Tag Archives: Investing

Margin of Safety

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“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger the margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.” Warren Buffett

Billionaire investor Warren Buffett, Chairman and CEO, Berkshire Hathaway, said, “The three most important words in investing are margin of safety.” Margin of Safety is a measure of how “on sale” a company’s stock price is compared to the true value of the company. You need to be able to determine the value of a company and from that value determine a “buy price”. The difference between the two is the margin of safety.

Effectively, margin of safety means you pay less for an asset than what it’s intrinsically worth. It means to buy $10 dollar bills for $5 dollars. That’s the secret to great and successful investing. The margin of safety is the difference between the intrinsic value of a stock and the current market price of the stock. The intrinsic value of an asset is its actual value, that is, the present value of the asset found by calculating the total discounted future income it’s expected to generate.

The intrinsic value is calculated based on the 10 year discounted free cash flow (DFCF).

In other words, if the stock price of a company is below the actual value of the free cash flow (income) and assets of a company, the percentage difference is the Margin of Safety.  This is the discounted price at which you are buying a share in the company.

A higher margin of safety will reduce your investment risk. If an investor can buy a stock below its intrinsic value, the potential for a bad outcome, risk, is usually lower.

Warren Buffett likes a margin of safety of over 30%, meaning the stock price could drop by 30%, and he would still not lose money. Margin of safety is only an estimate of a stock’s risk and profit potential.

Buffett determines margin of safety by estimating the current and predicted earnings from a company from today and for the next ten years.  He then discounts the cash flow against inflation to get the current value of that cash.  This is the Intrinsic Value of the company. He bases intrinsic value on the discounted future free cash flows. He believes cash is a company’s most valuable asset, so he tries to project how much future cash a business will generate.

Margin of Safety is a value investing principle strategy. If the total value of all shares of a company is 30% less than the intrinsic value of that company, then the margin of safety would be 30%. In other words, if the stock price of a company is below the actual value of the cash flow and assets of a company, the percentage difference is the Margin of Safety.  This is the discounted price at which you are buying a share in the company. Most value investors believe that the higher the margin of safety, the better.  In reality, a margin of safety between 30% and 50% is reasonable.

The Margin of Safety is the percentage difference between a company’s Fair Value per share and its actual stock price. If a company has profits and assets that outweigh a company’s stock market valuation, this represents a Margin of Safety for the investor. The higher the margin of safety, the better.

Margin of safety is only an estimate of a stock’s risk and profit potential. Most value investors believe that the higher the margin of safety, the better.  And, the larger the margin of safety, the more irrational the market has become. 

One of the keys to getting a great margin of safety is to understand that price and value is not the same thing. Price is what you pay for something, but the value is what you get.

The stock market rises about four out of every five years or about 80% of the time, according to Nick Murray. Said another way, the market only falls 20% of the time. You can fear that 20% or cheer for it.

No one ever got wealthy paying full price or top dollar for financial assets, according to Buffett. Most successful investors got that way buying assets that were distressed, out of favor, and therefore on sale. Unfortunately, few people see it that way. You need to take advantage of the sale during market selloffs and corrections when it occurs. Your money literally goes further because you can buy more share at lower prices that lead to market-beating returns later on.

If you want to make good long-term investment returns, you need to minimize your risk by purchasing companies selling at a significant discount to their intrinsic value due to market volatility. 

References:

  1. https://novelinvestor.com/10-lessons-learned-nick-murray/
  2. https://www.ruleoneinvesting.com/blog/how-to-invest/how-to-invest-margin-of-safety-the-growth-rate/
  3. https://www.liberatedstocktrader.com/margin-of-safety/

Inflation and the Bond Market

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The bond market—Treasuries, high-grade corporate bonds, and municipal bonds—are experiencing depressed yields in the 1% to 3% range and near-record negative real rates with inflation running at 6%. Barron’s

Real interest rates can be effectively negative if the rate of inflation exceeds the nominal interest rate, according to Investopedia. Real interest rate refers to interest paid to borrowers minus the rate of inflation. There are instances, especially during periods of high inflation, where lenders are effectively paying borrowers when they, the borrowers, take out a loan. This is called a negative interest rate environment.

