t o r o n t o i n v e s t . n d s n . c o m

TEST OF THE INTRINSIC VALUE THEOREM

The following is a preliminary report of my tests of Warren Buffett Intrinsic Value Theorm. The theory suggests that the true value of a company can be determined by treating a company with 'known' earnings as a bond.

The earnings would represent the 'coupons' of the business and are extrapolated into the future for 10 years. Each year's coupons would be discounted by the yield offered by the 30-year U.S. Treasury (because this is supposedly a long-term, risk-free rate) to determine it's present value. The present values are added together and represent the company's Earning Power over the next decade.

After the 10th year, I assumed a growth rate of 2% to infinity (The theory being that all businesses can't grow at 10-20% forever) and determined what a bond would be worth if it grew at 2% per year, forever. This value, put in present value, is called the Residual. Robert Hagstrom arbitrarily cuts the growth rate to 1/2 of it's 7-year average. This is too arbitrary for my liking. Due to my conservative nature, I relegated all companies to a 2% growth rate after 10 years.

The sum of Earning Power and Residual is supposedly the Intrinsic Value of the stock.

The only two requirements from the companies I selected was that they maintained an annual return on shareholder equity (ROE) of 15%+ for 7 years (as reference, the average ROE of American companies over the last few decades has been 12%) and they were trading at a Market Value below their determined Intrisnic Value.

A side benefit to a high return on equity is consistant and increasing earnings (all companies tested had 6-7 out of 7 years of increased earnings).

The Market Value of each company was monitored for the next 3 years to see if the Intrinsic Value was ever realized. All historical values were taken from the Value Line Investment Survey Jan-April 1998. All companies are real. Their names have been hidden to prevent theft of my ideas and research. I apologize for any inconvience.

Company 1
10-Year Avg. ROE: 18%
Intrinsic Value (1994): $41.63 per sh
Market Value (1994): $15 per sh.
Current Market Value (1998): $61 per sh.
# of years to reach Intrinsic Value: 2

Company 2
10-Year Avg. ROE: 43%
Intrinsic Value (1994): $30.73 per sh
Market Value (1994): $24 per sh.
Current Market Value (1998): $76 per sh.
# of years to reach Intrinsic Value: 1

Company 3
10-Year Avg. ROE: 25%
Intrinsic Value (1994): $44.70 per sh
Market Value (1994): $20 per sh.
Current Market Value (1998): $53.50 per sh.
# of years to reach Intrinsic Value: 3

Company 4
10-Year Avg. ROE: 20%
Intrinsic Value (1994): $45.60 per sh
Market Value (1994): $15.50 per sh.
Current Market Value (1998): $72 per sh.
# of years to reach Intrinsic Value: 2

Company 5
10-Year Avg. ROE: 17%
Intrinsic Value (1994): $48 per sh
Market Value (1994): $30 per sh.
Market Value (1998): $76 per sh.
# of years to reach Intrinsic Value: 3

Company 6
10-Year Avg. ROE: 17%
Intrinsic Value (1994): $34.60 per sh
Market Value (1994): $24 per sh.
Current Market Value (1998): $71 per sh.
# of years to reach Intrinsic Value: 1

Cheers,
Jim Chuong