a mind that’s ingrained in a game of guessing quarterly margins. As this example clearly shows, long term investors should focus on finding the truly outstanding businesses, and then watch them closely; there’s serious money to be made by holding on with a great business year after year after year.”

This conclusion should suggest something that I’ve started to consider more seriously as of late: the truly great businesses, the ones that can consistently generate outsized rates of return on their asset and equity, are worth a considerable premium to poor businesses; that relationship may not hold in any given quarter or year, but it becomes increasingly so as one’s time frame is extended.

Analysts have a time frame of (at most) one year, as disclosed in their reports; one can only hope that their compensation is reinforcing their short term focus, driving prices lower and lower on great businesses that are facing temporary headwinds (and creating more opportunity for us).

I look at this set of circumstances and come to a conclusion that I’ve voiced time and time again: Truly long-term investors (in practice, not just by name) are a small group; considering the constant barrage of noise, it can be difficult to remember what truly matters (not surprisingly, the vast majority of people who hold such short-term views – namely talking heads in the media – don’t make money from investing/trading; they make money by keeping viewers tuned in).

At times, waiting patiently can be disheartening, or even boring (three-quarters of the way through 2013, I’ve yet to place a single buy or sell order). But eventually, the tide will turn.

When it does, I think investors should focus on buying great businesses rather than searching frantically for the lowest multiple on current earnings; if we consider the definition of intrinsic value as presented above, this is where the hidden gems are likely to be found.

About the author:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 4.6/5 (32 votes)

Comments

skyaboveyou
Skyaboveyou - 11 months ago
Nice article... I've been wondering for some time about this and getting inclined to look for the quality but hadn't done the math. And the motive I hadn't done the math is that I believe it's a bit harder math than you present here. In fact you haven't taken into account the dividends (and immediate tax paid), the reinvestment ability on the higher earning business and the earnings sustainability (and as such the leverage ability which might result in a ROE way higher with little risk)

If you take that 6% earner but it pays a sustainable 10% dividend yield the returns will be quite different since you can use the earning paid out at a return above those 6% (by purchasing shares of the same company for example)... but then you'd have to discount for the immediate tax paid...

And the opposite goes for the 14% earner. If they insisted on paying a dividend you'd have to discount that since you might not be able to get a return that will coumpond at that pace

ps: why did you use a ROA instead of a ROIC or a ROE? The liabilities that you're able to get for each dollar invested make a big difference in the end result. If you earn 2% on assets but you're a bank leveraging 10x invested capital (which isn't that much) you'll get a 20% annual result

ps2: I understand the you decided to simplify and that's why I liked your article and the fact that you made us do the math and realize that a company at 25x earnings might yield the same as one at 3,5x earnings...

ps3: I know it's asking a bit too much but is there anyplace I can read about how to value the leverage ability, the discount I should give for taxes paid, the impact of dividends and such?.. I feel that if I try to do it myself I might end up reaching to the wrong conclusions and having no way to check

ps4: the motive I'm so interested in this is that I do have 35% of my portfolio on a reasonably safe 9% pre tax ROIC earner (so after tax very similar to yours 6%) but it does pay a 10% dividend yield and I sometimes wonder if I wouldn't be better off selling (tax on dividends is quite high over here)

thank you

John Huber
John Huber premium member - 11 months ago
Great post... and an example of Munger's method of inverting common and accepted practices.

The only thing I'll add is that there are some really rare skill sets that are required to truly be able to successfully identify businesses that can continue to produce 18% returns for the next 20 years. This is of course why moats are important. But I've noticed a lot of value investors achieving mediocre returns by buying high ROC businesses because if you pay 25x a high ROC business and the ROC goes from 18 to 12, then your returns deteriorate significantly.

Of course, this is why Buffett and Munger are so good. Just an anecdote for fun... I once did a quick comparison of Munger's partnership (high ROC investor) vs Schloss' partnership (cheap vs assets investor, and often low ROC businesses) and was surprised to see that Munger's outperformed Schloss (about 19% annualized to 14% annualized) during the period he operated from 1962-75. This was despite a 65% peak to valley decrease in Munger's equity during the 1973-74 period.

Not sure you can draw conclusions from one sample, but it was interesting nonetheless, especially since Schloss had such an incredible record. (He did go on to record an 8 year run after 1975 where he averaged over 30% annually though).

But your work does illustrate the power of buying and owning a great business that continues to produce above average returns on capital over many years. Thanks for posting...

aagold
Aagold premium member - 11 months ago
Science,

That Munger quote is famous, and it's certainly relevant, but I think it's also dangerous. In fact, for the vast majority of investors, it's extremely dangerous. The reason is, if you take it to its logical extreme, it implies that an investor need not worry about what price he pays for a stock. No price is too high for a high ROE company, right? In fact, according to that quote, investors don't need to worry about the whole concept of Intrinsic Value. Why bother? You should basically just buy stocks of companies that generate a high ROE, and then sit on your butt and wait. That quote basically advises people to be growth investors rather than value investors.

- aagold

Eric Sprague
Eric Sprague - 11 months ago
Nice article, Science.
The Science of Hitting
The Science of Hitting premium member - 10 months ago
Skyaboveyou,

Certainly the math starts to get a bit more difficult (or time consuming I should say) as you begin to make a deeper dive; I'd be more concerned with the fact that you can overdose on the models / math. The point of the exercise (as I see it) is to think deeply about what makes a company great, what affects its pricing power, what does management see as an appropriate use of FCF, and so on.