The real interest rate is the nominal interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to a bond investor. The real interest rate is calculated as the difference between the nominal interest rate and the inflation rate:

Real Interest Rate = Nominal Interest Rate – Inflation (Expected or Actual)

While the nominal interest rate is the interest rate actually paid on a loan or bond, the real interest rate is a reflection of the change in purchasing power derived from a bond or given up by the borrower. Real interest rates can be effectively negative if inflation exceeds the nominal interest rate of the bond.

There is risk for bond returns in 2022, when the Federal Reserve is widely expected to start lifting short-term interest rates to manage inflation.

And things could get worst for bonds if inflation persists. That could force the Fed to tighten more aggressively. It wouldn’t take a big rise in rates to generate negative returns on most bonds. The 30-year Treasury, now yielding just 1.9%, and most municipals yield 2% or less and junk bonds yield an average of 5%. Bonds would drop significantly in price if rates rise a percentage point.

The real interest rate adjusts the observed market interest rate for the effects of inflation.

“Cash has been trash for a long time but there are now new contenders for the investment garbage can. Intermediate to long-term bond funds are in that trash receptacle for sure.” Bill Gross, “Bond King”

References:

  1. https://www.barrons.com/articles/best-income-investments-for-2022-51640802442
  2. https://www.investopedia.com/terms/n/negative-interest-rate.asp

Tips for New Investors

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Getting started can be the biggest hurdle for new investors.

To get started, it’s important for new investors to set clear investment objectives, open a brokerage account, create a plan, and start investing with a long-term view. You’ll gain knowledge over time. While your investment strategy may change, getting started sooner rather than later is a good first step.

Additionally, every new investor should first make an honest assessment of where they are in life and their financial priorities. And they should leave emotion out of it. And, begin investing early in life so your money will have plenty of time to grow. A 10-year difference can have a significant effect on compounding returns.

https://fb.watch/9iNk-bRTiD/

Putting together a successful investment portfolio takes a combination of research, an investing plan, patience, and a little bit of risk.

For instance, there is plenty of research showing that frequently buying and selling stocks often leads to significantly lower long term returns than buying and holding. According to the investment research, investors who try to time the market more often get lower returns, but they also introduce more volatility into their portfolio.

By paying a lower price for an investment relative to its earnings or intrinsic value, one would expect a higher income yield in the near term, as well as the greater appreciation over the long term to the extent that free cash flow, earnings and net income increases in the future (of course, all investments involve risk and there can be no guarantees of any returns).

References:

  1. https://www.thebalance.com/the-6-dumbest-things-new-stock-investors-do-357191
  2. https://www.thebalance.com/things-investors-should-know-357631

Inflation: The Elephant in the Room

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November’s CPI report showed consumer prices rising at rates last seen four decades ago.

Inflation is the biggest risk facing the equity market and is likely to end the record long bull-market. Inflation has a long history of eroding the value of financial assets and brings with it higher interest rates as central bankers try to tamp it down.

The annual inflation rate accelerated significantly in 2021, from about 0.5% at the start of the year to over 3% by September. This was driven by increased demand as the economy reopened and by a sharp rise in energy prices, among other factors.

In October, inflation measured by the consumer price index was up 6.2% from a year earlier, the highest annual rate since November 1990. It marked the sixth straight month above 5%. Kiplinger expects inflation to hit 6.6% by year-end 2021 before falling back to 2.8% by the end of 2022 – above the 2% average rate of the past decade.

“Inflation is in the air, and it risks becoming a market issue, an economic issue and a political issue,” says Katie Nixon, chief investment officer at Northern Trust Wealth Management.

As we enter 2022, inflation is expected to remain a risk amid higher food and gas prices, rising pressures from non-energy industrial sectors such as steel and chemicals, higher food and consumer goods prices, and increases in the energy prices.

Economists expect headline CPI to peak between 4.5% and 5% in the first half of 2022 and approach 2.5% year over year by the end of 2022.

