How does one calculate a stock's intrinsic value?

[Ariyahn2011]

Does anybody have any calulations on how to work out a stocks intrinsic value?
Thanks in advance : - )

 

[luutzu]

Does anybody have any calulations on how to work out a stocks intrinsic value?
Thanks in advance : - )

V= E x (8.5 + 2g)

Where E is simply current year's earning, g the expected growth rate per year over next 7 to 10 years.

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Above from Graham's Intelligent Investor where he said it's the approximate of all those crazy discounted cash flow voodoo (my word).

It works great, particularly because there's only two variables to look at.. and when you apply correctly it does wonders.

 

[skc]

V= E x (8.5 + 2g)

Where E is simply current year's earning, g the expected growth rate per year over next 7 to 10 years.

---

Above from Graham's Intelligent Investor where he said it's the approximate of all those crazy discounted cash flow voodoo (my word).

It works great, particularly because there's only two variables to look at.. and when you apply correctly it does wonders.

Just wondering...

g = decimal or percentage?
V = equity value or enterprise value?

Also noting that there's no risk free rate in this equation... well there is, but it's embedded and fixed into the 8.5 constant. So it might work well for much of the times, but may not work very well when the risk free rate goes extreme to one end of the spectrum or the other (like we do now)?

 

[luutzu]

Just wondering...

g = decimal or percentage?
V = equity value or enterprise value?

Also noting that there's no risk free rate in this equation... well there is, but it's embedded and fixed into the 8.5 constant. So it might work well for much of the times, but may not work very well when the risk free rate goes extreme to one end of the spectrum or the other (like we do now)?

g is percentage.

So if g expected to be 3%, V = E*(8.5+(2*3))

V is enterprise value - the entire company.

I think Graham later revised it to incorporate bonds yield (assuming that's his definition of risk-free rate)... but that's a different formula.


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The above works fine by me... I don't need to look at any macro factors beside the company itself.

Have tested on a couple of companies Buffett bought... could be coincidental, but this seem to be about right. Though the perpetual bond thingy raised a while back is still valid, this is simpler and could be manipulated to give implications etc.

 

[tinhat]

Some previous discussions on calculating intrinsic value:

Present Value of Future Cash Flows

Buffett's 5 second intrinsic value calculation

Fundamental Analysis Techniques

Students of Roger Montgomery's (Buffett's) intrinsic valuation method

Who uses Discounted Cash Flow (DCF)?

 

[galumay]

Does anybody have any calulations on how to work out a stocks intrinsic value?
Thanks in advance : - )

Yes, but my view is that the best case scenario is to arrive at a valuation range, rather than a specific, precise value.

I use a free cash flow model, I have found earnings alone to be far too misleading for IV calcs. I also assume very low earnings growth, my studies lead me to believe analysts are almost always incorrect about future earnings.

I dont use discounted cash flow alone, i assess a whole range of metrics and try to understand the business model. There may be reasons for a company initially seeming to have a low or high IV, but then if I dig deep enough, (and get enough help from the really knowledgable guys!), i can often find an explanation.

Its not a precise science, I learnt a lot reading Aswath Damodaran's site, and here on ASF, craft has been an invaluable contributer in the DCF thread, along with other learned contributers like skc, ves etc.

I feel like I have a reasonable handle on it now, generally i have a level of confidence in my assessment as to whether a company is trading around, well above or well below IV. But i expect its something I will always be learning more about and fine tuning over time. I never expect it to spit out an exact value.

 

[craft]

Does anybody have any calulations on how to work out a stocks intrinsic value?
Thanks in advance : - )

Depends on what you define "intrinsic" to mean. What is your definition of intrinsic value?

If your definition of intrinsic value is the value that some calculation spits out then you are in an extremely dangerous place by trying to use "Intrinsic value".

 

[sinner]

The Iron Law of Valuation per Hussman

http://www.hussmanfunds.com/wmc/wmc140414.htm

The Iron Law of Valuation is that every security is a claim on an expected stream of future cash flows, and given that expected stream of future cash flows, the current price of the security moves opposite to the expected future return on that security. Particularly at market peaks, investors seem to believe that regardless of the extent of the preceding advance, future returns remain entirely unaffected. The repeated eagerness of investors to extrapolate returns and ignore the Iron Law of Valuation has been the source of the deepest losses in history.

A corollary to the Iron Law of Valuation is that one can only reliably use a “price/X” multiple to value stocks if “X” is a sufficient statistic for the very long-term stream of cash flows that stocks are likely to deliver into the hands of investors for decades to come. Not just next year, not just 10 years from now, but as long as the security is likely to exist. Now, X doesn’t have to be equal to those long-term cash flows – only proportional to them over time (every constant-growth rate valuation model relies on that quality). If X is a sufficient statistic for the stream of future cash flows, then the price/X ratio becomes informative about future returns. A good way to test a valuation measure is to check whether variations in the price/X multiple are closely related to actual subsequent returns in the security over a horizon of 7-10 years.

