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What Is Value?

A discussion on intrinsic value

November 11, 2016 | About:

In a recent article one of the best writers on GuruFocus, Geoff Gannon, wrote the following: "The value investor in me – the stuff I learned from the books I read in my teens – rebels against the idea of paying a high (price-earnings) P/E for anything. That’s a mistake. It’s better to pay 30 times earnings for a company like Luxottica (LUX) than 10 times earnings for a company like Weight Watchers (WTW)."

This caught my attention. In my previous article I discussed the difference between classic value investing and dynamic value investing. As I went back and thought about what I wrote, I realized that I omitted something that I should not have, which led to this article.

A few years ago when I first started my journey on value investing, I thought the same – one should rebel against the idea of paying a high P/E for anything. Today, I too, think it is a mistake. Because a high multiple, while on appearance may imply rich valuation, should not be categorically indicative of value at all. Value has little to do with P/E multiples and as value investors, our goal is to define value, not spotting valuation multiples.

Naturally this leads to the key question: What is the intrinsic value of a business? Here we all know that the theoretically correct answer is given by John Burr Williams and famously quoted by Warren Buffett (Trades, Portfolio):

"The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset."

In practice, we are faced with the conundrum that while we have the theoretically correct formula, we cannot determine precisely the future cash inflows and outflows. But this should not prevent us from applying the intrinsic value framework. We can modify Williams’ value definition so that it can have practical applications. My own version of intrinsic value is the following:

"The estimated intrinsic value of business today can be calculated by the thoroughly and rigorously analyzed best estimate of projected cash inflows and outflows – discounted at an appropriate opportunity cost – that can be expected to occur during the investment holding period."

From this definition, we can see there are three elements of value:

  • Projected future cash flow (including growth rate).
  • Opportunity cost-based discount rate, which should also include various other considerations such as the predictability of the business.
  • Holding period.

Now we can see the problem I have with the popular claim that stocks with a high P/E multiple are expensive so value investors should rebel against this notion of buying a high P/E stock – all three elements of intrinsic value are missing. What is the projected cash flow and what is the projected growth rate of cash flow? What is the appropriate discount rate for a specific company? What is your holding period?

Is a company that has 15% free cash flow margin growing 15% more expensive at a current static P/E of 30 than a company that has 2% free cash flow margin growing at 2% with a current static P/E of 10? It depends on how you view the world. If your holding period is one year, you would need to project the free cash flow at the end of the one year and assign a free cash flow multiple on the one-year terminal cash flow and discount it back for one year using your discount rate. If your holding period is 10 years, you would need to project the free cash flow at the end of the 10-year period and assign a free cash flow multiple on the 10-year terminal cash flow and discount it back for 10 years using your discount rate.

In my previous article, I wrote about two stocks as examples – Apogee Enterprise Inc. (NASDAQ:APOG) and Intuitive Surgical (NASDAQ:ISRG). Let’s go back to the beginning of 2006. Apogee was trading at an enterprise value-sales (EV/S) multiple of 0.8 times and Intuitive Surgical was trading at roughly 22 times. The investment result you get will be vastly different if you hold both for different time periods – one year, two years, three years, five years or 10 years. You will have different cash flow projections and you should use a different discount rate for Apogee versus Intuitive Surgical. The longer the time horizon, the more the outperformance Intuitive Surgical holds over Apogee and the shorter the time horizon, the less clear which stock is cheaper.

A very classic yet somewhat misleading argument for the cheapness of a stock is based on book value or liquidation value, whatever you want to call it. In this case, book value becomes the surrogate of intrinsic value and if a stock is trading below book value, it is perceived to be cheap. But is this so? Shouldn’t we answer the following questions before concluding?

  • Why in this case is book value a good measure of the intrinsic value of this company?
  • Is book value likely to grow or shrink from current levels? At what speed?
  • Why should the gap between book value and stock price close?
  • When will the gap between book value and stock price close?