References;

  1. https://www.kiplinger.com/investing/stocks/stocks-to-buy/603814/where-to-invest-in-2022
  2. https://investor.vanguard.com/investor-resources-education/article/simple-strategies-for-reducing-inflation-risk

Valuing a Company | Motley Fool

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The most common way to value a stock is to compute the company’s price-to-earnings (P/E) ratio. The P/E ratio equals the company’s stock price divided by its most recently reported earnings per share (EPS).

You can calculate it two different ways, by:

  • Taking the company’s market cap and dividing it by net income – or,
  • Dividing a company’s current stock price by earnings per share

You’ll wind up with the same number either way because in the share price approach, both numbers have already been divided by the total number of shares the company has outstanding. So it’s two different ways to the same place.

A low P/E ratio implies that an investor buying the stock is receiving an attractive amount of value.

You’ll usually see the P/E ratio quoted two different ways:

  • Trailing twelve month (TTM) – which looks at the company’s actual income over the past twelve months.
  • Forward – This approach takes analyst estimates of earnings expectations for the upcoming year and using that as the earnings figure.

If a company is growing, its forward P/E ratio will always be smaller than its trailing twelve month P/E ratio, because more income is expected and the denominator will be larger. If you see a P/E ratio out in the wild and it isn’t specified which kind it is, you can probably assume it’s based on the company’s trailing twelve month earnings.

The P/E ratio only works if there’s an E – or earnings. So it’s a helpful tool for companies that have income, but it’s totally useless if a company isn’t currently profitable. That’s why investors also use another tool for unprofitable companies, the P/E ratio would return a negative number, which really wouldn’t be very helpful, so instead investors use the price to sales ratio.

Price-to-sales is a company’s market cap divided by its total sales over the past twelve months. Because the P/S ratio is based on revenue instead of earnings, this metric is widely used to evaluate public companies that do not have earnings because they are not yet profitable.

High growth software companies can have price-to-sales ratios of over 10, while more established businesses are usually in the mid to low single digits. The P/E and P/S ratios are great because they allow you to normalize companies of different sizes and immediately get a sense of what investors are willing to pay for a piece of that company’s earnings or revenue.

You can use these ratios to compare how a company stacks up to the overall stock market, peers in their industry, or itself relative to the past. Generally, businesses that are posting high growth rates are going to have higher price-to-earnings and price-to-sales ratios. That’s because investors expect that company to be considerably bigger in the future, and they have bid up shares to reflect that. That doesn’t mean that they’re bad stocks to own, it just means that people are expecting big growth to continue and if it doesn’t, shares could fall dramatically.

Conversely, stodgy old businesses in crawling industries tend to have lower p/e ratios because they aren’t growing very quickly – for them this year’s earnings will probably look a lot like last year’s earnings. The market isn’t expecting much from stocks with low valuations, so if the outlook gets worse, they’re less likely to take a huge hit, but they’re also less likely to give investors huge returns.

All you’re trying to do with valuation is to get a sense of how much you have to pay for a dollar of earnings or revenue from a company, and what the market expects of that company.

You can look at to see how a company’s valuation compares to the growth the company is posting. The PEG ratio accounts for the rate at which a company’s earnings are growing. It is calculated by dividing the company’s P/E ratio by its expected rate of earnings growth.

Most investors use a company’s projected rate of growth over the upcoming five years, you can use a projected growth rate for any duration of time. Using growth rate projections for shorter periods of time increases the reliability of the resulting PEG ratio.

The generally accepted rule is that a PEG ratio of 1 represents a “fair value” while anything under 1 is cheap and anything over 1 is expensive compared to the growth the company is posted.

For all these ratios there aren’t absolutes, just guidelines.

As investors we’re looking for quality companies with good business models and exciting growth prospects — it’s worth paying a premium for companies like that, these metrics help us understand what the premium looks like and how it fits into the company’s growth story.

