Intrinsic Value

Intrinsic value is a balance sheet focused method of determing the true net value of an investment security. There are tens of different definitions used; but, the reality is that it is a mathematical formula modified to the respective industry in order to determine the worst case scenario of monetary compensation back to the investor.

Intrinsic Value – Application of Discounted Cash Flows

Discounted Cash Flows

Every student of investing is taught the core principle of discounted cash flows. This business principle is also used with intrinsic value. Application of discounted cash flows assists value investors in determining intrinsic value. Academia, major investment brokerages and the majority of investment websites place unquestionable belief in this single formula to equate value for a security. The problem here is that all of them forget or ignore the underlying requirements to use and rely on the outcome of the formula’s solution. In effect, with intrinsic value and the application of discounted cash flows, there is a very narrow set of highly defined parameters whereby this tool is applicable. Used outside of this framework, the result’s reliability quickly drops to nearly zero, like either side of the bell curve.

This article starts out by identifying the highly restrictive requirements to apply discounted cash flows. There are at most 20% of all marketable securities where this formula succeeds in determining intrinsic value. Secondly, the formula is explained to the student and why it is so important to apply it properly. There are several terms and values the user must include in the formula; this section explains them in layman’s words.

The third section below goes into the corporate financial matrix to explain how to determine cash flows. Furthermore, cash flows are just not the past year or years; it is really about future cash flows. How do you equate something in the future?

The final section puts it together when determining intrinsic value. Unlike what others state, intrinsic value is not a definitive value; it is a range. The job of the value investor is to narrow that range to a set of values that are reasonable and effective with generating gains with the value investor’s mindset of ‘buy low, sell high’.

The overall goal of value investing is to buy a security at less than intrinsic value, commonly referred to as creating a margin of safety; then waiting for the market price to recover to a reasonable high and then selling that security. The depiction here illustrates this concept well.

The most popular and improper method to determine intrinsic value is the discounted cash flows method. It was advocated in the book Security Analysis written by Benjamin Graham and David Dodd, the fathers of value investing. However, most so called experts didn’t read the entire book. Graham and Dodd only used this method under certain conditions. The same conditions as explained in the first section below. They strongly encouraged calculating intrinsic value from the assets valuation perspective (balance sheet basis) and not as a function of earnings plus cash adjustments (cash flow).

Dividends and Earnings Analysis – Railroad Stocks

Dividends and Earnings Analysis

Dividends and earnings analysis is one of the core requirements of calculating intrinsic value via security analysis. There is a relationship between dividends and earnings; one is a function of the balance sheet, the other is tied directly to the financial performance of the company as reported on the income statement. In general, there must be earnings in order to pay dividends. Investors, especially those holding common stock want rewards for their investment and often, are short-sighted when it comes to receiving dividends. Earnings reflect the power of the company to generate value for the investor. With value investing, the key tenet is to buy a security at as low of a price as allowed by the market and then sell this security at the highest price. In the interim, dividends serve as compensation for a value investor’s patience while waiting on the market price for the security to recover to a reasonable high price.

Railroad stocks are unique. This is one of the few industries whereby all the players have a very similar revenue and cost of production business matrix. There are exactly six publicly traded Class I Railways in North America. All of them have to play by the exact same set of legal compliance requirements; utilize the same physical and technological systems; and cooperate with each other to transport goods across the continent. Interestingly, all six have similar financial characteristics:

All generate a profit, the lowest net profit within the group is 22.8%;
All have positive operational cash flow and good free cash flow;
All issue dividends to their shareholders;
All have gross profit margins > 34.5% with the average over 37%;
All have low administrative overhead generating high operational profit margins; AND
All have similar 10 year growth lines related to share price.

One of the metrics that separates them from one another is their dividends and earnings relationship. Performing a dividends and earnings analysis gives a slight advantage to the value investor over traditional traders and in some cases, if the analysis is done properly and timely, a distinct advantage over professional traders. This particular article is in-depth and educates the investor about this aspect of security analysis for this one industry. The opening section introduces the relationship of dividends and earnings with business in general. There are certain key principles that bind these two financial items together. Understanding this interrelation is key to application of determining value for a company. With this understanding, the second section below develops the railways industry as a whole. It looks back over the last ten years of actual dividends and earnings for all six railroads and analyzes their trends. Here, the impact of this relationship and how it affects the stock market price for the industry as a whole is evaluated.