I think many investors take it for granted that you are getting a great bargain if you buy a stock trading below book value. Maybe partly because this is statistically true and definitively quantifiable. But without answering the above questions, it is precarious at best and reckless at worst to draw any conclusions.

By the way, I am by no means proposing we should buy stocks trading at 30x P/E multiples. My purpose is to seek the answer to one of the most important questions in value investing – what is value?

Value has little to do with multiple, especially in the long term. In the short term, I would caution that we should all be aware of the peril of becoming a disguised value investor.

Let me end with a long, great and seemingly fitting Mungersim:

"Another thing I think should be avoided is extremely intense ideology because it cabbages up one’s mind.

"You’ve seen that. You see a lot of it on TV – you know, preachers for instance. You know they’ve all got different ideas about theology and a lot of them have minds that are made of cabbage.

"But that can happen with political ideology. And if you're young it’s easy to drift in to loyalties and when you announce that you’re a loyal member and you start shouting the orthodox ideology out what you’re doing is pounding it in, pounding it in and you’re gradually ruining your mind so you want to be very careful with this ideology. It’s a big danger.

"In my mind I got a little example I use whenever I think about ideology and it’s these Scandinavian canoeists who succeeded in taming all the rapids of Scandinavia and they thought they would tackle the whirlpools in the Aaron Rapids here in the U.S. The death rate was 100%.

"A big whirlpool is not something you want to go into and I think the same is true about a really deep ideology."

Disclosure: No positions.

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About the author:

A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

Rating: 4.6/5 (11 votes)



Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Excellent stuff Grahamites. I think after 15 years of investing, I'm happy calling myself a value investor and knowing my methodology might be heresy for some and mothers milk to others. I simply stick with what works for me and allows me to sleep well at night. If I can do this - and provide adequate returns - for my investors then I will continue to tap dance to work (as Warren would say) each morning. Great article. Best. - Tom

Grahamites premium member - 4 years ago

Thanks Tom. Great attitude and great approach. You deserve the great result that you have achieved at Nintai and you also deserve the trust of your investors. I am still on my way to becoming a genuine value investor and hopefully will follow your steps in the near future:)

Batbeer2 premium member - 4 years ago

>> I simply stick with what works for me and allows me to sleep well at night.

FWIW I believe that's is at least 50% of succesful investing. If you can't do that (and many can't) you are very unlikely to achieve success trading stocks.

DanaBoy - 4 years ago    Report SPAM

PE...SHMEE/E...it's a horrible metric to value anything! It's for ACCOUNTANTS not INVESTORS!

Use the enterprise value divided by trailing 12 months free cash flow multiple.

Enterprise value includes cash and debt on the balance sheet. A stock's share price doesn't.

Reported GAAP earnings can be manipulated and milked. Free cash flow much less so, as the cash is either there or it isn't.

Happy investing!

Graemew - 4 years ago    Report SPAM

If you look back at some of those stocks which have done outstandingly well over the long term. We could name Coca Cola, Mc Donalds, Amazon, Microsoft, and many others, it would not have mattered the least what PE ratio you bought at, if you bought 15 to 20 years ago and held to today. It seems to me that the key is sustainability of growth over the long term, ie sustainable competitive advantage. The ability to assess that is key to long term investing success. Knowledge of how to calculate exotic ratios won't help you over a long time frame.

But on a shorter time frame, we now find ourselves in an environment where everything is just so expensive. What does one do? One wants to be active and not just sit on a pile of cash doing nothing. So a dangerous tendency develops to find a way of justifying the purchase of companies at very high multiples of earnings. When I look back at what I thought was fair valuation around 2011, well there is nothing good to buy at those multiples today. My value system has changed..and to be honest this concerns me. I feel it is right to be in cash, but that has been a very poor choice for a very long time since 2008. And I now also worry about inflation, and don't want to sit on a depreciating currency. This is quite a difficult time for value investors in my opinion.