References:

  1. https://www.fool.com/investing/how-to-invest/stocks/how-to-value-stock/

Beat Inflation with Dividend Stocks | Fidelity Viewpoints

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“Stocks that can boost dividends during periods of high inflation may outperform.” Fidelity Viewpoints

Key takeaways according to Fidelity Viewpoints

  • Dividends aren’t just nice to have, they’re essential to the stock market’s return—accounting for approximately 40% of overall stock market returns since 1930.
  • During periods of high inflation, stocks that increased their dividends the most considerably outperformed the broad market, on average, according to Fidelity’s sector strategist, Denise Chisholm.
  • Dividend-paying stocks’ regular, scheduled payments also may help to reduce the volatility of a stock’s total return.

The economy is gradually recovering from its pandemic-related slowdown and shutdowns, and inflation has hit its highest rate in 39 years. People are emerging from the pandemic and are spending money they saved or money they’re getting from the government. Thus, a combination of soaring pent-up consumer demand and persistent supply chain disruptions has tarnished an otherwise robust economic recovery.

The Bureau of Labor Statistics said the Consumer Price Index of food, energy, goods and services rose by 0.8 percent in November, pushing annual inflation above 6.8 percent. The level is the highest since 1982 and it also marked the sixth consecutive month in which annual inflation rates have exceeded 5 percent.

Currently, approximately 70 percent of Americans rate the economy negatively, with nearly half of Americans blaming Biden for inflation, according to a recent Washington Post-ABC poll.

This combination of economic challenges and consumer worries may make this an especially good time to consider investing in stocks that pay consistent dividends.

A few important things for investors to know about dividend stocks:

  • Dividend payouts typically happen quarterly, although there are a few companies that payout monthly.
  • Many high-quality companies routinely raise their dividend payouts, helping hedge against inflation.
  • A stock’s dividend yield moves in the opposite direction of its stock price, all else being equal, so a high yielding stock may be reason for caution.

Fidelity research finds that dividend payments have accounted for approximately 40% of the overall stock market’s return since 1930. What’s more, dividends have propped up returns when stock prices struggle.

Dividends account for about 40% of total stock market return over time

US stock returns by decade (1930–2020). Over various decades, dividends have remained a fairly steady component of stocks’ total returns amid more highly volatile stock prices. Past performance is no guarantee of future results. Source: Fidelity Investments and Morningstar, as of 12/31/2020.

To invest successfully in dividend stocks, one of the keys is finding companies with strong balance sheets and with secure payouts that can grow consistently over the long haul. Moreover, it’s important to understand the concept of dividend yield, which investors use to gauge how much dividend income their investment will produce.

Investing in dividend stocks

When selecting dividend stocks, it’s important to keep dividend quality in mind. A quality dividend payout can grow over time and potentially be sustained during economic downturns. It’s the primary reason investors must not focus solely on yield.

Steve Goddard, founder and chief investment officer of Barclay, prefers companies with high returns on capital and strong balance sheets. “High return-on-capital companies usually by definition will generate a lot more free cash flow than the average company would,” he says. And cash flow is what pays the dividend.

Although overall dividend health has improved markedly since 2020 and looks good heading into 2022, it’s equally important to check a company’s dividend policy statement so you know how much to expect in payment and when to expect it. Dividend yield is a stock’s annual dividend expressed as a percentage of its price.

It’s crucial to recognize that a stock’s price and its dividend yield move in opposite directions, as long as the dollar amount of the dividend doesn’t change. Investing in the highest-yielding shares can lead to trouble, notably dividend cuts or suspensions and big capital losses

This means a high dividend yield may be a red flag of a problem with the underlying company. For example, a stock’s yield may be high because business problems are weighing down the company’s share price. In that case, the company’s challenges may even cause it to stop or reduce its dividend payments. And before that happens, investors are likely to sell off the stock.

Fidelity Investments’ research has found that stocks that reduce or eliminate their dividends historically have underperformed the market by 20% to 25% during the year leading up to the cut.

Also consider the company’s payout ratio—the percent of its net income or free cash flow it pays in dividends. Low is usually good: A low ratio suggests the company may be able to sustain and possibly boost its payments in the future.

