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clarkmel (< 20)

What Is Intrinsic Value? Low Price?

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February 05, 2010 – Comments (18)

“Price is what you pay; value is what you get.”

Benjamin Graham

As with most things, the momentary price of a stock is easy to determine. Today, delayed stock quotes are available from many on-line services and real time quotes can be had through most on-line brokerage houses including mine, USAA Investment Management Company.  

As with most things, the value, or “intrinsic value”, of what you are about to buy is much harder to discern. John Templeton, one of history’s greatest investors seems to have equated value with low price. Or rather, he was certain that a basket of low priced stocks purchased during periods of market pessimism would perform well; with the good performers dominating the poor performers. He bet his life on this strategy at the beginning of his career as illustrated by the following quote from the web site http://www.sirjohntempleton.org/.

“While standard stock-buying advice is “buy low, sell high,” Templeton took the strategy to an extreme, picking nations, industries, and companies hitting rock-bottom, what he called “points of maximum pessimism.” When war began in Europe in 1939, he borrowed money to buy 100 shares each in 104 companies selling at one dollar per share or less, including 34 companies that were in bankruptcy. Only four turned out to be worthless, and he turned large profits on the others after holding each for an average of four years.”  

At least in this case, John Templeton didn’t try to determine the intrinsic value of the 104 companies in his 1939 portfolio. He assumed that most of them were worth more than the price he paid. If 52 of the companies failed and the other 52 doubled he would have broken even.

In hindsight, his risk seems small and apparently it seemed so to him at the time. However, because he borrowed the money used to buy the 104 companies, at lot depends on the terms and conditions of his loan and the speed in which his portfolio would grow. We don’t know the terms of his loan, but obviously the deal seemed favorable.  

Recently, this was a viable strategy again. Last spring one could have bought a basket of seriously depressed financial companies for under $10 per share. Those who pulled the trigger have done very well to date. I wasn’t one of them. And, despite the current much higher prices of financials, I have no desire to own any. My perception of their value is much lower than their current price.

The question is why do I think that? What does intrinsic value mean to me? I’m going to think this through over the next few posts.  

I think more clearly when I write. And there is nothing like a posting deadline to force me to write.

http://moneyinvestingbudgeting.blogspot.com/ 

18 Comments – Post Your Own

#1) On February 05, 2010 at 11:19 PM, truthisntstupid (80.81) wrote:

People can screw around with "intrinsic value"  calculations all they want.  They can do their computations, try to figure out exactly what the liquidation value of all a company's assets is, after taking into account that there may be equipment or buildings on the books with decades of depreciation on the books, leaving a book value far understating the market value, etc. 

What happens to all this value sometimes when a company goes under?  Does the "value"  according to what can be arrived at by GAAP accrual accounting principles, ever get realized; do the debits and credits balance out in the end?  After all the debtholders are paid, how often are the shareholders left holding the bag, and why?  

From  "Free Cash Flow:  Seeing Through The Accounting Fog Machine To Uncover Great Stocks"  by George Christy

Many investors think all the accruals and cash flows "even out in the end."  A viable company has no  "end,"  Every company is continually booking new accruals and modifying existing accruals and reserves. 

What if a company goes out of business?  Will accruals and cash finally coincide?  No, because in liquidation the accrual mirage is finally revealed for what it is not.  The accruals and shareholders'  equity balance are flushed down the drain.  All that is left is whatever cash can be generated by the sale of assets.  But before the owners get a dollar of the sales' proceeds, taxes and creditors must be paid.  The company's owners know one thing for sure:  The amount of cash they end up with will not equal the shareholders' equity number on the balance sheet.  The owners learn that in the end, only cash counts.

So much for the "intrinsic value"  mirage.   I figure that I'm left to decide what a share is worth to me.   As a dividend investor, this is how I look at it. 

1)  Is the company solid, does it have a competitive advantage that I can see?  Is it being eaten up by debt and poor capital allocation?  Does it have ample free cash flow?  Good return on equity?

2)  Does it pay a dividend?  This may not be important to you.  If it doesn't pay a dividend, though, I myself will pass.

3)  What is the dividend growth rate for the last 5 years?  The last three?  How many consecutive years has it raised its dividend? 

