Thursday, November 20, 2014

Intrinsic value - How much does it worth?

Firstly, this is a major and important topic in value investing. You can definitely do a PhD on this. Think about it, if you know the exact amount how much something is worth, and someone is selling it to you way below this value, you will be interested, wont you? at least you would check it out.

For example, If you know, the IPhone 6 is selling at RM2000, and we all know, it's price is very much controlled, then your best friend came up to you with a genuine brand new phone and offers you at RM1500 for what ever reason. You bet you are interested (if you are not, pass me the phone!)

Another example, if you are staying in Bandar Utama and you know the houses in your area are worth RM 1 million. All your Neighbors either bought at this price or sold at around this price recently. If  the house next door hangs a "for sale" notice., when you ring up the Australia migrated owner, he says he wants to sell at RM 2million! Why? because he personally decorated the house before moving to Australia 2 years ago! You probably would ask him to fly kite albeit a polite manner.

Similarly, if you know the value of a particular stock, and it's price is below this, you should be interested.


However, calculating a public listed company's intrinsic value is not that simple nor straight forward. It is a bit of science with a bit of art in it. One reason for this is the future. Very often, we make a investment looking forward for the future returns. Hence we would need to take assumptions with regards to the future earnings into the picture. We all know how certain the future is. I believe you have came across this quote :

"The only certainty is nothing is certain.."


Having said that, there are many methodology in the stock investment circle for finding intrinsic value. Famous investors such as uncle Warren said "Price is what you pay and value is what you get". His sifu, Benjamin Graham, also said "only buy when it is at least 20% below intrinsic value". So you can imagine the important of understanding the meaning of value.

So it is worth while to understand how to find the intrinsic value of public listed company,

Before, you read on, you might want to know that I am not an expert in this. What i am writing here is from a lay persons view and what works for me. Please understand,  the "only way" to deduce value...NONE. Even the experts are arguing over this.


Calculating Value:

There are many valuation methods, namely:
1. Comparative
2. Replacement value
3. Liquidation
4. Discounted cash flow
5. Earning Power Value
6. PER, Price to Book, etc.

The most popular method by most value investor is the Discounted Cash Flow (DCF). However, I have chosen Earning Power Value as my base to value companies that come to my attention. Why?

One of the known weak point of DCF is that assumption has to be made for future earnings of a company. It is difficult enough to estimate the earnings of next financial year let alone 10 years down the road. The end value is very much depends on the accuracy of your prediction. A small fraction of assumption deviation will end up with huge difference at the end value

Earning Power Value (EPV), does away with this troubling assumption.
I first came across this concept from the following book written by, Bruce CN Greenwald. a professor of finance at Columbia University Graduate school of Business.


This is one of those book you will read if you can't sleep at night..well maybe slightly better then Benjahim Grahams intelligent investor..  a dry read but valuable read none the less.

In this book, he also argues the difficulty in earnings assumption for Discounted cash flow model. Hence he introduce the concept of Earning power Value.

I would very much encourage you to read the book to fully understand the whole concept. (I find my self keep going back to the book whenever I have doubt on my calculation). What I share here is a summary of some sort from my own understanding.

Firstly, the formula of Intrinsic Value:

IV  = EPV + Growth



2ndly, formula for EPV

EPV=        Earnings       
             Cost of capital.  


Earnings: 
Only core earnings or earnings from normal business activities. Important to remove earnings which is not from the core business or one off items.
Cost of Capital: 
The interest charge on capital borrowed to do business. The Author recommends to use at least 2 times of the risk free rate. His examples were mainly using 10%

In the book he did not explain how he concluded the formula but, if you re-arrange the formula:

Earnings = EPV x Cost of Capital

This seem to be similar to our normal FD earning Formula:

Earnings = Capital x interest rate


the way I understood it is this: If I am earning RM1000 from a investment and I had borrowed the Capital at interest rate of 10%, how much is this investment's capability to make earning in equivalent to capital kept at FD with the same interest rate. EPV=RM1000/10= RM10000. So the value of this company, equivalent to cash in FD with a interest rate of 10% is RM10000


Tha Author has suggested, To drop growth from the equation and take growth as a margin of safety. Meaning if a company is trading at its EPV alone, yet a growth can be expected then it is already safe to buy at that price.

