## Intrinsic Value – What a stock is worth?

Without knowing what a stock is worth- in other words its Intrinsic Value- how can you know how much you should pay for it? Stocks should be purchased because they are trading at some discount to their intrinsic value, not simply because they are priced at a higher or lower point than similar companies.

The big drawback of the ratios discussed in the Stock Valuation framework is that they are all based on price – they compare what investors are currently paying for one stock to what they are paying for another stock. Ratios do not, however, tell you anything about value, which is what a stock is actually worth. Comparing ratios across companies and across time can help us understand whether our valuation estimate is close to or far from the mark, but estimating the intrinsic value of a company gives us a better target.

Pat Dorsey, Director of Stock Analysis, Morningstar Inc. in his very useful book – The 5 Rules for Successful Stock Investing – tells us how we can go about calculating what a stock is really worth- in other words, its Intrinsic Value. His writings are the primary source for this article.

Having an intrinsic value estimate keeps you focused on the value of the business, rather than a piece of the stock – and that’s what you want because, as an investor, you are buying a small piece of a business. Intrinsic valuation also forces you to think about the cash flows that a business is generating today and the cash it could generate in the future, as well as the returns on the capital that the firm creates. It makes you ask yourself, “If I could buy the whole company, what would I pay?

Second, having an intrinsic value gives you a stronger basis for making investment decisions. Without looking at the true determinants of value, such as cash flow and return on capital, we have no way of assessing whether a P/E of, for example 15 or 20 is too low, too high, or right on target. After all, the company with the P/E of 20 might have much lower capital needs and a less risky business than the company with the P/E of 15, in which case it might actually be the better investment.

### Cash Flow, Present Value, and Discount Rates

What is a stock worth? Economists Irving Fisher and John Burr Williams answered this question for us more than 60 years ago. The value of a stock is equal to the present value of its future cash flows. No more and no less.

Companies create economic value by investing capital and generating a return. Some of that return pays operating expenses, some get re-invested in the business, and the rest is free cash flow. Remember we care about the free cash flow because that’s the amount of money that could be taken out of the business each year without harming its operations. A firm could use free cash flow to benefit shareholders in a number of ways. It can pay a dividend, which essentially converts a portion of each investor’s interest in the firm to cash. It can buy back stock, which reduces the number of shares outstanding and thus increases the percentage ownership of each shareholder. Or, the firm can retain the free cash flow and re-invest it in the business.

These free cash flows are what give the firm its investment value. A present value calculation simply adjusts those future cash flows to reflect the fact that money we plan to receive in the future is worth less than money we receive today.

Why are future cash flows worth less than the current ones? First, money that we receive today can be invested to generate some kind of return, whereas we cant invest future cash flows until we receive them. This is the time value of money. Second, there is a chance that we may never receive those future cash flows, and we need to be compensated for that risk, called the risk premium.

The time value of money is essentially the opportunity cost of receiving money in the future versus receiving it today, and is often represented by the interest rates being paid on government bonds. Its pretty certain that the government will be around to pay us our interest in a few years.

Of course, not many cash flows are as certain as those from the government, so we need to take an additional premium to compensate us for the risk that we may never receive the money we have been promised. Add the government bond rate to the risk premium, and we have what’s known as a discount rate.

Now you can start to see why stocks with stable, predictable earnings often have such high valuations – investors discount their future cash flows at a lower rate, because they believe that there’s a lower risk attached to the likelihood that those future cash flows will actually show up. Conversely a business with an extremely uncertain future should logically have a lower valuation because there is a substantial risk that the potential future cash flows will never materialise.

You can see why a rational investor should be willing to pay more for a company that’s profitable now relative to one that promises profitability only at some point in the future. Not only does the latter carry a higher risk (and thus a higher discount rate), but the promised cash flows won’t arrive until some years in the future, diminishing their value still further.

Changing discount rates and the timing of cash flows can have a telling effect on present value. In all three examples, below -StableCorp, CycliCorp, and RiskCorp -the sum of the undiscounted cash flows is about $32000.

