There is generally a difference in the way people assess a company's future prospects. They also differ in their risk tolerance. Hence, unique intrinsic value should be easily assigned to a common stock upon which there is general agreement.
When computing intrinsic value, a company’s balance sheet should be studied. Some assets, such as cash and investments in marketable securities, are reported at market value. As a first approximation, the intrinsic value of such items can be taken to be the same as their market values. For most companies, however, the major component of intrinsic value comes from their future earnings.
To valuate future earnings, one can start by estimating a growth rate based on the valuation of the company's past performance. Then the estimated growth rate to current earnings can be applied to link expected earnings for a future year, say, 10 years from the current year. Finally, one can apply a P/E multiple to the future earnings per share to estimate the value of those earnings in the future and discount them to their present value. In addition, dividends should be properly accounted for.
Below are two examples of evaluating common stocks. One is Wesco (WSC, Financial) and the other is Coca-Cola (KO, Financial).
Wesco Financial Corporation is a subsidiary of Berkshire Hathaway (BRK.A, Financial)(BRK.B). Charlie Munger, chairman of Wesco, has estimated the intrinsic value of Wesco in selected prior years. Wesco has total assets of $3 billion, of which $298 million, roughly 10 percent, are in cash and cash equivalents. The marketable securities of $1.9 billion are primarily in different important companies. Thus, most of Wesco’s assets, amounting to $2.2 billion, are reported at market values and may be considered liquid assets.
Now it is necessary to subtract liabilities from these assets to the extent they are related to the assets. On the liabilities side, total reported liabilities are $673 million. There are only two meaningful items that are directly related to investments: The deferred income taxes payable of $231 million and the float of $215 million. The first amount is payable to the IRS only when the securities are sold. The true value of this liability has to be estimated. If one assumes that these securities will not be sold for a long time, the taxes will also not be paid for a long time. Then, most of this liability may be ignored for valuing Wesco.
The second liability is the term for money the company holds, and as long as insurance underwriting results are break-even, it costs the company nothing.
Wesco’s total net income for 2008 was $82 million. Out of this, $64 million came from investments, and the remaining $18 million came from operating businesses. Having already assigned a value to the investments, the remaining $18 million have to be considered. An examination of the earnings over the past few years suggests that these earnings are sustainable, as earnings have been similar in recent years. A simple approach to value these earnings can be used. A P/E multiple of 15 that results in a valuation of $270 million for the operating businesses is assigned. So, the estimate of intrinsic value of Wesco’s common stock is $2.08 billion + $270 million, or $2.35 billion. This translates into an estimated intrinsic value of $330 per share. In comparison, the market price at the end of 2008 was $288 per share.
Wesco’s intrinsic value depends a lot on the valuation of its investments.
For a more elaborate evaluation, computing intrinsic values of these holdings can be considered. The intrinsic value is an estimate — even more important; it is just one person’s estimate, which can vary widely across individuals. As the estimate was very close to market price, Wesco was not considered a good buy.
As regards Coca-Cola, it derives its value from its earnings.
At the end of 1998, Coca-Cola’s total assets of $19.14 billion were mostly represented by tangible assets. The company’s liquid assets in the form of cash and marketable securities were only $1.81 billion. Coca-Cola’s cash and marketable securities in 1998, at about 10 percent of revenues, were in line with historical levels.
In the 10 years before 1998, Coca-Cola’s revenues grew at the rate of 8.8 percent per year, and its earnings per share grew at 14.5 percent per year. However, in the immediately preceding five years, the growth in revenues had slowed to 6 percent, and earnings per share to 11.2 percent.
The company’s earnings for 1998 were $1.42 per share, which seemed sustainable because earnings per share for the prior three years were similar: $1.67, $1.40 and $1.18, respectively.
Under this assumption, in 10 years, expected earnings for 2008 would be $3.68 per share. Next, a reasonable P/E multiple for earnings per share for 2008 was estimated. For the purpose of this computation, a 15 P/E multiple that gives the expected value of earnings at the end of 2008 as 15 Ă— 3.68, or $55.20 per share was used.
The present value of $55.20 depends on the discount rate assumed.
The discounted value of $55.20 in 1998 at the discount rate of seven percent is $28.06 per share.
The cash dividend in 1998 was $0.60 per share. Assuming a 10 percent growth rate in dividends an investor would have received $0.66 in 1999, and so on.
Other changes and complications can be added to the examples. In the case of Coca-Cola, it is a stable company so it is easy to estimate future earnings.
Another advantage to computing intrinsic value is that it keeps anyone grounded so that he or she does not become nervous when the stock price goes down.
A question to be asked is: “How much lower should the price be relative to the intrinsic value?” Margin of safety is thought as the difference between a stock’s intrinsic value and its market price. If stock is purchased at its intrinsic value, there is no margin of safety. Stock should be bought with a large safety margin. An alternate way of thinking about looking for a large margin of safety is to require a large discount rate.
