“You don’t find out who has been swimming naked until the tide goes out.”

– Warren Buffett

The decade-long run for the current bull market and widespread concerns about elevated values in US stocks leading to days like Tuesday (Dec 4th 2018) and Friday (Dec 7th 2018) when the Dow Jones Industrial Average fell close to 800 and 550 points respectively, are reminders that getting at the true value of corporations is as important as it has ever been.

Even with just four days of trading, this past week was a headache for investors.

The Dow lost 4.5%, the S&P 500 dropped 4.6%, and the Nasdaq dropped 4.9%. For each of the major indexes, it was their worst week since March. For some market experts, this marks only the beginning of a rocky period for investors that will continue.

So no one should be making rash decisions, as Warren Buffett reminds the fearful that the stock market is there to serve investors, not instruct them (echoing Ben Graham’s maxim).

As many sector’s within the S&P 500 are in correction, every investor should be questioning the value of what they own in their stock portfolio.

The Concept of Intrinsic Value and Book Value

Intrinsic value is the preset value of the stream of cash that is going to be generated by any financial asset between now and doomsday. It is easy to say, but impossible to figure. What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids big mistakes.

Book value and intrinsic value are two ways to measure the value of a company. There are a number of differences between them, but essentially book value is a measure of the present, while intrinsic value takes into account estimates into the future.

Book value is based on the value of total assets less the value of total liabilities—it attempts to measure the net assets a company has built up until the present time. In theory, this is the amount that the shareholders would receive if the company were to be completely liquidated.

For example, if a company has $23.2 billion in assets and $19.3 billion in liabilities, the book value of the company would be the difference, $3.9 billion. To express this number in terms of book value per share, simply take the book value and divide it by the number of outstanding shares. If a given company is currently trading below its book value, it is often considered to be undervalued.

There are, however, several problems with the use of book value as a measure of value. For example, it would be unlikely that the value the company would receive in liquidation would be equal to the book value per share. Nevertheless, it can still be used as a useful benchmark to estimate how much a profitable company’s stock might drop if the market turns sour on it.

Intrinsic value is a measure of value based on the future earnings a company is expected to generate for its investors — it attempts to measure the total net assets a company is expected to build in the future. It is considered the true value of the company from an investment standpoint and is calculated by taking the present value of the earnings (attributable to investors) that a company is expected to generate in the future, along with the future sale value of the company.

The idea behind this measure is that the purchase of a stock entitles the owner to his or her share of the company’s future earnings. If all of the future earnings are accurately known along with the final sale price, the company’s true value can be calculated.

For example, if we assume that a company will be around for one year and generate $1,000 before being sold for $10,000, we can find the intrinsic value of the company. At the end of the year we will have received $11,000. If our required rate of return is 10 percent, then the present value today of the future earnings and sale price is $10,000. If we were to pay more than $10,000 for the company, our required rate of return would not be met.

Discounted Cash Flow Model is one of the ways the intrinsic value of the company is calculated. It requires the input of some significant assumptions, such as how long a company’s outperformance can last. The key is to start with the company’s strategy and current performance and ask how long that performance is likely to be sustainable, given the nature of the industry and competition. Much of the value estimate in DCF lies in terminal value.

The reason an intrinsic value model can work so well – in terms of making people lot of money – is that so few can effectively master them. “Since value is about the future, it is obviously based on forecasts. Forecasts have to be based on assumptions. The question really is how to make your assumptions sensible and grounded in fundamentals. That is why it is called fundamental analysis. If there is a mechanical way to do this, it will not have much pay-off in the investment process since everyone would have the same information, and it is tough to make money with common information in a market. So assumptions are a double-edged sword. They are subjective, but they are also the source of superior investment returns.

The principles related intrinsic value can be laid out, but there is no one formula into which an investor can plug the ideas and come out with the same result as an experienced investor does. If nothing more, the attempt to understand the ideas and calculate a publicly traded  company’s intrinsic value, even done imperfectly, could help an investor to avoid the big market blunders before hitting the buy button.

Or the investor would be perfectly correct to come away from an attempt to understand intrinsic value and say, I would rather just buy an S&P 500 index fund – this anti-stock picking strategy is also approved by experienced investors.

An investor would be wise to start by reading a lot more about intrinsic value, as this barely scratches the surface. Read everything you can such as equity research reports, 10-Ks and other company filings and be prepared to feel lucky if only 1% of it leads to a great investment idea.

If one can come up with the intrinsic value of the stock and apply a factor of safety of 50% as Ben Graham would suggest, because the factor of safety is actually a factor for ignorance in coming up with the correct intrinsic value, and pull the trigger to buy at that price, that is value investing and this strategy alone will make the investor very rich in the years to come. Now is the time when the markets are down in a bear market territory to get hold of such chock-full-of value stocks! Value stocks are on fire-sale!

Courtesy: CNBC’s Warren Buffett Archive