Category Archives: Intrinsic Value

Margin of Safety

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Seek investments where the asset’s intrinsic value significantly exceeds the market price – a concept known as a “margin of safety.”

Investing is all about finding opportunities to buy assets below their true worth.

“It is extraordinary to me that the idea of buying dollar bills for fifty cents takes immediately with people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find you can talk to him for years, and show him records, and it just doesn’t make any difference. They just don’t seem able to grasp the concept, simple as it is…I’ve never seen anyone who became a gradual convert over a ten-year period to this approach. It doesn’t seem to be a matter of I.Q. or academic training. It is instant recognition or it is nothing.” ~ Warren Buffett

Source:  http://mastersinvest.com/newblog/2017/6/12/50c-dollars

Peter Lynch Rule 3:

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In the short run, the stock market acts like a “voting machine”, while functioning in the long run more like a “weighing machine”. ~ Warren Buffett

Often, in the short term, there is no correlation between the success of a company’s operations and the success of its stock over years.

In the long term, there is a 100% correlation between the success of the company and the success of its stock.

The disparity is the key to successful long-term investing.

Such opportunities arise occasionally because in the short run the stock market acts like a “voting machine” (reflecting all kinds of irrational attitudes and expectations), while functioning in the long run more like a “weighing machine” (reflecting a firm’s true value).

Return on Invested Capital (ROIC)

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Return on invested capital, or ROIC, is a valuable financial ratio. Understanding ROIC and using it to screen for high ROIC stocks is a good way to focus on the highest-quality businesses.

Put simply, return on invested capital (ROIC) is a financial ratio that shows a company’s ability to allocate capital.

A high return on invested capital (ROIC) means investors are realizing strong returns on their investment in a company.

The higher the ROIC, the better a company is investing it’s capital to generate future growth and shareholder value.

For example, let’s say a management team had $1 million dollars to invest, and they could either invest in a new product line, or enhancements to their existing product line. After thinking it over, the Company invests the $1 million in a new product line. One year later, the Company looks back at what they have earned on the new product line, only to find out that it’s a measly $100,000.

As it turns out, if they had invested in the enhancements to their existing product line, they would have earned $500,000 over the same period of time. What does this mean?

Well, there could be more factors at play, but based on this example, the Company’s management team made the wrong decision.

As an investor, you want your management teams making the right decisions and investing in the areas that will generate the highest returns for you as an investor.
The common formula to calculate ROIC is to divide a company’s after-tax net operating profit, by the sum of its debt and equity capital.

Once the ROIC is calculated, it is evaluated against a company’s weighted average cost of capital, commonly referred to as WACC. If a company’s WACC is not immediately available, it can be calculated by taking a weighted average of the cost of a company’s debt and equity.

Cost of debt is calculated by averaging the yield to maturity for a company’s outstanding debt. This is fairly easy to find, as a publicly-traded company must report its debt obligations.

Cost of equity is typically calculated by using the capital asset pricing model, otherwise known as CAPM.

Once the WACC is calculated, it can be compared with the ROIC.

Investors want to see a company’s ROIC exceed its WACC. This indicates the underlying business is successfully investing its capital to generate a profitable return. In this way, the company is creating economic value.

Generally, stocks generating the highest ROIC are doing the best job of allocating their investors’ capital.

By calculating  a company’s return on invested capital, investors can get a better gauge of companies that do the best job investing their capital. Yet, ROIC is by no means the only metric that investors should use to buy stocks.

References:

  1. https://www.suredividend.com/high-roic-stocks/#top
  2. https://www.discoverci.com/stock-scanner/roic-screener

Margin of Safety

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“A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.” ~ Seth Klarman

Berkshire Hathaway CEO and Chairman, Warren Buffett, is known for his value investing approach, which involves finding companies that are undervalued by the market and investing in them for the long term. To invest like Warren Buffett, there are a few things you need to know.

  • First, you need to have a clear understanding of what value investing is and how it works.
  • Second, you need to be patient and be willing to hold onto your investments for the long term.
  • Third, you need to have the discipline to stick to your investing strategy even when the market is going against you.