However, the value of the discounted cash flows is quite different from company to company. In present value terms, CycliCorp is worth about $2700 less than StableCorp. That’s because StableCorp is more predictable, which means that investors’ discount rate isn’t high. CycliCorp’s cash flow increases by 20 percent some years and shrinks in some years, so investors perceive it as a riskier investment and use a higher discount rate when they are valuing its shares. As a result the present value of the discounted cash flows is lower.

The difference in the present value of the cash flows is even more acute when you look at RiskCorp, which is worth almost $8300 less than StableCorp. Not only are the bulk of RiskCorp’s cash flows far off in the future, bu also, we are less certain that they will come to pass, so we assign an even higher discount rate.

This is the basic principle behind a discounted cash flow model. Value is determined by the amount, timing, and riskiness of a firm’s future cash flows, and these are the three items you should always be thinking about when deciding how much to pay for a stock. That’s all it really boils down to.

### Calculating Present Value

To find the present value of a $100 future cash flow, divide that future cash flow by 1.0 plus the discount rate. Using a 10% discount rate, for example, a cash flow of $100 one year in teh future is worth $100/1.10. or $90.91. A $100 cash flow two years in the future is worth $100/(1.10×1.10), or $82.64. In other words, $82.64 invested at 10% becomes $90.91 in a year and $100 in 2 years. Discount rates are really just interest rates that go backwards through time instead of forwards.

Generalising the previous formula, if we represent the discount rate as R, the present value of a future cash flow (CF) in year N equals

### Fun with discount rates

Now that we have the formula down, we need to figure out what factors determine discount rates for use in Intrinsic Value calculations. How do we know whether to use 7 percent or 10 percent?

Unfortunately, there is no precise way to calculate the exact discount rate that you should use in discounted cash flow (DCF) model, and academicians have filled entire journals with nothing but discussions on the right way to estimate discount rates for Intrinsic value calculations.

Here’s what you want to know for practical purposes. As interest rates rise, so will discount rates. As a firm’s risk level increases, so will its discount rate. Let’s put these two together. For interest rates you can use the long-term average of treasury rates as a reasonable proxy. (Remember we use interest rate on treasuries to represent opportunity costs because we are pretty certain that the government will pay us our promised interest).

Now for risk, which is an even less exact factor to measure. Here are some factors that should be taken into account when estimating discount rates.

**Size**

Smaller firms are generally riskier than larger firms because they’re more vulnerable to adverse events. They also usually have less diversified product lines and customer bases.

**Financial Leverage**

Firms with more debt are generally riskier than firms with less debt because they have a higher proportion of fixed expenses (debt payments) relative to other expenses. Earnings will be better in good times, but worse in bad times, with an increased risk of financial distress. Look at a firm’s debt-to-equity ration, interest coverage, and a few other factors to determine the degree of a company’s risk from financial leverage.

**Cyclicality**

Is the firm in a cyclical industry (such as commodities or automobiles) or a stable industry (such as breakfast cereal or beer)? Because the cash flows of cyclical firms are much tougher to forecast than stable firms, their level of risk increases.

**Management/Corporate Governance**

This factor boils down to a simple question: How much do you trust the folks running the shop? Although its rarely black or white, firms with promotional managers (who leave no opportunity to drum up stock prices through their media appearances), managers who draw egregious salaries, or who exhibit any of the other red flags are definitely riskier than companies with managers who do not display these traits.

**Economic Moat**

Does the firm have a wide moat, a narrow moat, or no economic moat? The stronger a firm’s competitive advantage -that is, the wider its moat- the more likely it will be able to keep competitors at bay and generate a reliable stream of cash flows.

**Complexity**

The essence of risk is uncertainty. And its tough to value what you can’t see. Firms with extremely complex businesses or financial structures are riskier than simple, easy-to-understand firms because there’s a greater chance that something unpleasant is hiding in a footnote that you missed. Even if you think management is as honest as the day is long and that the firm does a great job running its operations, its wise to incorporate a complexity discount into your mental assessment of risk.

**How should you incorporate all of these risk factors into a discount rate? There is no right answer.**

Morningstar uses 10.5 percent as the discount rate for an average company based on the above factors and creates a distribution of discount rates based on whether firms are riskier or less risky than the average. A so mid-2003, firms such as Johnson and Johnson, Colgate and Wal-Mart fall at the bottom of the range at around 9 percent, whereas riskier firms such as Micron technology, JetBlue Airways, and E*Trade -top out at 13 percent to 15 percent.

