Intrinsic Value: Value Investing
How to Value a Stock: Calculating Intrinsic Value
In our “Deep Value Investing Definition” article we wrote that value investing is about buying a stock at a sufficient discount to intrinsic value. This article will further discuss classic definition or the first widely published formula that was used to calculate intrinsic value. We also introduce other various valuation methods that some investors use to arrive at an estimate of a stock’s (company’s) intrinsic value.
The calculation of intrinsic value is as much art as science. Any investor can run a mathematical screen to identify stocks trading at various metrics that could indicate potential value. However, it must take keen business sense and deep curiosity to ask why a stock may be trading at the level it is, whether there actually is business value and how much, and what potential catalysts could emerge to unlock value.
To calculate intrinsic value, Benjamin Graham created a simple formula:
Intrinsic Value = E (2 * R + 8.5) * 4.4 / Y
E = the company’s earnings per share
R = the company’s expected earnings growth rate
Y = the current yield on AAA corporate bonds
Graham advocated only buying stocks trading near or, preferably, significantly below its intrinsic value. (Source: Janet Lowe, Value Investing Made Easy)
Of course, the Graham’s intrinsic value formula assumes the company is a “going concern” (i.e. the company will continue to operate in a manner that allows it to earn revenue and contractually discharge its liabilities). This is quite different than valuing a stock on a “liquidation” basis which attributes little value to earnings (likely even a negative value for expected losses) and primarily considers the current market value of saleable assets after accounting for disposal costs. The details here are beyond the scope of this article but it is an important consideration worth mention.
The most successful value investor of all, Warren Buffet, was not always sold on the use of formulas. Buffet advocated buying great businesses at good prices. Buffet would first determine what type of business he wanted to buy and then waited to buy that business (stock) at a good price. Graham’s intrinsic value formula could be one tool to help assess whether the current trading price provides a sufficient margin of safety but Buffet always advocates that the first step is to identify great businesses.
In Value Investing, Greenwald et al. proposes that intrinsic value “is the discounted value of the cash that can be taken out of a business during its remaining life.” This is also commonly known at the Discounted Cash Flow (DCF) model. Of course, the calculation of DCF has many important underlying assumptions that can result in widely varying results. Consequently, it is not a model that all value investors rely upon nor is it a model that is supported in practice by Greenwald et al.
Further Discussion for Stock Valuation
Other methods of estimating or calculating the value of a stock include:
* Discounted Cash Flow
* Net Asset value (Book vs Market)
* Liquidation value
* Net Net Working Capital or Net Current Asset Value
* Other commonly quoted metrics: Price to Earnings, Price to Sales, Price to Book
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