“As a rule of thumb, no matter what the payout ratio is, it is always important to stress test a company’s payout ratio at all points in the business cycle in order to carefully judge whether it will be able to maintain or increase its dividend,” says Adam Kramer, portfolio manager for the Fidelity Multi-Asset Income Fund.

“It all depends on the stability of the cash flows of a company, so it’s more about that than the level of payout. You want to test the company’s ability to pay and increase the dividend under different scenarios. In general, when the payout ratio is more than 50%, it’s a good reminder to always stress test that ratio,” Kramer explains.

Be sure to diversify as you build a portfolio of dividend-paying stocks. To help manage risk, invest across sectors rather than concentrating on those with relatively high dividends, such as consumer staples and energy.

References:

  1. https://www.fidelity.com/learning-center/trading-investing/inflation-and-dividend-stocks
  2. https://www.barrons.com/articles/quality-dividend-stocks-51639134001
  3. https://news.yahoo.com/inflation-pinch-challenges-biden-agenda-200620196.html

Past performance and dividend rates are historical and do not guarantee future results. Diversification and asset allocation do not ensure a profit or guarantee against loss. Investing in stock involves risks, including the loss of principal.

Investors Need to be Patient and Rational

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“It’s a textbook example of why panic is not a[n investment] strategy, unless you’re deliberately trying to lose money.” Jim Cramer, CNBC Mad Money Host

CNBC Mad Money Host Jim Cramer made his comments after the stock market indexes moved higher after a previous major market downturn due to COVID-19 Omicron variant concerns and fear. Wall Street experienced a strong melt-up session led by the technology heavy Nasdaq Index’s 3% jump.

Markets had sold off sharply on November 26, with the Dow, S&P 500 and Nasdaq all losing more than 2% in market cap value as investors knee-jerked reacted to the discovery of the Omicron variant.

“I want you to use it as a reminder that, most of the time, it pays to wait for cooler heads to prevail rather than freaking out in a situation where everyone else is freaking out and lost their heads without complete information,” Cramer said.

“Look, it would’ve been great if you bought stocks something near the lows—that’s what I urged you to do, actually, even if you had to hold your nose because we were simply too oversold. I was relying on technicals,” Cramer said. “But the cardinal sin here was selling stocks out of fear, rather than sitting tight out of rationality.”

The obvious takeaway for investors is that fear and panic are not sound investment strategies, “…unless you’re deliberately trying to lose money.” Never make permanent investment decisions based on temporary market circumstances.

References:

  1. https://www.cnbc.com/2021/12/07/cramer-stocks-recent-rally-shows-need-for-investor-patience-not-fear-.html

Retail Investor Inflation Strategy

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Inflation refers to an aggregate increase in prices, commonly measured by the Consumer Price Index (CPI).

The federal government has pumped trillions of dollars into the economy through deficit spending and stimulus measures since the COVID-19 pandemic began. Meanwhile, the central bank of the United States, the Federal Reserve, has dropped interest rates to near zero and has committed to keeping them there through 2023.

The Federal Reserve’s mandates are to manage the money supply and set the federal funds interest rate in an attempt to keep inflation within a reasonable limit. This reasonable level of inflation is maintained because it encourages people to spend now, thereby promoting economic growth, rather than saving, as a dollar today is worth more than the same dollar tomorrow on average.

A constant level of inflation helps maintain price stability and is thought to maximize employment and economic well-being. Investors expect returns greater than this “reasonable,” average level of inflation, and workers expect wage increases to keep pace with the increasing cost of living.

The Consumer Price Index tracks prices for a broad range of products such as gasoline, healthcare, and groceries. The CPI rose 6.2% in October from the same month in 2020, the biggest spike since December 1990, according to the Labor Department.

High and variable inflation is considered bad for both investors and the wider U.S. economy because it can eat away at the value of financial assets denominated in the inflated currency, such as cash and bonds, particularly longer term bonds with more interest rate risk.

