What is intrinsic value?
Here’s the definition people toss around: “It is the discounted value of the cash that can be taken out of a business during its remaining life.”
So here’s the next question: how many readers have sat down and actually ran that calculation? And if you have, did you walk away feeling confident in your numbers?
My bet is zero on the first question – and even if I’m wrong, then a resounding “no” to the second one (if you’re being honest with yourself).
At most, I would bet a few people have done the following: they estimated cash flows for the next three to five years, then came up with some estimate for terminal value using the Gordon Growth Model or a market / industry multiple. I’ll use a simple example of the second approach:
Let’s assume a company will earn $100 each of the next five years, with a 100% payout ratio; at that point, the company is sold for 18X earnings – a terminal value of $1900 (a year five outflow of $1800 plus our $100 dividend). At a 10% discount rate, “intrinsic value” is just shy of $1500.
Stop to think about what that means in the simplest terms: the investor who pays ~$1500 today expects to receive $100 each of the next four years, and then $1900 in the fifth year. Rather than thinking in discount rates, I think it’s more intuitive to think of this as a forward rate of return: I must put up $1500 today to receive $2300 five years from now – an annual return of ~10% (well not exactly: the math assumes reinvestment of the cash flows as they are received at the IRR, which changes things a bit; let’s skip that discussion for now and stick to the point at hand).
I think this is a critical point to grasp: discount rates can be viewed as nothing more than required rates of return. When we start thinking about opportunity costs, this is a more intuitive way of grasping the concept: the return on risk free alternatives creates a benchmark for us to build our return requirements; the assumption of risk must come with a more than commensurate increase in expected return (assuming you’re risk averse, as most individuals are).
This quote from Seth Klarman (Trades, Portfolio)’s Margin of Safety captures this point succinctly:
“A discount rate is, in effect, the rate of interest that would make an investor indifferent between present and future dollars... The appropriate discount rate for a particular investment depends not only on an investor's preference for present over future consumption but also on his or her own risk profile, on the perceived risk of the investment under consideration, and on the returns available from alternative investments.”
For me, that eliminates the need for academic answers (like CAPM) and creates a rough, but workable, concept: if I think a stalwart like Berkshire Hathaway (BRK.B) is priced for 10-12% annualized returns for many years into the future, how much more should I require to dip into something like Weight Watchers (WTW)? Academia would tell you the answer lies in the historic movement of their stock prices as compared to the index; I think that’s nonsense.
Keynes knew what he was talking about: It is better to be roughly right than precisely wrong.
That same idea works for setting the alternative - in my example, Berkshire Hathaway; is 10-12% the right number? While this fluctuates as interest rates move, I’m of the opinion that these levels are in the right ballpark; like a circle of competence, the most important thing is a good feel for where the edges lie. At 5% per annum, no thanks; at 20% per annum, back up the truck.
The lack of specificity is a huge no-no for some. My personal opinion is that this is a microcosm of valuation as a whole: I’m willing to trade off the false sense of confidence that comes with certainty (like when someone states intrinsic value is $47.18 per share) for a mental model that is intuitive – and more importantly, cognizant of its shortcomings.
So that helps us with half of the puzzle – now how about those pesky cash flows? What can we take out of the business? Some people, in search of precision, model results for the coming five years (then gloss over the fact that the majority of their value estimate lies beyond year five); if you think you can do that successfully, best of luck. This task is difficult not only in its inherent uncertainty, but also due to the impact of behavioral biases: once you take a glance at the stock price, you can toy with the numbers to say pretty much anything you want – look no further than our analyst friends on Wall Street, who adjust their models and price targets to derive fair value estimates that are, amazingly, almost always within spitting distance of the current stock price.
Clearly, I’m a bit skeptical of those who claim the ability to predict whether operating margins will increase or decrease by twenty-five basis points a few years down the road; if we’re not going to take that approach, what other options do we have?
Again, Keynes words shouldn’t be forgotten: It is better to be roughly right than precisely wrong.
Rather than focusing on the numbers for any given year, let’s think about the broader concept: what drives intrinsic value? Some math will help us find the answer.
Let’s start with a simple case: a company with book value of $100 per share and a 20% return on equity that pays out 100% of earnings every year. Without any reinvestment, we’re looking at a perpetuity with $20 paid to investors a year; with a requirement for 10% per annum in returns, that means “intrinsic value” is equal to $200 per share – or 2X book. If we adjust our ROE to 30%, we can pay 3X book and still meet our return requirement (10% per annum, assuming perpetuity). The first point is a relatively simple one: a higher ROE business is worth a higher multiple of book value.
The second concept is a bit trickier: as we start moving away from dividends and towards reinvestment, intrinsic value can jump off the charts. Let’s assume a thirty year window for reinvesting 50% of the corporation’s earnings, at which point it matches the prior example (100% payout): the ability to reinvest over those 30 years back into the core business at a 20% return on equity brings intrinsic value from 2X book in the base case to nearly 5X book; that’s a going-in multiple of 10X earnings versus 25X earnings.
So clearly we’re concerned with two things: the attractiveness of the underlying business (in this case, as captured by ROE), as well as the ability to find attractive reinvestment opportunities (retention ratio); as a long term investor, I believe those two factors are of critical importance.
Now, we get into a more difficult conversation: how do we assess the future opportunities to reinvest – and depending on our assessments, how does that impact intrinsic value?
While I plan on doing that, it’s not going to happen today – this article has taken long enough to write on its own! As always, I hope others will share their opinions – particularly if they think I’ve made an error.
