Intrinsic Value Formula for Beginners

14 minutes

 

Stock Market

“The newer approach to security analysis attempts to value a common stock independently of its market price. If the value found is substantially above or below the current price, the analyst concludes that the issue should be bought or disposed of. This independent value has a variety of names, the most familiar of which is “intrinsic value”.

– Ben Graham, Security Analysis (1951 Edition)

Trying to determine the intrinsic value of a stock, car, home and iphone is an art form. There is no specific formula that can help you find the actual value of an item that does not have any error in it. There are many different formulas that can be used to determine the intrinsic value. But, unfortunately, there is no spreadsheet that you can plug numbers into that will give you that hard fast, rigid price.

Definition of Intrinsic Value

“A general definition of intrinsic value would be 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. The intrinsic value would then be found by first estimating this earning power, and then multiplying that estimate by an appropriate ‘capitalization factor’”.

Ben Graham, Security Analysis

Or this from Joel Greenblatt,

“Value investing is figuring out what something is worth and paying a lot less for it.”

Finally this from Investopedia.

“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. Additionally, intrinsic value is primarily used in options pricing to indicate the amount an option is in the money.”

All of these definitions say it pretty well. Intrinsic value is used for many things. It is mostly associated with buying stocks but it can be used for just about anything. Cars, homes, iphones, a loaf of bread. You get the idea.

Value investors use this theory and formulas to determine what the value of a company is. They use it to help find out what price they need to pay to achieve a margin of safety.

Notice that I haven’t mentioned price much? This is because intrinsic value focuses on what a company is worth, not how much it is trading for on the stock market. Price does not equal value.

“Price is what you pay, value is what you get.”

Warren Buffett

This is the first line in the value investing manual. Well, maybe not. But it should be. Price is a function of the vagaries of the stock market. Mr. Market has a field day with the price.

Value is something much more valuable than the price you pay for something. Can you put a price on your home? No, but you can put a value on it.

In the stock market world finding the intrinsic value is of utmost importance. This gives us the ability to determine a margin of safety. Which is critical to determining whether or not this is a company we want to invest in.

Why does intrinsic value matter?

In a broad sense using an intrinsic value formula to calculate that value gives you the opportunity to decide whether or not to buy or sell a company.

Continue reading “Intrinsic Value Formula for Beginners”

Patience Leads to Success When Examining Investing Opportunities

9 minutes

Baseball

“Baseball is the only field of endeavor where a man can succeed three times out of ten and be considered a good performer.”

Ted Williams

My favorite sport in the whole world is baseball. I love everything about it. The history, strategy, pace of play, intricacies, stats, and the grace of the game.

It can be breathtaking and heartbreaking, sometimes in the same play. There is nothing like watching a playoff game with the game on the line and both team’s best pitcher and hitter competing against each other.

To stand in the batter’s box and face a man that can throw over a 100 mph takes courage and an incredible amount of skill. This is not a skill that everyone has, to hit a round ball with a round bat and to do it successfully.

Michael Jordan was considered the finest athlete of my generation and he couldn’t hit a baseball. It is considered by some to be the hardest act there is in sports.

Consider this, to be a successful hitter in baseball means that you only succeed three out of ten times. In any other profession, you would be fired so fast with a performance like that. Imagine a computer repairman only fixing three out of ten computers.

Out of business.

Ted Williams, is considered arguably the greatest hitter in the history of the game. He played from 1939 to 1960 with the Boston Red Sox. His career average of .344 and 521 are some of the best in the history of the game. At the age of 39, he hit .388 which won him the league batting title that year. Which made him the oldest player to ever win a batting title.

In his final at-bat of his career, he hit a home run. Very fitting for a player of his caliber.

Simply put, the man could hit.

So what does this have to do with investing? Well, let’s take a look.

Ted Williams and the Science of Hitting

After his playing days, Williams still was a major influence on the baseball world. He did manager for a short time and did some consulting for the Red Sox.

But his greatest contribution was his study of hitting. During his career, he was a great student of hitting and was always reviewing what the pitchers were doing and using this information to analyze his approach to become better.

He said that most players during his time didn’t pay much attention to what the pitchers were throwing and how they did against those pitches. Bobby Doerr, who was a career .280 hitter would often come back to the bench without any idea what pitch was thrown, even if he hit a homerun.

In his seminal book “The Science of Hitting” he described his discipline with his approach of creating 77 cells in the strike zone, each the size of a baseball. Swinging only at balls in his best zone would allow him to hit .400. Reaching for balls in his worst zones, for example, the low and outside corner zone of the strike zone would reduce him to a .230 hitter.