The prospect of variable or high inflation introduces uncertainty to both the economy and the stock market, which doesn’t really benefit anyone. This uncertainty or variable inflation distorts asset pricing and wages at different times. Prices also tend to rise faster and earlier than wages, potentially contributing to economic contraction and possible recession.

“Cash is not a safe investment, is not a safe place because it will be taxed by inflation.” Ray Dalio, Bridgewater Associates

In an inflationary environment, “cash is trash” since inflation operates like a tax which causes saved dollars lose value over time. High inflation rates decrease the purchasing power of money and it discourages people from holding cash assets and saving. “Cash is not a safe investment, is not a safe place because it will be taxed by inflation,” Bridgewater Associates’ Ray Dalio, the founder of the world’s biggest hedge fund said on CNBC Squawk Box.

Here are several suggestions for investors to consider to counter the risk and derisive impact of inflation on assets and the economy.

  • Consider buying equity stocks like bank stocks or consumer goods companies that will benefit from higher inflation or higher interest rates. Banking, consumer staples, energy, utility, and healthcare equities are likely to perform well. Banks would come out ahead if the Federal Reserve eventually raises interest rates to combat inflation, and banks’ spreads between loans and deposits widen. Also, look for companies that benefit from rising labor costs and be very attentive to how much you pay for (e.g., the intrinsic value) of risk assets.
  • Consider buying TIPS, or Treasury inflation-protected securities, which are a useful way to protect your investment in government bonds. These U.S. government bonds are indexed to inflation, so if inflation moves up, the effective interest rate paid on TIPS will too. TIPS bonds pay interest every six months, and they’re issued in maturities of 5, 10 and 30 years. Because they’re backed by the U.S. federal government, they’re considered among the safest investments in the world.
  • Avoid fixed income assets such as corporate and government non-TIP bonds. If rates rise sharply, their principal value will take a major hit. If rates climb, then certificates of deposit, fixed annuities, bonds, and bond funds purchased today will look less attractive in the future. Similarly, buying a lifetime income annuity is less enticing in an inflationary environment. The monthly check you get for the rest of your life will lose value more quickly with high inflation.
  • Keep the right sort of debt. Don’t pay off that home mortgage or real estate investment mortgages early, you’re better off paying it off over time with watered-down dollars. Homeowners carrying fixed mortgages with low interest rates are in a great position. It’s highly recommended to refinance your mortgage to lock in low rates. If inflation takes off, homes prices are likely to climb and your fixed monthly payment may appear like a real bargain in a few years.
  • Consider commodities or gold. Investing in oil, natural gas, wheat and corn can be good hedges against inflation. Gold has traditionally been a safe-haven asset for investors when inflation revs up or interest rates are very low. Gold tends to fare well when real interest rates – that is, the reported rate of interest minus the inflation rate – go into negative territory. Investors often view gold as a store of value during tough economic times.
  • Make essential purchases and charitable giving. If consumers expect to spend money on home goods, renovations, car repairs, or other products and services, they might be better off doing so now, before prices climb even higher.
  • Expect rising health costs. Health costs have risen faster than inflation for years. The pandemic, which is driving some health professionals out of the field, could accelerate that trend.

Keep in mind that inflation is always happening within the economy, but hopefully at a relatively low and steady rate, and kept under control by the Federal Reserve. Investors with a long time horizon, a high tolerance for risk, and a high allocation to stocks shouldn’t be worried about short-term inflation fears.

However, it’s perfectly suitable and even desirable for retirees, risk-averse investors, and those with a short time horizon to have some allocation to inflation-protected assets like TIPS, REITs and bank stocks.

Rising inflation is a big concern for investors, but it remains to be seen whether current high levels of inflation will persist or end up being due to “transitory” factors. Investors will likely come out ahead using assets like equity stocks, REITs, short-term nominal bonds, and TIPS to hedge against inflation.

References:

  1. https://www.barrons.com/articles/protect-finances-from-inflation-51637782342
  2. https://www.optimizedportfolio.com/inflation/
  3. https://www.bankrate.com/investing/inflation-hedges-to-protect-against-rising-prices/

Investing in China

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Ray Dalio, founder and chairman of the world’s biggest hedge fund firm, Bridgewater Associates, on CNBC Squawk Box.