When deciding on how to invest in a company, the first step is to determine its worth or intrinsic value. According to Warren Buffett, the best companies to buy are those that are inexpensive to buy. His investment strategy is based on a few simple principles:

  • Buy quality companies that have a competitive advantage (moat),
  • Buy them at a reasonable price with a margin of safety, and
  • Hold them for the long term.

These principles of margin of safety have helped Buffett generate incredible returns over his career. Margin of safety is a strategy that involves investing only in securities at a significantly lower intrinsic value than their market price.

The margin of safety (MOS) allows investors to avoid overpaying for an investment or asset, and it protects investors from the potential of loss if the market price of the asset falls. Buffett has said that the margin of safety is the key to his investing success.

The margin of safety is a measure of how much room there is between the price of the stock and its inherent value. The wider your margin of safety, the less likely it is that overly optimistic valuation inputs will harm your investment.

Value investing is the process of making investment decisions using margin of safety. It is critical for value investors to find a high-quality, easy-to-understand company with good management priced below its intrinsic value.

The purpose of using a margin of safety in buying is twofold.

  • If your investment does not grow as quickly as you originally anticipated, you may be forced to make more conservative investments in your portfolio. If your estimates are correct, you will be able to achieve a better rate of return over time due.
  • If you purchased the investment at an extremely low price.

Discounted cash flow (DCF) is a method of valuing a company or asset using the principles of time value of money.

The objective of DCF is to find the value of an investment today, given its expected cash flows in the future. One popular way to value a company is using the discounted cash flow (DCF) method. This approach discounts a company’s future expected cash flows back to the present day, using a required rate of return or “hurdle rate” as the discount rate. The idea is that a company is worth the sum of all its future cash flows, discounted back to the present.

The DCF formula is: Value of Investment = Sum of (Cash Flow in Year / (1 + Discount Rate)^Year)

The “discount rate” is the required rate of return that an investor demands for investing in a company. This rate is also known as the “hurdle rate.” There are two ways to calculate the discount rate.

There are two ways to calculate the discount rate.

The first is the weighted average cost of capital (WACC). This approach considers the cost of all the different types of capital that a company has, including debt and equity.

The second way to calculate the discount rate is the discount rate for equity. This approach only considers the cost of equity, which is the return that investors demand for investing in a company.

Once the discount rate is determined, the next step is to estimate the cash flows that a company is expected to generate in the future. These cash flows can come from a variety of sources, including operating income, investments, and financing activities. After the cash flows have been estimated, they need to be discounted back to the present using the discount rate.

The present value of the cash flows is then the sum of all the future cash flows, discounted back to the present.

“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it’s over the Grand Canyon, you may want a little larger margin of safety.” ~ Warren Buffett

References:

  1. https://www.merchantshares.com/margin-of-safety-the-key-to-warren-buffetts-investing-success/
  2. https://www.merchantshares.com/the-dcf-method-of-valuing-a-company/
  3. https://www.merchantshares.com/how-to-win-warren-buffett-39/

Warren Buffett’s Investing Top Four

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“Don’t look at a stock like it is a ticker symbol with a price that goes up and down on a chart. It’s a slice of a company’s profits far into the future, and that’s how they need to be evaluated.” ~ Warren Buffett, Chairman and CEO, Berkshire Hathaway

Warren Buffett’s philosophy is simple. Buy with a “margin of safety” undervalued companies with strong fundamentals and balance sheet, and then wait. It’s possibly the most boring way to invest in the world. But it’s effective.

For Warren Buffett, deciding what stocks to buy is “simple but not necessarily easy,” according to CNBC Warren Buffett Guide to Investing.

In his Berkshire Hathaway 1977 annual letter to shareholders, he listed four attributes he wanted to see when investing, whether he’s buying the entire company for Berkshire, or just a slice of it as a stock.

1. “One that we can understand…”

When Buffett talks about “understanding” a company, he means he understands how that company will be able to make money far into the future.