Grahamites premium member - 4 years ago

Batbeer - True that!

C59661 - Believe me, accountants couldn't care less about P/E ratio. But the point is it doesn't matter which valuation metrics you use, it all boils down to the present value of free cash flow right?

Graemew: I agree assessing sustainable long term competitive advantage is key and that's not an easy game and I agree knowing how to calculating a valuation metric is almost meaningless in the long term.

There are always reasons to not to buy stocks in the short term and by short term, I don't mean 1 year. I actually think even 3-5 years also qualify for short term. So yes, the market doesn't look cheap. However, 1) there are still individual stocks that don't look expensive (for instance, American Express, Wells Fargo, AmerisourceBergen etc) relative to what the fundamentals will be in the future. 2) The harder game is,the shorter the timeframe. Also true is the less edge you have the shorter the timeframe. So you have to be comfortable with this fact and design a game plan acccordingly 3) if you worry about inflation, buy companies with hard assets or can pass along inflation and trading at reasonable multiples. 4) You can also invest oversees where stock markets aren't as expensive and inflation is not as likely. 5) Remember the market goes down 10% 15% 20% every couple of years. There were so many bargains earlier this year and in August last year when the market was down ( Berkshire, Colfax, etc) quite a bit. That's a great time to deploy some cash. And the market will go down 10%,20% or 25% in the future, you don't know when but it's good to have some cash ready. So don't beat yourself up for holding some cash.

DanaBoy - 4 years ago    Report SPAM

TGrahamites - Accountants surely care about the P/E ratio, because the "E" in the ratio -- as you already know -- refers to accrual based reported EARNINGS. And, as Buffet has said, the accountant's job is to report the financial numbers, NOT to analyze them.

Further more, reported earnings have nothing to do with cash-based accountig -- i.e., operating cash flow, free cash flow, etc. -- ehich is why the cash flow statement is INFINITELY more important to the investor than the accrual-based income statement.

Happy investing!

Grahamites premium member - 4 years ago

c59661 - Each financial statement serves its own purposes so to categorically place more importance on one over another may be inappropriate in my opinion. Sometimes cash flow statement can be misleading too and I wouldn't say reported earnings have nothing to do with cash based accounting - there are temporary and permanent differences and especially in the short term, but over the longer term, these temporary differences reverse so you should see reported earnings tracking cash earnings over a long period of time. Accrued based accounting or GAAP based earnings is a starting point, no doubt about that. Real earnings power is what matters in the end and it doesn't matter whether you use cash or accrued accounting.

When Mr. Buffett and Mr. Munger talk about accountants, I believe they are referring to the external financial auditors, not the corporate accountants. Corporate accountants in public companies sure care about the stock price and P/E ratio as their vested share based comps are totally dependent on them. But to external auditors, stock prices and P/E ratio matter very little. Hope this clarifies.

Thanks for commenting.

Rrurban - 3 years ago    Report SPAM

Central banks are forcing the investing herd into assets. I do not buy what the herd is buying, and truth be told, the best purchase is to buy from those forced to sell out of fear and/or leverage blowing up. There's lots of leverage, we're just lacking fear at the moment. Tides will turn and my comfort level will be hit when desperation is rampant. Still waiting in cash!!

Batbeer2 premium member - 3 years ago
C59661 said: "...as Buffet has said, the accountant's job is to report the financial numbers, NOT to analyze them."

Charlie Munger (Trades, Portfolio) said: "Just because Buffett said someting, does not make it so. "

Ugnksi - 3 years ago    Report SPAM

Sir, please explain why would u fabricate "opportunity cost" by picking different discount rates for each company. If you mentioning Buffett here and how he quotes John Burr i cant believe u missed such important factor from Warrentt that he applies same discount rate no matter what he is trying to value because based on his theory high reward shouldnt really equal in high risk. Also in your second point of definition of value "business predictability" should be applied to first point with "bussines growth" because thats what you trying to predict growth and not discout rate.

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