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September 22, 1997 |
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"Price is what you paid and value is what you get." - Warren Buffett Value is not necessarily synonymous with price, and it is value that investors should be focusing on in investing. In the past week, I've received quite a few E-mail from readers asking how to calculate the intrinsic value of a stock. Indeed, the ability to determine intrinsic value is one of the most important factors in successful investing. The word Invest, first recorded in English in the early 17th century, is thought to have originated in Italian investire from the idea of dressing one's capital up in different clothes by putting it into a particular business, stock, etc. The whole idea of investing is to put your cash into different forms of assets and hope that you will end up with more cash than you started with at the end of the day. In other words, one hopes to invest cash in an asset that will produce more cash over its lifetime than what one initially puts in. Defining Intrinsic Value Therefore the intrinsic value of any investment is the total amount of cash that can be taken out of that investment over its lifetime discounted back to the present worth at an appropriate interest rate. This approach of valuing investments will enable you to value any type of investments, be it real estate, bonds, high-tech or low-tech businesses, or even human beings (more on the economic value of humans below). In the case of a business, the cash that can be taken out of the business is its net after-tax profits adjusted for working capital changes. Then, add back depreciation and amortization, and subtract ongoing capital expenditures required for the business to remain competitive. This so called free cash, generated over the lifetime of the business, is then discounted back at an appropriate interest rate to give its present intrinsic value. For those of you not thrilled with accounting terminology, I'll attempt to discuss the concept of intrinsic value using a friend of mine as an example. My friend in this case is Johanne, a progressive secretary working somewhere in the East Coast. Net Profits And Working Capital The cash that Johanne can take out every year from her total salary is her annual income, less her living/personal expenses and income taxes that she has to pay to Uncle Sam. This is in essence her annual net after-tax profits. However, Johanne cannot take out all of the available net cash because at times before she receives her salary, she has bills to pay. She will need to leave a sufficient amount of money floating around to tie her over until the next pay check comes in. This "working capital" will always be circulating in Johanne's accounts as she needs to use this money on an ongoing basis to run her life. As such this working capital will be tied up and not be available for her to take out. If Johanne takes out all her available cash and leaves nothing behind for ongoing working capital, then she will have cash flow problems. The same is true for businesses. Any business will require working capital to keep the business running on an ongoing basis. Not all of the after-tax profits of a business can be taken out as cash, as a portion of it is tied up in the business as working capital. Working capital is defined as Current Assets minus Current Liabilities. The portion of a business' annual net after-tax profits that can be taken out as cash is its net after-tax profits for the year ended, less the difference between the working capital of the business for the current and preceding year ended. Capital Expenditures After leaving some cash for working capital, Johanne decides to take a course on learning the latest Microsoft Office 97 software programs. She knows her boss will be upgrading all the computers in her company to Microsoft Office 97, and it will be in her best interest to be current with the latest software tools. In this way she will remain competitive and be able to keep her job in the long run. Therefore, periodically, Johanne will need to spend money on training courses to keep herself competitive. If she doesn't, her skills will eventually become outdated, and she will lose her competitiveness in the job market. Such periodic expenditures will have to be deducted from the net cash that can be taken out by Johanne. She has to make allowances for such future spending that are essential to keeping her competitive. Under Generally Accepted Accounting Principles (GAAP), this type of expenditure by Johanne is not an expense, but rather a capital investment. Johanne is investing in herself to remain competitive and to stay current. GAAP allows Johanne to capitalize such an expenditure and write it off over the useful life of the investment. Given that Bill Gates is churning out upgrades to Microsoft's software every 2-3 years, Johanne can therefore depreciate this capital investment over 2 to 3 years. In a business, such depreciation becomes a "non-cash charge" to the Profit and Loss Statement of the business. Even though there is real cash outlay at the time of the capital expenditure, the outlay is capitalized and charged to the P & L of the business over the estimated life of the investment. When investment bankers or analysts try to find extra cash flow to justify a pricey acquisition or service debt, they frequently add back depreciation and amortization to earnings. They would rationalize that these are non cash charges and therefore are available to be taken out for debt service or dividends. However, in reality, these are real economic expenses that have to be deducted from the cash that can be taken out of the business, as illustrated above in the case of Johanne. In calculating cash that can be taken out of a business, if you add back depreciation and amortization to the earnings of a business, then you must also subtract from it the estimated ongoing capital expenditures required for the business to remain competitive, just like you have to estimate how much money Johanne will have to spend on training courses throughout her career as a secretary in