He’s often said he didn’t buy shares of what turned out to be very successful tech companies like Google and Microsoft because he didn’t understand them. At the 2000 annual meeting, a skeptical shareholder told Buffett he couldn’t imagine him not understanding something. Buffett responded, “Oh, we understand the product. We understand what it does for people. We just don’t know the economics of it 10 years from now.”

2. “With favorable long-term prospects …”

Buffett often refers to a company’s sustainable competitive advantage, something he calls a “moat.”

“Every business that we look at we think of as an economic castle… And you want the capitalistic system to work in a way that millions of people are out there with capital thinking about ways to take your castle away from you, and appropriate it for their own use. And then the question is, what kind of a moat do you have around that castle that protects it?”

— 2000 BERKSHIRE ANNUAL MEETING

A “moat” consists of things a company does to keep and gain loyal customers, such as low prices, quality products, proprietary technology, and, often, a well- known brand built through years of advertising, such as Coca-Cola. An established company in an industry that has large start-up costs that deter would be competitors can also have a moat.

3. “Operated by honest and competent people …”

“Generally, we like people who are candid. We can usually tell when somebody’s dancing around something, or where their — when the reports are essentially a little dishonest, or biased, or something.

And it’s just a lot easier to operate with people that are candid.

“And we like people who are smart, you know.

I don’t mean geniuses… And we like people who are focused on the business.” — 1995 BERKSHIRE ANNUAL MEETING

The quality of the business itself, however, takes precedence.

“The really great business is one that doesn’t require good management. I mean, that is a terrific business. And the poor business is one that can only succeed, or even survive, with great management.” — 1996 BERKSHIRE ANNUAL MEETING

4. “Available at a very attractive price.”

“The key to [Benjamin] Graham’s approach to investing is not thinking of stocks as stocks or part of a stock market. Stocks are part of a business. People in this room (Berkshire shareholders) own a piece of a business. If the business does well, they’re going to do all right as long as they don’t pay way too much to join into that business. — 1997 BERKSHIRE ANNUAL MEETING

Buffett’s goal is to buy with a “margin of safety” or when the market price is below a company’s “intrinsic value.” Buffett has said that the margin of safety is the “most important concept in investing.”

“The three most important words in investing are margin of safety…” ~ Warren Buffett

“The intrinsic value of any business, if you could foresee the future perfectly, is the present value of all cash that will be ever distributed for that business between now and judgment day.

“And we’re not perfect at estimating that, obviously.

“But that’s what an investment or a business is all about. You put money in, and you take money out.

“Aesop said, ‘A bird in the hand is worth two in the bush.’ Now, he said that around 600 B.C. or something like that, but that hasn’t been improved on very much by the business professors now.” — 2014 BERKSHIRE ANNUAL MEETING

References:

  1. https://fm.cnbc.com/applications/cnbc.com/resources/editorialfiles/2022/03/22/bwp22links.pdf

Focus, Discipline and Patience are Wealth Building Super Powers!

Intrinsic Value

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“Every investment is the present value of all future free cash flow.” Everything Money

Cash flow refers to the net amount of cash and cash equivalents that comes in and goes out of a company. Businesses take in money from sales as revenues and spend money on expenses. Cash received represents inflows, while money spent represents outflows.

“Intrinsic value can be defined simply as the discounted value of cash that can be taken out of a business during its remaining lifetime. “ ~ Warren Buffett

A company’s ability to create value for shareholders is fundamentally determined by its ability to generate positive cash flows or, more specifically, to maximize long-term free cash flow (FCF). FCF represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.

Intrinsic value is defined as the discounted present value of all future cash flow of a business.

The only reason to lay out money for an investment now is to get more money later.  When you invest in a bond, its very easy to see the future cash flow and the terminal value of a bond, its printed on the certificate.

When you invest in a stock,

Investing in any financial asset involves laying out cash now in order to get cash later out of the investment.  And investing in a business, can the business deliver enough cash to you (the owner) soon enough that it makes sense to buy it as its current market value?

