Arriving at Intrinsic Value
There are two key tenets of value investing:
Every asset has an intrinsic value.
Occasionally, an asset’s intrinsic value and market price differ.
Market prices are concrete. Anyone with a smartphone has them at their fingertips. But what exactly is intrinsic value? This post aims to answer that.
In Berkshire’s 2013 annual report Buffett told the story of purchasing a farm:
This tale begins in Nebraska. From 1973 to 1981, the Midwest experienced an explosion in farm prices, caused by a widespread belief that runaway inflation was coming and fueled by the lending policies of small rural banks. Then the bubble burst, bringing price declines of 50% or more that devastated both leveraged farmers and their lenders. Five times as many Iowa and Nebraska banks failed in that bubble’s aftermath as in our recent Great Recession.
In 1986, I purchased a 400-acre farm, located 50 miles north of Omaha, from the FDIC. It cost me $280,000, considerably less than what a failed bank had lent against the farm a few years earlier. I knew nothing about operating a farm. But I have a son who loves farming, and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm to then be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out.
This simple example shows how one of the best investors of all times thinks. According to Buffett:
Return = Normalized Earnings Yield + Growth Rate
To calculate intrinsic value first calculate the asset’s prospective return. Next, compare its return to all alternatives.
What is happening in this process is an examination of opportunity cost. Intelligent people make decisions based on opportunity costs—in other words, it’s your alternatives that matter. That’s how we make all of our decisions.
Charlie Munger, 2003 Berkshire Annual Meeting
On January 1, 1986 here’s what the investment landscape looked like:
10-year Yield: 9.2%
S&P 500 Earnings Yield: 7.0%
Inflation Rate: 3.9%
Investors always have at least two risk free investment alternatives: Treasury Bonds and the S&P 500. Risk means the probability of permanent loss, not short-term price volatility.
Treasury Bonds are simple because they have no growth. Their expected return is 9.2%.
Between 1874 and 2004 Robert Schiller estimated that the S&P 500 grew at an average rate of 3.9%. So the S&P 500’s expected return is 10.9%
From 1948 to 2015 US farm productivity grew at 1.4% (source). Adding this to the 1986 inflation rate (3.9%) suggests the farm’s earnings could grow 5.3% annually. This might be on the high end, since inflation was above average in 1986. If we assume the normalized inflation rate is 2.00% then the farm may grow 3.4% and produce returns of 13.4%.
Given this, the farm is a superior investment to the S&P 500 and treasury bonds.
At this point we haven’t attributed a specific intrinsic value to the farm. But we probably know enough to invest. You don’t always need to know exactly what something is worth. Knowing what it is not worth is often enough. We know that the farm offers a higher return then comparable assets, which means it is too cheap.
If you want to pin a specific intrinsic value on the farm the next step is to capitalize the farm’s income stream. This means figuring out what someone (i.e the market) would pay for the asset’s steam of cash flows.
To do this you’ll want to see how the market is valuing similar assets. For illustration purposes, let’s use the S&P 500 to find the intrinsic value of the farm. In reality, you’d want to use recent farmland transaction prices in the local area.
From here, the work is simple: apply the S&P 500’s 14x multiple to the farm’s normalized earnings to find its intrinsic value. A farm that produces $28,000 of net income annually should be worth approximately 14x, or $392,000. The market price of the farm is $280,000, which means it is undervalued by $112,000 or 40%.
Intrinsic Value = Multiple x Normalized Earnings
Notice that the formula above does not include growth. That’s because the multiple takes this into account. We’re assuming that the S&P 500 will grow at 3.9% while the farm will grow at 3.4%, which is close enough to use the same multiple.
Now let’s imagine one wrinkle in Buffett’s farm deal: the seller insists on selling the farm “as is”, which means with the farm’s silos full of last years grain.
This grain is a what I call a “non-operating asset”. An asset is “non-operating” when it is not used to create the income you estimated and capitalized. For example, a company that requires $1 million of working capital but has $11 million in the bank has $10 million that is not required for operations.
To account for this we alter our intrinsic value formula.
Intrinsic Value = Non. Operating Assets + Multiple x Normalized Earnings
To value a non-operating asset you need to figure out it’s market value. Cash and grain are easy because they are liquid assets with clear market prices. Sometimes non-operating assets are illiquid, like real estate or private business interests. In these cases, you’ll need to apply this valuation process to them.
If we assume that the extra grain is worth $100,000 then the seller should increase the price of the farm by $100,000. This doesn’t always happen, however, and non-operating assets can be great freebies for value investors that find them.
Now that we know how intrinsic value works, let’s apply it to a radically different asset: Facebook’s common stock.
As of Q3 2018, Facebook’s balance sheet showed cash, net of all liabilities, of $9.6 billion or $10 per share. This is a non-operating asset, since Facebook’s business model doesn’t require that much working capital.
Over the last twelve months Facebook earned $6.76 per share. Management guided for margins to contract into the mid-thirties. To account for this, we can apply a 35% net margin to Facebook’s actual revenue. This yields EPS of $6.30.
Today the S&P 500 is trading for approximately 22x EPS (source). Applying this to Facebook’s $6.30 normalized EPS yields a value of $138.60. Adding in the $10 of excess cash Facebook has, we arrive at an intrinsic value of $148.59.
Spreadsheets allow you to calculate this to ten decimal points if you want to. But that doesn’t make your answer any more correct. So let’s round our estimate to $150. Facebook currently trades for $140, so our valuation is close to the market’s. It looks like there is only 7% upside to intrinsic value for Facebook.
However, we didn’t consider growth. We used the S&P 500’s multiple, which is appropriate for an asset that can grow approximately 3.9% annually. Facebook, however, has historically maintained a dramatically higher growth rate. Facebook will eventually grow at a GDP-like rate, but only once the entire world is already on Facebook. Until then, Facebook can grow much faster as internet penetrates developing economies and users and marketers join. It’s not unreasonable to think Facebook could grow at 10%+ for many years.
Considering this, our estimate of Facebook is probably quite conservative. It assumes no growth beyond what the S&P 500 generates. Of course, if you believe Facebook will begin to lose users and shrink, then our intrinsic value estimate is too high.
Some investors will try to precisely estimate an asset’s growth rate and then apply an appropriate multiple. Both of these are exceptionally difficult, however.
My goal is to get growth for free. I want to pay a price such that if earnings never grow I’m still satisfied with its return. If it does grow, then that’s the cherry on top. I want growth, but I don’t rely on growth for the investment to work out.
No matter what your approach is, it’s important to understand the concept of intrinsic value. Intrinsic value is an imprecise but effective tool for weighing opportunity costs.
The intrinsic value you calculate is only as good as your assumptions. To deal with this ambiguity, build a margin of safety into your assumptions and the price you’re willing to pay.
Investors would do well to remember the wise words of John Maynard Keynes:
It is better to be roughly right than precisely wrong.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.