He found that if he waited for his pitch in a zone that he could handle then he was going to be very successful and if he swung indiscriminately at any pitch in any zone he was likely to very unsuccessful.

I would say that his philosophy worked out for him pretty well. He combined power, patience, and skill into a combination that has not been seen since his time in the league. Continue reading “Patience Leads to Success When Examining Investing Opportunities”

Who is Mr Market and why do we care?

9 minutes

 

Mr. Market

The stock market goes up and down every day. If you watch one of your stocks on a daily basis you could see it rise and fall even on the same day. It can be kind of maddening and extremely frustrating.

One of the questions that investors ask is why does the market behave this way? Frankly, there is no easy answer and there are lots of speculations about the real reason.

Stock prices can change daily as a result of market forces. This means that the prices rises and falls due to supply and demand. If more people want to buy or demand than sell it or supply. Then the price goes up. On the flip side if more people want to sell the stock than buying, then there would be a great supply than demand and the price would fall.

Now if only it were that easy, let me assure you it is not.

Who is Mr. Market?

Mr. Market is a creation of Benjamin Graham that he used to explain the vagaries of the stock market.

Benjamin Graham is considered the father of value investing and was a huge influence on Warren Buffett. In 1949 Graham wrote a hugely influential book titled “The Intelligent Investor”. This book is considered by most to be the biggest influence on investing out there.

In this seminal work, he included his character, Mr. Market.

So what does Mr. Market do?

Every day he shows up at your door offering to buy and sell his shares at a different price. Sometimes, the price quoted by Mr. Market seems reasonable, but most times it is ridiculous. The investor is free to agree with the quoted price and do a trade with him. Or to ignore him completely. Mr. Market doesn’t mind either way and tomorrow he will be back to quote another price.

Sounds simple, huh.

Let’s look at an excerpt from The Intelligent Investor, Revised Edition 2005, pages 204-5.

“Imagine that in some private business you own a share that costs you $1,000. One of your partner’s, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest on that basis. Sometimes his idea of value seems plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

“If you are a prudent investor or sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you would be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position. Continue reading “Who is Mr Market and why do we care?”

Interest Rates: How They can Help Us or Hurt Us

15 minutes

 

Today’s interest rates are currently the lowest in human history. There are some countries in the world that are offering negative interest rates which means that you have to pay your bank to keep your money in their accounts.

There has been a lot of talk in the news about interest rates and how they affect us. With the rates being so low and all the talk about how they are going to start raising them, I thought this would be a good time to discuss why this is big deal and how it affects our investments.

How did we get here, to begin with? Well in 2008 when everything went sideways in the markets, economy and real estate the Fed needed to do something to try to stop the bleeding. One of their actions was to lower the interest rates. They ended up lowering them to 0.25% which was the lowest in US history. Originally they had set the benchmark level to be a 1% but they felt that the only way to get ahold of this was to lower the rates to this unprecedented level.

The rates have remained at this level until recently they have begun to raise them slightly. Last year in December 2015 they raised the rates 25 basis points or 0.25% and this December 2016 they raised them another 25 basis points.

What is the Federal Reserve?

The Fed was established in 1913 and up to this time the US was a considerably more unstable place financially. Panics, seasonal cash crunches and a high rate of bank failures made the US economy a poor place for international and domestic investors to place their money.

It was J.P. Morgan who forced the government into acting on its decade’s long plans of creating a central bank. During the Bank Panic of 1907, Wall Street turned to J.P. Morgan to steer the country through the crisis that was threatening to push the economy over the edge and into a full crash and depression.

Morgan was able to convene with all the principal players at his mansion and command that all their capital flood the system, thus floating the banks, that in turn helped float the businesses until the panic passed.

The fact that the government had to rely on a private banker for its economic survival forced it to pass the necessary legislation to create a central bank and the Federal Reserve.

The Federal Reserve was given control over the money supply and, by extension the economy. During the crash of 1929 and the start of the Great Depression the Fed stood by and did little to nothing to prevent or soften the blow that followed during those years. This has been hotly debated in the years following about what impact they could have had but the fact that they did nothing was definitely a factor in the length and depth of the Great Depression.

During the crash of 1987 Alan Greenspan gathered all the leaders together echoing J.P. Morgan and during his meeting, he dictated that the major players flood the markets to keep the banks afloat. He also instituted lowering the interest rates as a weapon to control the economy. This was the first time it was done and it set a precedent.

The Fed uses the control of the interest rates to make corporate credit easy to get, thus encouraging business to expand and create jobs. Unfortunately, this can also cause inflation to rise. To control this they lower interest rates which cause the economy to slow and can cause unemployment. So it is a double-edged sword.

Continue reading “Interest Rates: How They can Help Us or Hurt Us”