New Essay: Price and Value

[racemize]

New Essay:

Price and Value: https://drive.google.com/open?id=1k4a41jaG3HrIfMVA79zb2xpg2HPeTWyJ

 

This essay looks at the length of time it takes for price and value to equilibrate, using the S&P 500, Berkshire, KO, and Giverny Capital as examples.

[Packer16]

Nice essay.  Are your changes intrinsic value based upon changes in BV plus dividends or is there some modification for situations above BV?

 

Packer

[Dynamic]

Nice analysis.

 

I think that on reading it, I was at times a little unsure whether high was good or low was good, and indeed they could both be good.

 

For example, say you buy XYZ Corp with $5 owner earnings per share per year, and you pay $70 thinking it's 30% undervalued and has an IV of $100 in 2019.

In year 2021, maybe it has distributed $3 a year in dividends and grown owner earnings to $6 a year, a 20% increase and you now think its IV is $120 in 2021 (a 20% increase). This is a good performance having retained less than half of owner earnings to reinvest in the business.

 

Scenario 1:

If its price is $77 in 2021 it is going to be more undervalued (having risen 10% versus a 20% increase in IV), is your metric of convergence of price and value going to be positive or negative. My instinct says negative. In this scenario a value investor could use the opportunity of widening gap between price and IV to add more capital to the position.

 

Scenario 2:

If its price has risen to $96 in 2021 (a 37% rise versus a 20% rise in IV), it's then only 20% undervalued so price and value have converged. My instinct says convergence should be positive. In this scenario a value investor could optionally take advantage of the narrowing gap to IV to selling the company to buy something else that is more deeply undervalued, or she could stick to this company despite the narrowing gap because it has grown owner earnings by 20% in 2 years despite paying out over 50% of owner earnings as a dividend, demonstrating a good return on incremental invested capital at least over that short period.

[racemize]

Nice essay.  Are your changes intrinsic value based upon changes in BV plus dividends or is there some modification for situations above BV?

 

Packer

 

Hi Packer, the proxy for IV changes depend on the company in question.  For Berkshire, I used Book value and also added 1% per year to make up for IV changing from 1->1.7 over the entire time period (per Buffett's comments this year).  For KO/S&P I used earnings.  For Giverny, I used his internal OE projections.  (Dividends are added in all cases)

[racemize]

Nice analysis.

 

I think that on reading it, I was at times a little unsure whether high was good or low was good, and indeed they could both be good.

 

Well, I was looking for convergence, so neither high nor low is "good" per se.  That being said, the formula was price growth - IV growth, so most investors would want it to be positive (i.e., that the price went up more than value did)

 

 

For example, say you buy XYZ Corp with $5 owner earnings per share per year, and you pay $70 thinking it's 30% undervalued and has an IV of $100 in 2019.

In year 2021, maybe it has distributed $3 a year in dividends and grown owner earnings to $6 a year, a 20% increase and you now think its IV is $120 in 2021 (a 20% increase). This is a good performance having retained less than half of owner earnings to reinvest in the business.

 

Scenario 1:

If its price is $77 in 2021 it is going to be more undervalued (having risen 10% versus a 20% increase in IV), is your metric of convergence of price and value going to be positive or negative. My instinct says negative. In this scenario a value investor could use the opportunity of widening gap between price and IV to add more capital to the position.

 

it would be negative in terms of the value that would be reported (price growth - IV growth).  This has nothing to do with whether that is a good outcome to the investor.  If the company is buying back shares or you are buying more shares, a wider discount is better for you.  It's an entirely different scenario if you are retiring and want to sell though.

 

 

Scenario 2:

If its price has risen to $96 in 2021 (a 37% rise versus a 20% rise in IV), it's then only 20% undervalued so price and value have converged. My instinct says convergence should be positive. In this scenario a value investor could optionally take advantage of the narrowing gap to IV to selling the company to buy something else that is more deeply undervalued, or she could stick to this company despite the narrowing gap because it has grown owner earnings by 20% in 2 years despite paying out over 50% of owner earnings as a dividend, demonstrating a good return on incremental invested capital at least over that short period.

 

The value would be positive because over that time period price growth was higher than IV growth.  Same explanation as above as to whether it is good or bad for the investor.

[Packer16]

Nice essay.  Are your changes intrinsic value based upon changes in BV plus dividends or is there some modification for situations above BV?

 

Packer

 

Hi Packer, the proxy for IV changes depend on the company in question.  For Berkshire, I used Book value and also added 1% per year to make up for IV changing from 1->1.7 over the entire time period (per Buffett's comments this year).  For KO/S&P I used earnings.  For Giverny, I used his internal OE projections.  (Dividends are added in all cases)

 

Thanks.  So for KO what did you use as your base value for IV?  I am assuming book value would have some issues due to buybacks & earnings above the WACC.

 

Packer

[racemize]

Nice essay.  Are your changes intrinsic value based upon changes in BV plus dividends or is there some modification for situations above BV?

 

Packer

 

Hi Packer, the proxy for IV changes depend on the company in question.  For Berkshire, I used Book value and also added 1% per year to make up for IV changing from 1->1.7 over the entire time period (per Buffett's comments this year).  For KO/S&P I used earnings.  For Giverny, I used his internal OE projections.  (Dividends are added in all cases)

 

Thanks.  So for KO what did you use as your base value for IV?  I am assuming book value would have some issues due to buybacks & earnings above the WACC.

 

Packer

 

Ah, I see.  I didn't have any base value, so there's no explicit calculation of an "IV".  There is only a proxy for the change in IV, compared to change in price, so in both cases the base price and the base IV are not considered, nor is there any consideration for the gap between price and IV. 

 

 

So, in the case of KO, I started with the first year's price and the first year's earnings, then compared annual growth of price+div and earnings+div from that start point.

[Packer16]

Thanks.