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.

Analysts use these formulas to determine whether to assign “undervalued” or “overvalued” tag to their analysis of a company.

One of the things I dislike about this approach is that they use this formula solely to assign one of these tags to a company. There are so many other factors that go into deciding whether the company is over or undervalued. The analysts use these formulas because it is an easy way to determine a value and then compare it to the price that is being quoted on the market.

As a value investor, using the intrinsic value formula is a tool that can help me determine what the value of said company is. Then I  can use that value to help me determine a margin of safety. Once I have that set then I can start my investigation into the company to determine whether or not I want to own a piece of that business.

Unfortunately, I am not Warren Buffett and have no option of just outright buying these companies, so I will just have to work with my measly pennies.

Using the intrinsic value formula should be a means for you to determine the value of a company and then determine your margin of safety. This can help lessen the blow if you make a mistake in your determinations.

We all make mistakes, and using one of these tools can help you lessen these mistakes. Even the great Warren Buffett has made a mistake or two along the way.

Remember that intrinsic value is an art? The reason for this comment is that it is subject to many variations and is imprecise. This is what Buffett had to say about the subject.

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

“The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure… two people looking at the same set of facts… will almost inevitably come up with at least slightly different intrinsic value figures.”

Because it is an art form, it takes practice.

Some of the key concepts to keep in mind that we are trying to determine are:

 

  • Looking at a company’s historical financials
  • Profitability
  • Stability of the operating business
  • Balance sheet
  • Evaluating its competitiveness or moat
  • Understanding its future prospects
  • Evaluating management

Now, obviously, we can’t evaluate all of those in a simple formula. The numbers can be plugged into a formula but the concepts need to have more investigation into to determine the value.

I read recently that it is more important to buy a great business at a good price, rather than a good business at a great price.

I take this to mean that we get more value out of a great business in the long run than simply paying a cheap price.

Ever heard the phrase “you get what you pay for.”?

 

intrinsic value

What do we get when we buy a company?

In simple terms, we are buying future earnings. If you notice to above quote by Graham he mentions earnings as the “most important single factor determining value”.

John Huber of Base Hit Investing wrote a fabulous two-part series on intrinsic value. It is a must read for those of you interested in this topic. I linked to it earlier in the post.

In his post, he mentioned a definition that I thought perfectly summed up his definition of intrinsic value.

  1. How much does the business earn in a normal year?
  2. What is that earnings stream worth to me?

Pretty simple and straightforward. When we buy a business we are assigning a value to that business’ future earnings.

What are earnings? According to thebalance.com

“The earnings of a business are the same as its net income or its profit. Either term means the same thing.

Earnings are usually calculated as all revenues (sales) minus the cost of sales, operating expenses, and taxes, over a given period of time (usually a quarter or a year).

For example, let’s say the gross sales of a company are $500,000 for a year. Reduce this number by the cost of sales at $300,000, operating expenses (including depreciation) of $80,000, and taxes of $20,000. The result is the company’s earnings (profit, net income) of $100,000.”

Earnings are the bread and butter of Wall Street. Analysts base their evaluations on earnings, and growth investors wait in anticipation for their release every quarter. Without them, a company cannot continue and thrive.

When it comes to earnings, in regards to intrinsic value. We are looking for future earnings. Not really focusing on what has happened in the past. But looking for a prediction of the company’s future earnings.

To break it down simply, we are looking for future earnings or the earning power of the company. We want to see a constant stream of cash from the company over the coming years. The intrinsic value formula will help you determine how much the company is worth and then we can decide how much those future earnings are worth to us.

Think of it this way. If a company can earn $5 a share. How much is that $5 worth to me now and in the future? If you think they can grow their business 10% a year by reinvesting and retaining part of those earnings. Then you can decide if that is worth more to you than the company that just pays out all of its earnings in dividends, as opposed to reinvesting them for more growth.

This is why they call valuation an art. There are no airtight rules governing these thoughts. Makes it a challenge. Also, gives you some idea of the difficulty of making these decisions. Plus you get some insight into why some investors only choose a few stocks a year to invest in. ie Warren Buffett, Monish Pabrai to name a few.

Intrinsic Value Formula per Ben Graham    

Now we get to talk some numbers. Don’t worry I will walk you through everything. It won’t be that bad and they are frankly pretty simple calculations.

