How to calculate the instrinsic value of a stock

From Wallstraits.com

Many investors, we realize, are alergic to mathematics—but to make intelligent investment decisions will require just a little bit of math, and today’s Prof Sage lesson is no exception. Certainly most of your time is wisely spent assessing the qualities of a business—substantially a qualitative exercise. However, at some point we must calculate an intrinsic value that can then be compared to the current market price in order to see if there is a margin of safety between the two. Without knowing the intrinsic value of the business the daily share price quotes become a mystery and buying stocks slides into a speculative guessing game.

Fear not, we will keep the following mathematical explanation as simple as possible. However, to keep the discussion short we will also assume readers are familiar with basic financial calculations. The value of any financial asset is the discounted value of the future net cashflows. For common stock, intrinsic value is the discounted value of the owner earnings that can be taken out of a business during its remaining life. We discount because $1 received next year, or the year after, does not have the same value to an investor as $1 received today.

Future owner earnings are determined by the strength and durability of the economic franchise, the quality of management and the financial strength of the business. Valuegrowth investing makes use of Warren Buffett’s definition of owner earnings, but with the additional factor in (c) and (d) of ’investment in all new value creating projects’. Owner earnings are defined as:

(a) reported earnings after tax; plus

(b) depreciation, depletion, amortization and certain other non-cash charges; less,

(c) the amount of capitalized expenditures for plant and machinery, etc. that a business requires to fully maintain its long-term competitive position, its unit volume and make investment in all new value creating projects; less,

(d) any extra amount for working capital that is needed to maintain the firm’s long-term competitive position, unit volume and make investment in all new value creating projects.

Thus, there are two types of investment. First, that which is needed to permit the firm to continue to maintain its existing competitive position at the current level of output. Second, investment in value creating growth opportunities beyond the current position.

So, for example, Want Want Holdings Limited recently reported first-half 2003 net earnings after tax of US$44 million. In drawing up the income (profit and loss) account deductions of $16.5 million were made for depreciation, and about $1 million for amortization. Want Want provided an estimate of capital expenditure to expand rice cracker and dairy products production capacity during the first-half of 2003 at nearly $13 million, and forecasts an additional capital expenditure of about $20 million for further expansions in the second half of 2003. We can estimate Want Want’s owner earnings as follows for full-year 2003:

Want Want Holdings full-year 2003 Owner Earnings:

Reported earnings after tax for first-half = US$44 million X 2 for full year = $88m; plus

Depreciation and amortization for first-half = $17.5m X 2 for full year = $35m; less

Expenditure on Capital Equipment for full-year = $33m

Owner Earnings estimate thus = $88m + $35m — $33m = US$90 million

The discounted value of all the annual owner earnings stretching to an infinite horizon is the annual owner earnings divided by the appropriate discount rate, when each year’s owner earnings are identical to all the other year’s and the first is to be received a year from now:

Intrinsic Value = Annual owner earnings / Discount rate

The discount rate is set as the required rate of return for an asset in this risk class. It is equal to the opportunity cost of placing funds in this stock rather than another one with equal risk. In other words, if the next best alternative use for the money shareholders put into Want Want pays a return of 10%, and that alternative has the same level of risk as Want Want shares, then the discount rate for Want Want shares is 10%.

Want Want Intrinsic Value = $90 million / 0.10 = $900 million.

By contrast, the current market capitalization of Want Want can be calculated as follows:

Want Want Market Cap = Share price X No. Shares = 0.91 X 1,274m = $1,159 million.

GROWTH OF OWNER EARNINGS

If we assume that Want Want has a series of new value creating (i.e. generating >10% returns) projects it can invest in. By investing in these projects owner earnings will rise by just 5% in each future year (owner earnings are on the one hand decreased by the need for additional investment under (c) and (d), but, on the other hand, reported earnings are boosted under (a) to produce a net 5% growth.) Thus:

Most recent owner earnings: US$90m

Next year’s owner earnings ($90m X 1.05) = $95m

In two years, owner earnings ($99 X 1.05) = $99m

In three years, owner earnings ($109 X 1.05) = $104m, etc.

Each of these future owner earnings is then discounted at the appropriate rate (10% in this case):

Intrinsic Value = ($99m / 1 + 0.1) + ($109m / (1 + 0.1)(1 + 0.1)) +.

This method of calculating intrinsic value could take a long time because owner earnings received decades into the future contribute to intrinsic value and therefore need to be discounted and included in the formula. Don’t be disheartened though. The long (infinite) formula with a constant growth of owner earnings from one year to the next can be simplified and the whole calculation completed in under 30 seconds. The formula below is equivalent to the one above—but much more simple:

Intrinsic Value = Owner earnings next year / Discount rate — Growth rate

Want Want Intrinsic Value becomes = $95m / (.10 — .05) = US$1,900 million

$1,900m / 1274m shares = $1.49/share intrinsic value.

Note that even a relatively modest rate of growth in owner earnings makes a large difference to the intrinsic value. A growth rate of 5% more than doubles intrinsic value (in the case where the discount rate is 10%) compared with the situation where there is no growth expected to occur.

Disclosure/Credits: Much of this article is extracted from Valuegrowth Investing by Glen Arnold, with the examples changed into local context. The WallStraits 8 Portfolio owns shares in Want Want Holdings Limited, and there is no intention to recommend this stock to others, only to use this familiar business as an example in the calculations presented. We do indeed utilize a simplified version of the Intrinsic Value calculation presented here to assess our WS8 business for Intelli-vest members on a quarterly basis. We have a full and open disclosure policy.