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.
There are many valuation methods, namely:
2. Replacement value
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
Cost of capital.
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.