How much am I willing to pay for a business, considering it makes $24B in cash flow per year, and is growing at 10% annually.

Once we determine the business intrinsic value, we compare that number to the business’ current market capitalization.  Market cap is the product of the total shares outstanding and the current market stock price.

  • Market cap is higher than intrinsic value = overvalued
  • Market cap is lower than intrinsic value = undervalued

Discounted Free Cash Flow since one dollar today is worth more thant $1 in five years due to opportunity costs and lost of purchasing power of that dollar.

  • Step 1:  Find the current free cash flow – Free cash flow is the amount of money left over for the owners of the business, after factoring in cash outflows that support its operations and maintain its capital assets. The ideal FCF for valuation would equal Operating Cash Flow minu Maintenance CapEx
  • Step 2:  Grow the current free cash flow out 10 years in the future – the growth rate used will have a big impact on the final intrinsic value calculation. Check historical growth rate for cash flow and industry growth rate for cash flow.  Or, look at trend and future capital investments.
  • Step 3:  Add a terminal value – what you can sell the business for in 10 years.  Use FCF multiple.
  • Step 4:  Discount all future cash flows to present value at a rate of 12% to 15%
  • Step 5:  Add together all future cash flows to find intrinsic value
  • Step 6:  Add a margin of safety (of 20% to 30%)

In the current market environment, most companies will be trading above the intrinsic value.

References:

  1. https://www.investopedia.com/terms/f/freecashflow.asp

Value Investing

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Value investing involves determining the intrinsic value — the true, inherent worth of an asset — and buying it at a level that represents a substantial discount to that price.

The gap between a stock’s intrinsic value and the price it is currently selling for is known as the margin of safety.

The greater the margin of safety, the more an investor’s projections can be off while still profitably gaining from an investment in the shares of the company being evaluated.

It can be helpful to ensure you understand what value investing is and is not. It is not searching for stocks with low price-to-earnings ratios and blindly buying the stocks that make that first cut. Instead, value investors employ a series of metrics and ratios to help them determine a stock’s intrinsic value and a sufficient margin of safety.

Value investing in stocks often means looking for mispriced shares in out-of-the-way places. This can include looking at companies in out-of-favor sectors, businesses in frowned-upon industries, companies that are going through some type of scandal, or stocks currently enduring a bear market. Unpopular sectors and companies are often treasure troves for the successful value investor, requiring the possession of both a long-term approach and a contrarian mindset. Regardless of where the investments come from, though, value investing is the art and science of identifying stocks priced below their actual worth.

Successful value investing exercise patience and hold during lean times. Taking just one example, in early 2015, American Express shareholders learned that AmEx lost its exclusive credit-card deal with Costco Wholesale locations. In the following months, Amex lost almost 50% of its market-cap value. Yet far from being a moment to panic, savvy investors might have seen an opportunity to buy AmEx for outsized gains. Within three years of its lowest point, American Express had almost doubled and reached new all-time highs.

Selling at lows while negative sentiment is at its highest will guarantee frustration and permanent loss of capital. It can be hard to wait while your thesis plays out, but patience is absolutely necessary for value investors who want to beat the market.

Of course, value investing is more than a waiting game. Investors must remain diligent in staying up to date on a company to ensure their thesis is proceeding as planned. This means paying attention to the company’s business performance — not its stock price.

The Big 5 Numbers 

Phil Town, founder and CEO of Rule #1 Investing, says there are “the big 5 numbers” in value investing.

The Big 5 numbers are:

  1. Return on Invested Capital (ROIC)
  2. Equity (Book Value) Growth
  3. Earnings per Share (EPS) Growth 
  4. Sales (Revenue) Growth
  5. Cash Growth

All the big 5 numbers will be 10% or greater if the company, and he numbers should be stable or growing over the past 10 years. 

The big takeaway

Value investing is not easy. It requires time, focus, discipline, patience and dedication to the craft. It will often mean looking and feeling foolish while you wait for an investment thesis to play out. If this doesn’t sound like it’s for you, investing in passive index funds is a perfectly suitable alternative.