An example:  A lot of people like Exxon.  Actually, I agree with them; it's just not a good dividend investment in my subjective evaluation.  It's not for me.  With a debt/equity ratio of 9%, it doesn't have much debt.  Nobody can deny it's a strong company financially.  But it's worth much, much more to many other people than it is to me.  It has raised its dividend for, I think, something like 40+ years.  Why don't I like it? 

It has a current dividend yield of 2.5%  and a dividend growth rate of about 8.5%. 

Using the rule of 72 tells me this dividend will about double every 8.5 years, then double again in another 8.5 years, if it maintains the same rate of dividend growth.  So if it maintains the same rate of dividend growth, I can expect shares I buy today to finally reach a yield on original cost of 10%  after I've held them for 17 long years.   Hey, I'm too old for that.  I could be dead by than.

So exxon would have to drop way lower for me to buy it.

If you do the same kind of figuring with CVX, starting with a current dividend of 3.7% and a dividedn growth rate of 10%,  a person might get a yield on cost of about 14% in about 14 years on shares bought today.

Intrinsic value?  I don't have a clue.  Knock yourself out.  I don't care, as long as I believe in the long-term viability of the company and I don't actually ever plan on selling it unless things start going downhill or it slows its dividend growth rate to a crawl.  This is my retirement income, with steady raises every year.  It isn't for sale, unless things change for the worst.

 

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#2) On February 08, 2010 at 10:05 PM, clarkmel (< 20) wrote:

I, too, am a dividend investor and I really appreciate your insights. I agree with you on XOM. I like CVX but the major oil in my portfolio is BP.

Thanks for the comment.

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#3) On July 26, 2010 at 2:02 PM, djshagggyd (72.54) wrote:

Clarkmel and Truth-

Both of you have made some very good insights and comments here... thanks for writing!

And Truth, thanks for pointing me towards this blog... it makes a whole lot of sense in regards to my post on AVTR. I really learned a lot, thank you!

~justin 

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#4) On August 02, 2010 at 7:33 PM, djshagggyd (72.54) wrote:

Truth and/or Clarkmel-

I just re-read this post and the commentary again... and I'm curious...

Do either of you feel as though calculating NCAVPS is still a useful tool for determining actual value? 

I'm curious because I know that you both admire and respect Graham.

Yet Truth, it sounds like you're saying calculations like NCAVPS  are not useful in today's market. 

Am I understanding you correctly?

I know that the section on NCAV in the Intelligent Investor was only a small portion of the book. But I found it particularly interesting. 

Thanks!

~justin 

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#5) On August 02, 2010 at 10:04 PM, truthisntstupid (80.81) wrote:

Justin-

While I think I could drag out a stack of books and in a few hours come up with an example or two in which investors'  'intrinsic value'  safety net didn't save them - my quick answer is as a dividend investor, there are just too many good, solid companies with strong competitive advantages and a lot less risk.

Intrinsic value calculations which may include NCAVPS might have radically changed between 2007 and now if they included real estate that turned out not to be as 'undervalued'  as people previously thought. 

And no matter how many books I read - and I'm a lifelong bookworm - who am I - a restaurant cook - to presume that I can actually correctly value a huge corporation.  Do that many people really believe they can?  Really?

That is why I'm skeptical.  Buffet can.  I'm no Buffet. Neither are most investors.  Maybe it's people like us that wind up "left holding the bag"  when a company goes under.  We can't read a few books and know what a lifetime in business and investing has taught people like Buffet and the people that wrote the books.  Perhaps we'll think we know enough but miss something that would be 'common sense'  to them - but not to us.  Perhaps such an activity as valuing a large business may involve a larger speculative component for most of us. 

A solid company with a strong competitive advantage that I can believe in, and a growing dividend that is covered very well by earnings/free cash flow (sometimes free cash flow is more important for evaluating dividend safety) makes me feel a lot more secure.

I think the more secure I feel, the more I've minimized the speculative component.  I want no part of trying to make money or even trying to break even on a company that's in a downhill spiral. What if I'm wrong?

And in many years of reading about investing, I've often read that in liquidation, shareholders often get unpleasantly surprised by what they thought they knew - but didn't.  I've read too often that there's rarely anything left for common shareholders when a company is forced into liquidation.  I have no desire to be one of those shareholders.