The key is to pick a discount rate you are comfortable with. Don’t worry about being exact -just think about whether the company you are evaluating is riskier or less risky than the average firm, along with how much riskier or less risky it is, and you will be fine.

**Discount rates for the Indian market context**

In the Indian market context we may use 15% as the discount rate for an average company (8 percent risk-free rate + 7 percent risk-premium). High-Quality companies may be discounted at a low rate of 12%, above-average companies at 13%, and poor quality companies may be discounted at a high of 18%.

### Calculating Perpetuity Values

We have cash flow estimates, and we have a discount rate. We need one more element called a perpetuity value. We need a perpetuity because it’s not feasible to project a company’s future cash flows out to infinity, year-by-year, and because companies have theoritically finite lives.

The most common way to calculate a perpetuity is to take the last cash flow (CF) that you estimate, increase it by the rate at which you expect it to grow over the very long term (g), and divide the result by the discount rate (R) minus the expected long-term growth rate.

The result of this calculation than must be discounted back to present, using the method discussed for calculating present value. For example, suppose we are using a 10-year DCF model for a company with an 11 percent discount rate. We estimate that the company’s cash flow in year 10 will be $1 billion and its cash flow will grow at a steady 3 percent annual rate after that. (Three percent is generally a good number to use as your long-run growth rate because it’s roughly the U.S. gross domestic product [GDP] growth. If you are valuing a firm in a declining industry, you might use 2 percent).

Perpetuity Value = $ 1 billion x (1+ 0.03) / (0.11-0.03)

= $ 1.03 billion/ 0.08

= $ 12.88 billion

To get the present value of these cash flows, we need to discount them using the formula

where n is the number of years in the future, CFn is the cash flow in year n, and R is the discount rate. Plugging these numbers, N = 10, CFn = $12.88 billion, R= 0.11

Discounted Perpetuity Value = $12.88 bn/ (1+0.11)^10 = $12.88 bn/2.839 = $4.536 bn

### Calculating Intrinsic Value

Now all that we need to do is add this discounted perpetuity value to the discounted value of our estimated cash flows in years 1 through 10, and divide by the number of shares outstanding.

That was a brief outline of the process. You can follow along by matching the following steps:1. Estimate free cash flows for the next 4 quarters. This amount will depend on all of the factors discussed earlier -how fast the company is growing, the strength of its competitors, its capital needs, and so on. Using Clorox as an example, our first step is to see how fast free cash flow has grown over the past decade, which turns out to be 9% when we do the math. We could just increase the $600 million in free cash flow that Clorox generated in 2003 by 9 percent, but that would assume the future would be as rosy as in the past. Mega retailers like Wal-Mart -which now accounts for almost a quarter of Clorox sales -has hurt the bargaining power of consumer-product firms. So, let’s be conservative and assume free cash flow increases by only 5 percent over the last year, which would work out to $630 million.

2. Estimate how fast you think free cash flow will grow over the next 5 to 10 years. Remember, only firms with very strong competitive advantages and low capital needs are able to sustain above-average growth rates for very long. If the firm is cyclical don’t forget to throw in some bad years. We won’t do this for Clorox because selling bleach and Glad bags is a very stable business. We will however be conservative on our growth rate because of the “Wal-Mart factor”, and will assume free cash flow increases at 5 percent annually over the next decade.

3. Estimate a discount rate. Financially Clorox is rock-solid, with little debt, tons of free cash flow, and a non-cyclical business. So we will use 9% for our discount rate, which is meaningfully lower than the 10.5 percent average we discussed earlier. Clorox, is a predictable company, after all.

4. Estimate a long-run growth rate. Because people will still need bleach and trash bags in the future, and its a good bet that Clorox will continue to get a piece of that market, we can use the long-run GDP average of 3 percent.

5. That’s it! We discount the first 10 years of cash flows, add that value to the present value of the perpetuity, and divide by the shares outstanding.

