How much should you pay for a business?
When you buy a stock, you are investing in a company, which translates into you investing in that company’s business. Every day the stock market offers prices for thousands of businesses, but how do you know if the price for any particular business is too low or too high?
To succeed as an investor, you must be able to estimate a business's true worth, or "intrinsic value," which may be entirely separate from its stock market price.
For legendary investor and author Benjamin Graham, a business's intrinsic value could be estimated from its financial statements, namely the balance sheet and income statement.
Here’s a case in point where Graham make a killing on a stock where the company’s intrinsic value was much more than its market value.
Standard Oil was an American oil producing, transporting, refining and marketing company, and also the largest oil refiner in the world in the 1920s. Viewed as a monopoly, under the Sherman Antitrust Act, the U.S. government split Standard Oil into smaller independent entities.
As Benjamin Graham was conducting his research on the companies, he discovered that all the pipeline companies owned huge amounts of the finest railroad bonds. He also discovered that they were doing a comparatively small gross business, with a large profit margin, carried no inventory and had no need whatever for these bond investments.
He narrowed down on Northern Pipeline because it had the greatest amount of securities per share relative to its market price. The company, responsible for transporting crude oil to Standard’s refineries, held $95 per share in railroad bonds and other liquid assets, nearly all of which it could distribute to its stockholders without the slightest inconvenience to its operations. Meanwhile its stock was trading at $65 per share.
To read the entire account in detail, click here.
Graham, in his book, Security Analysis, defines intrinsic value as “that value which is justified by the facts—e.g., assets, earnings, dividends, definite prospects. In the usual case, the most important single factor determining value is now held to be the indicated average future earning power. Intrinsic value would then be found by first estimating this earning power, and then multiplying that estimate by an appropriate ‘capitalization factor.”
The intrinsic value is the actual value of a stock as opposed to its current market price.
The intrinsic value is arrived at taking into account current cash flows, estimated future cash flow, growth potential, and competitive positioning that accounts for variables such as brand, trademarks, patents and copyrights.
The discounted cash flow approach is most commonly used. This starts with the proposition that the value of the stock is not what someone perceives it to be worth but it is a function of the expected cash flows on that asset. So a company with high and predictable cash flows should be assigned a higher value than one with low and volatile cash flows.
In discounted cash flow valuation, the analyst will estimate the value of the stock as the present value of the expected cash flows on it, discounted back at a rate that reflects the riskiness of these cash flows.
In the article Attaining investment serenity, Aswath Damodaran, professor of finance at the Stern School of Business, NYU, referred to himself as an intrinsic value investor.
He went on to explain that each investment in his portfolio has to meet the same test to remain in the portfolio, as it did when he first bought it. That test is a simple one: He should buy when a stock trades at a price below its intrinsic value and should not if it trades above it.
How does he explain intrinsic value?
It is the value that you would attach to an asset, based upon its fundamentals: cash flows, expected growth and risk. At its core, if you stay true to principles, a discounted cash flow model is an intrinsic valuation model, because you are valuing an asset based upon its expected cash flows, adjusted for risk. Even a book value approach is an intrinsic valuation approach, where you are assuming that the accountant's estimate of what fixed and current assets are worth is the true value of a business. (Source: Thoughts on intrinsic value).
