Understanding Intrinsic Value- Three Criteria

The term Intrinsic Value (IV) is thrown around alot in financial circles, particularly when we walk about stocks. Yet I wonder if you have a robust process to define and then manage your stock holdings over the long term? Today we will examine the concept of IV further and give you three criteria to help you build such a process.

What is Intrinsic Value?

Intrinsic Value (IV) is the key concept used by Value Investors when they decide when to buy a stock. We only buy a stock when the market price is at or preferably below IV. This gives us the classic ‘margin of safety’- a safety net that can ensure long term growth in the stock price. IV allows us to ‘buy cheap and sell dear.’

The concept of IV is best summarised by Ben Graham himself-

“Any business is worth the sum of free cash flow from now, to eternity discounted to present value using a reasonable risk-free interest rate”- Benjamin Graham.

I have highlighted three key terms.

1. Free Cash Flow

Free cash flow can be determined in a number of ways. A effective way is to determine Net Income (NI) and allow for Depreciation/ Amortisation and Capital Expenditure. This is classically called Owner Income (OI). From here we can then determine the annual growth rates of OI and average this out over time.

2. Future and Present Value

From the growth rates of OI above, we can project these to say 5 or 10 years in the future using conservative growth rates, allowing for relevant micro and macro factors. The future OI resulting is then discounted back to a present value using a certain percentage- the Discount Rate.

3. Discounted

We discount future value of OI so we can get a present value of OI. This allows us to consider it in today’s terms and to more realistically determine the value of the company. The determination of the Discount Rate (DR) is the key issue, and a number of factors are looked at here. For instance, sector differences such as increased volatility in the tech sector should not be overlooked.

In some models, the DR, or a comparison rate can be used as Graham originally intended. The comparison rate might be benchmarked, say against long term bond yields.

Conclusion

In our work we have developed a finely-tuned mathematical and qualitative process to calculate and manage Intrinsic Value for any stock over time. The classical approach of Graham is predicated on the power of past earnings as a reliable indicator of future earnings. This premise is one which most do not question, and it is clearly evidenced through some basic Technical Analysis. The premise and power of earnings has held water for many, many decades. If you are investing in stocks and do not do some basic analysis of earnings and price, then you are truly throwing darts. We trust this short article and the three factors we have identified can help you build your own robust process.

Lee Spano, Founder & CEO

Creatness International, www.creatness.com

© Copyright Lee Spano. All rights reserved.