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
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
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:
- Security Analysis 101: Margin of Safety
- Foolish Fundamentals: Valuation
- Private Equity Turns Focus to Nursing Homes
Coca-Cola is a Motley Fool Inside Value recommendation, and Wrigley is a Motley 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 [email protected]. The Fool has a disclosure policy.