The final section explores each company individually and explains how this dividend and earnings analysis impacts each company’s respective intrinsic value. The goal is to assist with determining reasonable relationships to the actual stock market price for the company’s shares. The end result is security analysis for each railroad stock as it relates to the dividends and earnings.

Understanding the relationship of dividends and earnings is essential as one of the value investment metrics used by value investors when determining intrinsic value along with expected market highs and lows for a particular stock.

Value Investing – Setting Buy and Sell Points (Lesson 16)

Setting Buy and Sell Points

Setting buy and sell points for any investment security determines the investment’s final return. If the buy is made too early while the security is falling in price, the value investor loses out on not only additional margin upon the sale of that security, but also reduces their margin of safety associated with the intrinsic value point. It is similar on the other side of intrinsic value. If sold too soon, the value investor leaves money on the table. Thus, setting the buy and sell points are important decisions for every investment.

There are tools available to determine these two values. In the simplest of statements, the easiest rule to follow is the Pareto Principle, the old 80/20 rule. This rule basically states that roughly 80% of all outcomes are within 20% of of the value. With security pricing, this principle is simply that 80% of the value change will occur within 20% of the starting point. Thus, if a security’s intrinsic value is $80, then the probability is that 80% of the maximum change in value will happen within 20% points of the price shift. Therefore, the buy is approximately $64 and the sell point is $96. Almost certainly, this rule isn’t pure with security investing. The conception is that if the end results are beyond this 20 percent under and over the intrinsic value point, the value investor must have additional financial support and a lot of history with the security to validate expanding the buy and sell points beyond 20% fluctuation.

This lesson first introduces a basic model to illustrate and reinforce setting the respective buy and sell points. This model emphasizes an important aspect of price change. The angle of change affects the return on the investment. The steeper the price change, the shorter the time period for the change. The shorter the holding period for any investment, the greater the return on the investment. This is illustrated with a chart in this section of the lesson.

Value Investing – History and Modern Day Concept

Value Investing

There are tens of different definitions or interpretations of value investing. There is no single finite definition as even Benjamin Graham or David Dodd didn’t even use the term in their famous book, Security Analysis. What Graham and Dodd advocated in their writings was how to use multiple different financial tools, formulas, principles and economic concepts to determine the underlying value of any of a company’s financial instruments sold in the market. Given the wide variety of financial instruments (stocks, bonds, options, preferred stock, convertible debentures and more) available for sale, an investor must understand the proper methods to determine intrinsic value for the respective instrument. Furthermore, much of this is predicated with an understanding of how to value a company’s assets, liabilities, equity and income statement sections in order to truly determine the intrinsic value of a company.

The key term used by Graham and Dodd is intrinsic value. Intrinsic value is essentially the most likely and probable price point most informed sophisticated buyers are willing to pay for the respective ownership privilege.

There are two common price points in the securities market today. The first is called ‘market price’. Market price represents the exchange value among a large group of knowledgeable buyers and sellers for a respective financial instrument (security). It is influenced by many circumstances which change daily. The key is that there must be many buyers and sellers willing and able to purchase/sell the respective asset, in this case, a financial instrument. Furthermore, all the buyers and sellers have access to all of the facts and circumstances surrounding the sale of the respective asset; thus, no single buyer or seller has a distinct advantage over others. The only modern day system that this is considered normal is the stock market which includes the sale of all kinds of financial instruments.

The second common price point and infrequently used is intrinsic value. Intrinsic value IS NOT a value determined by group input. Intrinsic value represents the most likely dollar amount a security/financial instrument will provide in a worst case scenario.

Value Investment Fund Status Week 15 – Amazing Movement Forward

What a great week! Essex Property Trust reported their 4th quarter results and as expected, the stock’s market priced jumped almost $20 higher per share. The interesting part is that it wasn’t as if Essex reported great results; actually, their financial profits were in line with the third quarter profit. The market was holding back on amping this stock because it doesn’t know how to evaluate pricing equity based apartment complex real estate investment trusts. Per the article written several weeks ago, ‘Intrinsic Value of Essex Property Trust’, Essex’s intrinsic value is approximately $255 and a reasonable market value for this stock is around $285 to $290 per share. 

On Friday the 5th of February, 2021, the stock closed at $258.10. Thus, the market price is approximately the intrinsic value of the company on a per share basis. If the first quarter results mirror the 4th quarter performance, the stock price will surpass $270 and well on its way towards the target sell price. It may take two more quarters to acheive this reasonable market recovery price. In the interim, this single stock with several thousand dollars of unrealized value will keep the investment fund on target for the fiscal year goal of more than 30% return. The other two REITs report this week; if their results are similar to Essex’s, then the Fund’s balance will have a solid foundation for the next six months.