...

Put simply, every security is a claim on some future expected stream of cash flows. For any given set of expected future cash flows, a higher price implies a lower future investment return, and vice versa. Given the price, one can estimate the expected future return that is consistent with that price. Given an expected future return, one can calculate the price that is consistent with that return. A valuation "multiple" like Price/X can be used as a shorthand for more careful and tedious valuation work, but only if X is a sufficient statistic for the long-term stream of future cash flows.

...

The question is whether P/E multiples, or the Shiller cyclically-adjusted P/E, or the forward operating P/E, or price/book value, or market capitalization/corporate earnings, or a host of other possibilities can be used as sufficient statistics for stock market valuation. The answer is no.

What we find is that both margins and multiples matter, and they matter with nearly the same regression coefficients – all of which imply that revenue is a better sufficient statistic of the long-term stream of future index-level cash flows than a host of widely-followed measures. Emphatically, one should not use unadjusted valuation multiples without examining the relationship between the underlying fundamental and revenues.

 

[craft]

The Iron Law of Valuation per Hussman

http://www.hussmanfunds.com/wmc/wmc140414.htm

Nice to see Hussman has his definition upfront.

claim on an expected stream of future cash flows.

This is what the OP needs to do before even thinking about the appropriate calculation. Importantly he must decide if a 'price' for re-sale (and at what time frame) of the asset forms part of the cashflow.

What we find is that both margins and multiples matter, and they matter with nearly the same regression coefficients – all of which imply that revenue is a better sufficient statistic of the long-term stream of future index-level cash flows than a host of widely-followed measures. Emphatically, one should not use unadjusted valuation multiples without examining the relationship between the underlying fundamental and revenues.

I have bolded a bit that I think is important. The aggregation makes price/sales useful for indexes that approximate the overall economy. Not so useful a measure for individual companies

 

[sinner]

I have bolded a bit that I think is important. The aggregation makes price/sales useful for indexes that approximate the overall economy. Not so useful a measure for individual companies

Some points:

First, I don't necessarily disagree, price/sales is more useful for economic indices (country, sector, etc) than individual equity names. But I think this highlights the importance of understanding and finding a sufficient statistic (be it for investing in bonds, stocks, realestate, term deposits or anything else).

Secondly, I think the main gist that you should account for margins as well as multiples in your choice of sufficient statistic still stands.

Thirdly, although there are some single year ratios which perform better than P/S (EV/EBIT comes to mind), P/S has still been demonstrated to be about as sufficient as, say P/E or P/B in the sense that the annual value decile outperforms the median decile and glamour decile in market wide portfolios for decades (although admittedly the performance of deciles is not perfectly systematic).

 

[tech/a]

Now I can see why one expert thinks a stock is a bargain and another thinks its expensive or fairly priced over the opinion of another.

I really keep coming back to the conclusion that in most cases profit is gleaned from "a rising tide floating all boats' rather than any analysis'---in particular to trading stock.

Analysis--any analysis T/A or F/A can sit and wait or be applied and re applied until the tide arrives.
Limiting losses until it rises and sitting long on the rise---equals profit.

Rising tides make T/A triggers frequent and reliable.
Rising tides bear out F/A valuations particularly those that rise toward a fairer valuation.

In BOTH cases falling or dodge tides make both forms of analysis look poor---even guess work.

 

[sinner]

Now I can see why one expert thinks a stock is a bargain and another thinks its expensive or fairly priced over the opinion of another.

I really keep coming back to the conclusion that in most cases profit is gleaned from "a rising tide floating all boats' rather than any analysis'---in particular to trading stock.

Analysis--any analysis T/A or F/A can sit and wait or be applied and re applied until the tide arrives.
Limiting losses until it rises and sitting long on the rise---equals profit.

Rising tides make T/A triggers frequent and reliable.
Rising tides bear out F/A valuations particularly those that rise toward a fairer valuation.

In BOTH cases falling or dodge tides make both forms of analysis look poor---even guess work.

In a perfectly functioning market, with books thick with real orders and all stops honoured, I do not disagree with your sentiment. Both strategies attempt to enforce return convexity onto the asset in question, only via different means.

However, if market function is poor (think 1987 crash, flash crash, etc) then T/A strategies are much riskier and correctly implemented value strategies much less so.

The other major difference, I would say, is after tax performance for investors who don't have the benefit of being registered as traders, since in that case short term stuff will cost them significantly more in CGT.

 

[McLovin]

Secondly, I think the main gist that you should account for margins as well as multiples in your choice of sufficient statistic still stands.

You never know when you're at the top or the bottom of the cycle but margins give you a good idea as to where you are on the pendulum. There are other good indicators around asset utilisation that can also aid in determining where the cycle is. The mining services companies are a great case study in mean reversion.