For investors who enjoy the hunt of looking for undervalued assets — and beating the market at its own game — value investing can be richly rewarding in more ways than one. By following this simple guide, investors can be well on their way to understanding how value investing can beat the market.

References:

  1. https://www.foxbusiness.com/markets/how-to-be-a-successful-value-investor
  2. https://wp.ruleoneinvesting.com/blog/how-to-invest/value-investing/
  3. https://valueinvestoracademy.com/i-read-rule-1-by-phil-town-heres-what-i-learned/

Value Investing: The 4 Ms of Investing

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“The one and only secret to stockpiling is to make sure the value of the business is substantially greater than the price you are paying for it. If you get this right, you cannot help but get rich.” ~ Phil Town

Value investing is a strategy that focuses on investing in individual assets, but not just any asset, assets in wonderful companies or real estate that are priced well below their value, explains Phil Town, founder and CEO of Rule 1 Investing.

Value investing aims to reduce risk by increasing understanding of what you’re investing in order to make wiser investment decisions, and purchasing it at a price that gives you a margin of safety.

  • Value investing is a focused, disciplined and patient strategy, it’s a buy-and-hold for the long-term strategy. You need to be disciplined, patient and keep your focus on long-term profits.
  • It’s about making investing decisions based on the intrinsic value of a company, or what it’s actually worth, which is not to be confused with its sticker or market price.
  • A key component of value investing is buying stocks at the right time, and the right time will present itself if you remain focused, disciplined and patient.
  • The value investor isn’t swayed by the general public’s reaction or market fear. Fear can make people sell too early or miss an excellent opportunity to buy. But, the value investor decides when to buy or sell based on a wonderful company’s intrinsic value, not based on the prevailing fear or greed in the stock market.

Growth at a Reasonable Price (GARP)

Value investors focuses on finding companies that were both undervalued and are what you might call “wonderful companies” with a high potential for growth. Thus, it wasn’t enough for a company to just be undervalued. Instead, the best companies to invest in were ones that were both undervalued and wonderful companies.

To spot undervalued companies, it’s also important to ensure that the companies you are investing in are high-quality and can retain their value throughout the time that you are holding them. Phil Town likes to evaluate whether or not a business is a quality company with what he calls the 4 Ms of Investing: Meaning, Management, Moat, and Margin of Safety.

If you can check off each of these 4 Ms for a company you are considering investing in, it will be well worth your while.

Meaning

The company should have meaning to you. This is important because if it has meaning to you, you understand what it does and how it works and makes money, and will be more likely to do the research necessary to understand all elements of the business that affect its value.

Management

The company needs to have solid management. Perform a background check on the leaders in charge of guiding the company, paying close attention to the integrity and success of their prior decisions to determine if they are good, solid leaders that will take the company in the right direction.

Moat

The company should have a moat. A moat is something that separates them from the competition and, thus, protects them. If a company has patented technology, control over the market, an impenetrable brand, or a product or service customers would never switch from, it has a moat.

Margin of Safety

In order to guarantee good returns, you must buy a company at a price that gives you a margin of safety. For Rule #1 investors, 50% is the margin of safety to look for, explains Town. This provides a buffer that makes it possible to still experience gains even if problems arise. This is arguably the most important.

These 4Ms draw heavily from the rules of value investing. Both sets of rules dictate that you must buy a company below its actual value in order to make a profit. That’s the bottom line.

Even if a company is in a great position today, it needs to have future potential to triple or 10x your investment. The market cap is a reflection of what you would pay today to own a piece of the company. But the market price is not the true value of the company.

You, as a value investor, should rely on the “intrinsic value” to determine whether a company is a worthy value investment. Then, you can use the market cap to help you determine if the company is on sale and if it has the growth potential.

References:

  1. https://wp.ruleoneinvesting.com/blog/how-to-invest/value-investing/
  2. https://www.ruleoneinvesting.com/blog/financial-control/market-capitalization/

Phil Town is an investment advisor, hedge fund manager, and 3x NY Times Best-Selling Author. Phil’s goal is to help you learn how to invest and achieve financial independence.

