Boring Portfolio

Intrinsic Value
Bore Philosophy continued...

By Alex Schay (TMF Nexus6)

ALEXANDRIA, VA (Oct. 9, 1998) -- Before we get into cost of capital considerations and a discussion of the low friction goals of this portfolio, it's important to dedicate a couple of paragraphs to the concept of intrinsic value. A good place to begin is Graham and Dodd's Security Analysis, in which an entire chapter is dedicated to those two oft-misunderstood words.

"In essence, the intrinsic value of the firm is its economic value as a going concern, taking account of its characteristics, the nature of its business(es), and the investment environment. This definition of intrinsic value is both normative and dynamic. It is a normative concept in that it is based on expected average relationships and thus seeks to estimate what price should be in terms of worth in contrast to what actual price may be. Although the primary objective of defining intrinsic value is to emphasize the distinction between value and current market price, an aura of permanence is not imputed to this value. In reality, the computed intrinsic value will change from year to year...."

So, what is a company worth? This, of course, is the million dollar question, but a good way of looking at the problem is to ask, what is the company not worth? The answer is that a company can't be worth more than what it can earn (note: not earnings). Why would you want to pay more for something than the underlying assets can readily produce? The only reason for putting cash into any kind of investment today is because you expect to take cash out at some later date. The value of any stock, bond, or business then, as articulated by John Burr Williams over 50 years ago, is determined by the cash inflows and the cash outflows -- discounted at an appropriate interest rate that can be expected to occur during the remaining life of the asset. Warren Buffett distills this concept in terms of intrinsic value:

"If we could see, in looking at any business, its future cash inflows and outflows between the business and its owners over the next, call it, 100 years, or until the business is extinct, and then could discount them back at the appropriate interest rate, that would give us a number for intrinsic value."

This of course begs the question, what is the appropriate discount rate to put on these bonds with an open ended maturity -- otherwise known as companies? Businesses have coupons that are going to materialize in the future -- the only problem is that they aren't printed on the security. Let's take a very brief look at the "accepted" method of estimating the cost of equity capital in terms of the expected return on any risky asset -- which is composed of three factors (AOL readers, please maximize the window for best reading):

 Expected Return = Risk-free     + Inflation + Risk 
 on risky asset    interest rate   premium     premium 

The owner of any "risky asset" is expected to generate a return from three sources. The first stems from the opportunity cost that is incurred when holding the asset; the second deals with compensation for the declining purchasing power of the investment over time; and the final source is the return expected for bearing the risk. Fortunately, a reasonable shorthand method of assessing the expected return has emerged, whereby the first two sources are mashed together into the expected return on a default-free bond, such as a government bond. In an alternate way of looking at this, government bond holders expect a return from the first two sources, but not the third. This has resulted in a situation where it is common to refer to the interest rate on the government bond as the risk-free rate.

 Expected Return = Interest rate on + Risk 
                   government bond    premium 

Therefore, in traditional investment theory, the challenge comes when attempting to estimate the risk premium. Although even here, some simplification has emerged. On average, over the period from 1926 to 1995 the annual return on common stocks exceeded the return on government bonds by seven percentage points. Therefore, historically, for an "average risk" company the expected return should be the government bond rate plus this seven point risk premium.

Of course, what the heck is an average risk company? To answer this, a somewhat flawed risk premium system has emerged (but it's the only quantitative method we have) that involves the concept of beta, which we won't get into here. Utilizing beta can result in some bizarre situations where a company suddenly becomes dramatically more risky once it's share price has gotten clobbered. Anyway, you should take away from this discussion a general sense of what's involved when assessing returns. On Monday, here's where we're going with all this:

  • Why does Warren Buffett just use the risk-free rate?
  • Why discount at all?
  • Is this process getting harder or easier?
  • How does any of this help? (Hint: It doesn't, you still have to estimate what the company can earn yourself.)
  • Close: Investing is about Specifics
From there, it's the end of philosophy and on to more concrete elements, like how we evaluate business returns and how the Boring portfolio will operate in general.

For continued discussion in the meantime, please visit the Boring message board.

10/01/98: The New Boring Port Transitions Facts

FoolWatch -- It's what's going on at the Fool today.

10/09/98 Close

Stock  Change    Bid 
 ANDW    ---    11.31 
 CGO   +1 13/16 25.00 
 BGP     ---    22.06 
 CSL   +  5/8   33.50 
 CSCO  +3 3/8   50.06 
 FCH   +1 7/16  19.63 
 PNR   -  1/16  30.44 
 TBY   +  1/4    5.56 
                    Day   Month    Year  History 
         BORING   +3.33% -11.31% -24.11%  -4.51% 
         S&P:     +2.59%  -3.21%   1.43%  58.35% 
         NASDAQ:  +5.17% -11.89%  -4.96%  43.38% 
     Rec'd   #  Security     In At       Now    Change 
   6/26/96  225 Cisco Syst    23.96     50.06   108.98% 
   2/28/96  400 Borders Gr    11.26     22.06    96.00% 
   8/13/96  200 Carlisle C    26.32     33.50    27.26% 
    3/5/97  150 Atlas Air     23.06     25.00     8.42% 
   4/14/98  100 Pentair       43.74     30.44   -30.42% 
   5/20/98  400 TCBY Enter    10.05      5.56   -44.62% 
   11/6/97  200 FelCor Sui    37.59     19.63   -47.79% 
   1/21/98  200 Andrew Cor    26.09     11.31   -56.64% 
     Rec'd   #  Security     In At     Value    Change 
   6/26/96  225 Cisco Syst  5389.99  11264.06  $5874.07 
   2/28/96  400 Borders Gr  4502.49   8825.00  $4322.51 
   8/13/96  200 Carlisle C  5264.99   6700.00  $1435.01 
    3/5/97  150 Atlas Air   3458.74   3750.00   $291.26 
   4/14/98  100 Pentair     4374.25   3043.75 -$1330.50 
   5/20/98  400 TCBY Enter  4018.00   2225.00 -$1793.00 
   1/21/98  200 Andrew Cor  5218.00   2262.50 -$2955.50 
   11/6/97  200 FelCor Sui  7518.00   3925.00 -$3593.00 
                              CASH   $5750.59 
                             TOTAL  $47745.90