This is all off the top of my head.  I don't have the time and energy to read and study during the summer that I do in the winter when I'm laid off. 

But I can look at a company's payout ratio.  I know what return on equity is.  I can do a discounted cash flow analysis.  These things I know I can understand.

Maybe there's a lot of people smarter than I am.  I'll stick with concepts I know I can master. 

I liked your analysis of TNDM.  How on earth do you balance your time between work, your music, and learning this stuff?  You must be very intelligent.  I'm very impressed!

 

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#6) On August 02, 2010 at 10:18 PM, NOTvuffett (< 20) wrote:

truth,

I no longer trade in banking stocks because nobody knows what their balance sheets mean.

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#7) On August 02, 2010 at 10:31 PM, truthisntstupid (80.81) wrote:

I'm sorry, I just for some reason assumed that we were talking about NCAVPS as a component of 'intrinsic value', since that was what Clarkmel and I were discussing.  And why my opinion is that valuation is overrated. Uh - is that what we were talking about?  That's what my mind jumped to.  Anyway, I just wrote a pitch on Sysco as a CAPS pick a few days ago.  I'd like to know what you think!

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#8) On August 02, 2010 at 10:38 PM, truthisntstupid (80.81) wrote:

NOTvuffet -

I've got a couple good books that go over some metrics applying to bank stocks, but haven't spent any real time studying them yet.  I figure a lot of people smarter than I am have been burned by them.

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#9) On August 02, 2010 at 11:51 PM, truthisntstupid (80.81) wrote:

I'd like to know what Clarkmel thinks...

Have you read the rest of his blogs?  They're really good....

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#10) On August 03, 2010 at 1:46 PM, djshagggyd (72.54) wrote:

Ah darn it!!

I just wrote you a full-page response Truth... but my browser crashed and erased it. How frustrating. Oh well, I will retype it on my lunch break later... arg!

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#11) On August 03, 2010 at 3:07 PM, djshagggyd (72.54) wrote:

Truth-

Ok... here goes the retyping :) 

First off yes, you're right... I was asking about NCAVPS as it relates to intrinsic value. 

And wow! Thank you so much for your thorough response. I feel like I learned a lot (as always) from your insights. 

These particular sections of your comments really hit-home: 

"to presume that I can actually correctly value a huge corporation.  Do that many people really believe they can?  Really? "

and

"Perhaps we'll think we know enough but miss something that would be 'common sense'  to them - but not to us.  Perhaps such an activity as valuing a large business may involve a larger speculative component for most of us. "

Well put friend! And I think you're right. I think I have been fooling myself into believing I know more than I really do. And it's causing me to speculate when I mean to be investing.

I didn't go to college. I got good grades in high school, but I didn't even take a math class junior or senior year. All the knowledge I have regarding the market has come straight from TMF, the Intelligent Investor, and my Foolish friends like you. I don't even know anybody in "real-life" who invests.

Yet here I am thinking I can reliably evaluate the financial health of corporations run by highly educated, swarthy, millionaires. How foolish of me... (...the bad kind with a lower case "f"). 

" I'll stick with concepts I know I can master. "

Too often in life I try to be a jack-of-all-trades... it causes me to be less focused than I should be... and therefore less effective.

But I want to follow your lead. I want to master the concepts which make the most sense for me as an individual. I admire your self-awareness and the way it has allowed you to master your style.

Me on the other hand... I'm still just discovering my style... and I've got a long way to go before I will be able to consider myself a "master" of anything. Thank you for helping me to stay focused. I appreciate it very much. 

Haha... as far as how I balance it all...

I suppose it depends on your definition of "balance"! Most people who love me would say I need to slow down and relax... and that I don't sleep enough. All of which is probably true...

But I figure if I've got the energy I may as well use it! I know I won't be able to move this fast forever... So right now I am going to enjoy it while it lasts.

Also... thank you for the kind words, but I think my victories in life have a lot less to do with intelligence... and a lot more to do with insatiable curiosity and grim determination. In addition, I'm the type of guy who gets back on the horse even when he probably shouldn't... haha... (I wouldn't be surprised to find out I have a very low IQ!)

