What is Intrinsic Value?

What is Intrinsic Value?

Value investors, including Warren Buffett, often calculate intrinsic value when deciding whether to purchase a business or equity. One of the key objectives of value investing is to exploit the difference between intrinsic value and market value. When intrinsic value is higher than market value by a specific margin of safety, an investment opportunity is presented. While valuations are constantly changing with corporate earnings and market psychology, intrinsic value can be estimated. The subject of intrinsic value is extensive and only an overview of the topic will be discussed.

Intrinsic value is the discounted value of cash that can be taken out of a business during its remaining life. The first step in calculating intrinsic value is to determine owner earnings. Owner earnings are net income + depreciation + amortization – capital expenditures. Owner earnings are the amount of cash an investor can put into his pocket each year. Because non-cash expenses (depreciation and amortization) are added back to net income and capital expenditures are subtracted from it, owner earnings are considered to be more accurate than net income by itself.

The second step of intrinsic value is to determine the annual growth rate of owner earnings over the past five- to ten-year period. The annual growth rate will differ depending on whether averaging or compounding is used. To determine annual growth, the majority of value investors use compounding, especially when owner earnings have been inconsistent and contain extreme highs and lows. Once the annual growth rate has been determined, it is used to project owner earnings in the future.

The third step of intrinsic value is to discount the projected owner earnings over the holding period. The projected owner earnings are discounted to reflect their present value. Present value is the amount an investor will pay today for future earnings. To determine present value, a discount rate is used. The discount rate is equal to the investor’s opportunity cost. The opportunity cost is the return the investor could reasonably achieve by purchasing another investment with comparable risk.

When steps one through three have been completed, an estimate of intrinsic value is established. The fourth step is to apply a margin of safety (MOS) to determine an acquisition price.  MOS is the amount below the intrinsic value an investor will pay for a business or equity.  Benjamin Graham, recommended a MOS of 33% (preferably greater). Thirty-three percent is equal to purchasing a dollar worth of assets for 67 cents. MOS protects against economic downturn and provides for upside based on the range between the acquisition price and full intrinsic value.

To illustrate: In 2007, Tempur-Pedic International (TPX) had 74,670,000 shares outstanding. The company’s owner earnings were $157,660,000. Over the last six years (2002-2007), management grew owner earnings by an annual compounded rate of 42%. While TPX achieved significant double-digit growth, the majority of value investors are strong proponents of using conservative projections in their analysis. The growth rate used, whether aggressive or conservative, should be based on the key qualitative and quantitative factors of the business or equity.

Scenario 1: If a growth rate of 10% is applied to TPX’s owner earnings over the next ten years and 5% thereafter (terminal value), the company’s estimated intrinsic value is $2,306,233,591 or $30.89 per share. These figures assume a 15% discount rate. If a 33% margin of safety is applied, the target acquisition price is $20.69.

Scenario 2: If a growth rate of 5% is applied to TPX’s owner earnings over the next ten years and 3% thereafter, the company’s estimated intrinsic value is $1,533,857,509 or $20.54 per share. These figures assume a 15% discount rate. If a 33% margin of safety is applied, the target acquisition price is $13.76.

Based on the above, I purchased TPX on Thursday, April 17th, for $10.51 per share. Under Scenario 1, I have 194% upside from the purchase price to full intrinsic value. If it takes ten years for the stock to reach $30.89, my annualized return will be 19.4%. Under Scenario 2, I have 95% upside from the purchase price to full intrinsic value. If it takes ten years for the stock to reach $20.54, my annualized return will be 9.5%. Over the last ten years (1998-2007), the S&P 500 averaged 5.6% per year. Under both scenarios, the estimated return exceeds the historical return.

In addition to intrinsic value, several other factors should be analyzed by an investor before a business or equity is purchased. These factors include: book value, debt, durable competitive advantage, management, net margin, return on equity, etc. These factors will be the subject of subsequent articles.

All contents copyright © 2008, Josh Lowry. All rights reserved.

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