This is a very simple DCF model. The one used at Morningstar has about a dozen excel tabs, adjusts for complicated items such as pensions and operating leases, and explicitly models competitive advantage periods, among many other things. But a model doesn’t need to be super complex to get you most of the way there and help you clarify your thinking.

The important thing is that we forced ourselves to think through these kinds of issues as discussed earlier, which we wouldn’t have if we had just looked at Clorox’s stock chart or if we had just said, “Sixteen times earnings seem reasonable”. By thinking about the business, we arrived at a better valuation in which we have more confidence.

Valuing Clorox using a Discounted Cash Flow model

## Margin of Safety

We have analysed a company, we have valued it – now we need to know when to buy it. If you really want to succeed as an investor, you should seek to buy companies at a discount to your estimate of their intrinsic value. Any valuation and any analysis is subject to error, and we can minimise the effect of these errors by buying stocks only at a significant discount to our estimated intrinsic value. This discount is called the Margin of Safety, a term first popularised by investing great Benjamin Graham.

Here is how it works. Let’s say we think Clorox’s intrinsic value is $54, and the stock is trading at $45. If we buy the stock and we’re exactly right about our analysis, the return we receive should be the difference between $45 and $54 (20 percent) plus the discount rate of about 9 percent. That would be 29 percent, which is a pretty darn good return, all things considered.

But what if we are wrong? What if Clorox grows even more slowly than we had anticipated -may be a competitor takes market share – or the firm’s pricing power erodes faster than we had thought? If that’s the case, then Clorox’s intrinsic value might actually be $40, which means we would have overpaid for the stock by buying it at $45.

Having a margin of safety is like an insurance policy that helps prevent us from overpaying – it mitigates the damage caused by overoptimistic estimates. If, for example, we had required a margin of safety of 20 percent before buying Clorox, we wouldn’t have purchased the stock until it fell to $43. In that case, even if our initial analysis had been wrong and the fair value had really been $40, the damage to our portfolio wouldn’t have been as severe.

Because all stocks aren’t created equal, not all margins of safety should be the same. It’s much easier to forecast the cash flows of, for example, Anheuser-Busch over the next 5 years than the cash flows of Boeing. One company has tons of pricing power, dominant market share, and relatively stable demand, whereas the other has relatively little pricing power, equal market share, and highly cyclical demand. Because I am less confident about my forecasts for Boeing, I’ll want a larger margin of safety before I buy the shares. There’s simply a greater chance that something might go wrong, and that my forecasts will be too optimistic.

Paying more for better businesses makes sense, within reason. The price you pay for a stock should be closely tied to the quality of the company, and great businesses are worth buying at smaller discounts to intrinsic value. Why? Because high-quality businesses – those that have wide economic moats – are more likely to increase in value over time, and it’s better to pay fair price for a great business than a great price for a fair business.

How large should your margin of safety be? It ranges all the way from just 20 percent for very stable firms with wide economic moats to 60 percent for high-risk stocks with no competitive advantages. For above-average firms we would require a 25 percent margin of safety, while on average, we require a 30 percent to 40 percent margin of safety for most firms.

Having a margin of safety is critical to being a disciplined investor because it acknowledges that as humans, we are flawed. Simply investing in the stock market requires some degree of optimism about the future, which is one of the biggest reasons that buyers of stocks are too optimistic far more often than they’re too pessimistic. Once we know this, we can correct for it by requiring a margin of safety for all of our share purchases.

Every approach to equity investing has its own warts. Being disciplined about valuation may mean that you will miss out on some great opportunities because some companies wind up performing better for longer periods of time than almost anyone could have anticipated. Companies such as Microsoft looked very pricey back in their heyday, and its unlikely that many investors who were very strict about valuation would have bought it early in their corporate lives.

Being disciplined about valuation would have meant missing those opportunities, but it also would have kept you out of many investments that were priced like Microsoft, but which wound up disappointing investors in a big way. Although we acknowledge that some high-potential companies are worth a leap of faith and a high valuation, on balance, we think its better to miss a solid investment because you are too cautious in your initial valuation than it is to buy stocks at prices that turn out to be too high.

After all, the real cost of losing money is much worse than the opportunity cost of missing out on gains. that’s why the price you pay is just as important as the company you buy.