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How to calculate intrinsic value

frommi

By frommi
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frommi Newbie

frommi

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Hello,

 

I am new to this forum and learned about value investing only 6 month ago. I have read

 

Security Analysis

The Intelligent Investor

Margin Of Safety

The Aggressive Conservative Investor

 

and lots of value blog posts and forum posts in here. But i couldn`t really find the one or two approaches that are commonly used.

 

I have seen around 3 different approaches to calculate intrinsic value, most value blogs concentrate on tangible bookvalue. Some posters use EV/EBITDA multiples, others EV/EBIT multiples. And on some websites they use EPS*(8.5+2*growth rate) as a quick and dirty DCF proxy. With a DCF approach you have the option to add tangible bookvalue to it.

 

I think i need two ways to calculate intrinsic value, one for the liquidation value (tangible book value should be ok?) and one for the prosperous business. I use the DCF proxy currently for the last ones, but should i add tangible bookvalue to it or is it a too simplistic or even the wrong approach? Given the fact that most businesses are not liquidated, is it really useful to calculate a liquidation value?

 

So my main question is how exactly do members of this forum calculate intrinsic value?

 

Sorry for my beginner questions.  ;D

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gary17 Newbie

gary17

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i think there's the intrinsic value of the asset as well as intrinsic value of the future earnings of the company --

 

intrinsic value of asset - the best example i could give is when i was at a garage sale once and i saw a nice leather jacket for sale for $20...  I KNEW right away that's a good leather jacket that retails over $400 and this one was barely worn.  So I bought it and sold it for $150 within a week on craigslist - that was one of my best investments...  the asset was useful, but probably generated very low earnings

 

intrinsic value of earnings - more specifically owner's earnings or in some cases free cash flow which can be used by the company for buybacks or payout dividends....    this is like looking at how much 'income' can the asset generate in its expected lifetime and discounted for today's dollar value...  i believe the example warren gave was the value of your education - the price is the $50,000 or whatever you pay for college education, but the value is probably $2M or so if you make $100K average for 25 to 30 years....  (just very rough estimate, don't pull out your calculator here)

 

so it'd be great if you find companies that's cheap based on asset or based on earning

 

it'd be exceptional if you find that they are cheap for BOTH reasons... this probably happened in 09 when there was a lot of fear.... but hindsight is always 20/20 - it was a very interesting period and it really felt like the sky was falling  ;D

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frommi Newbie

frommi

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I mostly like using the (discounted) value of all future free cash flows. Earnings are too often manipulated and assets are only useful as a minimum value if the company is going to close shop and liquidate.

 

Yes i agree, but according to this article http://www.gurufocus.com/news/39330/what-worked-in-the-market-from-19982008-intrinsic-value-discounted-cash-flow-and-margin-of-safety GAAP earnings work better than free cashflow.

 

What i miss in a pure DCF calculation is if the company has debt or cash on the balance sheet.

Therefore i thought it would be a good idea to add tangible bookvalue to the result of the DCF. I buy the assets+the cashflow or not?

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wachtwoord Newbie

wachtwoord

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I mostly like using the (discounted) value of all future free cash flows. Earnings are too often manipulated and assets are only useful as a minimum value if the company is going to close shop and liquidate.

 

Yes i agree, but according to this article http://www.gurufocus.com/news/39330/what-worked-in-the-market-from-19982008-intrinsic-value-discounted-cash-flow-and-margin-of-safety GAAP earnings work better than free cashflow.

 

What i miss in a pure DCF calculation is if the company has debt or cash on the balance sheet.

Therefore i thought it would be a good idea to add tangible bookvalue to the result of the DCF. I buy the assets+the cashflow or not?

 

Obviously I always add/subscract net cash/debt from the discounted cash flow calculation. (it's nice to check FCF yield based on both market cap and company value as well if there is much cash or debt this might vary a lot).

 

Oh and GAAP earning was what I was referring too. Companies mess around a lot with earnings. Cash flow is actual money coming in and going out, can't get much more pure than that.

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matjone Newbie

matjone

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When I started reading this stuff a few years ago I had questions like yours.  I am more of left brain mathematical type of person so I  had the mentality of solving things with formulas and rules, and I was doing a lot of DCF calculations in excel, but eventually someone told me that real practitioners don't do it that way.  They just look at a lot of stuff and read a lot until they see something that is obvious to them.

 

You can look at some of Buffett's early investments in Union Street Railway or Western Insurance, or read up on how Graham and Schloss operated for examples of the quantitative bargain style.

 

For the growth investors looking for great businesses I don't think DCF matters that much.  The thing that matters is being able to look at the management and the business and seeing why it has a good chance of earning high returns for a long time to come.  For example, if you were looking at Wal Mart in 1975, the thing to study was how Sam Walton was growing the business so fast and how he was beating all the other retailers in all these little towns, and then determining that he could probably continue to do that in thousands more little towns across the country.  Sitting down doing DCF would have been a waste of time.  You wouldn't be learning anything important about the business and none of your calculations would have come close to what actually happened.

 

There is a part in one of his books where Graham answers your question about liquidation value.  The point wasn't necessarily that the businesses would  be liquidated..  It was that a price less than liquidating value was obviously too low for a business with decent prospects and a decent record.

 

Anyway, I know that's kind of a rambling non-answer but I hope it helps.

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vinod1 Newbie

vinod1

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I would strongly recommend "Value Investing: From Graham to Buffett and Beyond" by Greenwald. It specifically addresses valuation and the approach to use in different situations. This is the approach that is most helpfully in practice. I cannot recommend this book highly enough.

 

However to get a good understanding of valuation and the pitfalls, assumptions, limitations, etc I would suggest "Investment Valuation" by Damodaran. It takes a textbook approach that you would really not use in practice, but when you are using shortcuts like earnings multiples, you would miss subtle points that might trip you up.

 

Vinod

 

 

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Green King Newbie

Green King

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Look at  the annual report from 2002 or a good period of time look at the current annual report.

If looks good look at the annual reports for the last 5 to 10 years.

 

Look for the basic business economics and determining factors from the annual report.

 

Try to visualize the business economics and determining factors as a living organism.

 

Try to visualize the future of the business  five years from now.

 

How much cash flow will it generate ?

Will the business still be around ? Goods or service still needed ?

 

Think about the over all business and think if it can reach the investment return you desire and with the risk exposure you like.

 

What is Beyond the above takes practice, time ,experience with businesses and markets.

 

Things as simple and as hard as value investing has no simple answers like solving for X. 

 

takes time looking at businesses. were you eventually will find those that you can predict the future with reasonable certainty selling at a big discount.

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