In a case study of WD40, the Author went on to use the final IV formula:

IV= EPV + Net Cash 


His rational seems to mean: in a running business that you are taking over, any cash in the company is at you disposal. So the intrinsic value of a running company should be the capability of the company to earn money (Which is the EPV portion) + Net cash ( + growth but this is used as margin of safety)

For my own personal use, I have made some modification to the formula. Instead of Net cash, I replaced it with Liquidated asset value. Which is the Net asset value in situation if the company is liquidated. My reason is when i buy a company, I am buying the assets and earning capabilities, if I made a mistake in valuing its earning capabilities, worst case scenario I should be able to sell the assets and take back some money invested. So my formula is:


IV = EPV + Net Asset for liquidation.


Like any Intrinsic value model, the final figure comes with many assumptions. Although, this model tries to reduce the need for many assumptions, it still depends on some assumptions. When using this formula it is important to remember it is a guide and not a definite figure.

9 comments:

  1. hi Green Tea,
    how you compute the net asset for liquidation ? is NTA?

    IV is value of the fixed asset and also growth asset.. since the EPV is compute the value of asset without expecting any growth, would it be double count if u add the net asset for liquidation ?

    ReplyDelete
  2. HI Horsefield,
    In general, To calculate Net asset for liquidation, I would remove or discount certain items from the assets which normally are difficult to be converted to cash in the event of liquidation. eg: remove all goodwill figures, discount 50% of stocks, 30% of receivables and etc. The amount to reduce very much depends on the company and nature of business. If lets say the bulk of the stock are commodities like wood or precious metal which can be kept and resold easily, then the reduction amount is lower. However if it is like Padini, the stock is finish goods and might be difficult to resell, then i would take a bigger discount. Finally this adjusted asset figure is minus with total liabilities.

    If you refer to the example of WD40 in chapter 6, he calculates IV as earnings capability + Net cash. So EPV tells us the ability of the company to make earnings. Hence, I am incline to value a company by its earning capabilities + its liquidated net asset value.

    ReplyDelete
  3. appreciate your reply.

    i think the net asset you mentioned is the alternate form of NCAV by apply discount on both fixed and current asset.. I consider it as asset base valuation..

    However, epv is kind of earning base valuation by examine the earning from its fixed and also current asset..

    if you added the liquidated asset into EPV to arrive the IV, it will be double count; i.e. earning power of asset + adjusted book value of asset.. it will be too conservative for heavy leverage/light asset firm or too generous for net cash/valuable asset firm (double count) by using the approach..

    Personally, I will add excess cash & valuable non operating asset less minority interest and convertible bond into epv to arrive IV.. just my thought.. what is your opinion ?

    ReplyDelete
  4. Hi HorseField,
    Yes, it would be bias to the 'old school' economies of brick and mortar. Techno would be valued lower. i had decided to accepted this.
    I remeber reaing somewhere, The author did present that 3 diffrent EPVs, EPV operating business, EPV company and EPV equity. with EPV company he adds excess cash and real estate. This seem to be what you have suggested.

    what other valuation method are you using? if you don't mind sharing..

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  5. Hi Green Tea,

    Ya, I think I'm using EPV operating business / asset..

    Besides EPV, I'm also using discount cash flow, discount dividend, EV/Ebit, ncav, PE, etc.. generally, EPV will give most conservative IV..

    what method you are using except EPV? looks forward to see you writing more about these valuation method..

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  6. Beside, EPV I am using Earnings Yield (Which is actually inverse PE). I have learnt this from Equities Tracker. Comparing the current EY against its historical EY std deviation band works for me. However, with the whole market running up, pretty difficult to find any stock that meets this valuation.

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  7. sound interesting as it seems combine both FA and TA.. wish you can write an article on it.. I prefer to use ev/ebit to get the earning yeild but PE is more popular in malaysia..

    ya.. it is difficult to find good bargain at the moment.. perhaps a major correction can help it..

    ReplyDelete
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    ReplyDelete