Intrinsic value: the holy grail of value investing

If you think market valuations of companies are sometimes wrong then implicitly there must be correct values for those companies. If only you could work them out out you would truly be in the money. You would, in the vernacular of value investors, be buying dollars for 40c.

But the intrinsic value of a company now, depends on what it does in the future. If it goes on to make a lot of money, it’s worth a lot now. If its future lies in the hands of the administrator it’s not worth much. Since businesses are complex, like the economy, or the weather, it’s very hard to make accurate predictions about them.

Many of us use rough-and-ready proxies for value, like a multiple of earnings, or asset values, and compare the market’s valuation to them. Because these proxies have a loose relationship to intrinsic value we are, on average, buying companies at lower prices, without the bother of working out what exactly their intrinsic values are.

A recent note from SG’s Dylan Grice has got me thinking about the holy grail again though. It explains how he calculates intrinsic value, and when I’ve worked it out I’ll write a note about it on this blog. To start with, he’s sent me scurrying back to my copies of Security Analysis and The Intelligent Investor to find out what Benjamin Graham meant by intrinsic value, since just like Grice today, Graham compared it to the market price to decide whether a company was undervalued.

The first chapter of Graham’s 1940 edition of Security Analysis defines the concept of intrinsic value:
In general terms it is understood to be that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses.
But unlike the price targets we see calculated today, Graham stressed the indefinite nature of intrinsic value:
The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish either that the value is adequate—e.g., to protect a bond or to justify a stock purchase... For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight.
Or to mangle an aphorism, if it looks like a bargain, and smells like a bargain, it probably is a bargain.

At it’s simplest, intrinsic value analysis is like using the plain old PE ratio. Saying a company is cheap because it has a PE of, say, ten is the same as saying its cheap because it should be worth more than ten times its past earnings, a level at which it might pay an investor a reasonable return of 10% in a typical year (one tenth of your investment of ten times earnings). But that’s a generalisation. Some companies will be facing remorseless competition, some may succumb to their own debts, and others may be mismanaged into oblivion. Some will earn bigger profits in future.

Although, I think, very few investors decide which shares to buy based purely on the PE ratio, or price to book, some mechanical investors rely on a cocktail of two or more statistics to shield them against some of the risks and tilt their portfolios towards value. Other investors, like me, add a dollop of common sense to their algorithms in the expectation it will juice the returns.

I doubt a significant proportion of private investors actually calculate intrinsic value, and seek to pay less than a pre-ordained fraction of it (Graham favoured 2/3 after estimating intrinsic value very conservatively). It’s just too much work, there are countless very well resourced analysts doing it in the City, and as the complexity of forecasting future sales and profit margins builds up when you consider all the factors that could influence them, so do the uncertainties.

Even Graham had had enough by the end of his career, saying in 1976:
I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham and Dodd" was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.
Instead he favoured a semi-mechanical system using the venerable PE ratio as a proxy for value, and the ratio of equity to assets to guard against poorly financed companies.

But Grice’s Intrinsic Value to Price (IVP) method is a step back towards the kind of shorthand most of us use. Instead of basing his calculation on earnings forecasts, he extrapolates future dividends and increases in book value (which together are earnings) from the median Return on Equity over the last ten years.

I’m attracted by it because profitability, of which ROE is a measure, can, like value and financial strength, help us discriminate between winning shares and losing shares (Joel Greenblatt’s Magic Formula demonstrates it). A number of bloggers, myself, Yorkiem and UKVI, included, are experimenting with including ROE in our screens because we believe that in general high ROE is predictive of higher earnings in future.

In other words, we’re looking for a way to build earnings growth into our calculations, without having to make traditional forecasts.

As I said, when I can do a worked example, I’ll share it with you. To speed up the process, I’ve sent Grice’s note to some bloggers who may be able to help.

Comments

I believe the model Grice uses is called the Residual Income model. Basically you take the book value, add in the growth in equity, remove the dividends and multiply it by the cost of capital.

The goal of the model is to determine if a company is making an economic profit. Many companies earn nominal profits but don't cover their cost of capital, residual income tries to capture it. Where the model really excels is companies where the book value of the company is instrumental in generating income, such as an industrial business. This model wouldn't apply as well to something like a tech company where the assets are things like knowledge and people instead of equipment.

I can recommend a value investing book by Roger Montgomery, who incorporates the determination of intrinsic value as part of his value investing approach. His blog is also quite informative, although Australian focussed.

@ Nate, thanks for your comment. Yes, it's a refinement of Stephen Penman's Residual Income Model. I have Penman's textbook so I was thinking of learning that first and then seeing what Grice had to add. BTW I see from your blog, you've got shares in Titon - they're in my Thrifty 30 model portfolio too.

@ BenM Astonishing, I happened on Montgomery's site just today and he certainly has quite a following. He seems to publish the book himself, and it's not available on Amazon or anywhere as far as I can tell except by airmail from Australia. No reviews (except countless rave reviews on his site). How does he calculate IV?

Richard,

This post actually fits my feelings on Titon perfectly. I took a look at the company, read the reports and just knew it was a bargain, I didn't go through anything crazy to get an exact intrinsic value, I just know it's a lot more than what I paid.

Titon's interim results should be out soon, they had a press release recently which blamed the snow storms for a bad December, so I'm not holding up much hope for good results.

Hi Richard

Are you able to forward me a copy of Dylan's research report? I am interested in his original workings and have not been able to find a copy.

Regards

Bryan

"extrapolates future dividends and increases in book value (which together are earnings) from the median Return on Equity over the last ten years"

That sounds eye-wateringly similar to what I've just written about. Perhaps there's something to it after all...

@ John: It's proving a bit of a beast to replicate!
@ Bryan: yes, you should have it now :-)
@ Nate: we'll just have to wait and see, and then wait some more perhaps.

Yes, he sells the book direct (which perhaps sounds more amatuerish then it is).

He calculates IV by multiplying equity per share by a multipler based on ROE and a suitable discount rate. The maths is straight forward and he has provided tables which identify the appropriate multiple for different combinations of ROE and discount rates.

It sounds like shorthand for Grice's version of the Residual Income model. Very interesting. Thanks Ben.

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