order to remain competitive. Without such ongoing capital expenditures, a business (or Johanne) will eventually lose its competitive position and slowly wither away. Maintenance Versus Growth Note that the above are maintenance capital expenditures and are different from growth capital expenditures. The former are compulsory expenditures required for maintaining a business' competitiveness, whereas the latter are optional expenditures for growth of the earning power of the business. Suppose Johanne wants to increase her income substantially and therefore decides to go to law school at night to study law. She figures she has a much better future as a lawyer than as a secretary. In this case, Johanne elects to make this investment because she wants to increase her future income. As such this capital expenditure is optional - she chose to reinvest in herself for future growth instead of taking it out - and therefore is not deducted from the net cash available to Johanne. It is counted as cash that she can take out but she opted not to take it out and reinvest it in herself to become a lawyer. Whether this is a wise investment of Johanne's remains to be seen. If the investment results in increasing her income in the future, then it is money well spent. If Johanne belatedly finds out that she really has no aptitude to be a lawyer, then it will be money down the drain. In business, the same situation occurs when a business reinvests its excess cash in new products or acquisitions to grow future income. Usually the further that cash is invested from the company's core business, the greater the chance of squandering it. In any case, such growth capital expenditures are not deducted from the free cash flow of the business in calculating intrinsic value. To recap, I have taken the net after-tax profits from Johanne's salary, adjusted for working capital tied up, added back depreciation, and subtracted maintenance capital expenditures. This results in the free cash that can be taken out of Johanne. To calculate her intrinsic value (in an economic sense), you discount this free cash that can be taken out of Johanne during her remaining life back to the present worth using an appropriate discount rate. Discount Rate If you put $1 in a savings account with an interest rate of 6% p.a. and reinvest all the interest into the savings account, you will have $2 in 12 years. Simple compound interest in the works here. The corollary is true also - $2 paid out 12 years from now is only worth $1 today if you required a 6% interest rate. That's discounting, as opposed to compounding. In calculating intrinsic value, you simply reverse the compounding process and discount the cash that can be taken out of an investment throughout its life by applying an appropriate interest rate to arrive at the present worth. There is a lot of debate on the discount rate, but I believe what discount rate you use is simply a matter of personal preference. Warren Buffett uses 30-year US treasury bond yields as his discount rate in calculating intrinsic value. This is in essence a "risk-free rate" (US government bonds are supposedly the safest). If you use the US long-bond rate, then the intrinsic value that you arrive at will be the "full" value of the investment. There is no room for errors in judgment or changes in future interest rates. Also, your return will be the same as buying long bonds if you buy at this full price (assuming no change in future interest rates and correct estimation of free cash flow). As such, one of Warren's bedrock principles is to buy stocks or other investments at a substantial discount from their intrinsic value to give himself a margin of safety and increase his returns. Another point is intrinsic value is not a fixed value. Rather it changes with changes in interest rates and future cash flow of the investment. So, every now and then, one needs to reevaluate intrinsic value taking into consideration these changes. Once you have mastered the ability to calculate intrinsic value, then the entire game of investment becomes putting your money into investments that will give you the best value - finding investments with the lowest price in relation to their intrinsic value. So it goes back to value and price as stated in Warren Buffett's quote at the start of this entry. Start With The Business FFrom the above process of calculating intrinsic value, it is obvious that the most important thing in the whole equation is the ability to estimate the cash that can be taken out of the investment throughout its life time. You can only do this if you understand the investment - in the case of stock, understand the business. If you don't know anything about being a secretary it will be impossible for you to calculate Johanne's intrinsic value. That's why in researching stocks, I never screen companies based on low P/Es or high P/Es, or what their beta is, or some pre-set discount ratio to Net Asset Value, etc. Instead, I always start with the simple question "Do I understand the business?" and I go on from there. Valuing Brain Surgeons And Secretaries The secretary business is a tough business with little meaningful differentiation in services offered and ease of entry. The result is a commodity type of business where pricing is a key consideration in hiring decisions. Secretaries' income will be dictated by supply and demand with tight supply leading to higher income. Contrast the underlying economics of a secretary with a brain surgeon. An established brain surgeon with a good reputation can command premium pricing (at least before the HMOs romp through the hospitals) and is relatively immune to the forces of supply and demand. Would you take the low bid, opting for someone you don't really know or trust to screw around with your head? Not likely. Thus, prosperity is almost certain for the competent brain surgeon. Food For Thought Which is a better investment - a brain surgeon with an intrinsic value of $67/share selling at the market for $55/share or a secretary with an intrinsic value of $150/share and selling in the market for $100/share? You are welcome to send in your answers and thoughts to me. |