I will check out your pitch for Sysco later this evening... looking forward to it! I'm also looking forward to reading more of Clarkmel's blogs... it's been on my to-do list for awhile.

Thanks again Truth! I hope you're having a nice week,

~justin 

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#12) On August 03, 2010 at 3:23 PM, djshagggyd (72.54) wrote:

I thought maybe you'd be interested to read TMFDeej's response to my questions about NCAVPS and intrinsic value... although you both have a different style, it seems like he agrees with your core concepts:

I always try to be uber-conservative when looking at stocks in terms of their liquidation values.  The #1 factor for me is the amount of straight cash that a company has on its books.  Given the fact that IMN {Imation Corp} supposedly has $250 mil, it does very well in that category.  This information can be found on the "cash and cash equivalents" line of the balance sheet.

The other types of "current assets" are a little trickier to evaluate.  One really never knows how likely the company is to ever receive the money that is listed under "net receivables," so I usually apply a huge haircut to it.  

I usually apply a huge discount to inventory as well, unless I have a very good idea of what it is and how much it would be worth on the open market.  With Imation, I don't have a solid handle on that.  For all I know its inventory could be a warehouse full of floppy disks.  There's some value there, but I again would assign a huge discount to it.

The last category under "net receivables," ""other current assets" is so vague that I usually ignore it completely.

Again, this is a fairly conservative way at looking at a company's potential liquidation value.  I definitely would add something for "property, plant, and equipment" to the "current assets."  How much is the question.  Again I would apply only a percentage of what the company lists as its value for its hard assets unless I had an excellent grasp of what they are.

Most of this is self-taught through lots of reading.  I'm sure that there's other ways to look at company's liquidation values...but I like to be as conservative as possible. 

Deej  

Here is a link to his original post 

I think I may post a blog about NCAVPS and intrinsic value... it will mostly be quotes from you, TMFDeej, and Clarkmel. I'm thinking it would be beneficial to the Fool community if more people were exposed to the ideas you shared with me.

~justin 

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#13) On August 03, 2010 at 3:28 PM, truthisntstupid (80.81) wrote:

DJ

Don't misunderstand me.  I do believe we can evaluate the financial health of a company by analyzing it's interest coverage, cash flow, quick ratio, current ratio, etc. etc. 

But I may be willing to pay more - or less - than other people think it's worth.  See my Exxon example above.  Your young.  Might be a good investment for you.  For the reasons I gave above in my first response to Clarkmel, I myself don't find it attractive.

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#14) On August 03, 2010 at 3:35 PM, truthisntstupid (80.81) wrote:

"You're"  not "your".  

There are grammar police out there!

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#15) On August 03, 2010 at 11:15 PM, djshagggyd (72.54) wrote:

Truth-

I think I understand you... though I may have worded my response strangely... (as I have a tendency to do when I'm on break at work and typing fast)...

Maybe what I should have said was:

I've been a fool with a lower case "f" because... I've been placing too much emphasis on "intrinsic value" concepts that I don't fully comprehend yet.

I need to gain more understanding of the meaning behind the numbers in a company's balance sheet before I give it so much weight in my analysis. 

Fair enough? 

Have a good night! I'm on my way to check out your latest pitches...

~justin 

 

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#16) On August 03, 2010 at 11:22 PM, djshagggyd (72.54) wrote:

Speaking of grammar... I made a typo in the first sentence of a comment I left on TMFSinch's page earlier today.

He's always so detailed and meticulous... leaving a typo on his blog felt like felt like a sin. I honestly felt guilty about it!

 

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#17) On August 03, 2010 at 11:33 PM, truthisntstupid (80.81) wrote:

Hi again ,dj

I posed a few more questions and doubts regarding this discussion on TMFDeej's blog you provided a link to...with a little more detail than I went into here.  I'm starting to wonder if we aren't being a little rude to keep "taking over"  Clarkmel's blog, though.  I wish he would come back!  I posted a blog asking if he's still around! 

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#18) On August 04, 2010 at 1:46 AM, djshagggyd (72.54) wrote:

Yes Clarkmel... I hope we aren't being rude.

Thank you for letting us use your blog!

I will move any further discussion over to Truth's post.

 

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