There are many formulas that can be applied to the intrinsic value. For our purposes today I am going to discuss the first of two that I use. We will discuss the other, discounted cash flows, next week. The first is the formula created by Benjamin Graham, of The Intelligent Investor fame. Also taught this guy named Warren Buffett too.

His original formula is:

V = EPS X (8.5 + 2g)

Where:

V = Intrinsic Value

EPS = The trailing twelve month EPS (Earnings Per Share)

8.5 = Is the PE ratio of a stock that has 0% growth

G = growth rate for the next 7 to 10 years

The formula was later revised to

Intrinsic Value Formula

The formula is basically the same with two exceptions. He added a required rate of return, which he set at 4.4. All this would be divided by AAA corporate rate bond, which would be his risk-free rate. This would be represented by his Y.

A note on the EPS or earnings per share. This number should be taken with a grain of salt. This is because there is a lot of manipulation that can occur with this metric. I prefer to stick to the normalized EPS or one year EPS, as opposed to historical. Remember we are looking for a snapshot of value.

To be more conservative I would like to suggest we use a modification to the formula that Jae Jun at Old School Value came up with. I like his thoughts and he makes some great observations.

 

Intrinsic Value Formula

 

It is almost the same, but Jae has made it more conservative. The reasoning behind this was that Graham never encountered the high growth companies that we do today. Some of these companies have 30%,40% or even 100% growth and the numbers need to be adjusted to reflect this. Jae considers the Graham the upper limit of valuation and in the light of trying to be conservative, I would agree.

The more conservative we are the more we can build in a better margin of safety to help protect us in case make an error in our valuations.

Let’s try this out on some companies.

We’ll try a few big names to give you a taste for how this works and then we will illustrate a couple lesser known companies.

To help illustrate the ease of locating these numbers I am going to include a few screenshots to show how I arrive at these numbers. I will use two resources to locate these numbers. Morningstar and Yahoo finance

Facebook (FB)

EPS = 3.49

G = growth of 23.50%

Y = 20 year AAA corporate bond of 3.98

So after plugging all the numbers from above into the formula, we get the number of $117.68.

That was pretty easy, wasn’t it? Did you have any trouble following that?

Let’s try another.

Walmart (WMT)

EPS = 4.57

Growth = 2.83

20 AAA Corporate Bond or Y = 3.98

So our intrinsic value for Walmart would be $50.12

Okay, now let’s try a few that are little less well known. First up we’ll take a look at Gamestop. They are a video game, electronics, and wireless services, retailer. Their market cap is $2.6 Billion, which is quite a bit smaller than Walmart or Facebook. So I thought they would be a good choice to see how a smaller company stacks up.

Gamestop (GME)

EPS = 3.78

Growth = 7.25

20 AAA Corporate Bond or Y = 3.98

So our intrinsic value for Gamestop would be $60.09

Ok, the last one and then we will discuss our results and what to do with them.

Principal Financial Group (PFG)

Principal Financial Group is a global financial company that specializes in retirement accounts, insurance, and investments. Their market cap is $17.8 Billion so smaller than the big boys of the market.

  • EPS = 4.50
  • Growth = 7.83
  • Y = 3.98

After plugging in our numbers we have an intrinsic value of $73.78.

After calculating intrinsic value, now what?

So now that we have looked at the formula for calculating intrinsic value. We can take those numbers to begin the next step which would be to determine the margin of safety that we would want to calculate in.

This gives us a cushion in case we have made a mistake in our calculations. Or if we misjudged our story about the company.

Let’s take a look at our results from our calculations. We should also compare them to current market price of each company. We can then see how it fares to the current price and whether or not we can achieve any margin of safety at this time.

TickerCurrent PriceIntrinsic ValueDifferenceMargin of Safety
FB133.85117.68-16.17-13.74%
WMT68.6650.12-18.54-36.99%
GME25.7460.0934.3557.16%
PFG62.0673.7811.7215.89%

 

We can see by the numbers that both Facebook and Walmart are quite a bit above their intrinsic value. Both are selling for a price that is above what we feel they are worth.

As for the other two, you can see that they are currently priced below their intrinsic value. In the case of Gamestop, quite a lot below.

This gives us a snapshot of the values of these companies as well as a comparison to their current price. Remember what we mentioned earlier, that price is what you pay, value is what you get.