When computing intrinsic value, a company’s balance sheet should be studied. Some assets, such as cash and investments in marketable securities, are reported at market value. As a first approximation, the intrinsic value of such items can be taken to be the same as their market values. For most companies, however, the major component of intrinsic value comes from their future earnings.
To valuate future earnings, one can start by estimating a growth rate based on the valuation of the company's past performance. Then the estimated growth rate to current earnings can be applied to link expected earnings for a future year, say, 10 years from the current year. Finally, one can apply a P/E multiple to the future earnings per share to estimate the value of those earnings in the future and discount them to their present value. In addition, dividends should be properly accounted for.
Below are two examples of evaluating common stocks. One is Wesco (WSC, Financial) and the other is Coca-Cola (KO, Financial).
Wesco Financial Corporation is a subsidiary of Berkshire Hathaway (BRK.A, Financial)(BRK.B). Charlie Munger, chairman of Wesco, has estimated the intrinsic value of Wesco in selected prior years. Wesco has total assets of $3 billion, of which $298 million, roughly 10 percent, are in cash and cash equivalents. The marketable securities of $1.9 billion are primarily in different important companies. Thus, most of Wesco’s assets, amounting to $2.2 billion, are reported at market values and may be considered liquid assets.
Now it is necessary to subtract liabilities from these assets to the extent they are related to the assets. On the liabilities side, total reported liabilities are $673 million. There are only two meaningful items that are directly related to investments: The deferred income taxes payable of $231 million and the float of $215 million. The first amount is payable to the IRS only when the securities are sold. The true value of this liability has to be estimated. If one assumes that these securities will not be sold for a long time, the taxes will also not be paid for a long time. Then, most of this liability may be ignored for valuing Wesco.
The second liability is the term for money the company holds, and as long as insurance underwriting results are break-even, it costs the company nothing.
Wesco’s total net income for 2008 was $82 million. Out of this, $64 million came from investments, and the remaining $18 million came from operating businesses. Having already assigned a value to the investments, the remaining $18 million have to be considered. An examination of the earnings over the past few years suggests that these earnings are sustainable, as earnings have been similar in recent years. A simple approach to value these earnings can be used. A P/E multiple of 15 that results in a valuation of $270 million for the operating businesses is assigned. So, the estimate of intrinsic value of Wesco’s common stock is $2.08 billion + $270 million, or $2.35 billion. This translates into an estimated intrinsic value of $330 per share. In comparison, the market price at the end of 2008 was $288 per share.
Wesco’s intrinsic value depends a lot on the valuation of its investments.
For a more elaborate evaluation, computing intrinsic values of these holdings can be considered. The intrinsic value is an estimate — even more important; it is just one person’s estimate, which can vary widely across individuals. As the estimate was very close to market price, Wesco was not considered a good buy.
As regards Coca-Cola, it derives its value from its earnings.
At the end of 1998, Coca-Cola’s total assets of $19.14 billion were mostly represented by tangible assets. The company’s liquid assets in the form of cash and marketable securities were only $1.81 billion. Coca-Cola’s cash and marketable securities in 1998, at about 10 percent of revenues, were in line with historical levels.
In the 10 years before 1998, Coca-Cola’s revenues grew at the rate of 8.8 percent per year, and its earnings per share grew at 14.5 percent per year. However, in the immediately preceding five years, the growth in revenues had slowed to 6 percent, and earnings per share to 11.2 percent.
The company’s earnings for 1998 were $1.42 per share, which seemed sustainable because earnings per share for the prior three years were similar: $1.67, $1.40 and $1.18, respectively.
Under this assumption, in 10 years, expected earnings for 2008 would be $3.68 per share. Next, a reasonable P/E multiple for earnings per share for 2008 was estimated. For the purpose of this computation, a 15 P/E multiple that gives the expected value of earnings at the end of 2008 as 15 Ă— 3.68, or $55.20 per share was used.
The present value of $55.20 depends on the discount rate assumed.
The discounted value of $55.20 in 1998 at the discount rate of seven percent is $28.06 per share.
The cash dividend in 1998 was $0.60 per share. Assuming a 10 percent growth rate in dividends an investor would have received $0.66 in 1999, and so on.
Other changes and complications can be added to the examples. In the case of Coca-Cola, it is a stable company so it is easy to estimate future earnings.
Another advantage to computing intrinsic value is that it keeps anyone grounded so that he or she does not become nervous when the stock price goes down.
A question to be asked is: “How much lower should the price be relative to the intrinsic value?” Margin of safety is thought as the difference between a stock’s intrinsic value and its market price. If stock is purchased at its intrinsic value, there is no margin of safety. Stock should be bought with a large safety margin. An alternate way of thinking about looking for a large margin of safety is to require a large discount rate.