Stock investors tend to use a vocabulary that is seemingly alien to others. Here are three basic terms investors or potential investors should familiarize themselves with.
Intrinsic Value
The intrinsic value is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value.
Intrinsic value refers to an investor's perception (and it differs among investors) of the inherent value of the company’s stock. It arrives at its “true value” taking into account tangible and intangible aspects of the business.
Morningstar’s analysts arrive as such a value using a discounted cash flow model. This valuation technique is based on the premise that a company is worth the sum of its future free cash flows, discounted back to the present at a rate that provides an adequate return on investors’ capital. When doing so, the analysts make specific forecasts about a company’s future revenue, operating costs, working capital investments, capital expenditures, and other financial statement line items. They must also estimate a discount rate—a weighted average of the cost of debt (which can be observed, though it changes over time) and the cost of equity (which is unobservable and requires us to make an educated guess about the returns required by stock investors).
Margin of Safety
If stock prices always reflected the true intrinsic value of the underlying businesses, there would be no point to stock-picking. However, the reality is that stock prices often deviate from fair value, sometimes by a wide margin.
Value-investing pioneer Benjamin Graham provided our favorite analogy: In the short run, the market is a voting machine—a stock’s price reflects its current popularity and the market’s whims. However, in the long run the market is a weighing machine—stock prices eventually converge toward the intrinsic value of the businesses they represent.
Let’s say you estimate the intrinsic value of a stock at Rs 100. You believe that is what the stock is really worth. But you don’t buy it. And it would be foolish to buy it at Rs 98 too. There’s no room for error. But if you buy it at Rs 70, then you have a 30% margin of safety. The Rs 30 difference between estimated intrinsic value and purchase price is the margin of safety. This is the buffer in case unforeseeable events alter the business landscape. Or, if you are wrong on your intrinsic value calculation by placing it too high, you still have a strong chance of making money. By purchasing the stock at Rs 70, it allows you to be wrong by 30%. Since there are no guarantees in stock market investing, this will not guarantee that you won’t make a loss but it does vastly reduce the likelihood of your doing so.
To understand the link between Intrinsic Value and Margin of Safety better, read How to buy stocks and cut your risk
Moats
A company with a very profitable business is like a castle that is constantly under attack by competitors. Without a strong defense, competitors will soon imitate the company’s products, charge lower prices, steal market share, and erode profit margins to the point where the business is merely average, at best.
An economic moat —a term coined by Warren Buffett— is what keep competitors at bay.
It is a sustainable competitive advantage that allows a company to earn excess returns on capital (that is, returns on invested capital greater than the cost of capital) for a very long time.
We define a wide moat as a competitive advantage that is almost certain to last at least 10 years, and probably 20 years or more. Wide moat companies are very hard to attain and very few companies globally have a wide moat rating. The standard for a narrow moat is lower—it only needs to be more likely than not that the competitive advantage will last for 10 years.
The vast majority of companies have no moat. So even if they are earning excess returns now, it is not wise to expect them to persist long into the future.
For instance, when our analyst looked at RIL and L&T two years ago, no economic moat was assigned to either. Coal India, on the other hand, was given a Narrow moat rating.
While it makes for an excellent investment strategy, investing in a wide or narrow moat company is no guarantee to success. Valuation does play a very critical role. So don’t over pay for quality companies. Buying them when they are trading at a discount to their fair value is a really important consideration.
For more detail on how to identify a moat with examples, do read Why equity investors must understand moats
Economic moats aren’t stagnant over time. Rather, competitive dynamics are constantly shifting as technology develops, regulations change, competitors exit or enter a market, companies gain scale, and so on. For example, the switching costs and network effects that historically benefited Microsoft’s Windows operating system were steadily eroded by the growth in smartphones and tablets, where Google’s Android and Apple’s iOS dominate.
This is where our moat trend ratings come in.
If the underlying sources (or potential sources) of a company’s competitive advantage are improving over time, the company has a positive moat trend. If the underlying sources (or potential sources) of an economic moat are weakening or a company faces a substantial competitive threat that is growing, then it has a negative moat trend.