In the case of both Facebook and Walmart, they are both overpriced according to our intrinsic value formula. And in the case of Walmart, way more than I would want to take a chance on.

The whole reason for this exercise has been to try to determine what we feel these companies are worth. We do this to arrive at a price that we would be willing to pay and then we assign a margin of safety to that number to give us a cushion for any mistakes we might make.

They could be in the area of miscalculating the formula, assigning the wrong numbers, or just plain not doing enough research on the company to determine it’s value.

The amount of margin of safety you want to bake into the formula is up to you. Warren Buffett used to insist on 50%, which would be awesome. But in today’s world, those are so much harder to come by and you could end up waiting for a long time to pull the trigger on a company.

I personally shoot for at 25%, but that is not a hard, fast number. If it fluctuates a little from time to time that is ok. In the case of the stocks that we just evaluated, I would definitely continue my research on Gamestop, and possibly Prudential. But the others would be a no go at this time.

Just because you pass on a company once doesn’t mean that it will never fall into your path again. You never know how things will work out in the market. If you find a company that you really believe in and have done some research to find out it is pretty wonderful, then you must add it to a watchlist. That way when there is a market correction and the price falls into your window of a margin of safety you can feel confident in your purchase.

Keeping a watchlist of stocks is vital to your growth as an investor. It helps keep you looking for other opportunities and it keeps any company that you find interesting in your memory.

I have to admit that I cheated a little on our evaluations of the intrinsic values of our companies. I have been following Gamestop for a little while now and have been waiting for the price to drop enough. Which it did recently so I was able to add it my portfolio.

The other companies I was pretty confident would be overpriced, according to the formula. Often times, when a stock is favored by the press or institutional investors it will be priced higher than it’s intrinsic value. Part of this is that people will see a run up on a stock and want to get in on the action. The fear of missing out is pretty strong, especially in the stock market.

Another factor is the name recognition. People buy what they know, often without doing any homework. You have to remember that when we are buying stocks we are going up against pros, as well as amateurs.

Our advantage is that we are doing the research, determining the value of the company and then making a decision based on that data and our experience. All while determining a margin of safety, because we are human after all.

Buying just because you know the name and like the product is not enough. That is one of the easiest ways to get burned in the market.

Badly.

Final Thoughts

Intrinsic value is incredibly important to the success of any investor. Frankly, without determining what you think a company is worth you are doomed to failure. Without that information, you are just gambling with your hard earned money.

We discussed many of the great investor’s thoughts on finding intrinsic value and what importance it has. Warren Buffett, Joel Greenblatt, Ben Graham, and Seth Klarman all have valuable, insightful things to say about intrinsic value.

If they find it of importance, then who am I to not take it seriously. As I discovered this concept and the formulas associated with. It became an important part of my investing toolkit.

There are two common intrinsic value formulas that are used. We discussed the one created by Ben Graham today, with some modifications. This is a pretty straightforward formula and fairly easy to calculate. It gives you a good snapshot of the intrinsic value of the company at this time.

It also allows us to determine the margin of safety. Which we can use to determine if we are at a place to buy at this time.

I want to mention that calculating intrinsic value and margin of safety are both high on my investing checklist. I do this process right after I find a company that I want to investigate further. After I screen for stocks or use another resource to find ideas I will use the intrinsic value formula to compare it to the current market price. If there is a margin of safety at that time or close to it. I will continue my research and go from there. If not then I might add it to my watchlist for later research.

I will never, ever buy a company solely on these calculations!

These are tools that I use to help validate my decision to buy a company. The process never changes and to not do my due diligence would give me the feeling that I am gambling. And I am not a gambler, ask anyone who has seen me play blackjack. Not pretty.

As with any company that I evaluate. I am not passing judgment on that company. What I am merely trying to ascertain if it is right for me to become a part-owner at that time. I think both Facebook and Walmart are wonderful business’, but at this time they are not on sale enough for me.

Intrinsic value helps us find bargains, that is what we are after. We want to find sales and this tool can help us find them.

As always, thank you for taking the time to read this post. I hope you find it of some value.

I would love to hear of some bargains you have come across, either in the stock market or elsewhere. Let me know of your wins in the comments.

Next week we will tackle part two of Intrinsic Value Formula with the discounted cash flows.

Until next time,

Take care,

Dave

 

 

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