Methodology: Part 2. Intrinsic Value

January 5, 2011 § Leave a comment

This is my series on how I decide to buy what I buy.
Part 1. Part 3.

Ok, so in the first part of this methodology survey we looked at some of my favourite metrics and the tests that businesses need to pass in order for me to consider them a good business qua business and also at a potentially a good value.

The second part of my methodology is to now really home in on that intrinsic value and see if I want to buy it at the price that is being offered.

Now, intrinsic value is not math. I mean, there is a lot of math involved, but there is no exact number you can reach. You can reach a ballpark figure, and if you have a big enough margin of safety, you don’t have to be perfect, just close. If you’ve calculated the intrinsic value of Graemecorp to be $25.50 a share and it is trading at $21 you don’t want to buy because you–like me–are probably wrong. Accept it. Respect the complexity.

Now, if Graemecorp is trading at $8 you may want to start thinking about buying. But the calculation of $25.50 that you reach is not infallible, no matter how much work you put into it.

But how do I determine intrinsic value? Well, its tricky, because the methodology is going to vary for different companies in different circumstances. Getting a good idea for fair value of a shipping company (which generally trades close to book value and low P/E) is going to be way different than for a venerable company like Johnson and Johnson, who has such a consistent history that you can feel comfortable if they are quite over book or have a higher P/E. So, sorry, you can’t just plug in a bunch of numbers into some sort of divine formula and get the perfect intrinsic value number. It’s an art!

So what I try to look for are floors and ceilings. A good floor to look for is what is called the liquidation value of a business, or in other words, what the business would be worth if you sold ever last paperclip, pencil and cleared out the inventory. (What this doesn’t take into effect is the value of the future profitability of the business.)

Two good numbers to give you a potential liquidation value are the Net Current Asset Value (NCAV) which is simply the Current Assets – Total Liabilities. If the number is positive and if the per share price of the NCAV is higher than what is on the market, man you may have a good thing on your hands (note: often times the NCAV is positive is the company has a ton of cash on hand. Cash on hand is very good, but if it is just sitting there not doing much, not being reinvested nor being paid out in a dividend, you may question whether you want to pay for money to be sitting around.

The second good number you can find is the Net Net Working Capital. This was Benjamin Graham’s (go read him now) pet figure. It is perhaps the best detailed number you can find for a liquidation value.

NNWC = Cash + Short Term Investments + (0.75 * account receivables) + (0.5 * inventory) – liabilities

The logic of this formula is that if you are liquidating a company, you wont be paying full price for account receivables or inventory, so these are some pretty conservative haircuts Graham uses to measure the value. Again, if the per share price is below this, then the business is worth looking into. If you feel that they wont go bankrupt, then you may have a good pick on your hands.

Now, that being all said, these are floors for me. If prices are below these floors (rare) then they are falling into a “special interest” category and should be looked at further. It could be awesome, but it could be deadly and the company is in serious trouble.

But once you have a good ballpark on liquidation value, you can now start looking for a good ceiling. For me, a good ceiling is what the company is worth when skies are blue and all they need to worry about is not screwing up. They don’t need to be heroes; they just need to run a healthy business. If they still look cheap after passing this test, then we’re really sitting on something nice.

So what I run are two different valuation tests: the Discount Cash Flow (using a normalized CROIC as my growth rate) and the Ben Graham Intrinsic Value calculation. To get a great handle on the DCF, read about it here. (Fun fact: I didn’t know you could find really easy DCF calculation tools online, so I did a whole spreadsheet exactly like the one on Investopedia. It was a disaster. Total unmitigated disaster. I didn’t know a thing about Cash Flow. I think I valued Coke at like $17 a share. That was a grumpy evening.)

With a DCF there are two big numbers you need to make a decision about: the growth rate and the discount rate. For me the growth rate is pretty easy: you can either choose the 10 year average of revenue growth, EPS growth, FCF growth etc. But what I like to use is the 10 year average CROIC rate (with a bit of a haircut for safety). So I use a 80% of the 10 year CROIC average for my growth rate. My reasoning is that CROIC really tells you about the worth of a company and not just what the company says they’ve done.

Now the discount value is a bit tricky. Investment banks churn out crazy greek numerical values and something that is called a Weight Average Cost of Capital (or WACC) in order to find the number that you will discount future earnings by. But for me it’s simple (common theme eh?). I tend to use a discount value between 12% and 15% because it is insanely high. But seeing as I would be really happy with an annual 12-15% appreciation on my invested money, this is a further built in margin of safety. I also look at a DCF model using the average 30 year corporate bond rate (around 6%) just to see the ballpark range I’m playing with.

The second valuation I run is the Graham Intrinsic Value metric. Ben Graham talked about this a lot in his book and Jae Jun over at Oldschool Value has a great updated version of the formula that he uses (and that I stole!)

So let’s recap. I now have:

a NNWC value
a NCAV value
a DCF using CROIC and with a discount value
a Graham Intrinsic Value calculation.

So now I have a pretty good idea of my floor (NNWC, NCAV and a book value per share) and my ceiling (DCF) with my Graham value somewhere in the middle. All things being equal, my intrinsic value should be closer to my ceiling than my floor, so if I want to get good value I need to buy at a healthy discount of my ceiling. So I look for a 50% off of the DCF and I try to practice what Graham preaches with a 66% off of his intrinsic value calculation but it’s rare to find something like this.

So that’s my check list! You can see the breakdown here:

Yes, this is a screen shot of a spread sheet. Fancy eh?

Now, all this being said, each business and each circumstance around the business is unique and they are all treated differently. These are just my checklists, but there are instances where the company doesn’t pass the checklist, but still seem an attractive buy. And also there are companies that pass the checklist, but I don’t jump in because I’m not gung-ho about the business model. So in order to compensate for this, I have a bunch of questions/emotional checks and balances that I ask myself in order to see if I’m being a smarty-pants or actually being wise.

More of that in post 3


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