Intrinsic Value – An Inexact Science

As we have discussed, a value investor has a deep-rooted belief that irrationality of market participants can and does lead to unusual, and sometimes extreme, variations in the price of a stock in either direction. Such divergence from true “intrinsic value” creates valuable opportunities for the value investor – the caveat being: what, exactly is intrinsic value? To take one definition, as stated by no less an investor than Warren Buffett, intrinsic value is “the discounted value of the cash that can be taken out of a business during its remaining life.”

It’s important for the value investor not to attempt to calculate an exact value; rather it is far better to calculate a range for intrinsic value, from consideration of past fundamental data such as cash flow, earnings and future projected growth rates. The calculated intrinsic value may be wildly different from the company’s market price. For some industries and companies, calculation of a reliable intrinsic value will be well nigh impossible – in particular early stage firms, and firms in rapidly changing industries with rampant speculation and uncertainty. It would be as well to give these a miss altogether.

Fortunately for us, Ben Graham provided a simple and effective formula for calculating intrinsic value which he outlines in Chapter 11 of The Intelligent Investor (a chapter which provides an excellent thesis on valuation), under the heading “Capitalization Rates for Growth Stocks. It’s this formula that we use in our intrinsic value stock screen.

Graham stated “the ideal form of common-stock analysis leads to a valuation of the issue which can be compared with the current price to determine whether or not the security is an attractive purchase. This valuation, in turn, would ordinarily be found by estimating the average earnings over a period of years in the future and then multiplying that estimate by an appropriate capitalization factor.” Graham was also careful to list the factors which affect the capitalization rate of a company – general long-term prospects, management, financial strength/capital structure, dividend record, and current dividend rate.

The aforementioned intrinsic value formula was intended by Graham “to produce figures fairly close to those resulting from the more refined mathematical calculations” or “approximated the results of the more elaborate calculations in vogue” and is stated as:

Value = Current (Normal) Earnings x (8.5 plus twice the expected annual growth rate)

With the growth figure being that expected over the next seven to ten years.

This entry is part of a series, Value Investing In Practice»