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t o r o n t o i n v e s t . n d s n . c o m |
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INTRINSIC VALUE |
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t o r o n t o i n v e s t . n d s n . c o m |
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INTRINSIC VALUE |
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Since the release of The Warren Buffett Way many investors have learned to use the Intrinsic Value Test. Armed with this hammer, every stock looked like a nail. There has been no discussion about the conditions where the test applies (or doesn't apply) or it's validity in determining a company's 'true' value. This lemming like devotion to a concept (a.k.a. the Institutional Imperative) is well documented by Mr. Hagstrom in his book. |
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The Intrinsic Value Test determines the intrinsic value of a stock based on its earnings (earnings adjusted for depreciation and capital expenses, but earnings nonetheless). In general, the test compares a company to a bond with annual 'coupons' (earnings) and discounts the sum of these 'coupons' by a discount rate to determine its present value. It is crucial that the 'coupons' of the company are predictable or the test is not valid. A company with 7 years of consistently increasing earnings is predictable. A company with 7 years of consistently decreasing earnings is predictable. A company with 7 years of constant earnings (neither increasing nor decreasing) is predictable. As many users of this formula know, the discount rate that is used is 9% or the 30-year U.S. Treasury Bond, whichever is higher. This rate was chosen almost arbitrarily by Mr. Buffett and warrants further investigation. "At too many companies, the boss shoots the arrow of managerial performance and then hastily paints the bullseye around the spot where it lands." Mr. Hagstrom mentions that during times when rates are low, it is customary to use a discount rate of 9-10%. Why this rate is used is unknown. The book mentions that the 30-year Treasury is a risk-free rate, but goes no further than that. What makes a 9-10% discount rate more 'risk-free' than a 6% U.S. Treasury is not explained - it is simply taken on faith. It is obvious from the math that 5-6% will give a higher intrinsic value than 9-10%, but that really doesn't mean anything. To determine whether or not 9-10% is valid, we would need to run a test on historical financial data. If nothing else, it will provide us with an idea of how often a 9-10% discount rate results in the accurate prediction of intrinsic value. The test would have the following assumptions:
A successful test would result in the intrinsic value being reached by the company after the 7th year. The test would involve at least 15 different companies with 'predictable' earnings: 5 with increasing earnings, 5 with decreasing earnings and 5 with stagnant, constant earnings. Seeing an 80%+ correct score should provide the investor with a certain level of confidence in the method. It is probably a good bet that Mr. Buffett has done this test for himself either through experience or brute-force number crunching. "We subscribe to the philosophy of Ogilvy & Mather’s founding genius, David Ogilvy: 'If each of us hires people who are smaller than we are, we shall become a company of dwarfs. But, if each of us hires people who are bigger than we are, we shall become a company of giants.' " OTHER NOTES Investors, who have done the Intrinsic Value calculation, know that there is a kicker to this method in the last step. After the 10th year, Mr. Hagstrom assumes the growth rate of the company to be half of the value used in years 1-10 and determines the value of earning that rate forever. Thus, there are two sums that are totaled at the end of the Intrinsic Value Test. The first, is the Sum of (present value) Owner Earnings from years 1 to 10 and the second (and most crucial) is the (present value) Residual. Oftentimes, with companies that have 7-10 years of increasing earnings, the Residual adds up to 90% of the company's supposed intrinsic value! Needless to say, this is a huge portion of the intrinsic value and makes it plainly clear that the calculation is appropriate only if you buy and hold a stock forever! What if you decide to liquidate after 10 years? The first part (Sum of Owner Earnings from years 1 to 10) would be fine, however, the Residual amount would be totally meaningless because it doesn't apply! "...regardless of price, we have no interest at all in selling any good businesses that Berkshire owns..." Investors that doubt their ability to hold a stock forever should base their intrinsic value calculations on a 10-year holding period. In order to do this, the intrinsic value method should be modified to consider the Sum of (present value) Owner Earnings from years 1 to 10 and the Liquidation Value of the Company at year 10. What would the company be worth if you sell it at year 10? Well, you could determine the company's worth by it's liquidation value (assets minus liabilities), it's value as a going concern (cash-like assets - long-term debt + 'X' years of earnings power) or 0 (you've sold it, therefore it has no value). Again, your result will be heavily influenced by the method you choose. To determine what a company is worth as a going concern you need to add up it's future earnings power and it's tangible/intangible assets. It's earnings power is evaluated by continuing the Intrinsic Value Test from year 10 to year 25 at half the company's earnings growth rate and summing up the coupons. Then add up all year-10 cash, cash equivalents, land values and subtract any long term debt. Add the two values together and discount the total back to the present. Obviously it will be difficult to predict the amount of cash, cash equivalents and long-term debt at year 10. It's something Buffett's Intrinsic Value Test doesn't need to consider because it is designed to evaluate the worth of holding a stock forever. What is probably appropriate for most investors is to conduct the 10-year Intrinsic Value Test for a holding period of 10 years, re-evaluate the company at the end of 5 years, and if the fundamentals are still there, re-calculate using the 'hold forever' test. However, if you're not going to hold forever, be prepared to start making more estimates because Coca Cola isn't going to be intrinsically worth $180 per share for everybody. Cheers, Test of Warren Buffett's Intrinsic Value Theorem |
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