Dalio has long been vocal in support of Chinese investments and Bridgewater Associates is among the largest foreign asset managers operating in China, according to Forbes. 

However, much of Wall Street disagrees and many American investors fled after China’s recent regulatory crackdowns on the technology and education sectors. 

Source: https://www.cnbc.com/2021/11/30/ray-dalio-says-cash-is-not-a-safe-place-right-now-despite-heightened-market-volatility-.html

Intrinsic Value of a Company

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“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”  Warren Buffett

Intrinsic value is an important concept to evaluate the relative attractiveness of investments and businesses.

Intrinsic value can be defined as the discounted value of the cash that can be taken out of a business during its remaining life, explains investing guru Warren Buffett, Chairman and CEO, Berkshire Hathaway. It measures the value of an investment based on its current and future cash flows. Where market value tells you the current price per share other investors are willing to pay for an asset, intrinsic value shows you the asset’s value based on an analysis of its future cash flows and its actual financial performance.

Essentially, valuing a company intrinsically allows you to look analytically at a business and determine how much cash that business will generate over time, and then you discount the cash flows back to the present day.

Book value vs intrinsic value

In most cases, a company’s book value tends to understate its intrinsic value because many businesses are worth much more than their ‘carrying value’. The ‘carrying value’ is the original cost of an asset as reflected in a company’s books or balance sheet, minus the accumulated depreciation of the asset.

As a result, a company’s intrinsic value often exceed its book value, a result that proves capital was wisely deployed. In many cases, book value is not a reliable indicator of intrinsic value or a true representation of an asset’s fair value or market value. Thus, a company’s book value alone is somewhat meaningless as an indicator of its intrinsic value.

However, intrinsic value tend to be only effective on stocks that are stable and less volatile so that you can reliably valuate. If you see the book value growth and dividends all over the place, your estimates would be very uncertain.

You need 3 factors to determine a company’s intrinsic value:

  • Current free cash flow or owner’s earnings
  • Free cash flow growth rate over an eight to ten year period. Determine free cash flow growth rates by looking at past 5 year and 10 year growth rate.
  • Discount rate to discount future free cash flow to present day.

Discounted future cash flows

Cash taken out of a business in the future is not worth the same as it is today. If you had the money today you could invest it today. Money in the future is partly eaten up by inflation, but more importantly more uncertain if it is there at all.

The calculation of intrinsic value is not so simple. Intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised.

To calculate owner earnings, or another way to look and to calculate free cash flow, one adds things back in such as depreciation, changes in working capital and such. Buffett feels that “owner’s earnings” more accurately reflects the actual cash flow that an owner receives.

Net present value for the ten years and your discounted terminal value for the 10th year we can calculate the intrinsic value.

When investing in a company, you first must determine the value of the company according to your estimates of discounted cash flow. You want the biggest difference between its intrinsic value (high as possible) and its market price which is the current price of the stock that is traded on the exchange (low as possible). Over time, you should expect the market value to intersect its intrinsic value.

When you arrive at an intrinsic value it will not necessarily match the current market value or price of the stock. In most cases you will find that there is a vast difference. You have potentially found a great company at a bargain and with a margin of safety. If the market price is much higher than the intrinsic value, it is also great. You can avoid the common mistake made by many retail investors of overpaying for a stock.

Knowing the value of a stock is perhaps the most desired skill. And in summary, intrinsic value is simply the discounted value of the cash that can be taken out of a business during its remaining life, according to Warren Buffett.

References:

  1. https://einvestingforbeginners.com/intrinsic-value-warren-buffett-aher/
  2. https://acquirersmultiple.com/2017/02/warren-buffett-how-to-calculate-intrinsic-value/
  3. https://corporatefinanceinstitute.com/resources/knowledge/accounting/carrying-amount/
  4. https://www.buffettsbooks.com/how-to-invest-in-stocks/intermediate-course/lesson-21/