Find the situations where the expectations seem out of whack by a wide margin, and work endlessly to confirm that you're thesis is in fact appropriate; my own buying and selling this year (or lack there of) speaks for itself - I believe in being very patient, and doing nothing if the opportunities aren't there.

PS - I did it for the sake of simplicity, and am building up to an article that addresses ROA / ROE / ROIC; the article was already somewhat long, and the conversation gets messy when you bring in ROE.

PS 2 - That was the main point; keep that front of mind and the minutia secondary.

PS 3 - I'm not entirely sure what you're asking; for something like dividends paid, it would simply be a current cash flow rather than reinvestment. Personally, I would look at the company's long term track record (last 10 years, at least) and think about what it would mean if that trend continued; I'd spend a lot of time thinking about the competitive dynamics and opportunity set looking forward, and wonder what could cause future rates of return on reinvested capital to diminish. This exercise would have a decent amount of math, but not an overload; if we require a wider margin of safety, many of those concerns start to fade away (because they're marginal). We're looking for 300-350 pound fat people, not 200-250.

PS 4 - I wouldn't be too worried about the tax consequences on a position that accounted for more than 1/3 of my portfolio; I'd be more concerned with it's safety and future prospects.

Thanks for the comment!

The Science of Hitting
The Science of Hitting premium member - 10 months ago
John,

Very true; as Munger has noted in the past, "none of this is easy - and anybody who thinks it is easy is stupid". I certainly don't think it's easy; but you've got to know where you should be looking before you can even get into the hard stuff! :)

Interesting study on Schloss and Munger; thanks for the comment!

The Science of Hitting
The Science of Hitting premium member - 10 months ago
Aagold,

If you had perfect insight into what would happen in the coming decades, then you could theoretically pay a very high price (on a multiple of current earnings) and still attain satisfactory returns. You can tell by my actions so far this year (or lack their of) that I don't subscribe to the "pay anything" approach.

"You should basically just buy stocks of companies that generate a high ROE, and then sit on your butt and wait."

Yep, I agree entirely. As well know, markets have a tendency to jump from one extreme to another; with a bit of patience, I bet even the best businesses will sell at a multiple of 15X or less on trailing three year FCF (or some other metric of normalized earnings power). We saw that here not too long ago...

Thanks for the comment!
The Science of Hitting
The Science of Hitting premium member - 10 months ago
Eric,

Thanks for the kind words!
ansgarjohn
Ansgarjohn - 10 months ago
There's more than 1 way to get to Rome.

If you don't have to pay capital gains taxes, you can pick up stocks at bottom and sell them if and when they go up a bit. And it might actually be very easy. As Ben Graham said in his last interview:

" (I recommend) buying groups of stocks at less than their current or intrinsic value as indicated by one or more simple criteria. The criterion I prefer is seven times the reported earnings for the past 12 months. You can use others--such as a current dividend return above seven per cent or book value more than 120 percent of price, etc. We are just finishing a performance study of these approaches over the past half-century--1925-1975. They consistently show results of 15 per cent or better per annum, or twice the record of the DJIA for this long period. I have every confidence in the threefold merit of this general method based on (a) sound logic, (b) simplicity of application, and (c) an excellent supporting record. At bottom it is a technique by which true investors can exploit the recurrent excessive optimism and excessive apprehension of the speculative public. "

Over long periods of time up to and including 2013 (Graham) screens seem to being doing just fine.

Kind regards from Amsterdam.
The Science of Hitting
The Science of Hitting premium member - 10 months ago
Ansgarjohn,

Very true - more than one way to get things done; I'm simply discussing the methods that I've found most useful in my experience.

Thanks for the comment!
jtdaniel
Jtdaniel premium member - 10 months ago
Hi Science,

Thank you for another great article, and especially the last two paragraphs. I really enjoy your thoughtful writing. You are so right about the importance of patience and waiting for the right opportunity. This year I felt confident in picking up some IBM at $182 and Heineken at $32.60, but otherwise it has been a drought. I have consoled myself through this miserable bull market by raising cash to 14% in my taxable account and 68% in my 401(K). Just waiting and watching, you know.

The Science of Hitting
The Science of Hitting premium member - 10 months ago
Jtdaniel,

Thanks for the kind words! I've got a teens cash position in my taxable account as well.

Waiting and watching is all right indeed :)
batbeer2
Batbeer2 premium member - 10 months ago
Hi SoH,

Thanks for an article worth reading.

Some thoughts....

Within the same industry, the company with the superior ability to generate incremental returns on retained earnings, will gradually kill the competition. That is what moats are about. Sustainable competitive advantges.

This means the company with the lower ROA is not only going to generate inferior returns over the long run, it is actually more risky. In your example, the lower ROA busness, assuming it competes with the other one, will wither and die..... given time.

In other words, time is the enemy of the mediocre business. If you find a business with 15% returns on retained earnings, watch out if it competes directly with a company that generates 25%. You may be looking at a cyclical industry at it peak.

I have sometimes invested in businesses with single digit returns if I found they were competing with with some others that were doing significantly worse.... a situation like that can sometimes be found at the bottom of the cycle in a cyclical industry.
Pavelg
Pavelg - 10 months ago


Thank you Science.

Very interesting article.
The Science of Hitting
The Science of Hitting premium member - 10 months ago
Batbeer2,

Good comment as always - thanks!

Pavelg,

You're welcome; thanks for the kind words!

Please leave your comment:


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