Security Analysis 201: Intrinsic Value

In my article "Security Analysis 101," I discussed the concept of margin of safety and expressed why all investors must have one, if they want to reduce the likelihood of permanent loss of capital.

But to have a satisfactory margin of safety, you first must determine a company's intrinsic value, because a margin of safety occurs only when a business can be acquired at a significant discount to its intrinsic value. The wider the gap, the better. Warren Buffett likes to invest with a 50% margin of safety. Mason Hawkins at Longleaf Partners says his group looks for businesses trading at 60% or less of intrinsic value.

What is intrinsic value?
Every business has an intrinsic value. According to John Burr Williams in his 1938 publication The Theory of Investment Value, that value is determined by the cash inflows and outflows -- discounted at an appropriate interest rate -- that can be expected to occur during the remaining life of the business.

This definition is painfully simple. Let's consider a simple illustration.

Imagine that at the end of this year, your local movie-rental store is up for sale, and the owner is offering it at $500,000 today. Further, let's assume that the movie store can be sold for $400,000 after 10 years. The store generates free cash flow -- money that can be pulled out of the business -- of $100,000 a year for the next 10 years. Meanwhile, you have an alternative low-risk investment opportunity that would yield an annualized 10% return on that same $500,000. Should you buy the movie store, or take the virtually assured 10% return? Take a look.

Discounted Cash Flow of 10%, Low-Risk Investment

Year

Free Cash Flow

Present Value of Cash Flow

2007

$50,000

$45,454

2008

$50,000 

$41,322 

2009

$50,000

$37,566 

2010

$50,000

$34,151 

2011

$50,000

$31,046 

2012 

$50,000

$28,224

2013 

$50,000

$25,658 

2014

$50,000

$23,325 

2015 

$50,000

$21,205 

2016 

$50,000

$19,277 

2017

Return of $500,000 Investment

$192,772

Total 

 

$500,000

Discounted Cash Flow of 10%, Movie Store

Year

Free Cash Flow

Present Value of Cash Flow

2007

$100,000

$90,909

2008

$100,000

$82,645

2009

$100,000

$75,131

2010

$100,000

$68,301

2011

$100,000

$62,092

2012 

$100,000

$56,447

2013 

$100,000

$51,315

2014

$100,000

$46,650

2015 

$100,000

$42,410

2016 

$100,000

$38,554

2017

Sale Price of $400,000

$154,217

Total 

 

$768,674

Obviously, the intrinsic value of the $500,000 invested at 10% and discounted at 10% is exactly $500,000. The movie-store investment provides a better investment opportunity, provided that your annual cash flow and sale price are virtually assured.

For the most part, however, cash flows are never guaranteed, and that's why the intrinsic-value figure is only an approximate value, and not an exact figure. Yet it does provide the most accurate approximation of a business' true worth. The better your understanding of a business, the better your calculation of intrinsic value. And the more data and reasoning you have, the more accurate your intrinsic value becomes.

There's a good reason why guys like Buffett stick to simple, easy-to-understand businesses. Determining the cash flows of a business such as Wrigley (NYSE: WWY  ) several years out is much easier to do than figuring out how much cash Advanced Micro Devices (NYSE: AMD  ) will produce.

Investing is simple, but it's not easy
When you see a wide gap between Mr. Market's price and the intrinsic value of a business, and the gap is in your favor -- with intrinsic value being far higher than the stock price -- it makes sense to invest. Buffett made a killing on Coca-Cola (NYSE: KO  ) in the 1980s by investing this way. So has Mohnish Pabrai, who has generated huge returns with Pinnacle Airlines (Nasdaq: PNCL  ) and IPSCO.

Buffett said, "I am a better investor because I am a businessman and a better businessman because I am an investor." And Ben Graham famously noted, "Investment is most intelligent when it is most business-like." Such a business-oriented outlook toward investing -- one that looks for high-quality businesses trading at prices below their intrinsic value -- is the only form of intelligent investing.

Related articles:

Coca-Cola is aMotley Fool Inside Value recommendation, and Wrigley is aMotley Fool Income Investor recommendation. Both newsletter services are beating the market by five percentage points. Take a free 30-day trial of either service and find out why.

Fool contributor Sham Gad is the managing partner of the Gad Partners Fund, a value-focused investment partnership launching next month. He owns no positions in the company's mentioned. Reach him at shammf@gmail.com. The Fool has a disclosure policy.


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