The historical high for Essex Property Trust is $331.30 back in October of 2019.

Calculating Intrinsic Value for Bank Stocks

Intrinsic Value of Bank Stocks

Financial institutions, including banks, are highly regulated, extremely leveraged, and susceptible to interest rate fluctuations. Due to this unique exposure, calculating intrinsic value for bank stocks requires modification of the most popular valuation models. There are about five widely accepted intrinsic valuation models used with determining the core price for stock of most companies. Novice or lazy investors rely heavily on these so-called textbook models to calculate intrinsic value as the baseline for buying stock. Sophisticated investors will modify popular models to create a customized formula for each respective industry. It requires some reasoning and reasonable assumptions to design and implement a model for any industry. This article goes into detail about designing and executing an intrinsic valuation model for banks.

To cover the thought process of creating this banking model, it is first explained how banks are in their own corner of the business world. These certain business attributes are unusual and therefore demand modification to any intrinsic calculation model. Secondly, compliance regulation further complicates calculating value. In some situations, the government penalizes banks by restricting their ability to conduct business which then impacts earnings. Since most valuation models are oriented around earnings, compliance in banking demands changes to the intrinsic formula. A third dynamic with banks is the leverage issue. Most stock price valuation models assume the respective company is at least mildly leveraged. Banks are not not mildly leveraged in comparison to other industries. A bank’s asset side of the balance sheet is customarily more than 85% weighted with loans and other earning assets. Therefore, the respective intrinsic value formulas must take this into consideration. Finally, banks and other financial institutions are susceptible to net interest margins which is tied to the portfolio’s risk factors (types of loans) and the sourcing of capital to finance these earning assets. Thus, the formula for intrinsic value must adapt to this interest spread between what is earned and what is paid out for use of money.

This article goes into great detail about how banks make a profit. The intrinsic value formula is designed around this unique business model. The final section goes through an eight step procedure to determine intrinsic value of bank stock. This article is for members only of this site’s Value Investment Club. It uses Wells Fargo as its sample and sets Wells Fargo’s intrinsic value point as of February 2021. For those of you desiring to read the entire article, you must join as a member; click on the Value Investing tab above and select Membership to read about the program and join the Club.

Value Investing – Principle #2: Intrinsic Value (Lesson 7)

Intrinsic Value

Intrinsic value is just one of the four principles of value investing. Intrinsic value sets the floor price of the investment; i.e. it is an automatic buy. Any price higher than this intrinsic value must be substantiated by other value investing criteria. In effect, other criteria may increase the buy point upwards of 20%.

Intrinsic value utilizes one or more of three different valuation methods. The first method and customarily applicable to high quality stocks is the discounted future free cash flow formula. The second method works best with penny and small-cap stocks; this is the traditional book method. Mid-caps’ intrinsic value is best served by the net assets value method adjusted to fair market value of the underlying assets. Those companies with strong fixed asset positions in the mid-cap market capitalization range are best served by this particular method. In effect, the accuracy increases significantly with the net assets value adjusted by fair market values for the underlying fixed assets.

Value investors customarily use the discounted cash flows method; but here too, there are adjustments tied to certain criteria to provide a more accurate and reasonable intrinsic value for the stock.

Value Investing – Reasonable Expectations (Lesson 1)

Value Investing

Value investing is superior to other investment models over long journeys of time. In the short run, volatility can paint a false picture of success for other methods of investing. Adherence to core principles and preset buy/sell points will win, not in large increments, but will prevail over extended time in years. The key is to have reasonable expectations from the results of an investor’s hard work. Don’t be mistaken, value investing does require some commitment by investors. An investor should be willing to invest one to two hours per work on their portfolio, most of this reviewing financials and implementing the buy/sell orders to the broker.

There are three reasonable outcomes a value investor expects. The first relates to actual returns on the investment, net of fees and taxes. Secondly, value investors will also experience less stress than other forms of investing. This is a reflection of setting up financial boundaries and simply allowing time to do its job. Finally, don’t kid yourself; this is not an easy program. It does require some work. A reasonable expectation is one to two hours per week for a portfolio less than $1 Million. Once you understand the system, it is relatively easy to methodically follow a regimen of checking resources and verifying compliance to the plan.