I’ve been asked many times, “What do you think the intrinsic value is for this company?” Two years ago my answer would be “the intrinsic value of this company is $50, if you assume x% of free cash flow growth in the next few years and y% terminal free cash flow growth and y% discount rate.” If you ask me this question today, I would say, “First of all, that depends on my opportunity cost, which is reflected in the discount rate I use and secondly, over what period of time?”
This evolution comes from learnings from my personal experiences, and conversations with some of the best value investors such as Tom Russo (Trades, Portfolio), Donald Yacktman, David Rolfe, etc. In the first few years of my value investing journey, I was a firm believer of the conventional wisdom, which says whatever method you use, be it DCF, liquidation value or the Multiple approach, one should calculate the range of intrinsic value of the security and apply a margin of safety when buying the security. If the intrinsic value of the company according to your calculation is $100 per share, you pay $70.
Today I firmly believe there are a few things missing in the conventional wisdom.
First of all, while in theory, intrinsic value is the present value of future cash flows a business can generate discounted at a proper discount rate; in practice, investors use many proxies of intrinsic value which are not necessarily apple to apple. Second, intrinsic value is probabilistic and dynamic, not static and a single-outcome.
To illustrate the above points, let’s say you have calculated the intrinsic values of the following three companies:
Company A –Â Intrinsic value $3 billion based on current liquidation value
Company B – Intrinsic value of between $2.8 billion to $3.2 billion based on DCF with a probability weighted value of $3 billion
Company C – Intrinsic value of between $2 billion and $10 billion based on Terminal Multiple approach with a highly uncertain probability-weighted value of also $3 billion
Mr. Market assigns the following values to each company:
Company A –Â $1.5 billion.
Company B –Â $2.5 billion.
Company C –Â $2 billion.
Which company should you buy? Company A gives you the widest margin of safety based on discount to liquidation value based intrinsic value. Company C has the highest potential. Company B is more predictable, but the discount pales next to the other two. You are not sure which one to buy so you put 33% in each.
Let’s say one year later, you performed the intrinsic value calculation again and now you are both befuddled and inspired:
Company A –Â Intrinsic value shrunk to $2 billion based on current liquidation value.
Company B – Intrinsic value of between $3.2 billion to $3.7 billion based on DCF with a probability weighted value of $3.45 billion
Company C – Intrinsic value now between $0 and $15 billion based on Terminal Multiple approach with a highly uncertain probability-weighted value of $3 billion
If there’s no valuation change, which is out of management’s control, Mr. Market would assign the following values to the companies one year later:
Company A –Â $1 billion
Company B –Â $2.875 billion
Company C – $0 billion  to $15 billion.
Your one year scorecard will look like this:
Company A – (-33%)
Company B – +15%
Company C – (-100%)- 650%
While you thought you were getting the widest margin of safety on Company A, the deterioration of the fundamental makes the liquidation value-based intrinsic value, and hence the margin of safety, smaller as each day passes whereas with Company B, the margin of safety becomes larger every day as time passes due to the improvement of the business fundamental. With Company C, you may lose 100% of your money or you make a multi-bagger. But you simply can’t say with confidence that the margin of safety exists when the distribution of outcome is so wide and unpredictable. How you define intrinsic value in each case, and the future pathway of the intrinsic value of each company matter enormously but they were not properly captured by the mathematical calculation.
Another thing that’s missing from the conventional definition of the intrinsic value is that there’s no absolute intrinsic value of a company. What you think the company is worth and how much you want to pay for it should mostly depend on your opportunity cost, not someone else’s opportunity cost. And to determine your opportunity cost is no easy task – multiple times harder than running a DCF. And every day your opportunity cost changes as the market price of your securities change. The intrinsic value of Coca-Cola (KO, Financial) should be absolutely different for Berkshire Hathaway (BRK.B, Financial) than it is for you and me unless our opportunity cost and holding period is the same as Warren Buffett. I’d argue that for me, my discount rate is higher than Buffett's at this point because the size of Berkshire Hathaway makes his universe very limited. Therefore, Wells Fargo (WFC, Financial) and American Express (AXP, Financial) worth less to me than they are to Berkshire.
Furthermore, opportunity cost varies enormously in different part of the world. What Markel (MKL, Financial) is worth to me should be different from what Markel is worth to, say, someone in Japan, India or Europe. As interest rates and inflation rates change, the intrinsic value of Markel changes as well. I may use 15% discount rate today but if both interest rate and inflation rate are much higher in 5 years, I will certainly use a much higher discount rate and my calculation of Markel’s intrinsic value will certainly be much lower.
My thinking is still evolving on this topic. There’s so much more about opportunity cost, intrinsic value and margin of safety that simply cannot be learned any other way than experiences. My hope is that over time, my understanding and judgment will get better.
Let me end with one of my favorite quotes:
“Not everything that counts can be counted, and not everything that can be counted counts.”