 

[craft]

Some points:

First, I don't necessarily disagree, price/sales is more useful for economic indices (country, sector, etc) than individual equity names. But I think this highlights the importance of understanding and finding a sufficient statistic (be it for investing in bonds, stocks, realestate, term deposits or anything else).

Yep agree, but there just isn't a universal sufficient statistic for individual companies - that's why no short cut formula adequately suffices for an individual analysis of the unique value drivers at a company level.

Secondly, I think the main gist that you should account for margins as well as multiples in your choice of sufficient statistic still stands. I would say profitability as well as multiples. Margin is just one aspect of profitability.

Thirdly, although there are some single year ratios which perform better than P/S (EV/EBIT comes to mind), P/S has still been demonstrated to be about as sufficient as, say P/E or P/B in the sense that the annual value decile outperforms the median decile and glamour decile in market wide portfolios for decades (although admittedly the performance of deciles is not perfectly systematic).

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[sinner]

...

By market wide, I do really mean, take all of the stocks on the ASX or NYSE or whatever, apply a minimal liquidity filter and then sort the remaining universe by one ratio or another. So yes, you would be comparing the P/S of Woolworths with the P/S of Oceana Gold.

This does work, even if it is a little counterintuitive. Like I said, it's provably sufficient.

The bet is a little bit more crude than you're probably thinking when someone says "value premium", but essentially the value decile is often full of crap businesses, with outperformance driven by the fact that the businesses are often not as crap as the market price implies.

 

[craft]

By market wide, I do really mean, take all of the stocks on the ASX or NYSE or whatever, apply a minimal liquidity filter and then sort the remaining universe by one ratio or another. So yes, you would be comparing the P/S of Woolworths with the P/S of Oceana Gold.

This does work, even if it is a little counterintuitive. Like I said, it's provably sufficient.

The bet is a little bit more crude than you're probably thinking when someone says "value premium", but essentially the value decile is often full of crap businesses, with outperformance driven by the fact that the businesses are often not as crap as the market price implies.

I don’t think Hussman was referring to low P/S beats high P/S from a deciles perspective and thats not what I’m talking about – different discussion entirely. Rather P/S is a sufficient statistic for mean reversion at the index level.

Aggregated market wide or for large indexes etc we agree P/S is a good measure, maybe the best available. I'm simply saying it doesn't transfer to the individual company level.

What Woolworth may lose in profitability because of a structural change to competition is very important to the valuation of Woolworths. In aggregate, what Woolworths loses Aldi or somebody else in the economy picks up.

Putting it another way, WOW could have depressed price to sales ratio but that wouldn’t say anything about the likely hood of reversion to a historical p/s ratio for WOW if its profitability is being structurally eroded by competition. Take a step up to industry level and P/S still doesn’t tell you a lot if the industry is in structural decline/acceleration compared to other industries – but go to economy level and what one party loses another tends to gain unless the economy has shrunk. Only in aggregate can p/s(in isolation) tell you something about where you sit on the price multiple pendulum.

 

[Triathlete]

However, if market function is poor (think 1987 crash, flash crash, etc) then T/A strategies are much riskier and correctly implemented value strategies much less so.

Like to share some examples of this..?

It has been my experience that trading over a medium time frame using advanced T/A techniques and applied correctly is as safe as any strategy and further more will get you out of potential bad position much sooner then any F/A strategy once you are in a position IMHO...eg Forge group...WOW....

 

[galumay]

Like to share some examples of this..?

It has been my experience that trading over a medium time frame using advanced T/A techniques and applied correctly is as safe as any strategy and further more will get you out of potential bad position much sooner then any F/A strategy once you are in a position IMHO...eg Forge group...WOW....

I am a bit confused about the point you are making, how are Forge or WOW relevant to a flash crash or GFC in your example?

Secondly I dont see a case for buying positions in either based on FA at the areas in time before they suffered significant drops in price.

 

[Triathlete]

I am a bit confused about the point you are making, how are Forge or WOW relevant to a flash crash or GFC in your example?

Secondly I dont see a case for buying positions in either based on FA at the areas in time before they suffered significant drops in price.

Maybe I miss understood what was being said regarding T/A being riskier than F/A...

The reason I put Forge group as an example was I remember two of the countries leading personnel investment firms at the time that base there selections on F/A had this company as a great buy at the time ( i nearly bought some) however after some T/A decided against it as the technicals were against me so that helped me stay out of the stock and would'nt you know it a few months later they went out of business.

My main point though is I do not think you can make a statement that one type of analysis is more riskier than another as it all depends an how each person is applying it.

 

[galumay]

My main point though is I do not think you can make a statement that one type of analysis is more riskier than another as it all depends an how each person is applying it.

Ok, I see where you are coming from now.