Price to Earnings (P/E) Ratio

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Price is what you pay. Value is what you get.

The price-to-earnings ratio, or P/E ratio, helps investors compare the price of a company’s stock to the earnings the company generates. The P/E ratio helps investors determine whether a stock is overvalued or undervalued.

By comparing the P/E ratios companies in the same industry, investors can determine which companies are relatively under or over valued in comparison to their industrial peers.

The P/E ratio is derived by dividing the market price of a stock by the stock’s earnings.

The market price of a stock tells you how much people are willing to pay to own the shares, but the P/E ratio tells you whether the price accurately reflects the company’s earnings potential, or it’s value over time.

If the P/E ratio is much higher than comparable companies, investors may end up paying more for every dollar of earnings.

The typical value investor search for companies with lower than average P/E ratios with the expectation that either the earnings will increase or the valuation will increase, which will cause the stock price to rise.

On occasion, a high P/E ratio can indicate the market is pricing in greater growth that’s expected in the future years.

A negative P/E ratio shows that a company has not reported profits, something that is not uncommon for new, early stage companies or companies undergoing financial perturbations.

Current stock price may be important in choosing a stock, but it shouldn’t be the only factor. A low market stock price does not necessarily correlate to a undervalued or cheap stock.

The P/E ratio is a key tool to help you compare the valuations of individual stocks or entire stock indexes, such as the S&P 500.

References:

  1. Rajcevic, Eddie, Greenbacks & Green Energy, Luckbox, May 2022, pg. 58.
  2. https://www.forbes.com/advisor/investing/what-is-pe-price-earnings-ratio/

The Greater Fool Theory

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“The greater fool theory states that the price of an object is determined not by its intrinsic value, but rather by irrational beliefs and expectations of market participants. As long as there is a greater fool around the corner willing to pay a higher price, the value will continue to rise,” — Ashwin Sanghi

The “greater fool theory” refers to the principle that one can make money by investing into overvalued assets and selling them for a profit later, because there will always be someone else, “the greater fool”, who will come along and pay a higher price for the assets.

Billionaire Microsoft co-founder and investor Bill Gates has dismissed investments in cryptocurrencies, such as Bitcoin, and non-fungible tokens (NTFS). He opined that the digital assets market is largely driven by rampant speculation, greed and the greater fool theory.

Gates stated that the phenomenon of cryptocurrencies and non-fungible tokens as something that’s “100% based on greater fool theory,” since there will always be other speculators willing to pay more for assets.

Gates said he doesn’t own any crypto because he prefers investing in assets with determinable intrinsic value (value that is justified by facts) or “things that have valuable output.”

Thus without having a determinable intrinsic value, — a value that is justified by “facts”; such as assets, liabilities, earnings, dividends and other definite values — investing in cryptocurrency and NTFs is purely speculative by investors.

In the past, intrinsic value was equated to a company’s “book value”. Subsequently, a new concept was developed; the intrinsic value was determined by the earning power or the present value of the discounted future cash flow of a company.

Regarding intrinsic value: “To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight..” — Security Analysis by Benjamin Graham, David Dodd, Warren Buffet.

According to Corporate Finance Institute, the best way to avoid being a “Greater Fool” is to:

  • Do not blindly follow the herd, paying higher and higher prices for something without any good reason.
  • Do your research and follow a plan.
  • Adopt a long-term strategy for investments to avoid bubbles.
  • Diversify your portfolio.
  • Control your emotion of greed and resist the temptation to try to make big money within a short period of time.
  • Understand that there is no sure thing in the market, not even continual price inflation.

References:

  1. https://decrypt.co/102973/bill-gates-crypto-and-nfts-100-based-on-greater-fool-theory
  2. https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/greater-fool-theory/
  3. https://medium.com/the-peanut/the-concept-of-intrinsic-value-in-security-analysis-baa26ed1d42a