[The table was corrected on 6/20/03 to show both the discount to estimated intrinsic value at purchase and the potential upside from the purchase prices to the estimates of intrinsic value. The text was corrected to show that Sportsman's Guide discount at purchase was 42%, not 73%.]

What is value investing? For investors, the question is one of life's conundrums, along with "where did I put my glasses?" and "what's the difference between the two major political parties, anyway?"

Longtime Motley Fool contributor Whitney Tilson provides an excellent answer in Thoughts on Value Investing. Among his observations, he notes that while many people think value investing is buying companies with single-digit P/E ratios, he sides with Warren Buffett, who wrote in his 1999 letter to Berkshire Hathaway (NYSE:BRK.A) shareholders:

"If the choice is between a questionable business at a comfortable price, or a comfortable business at a questionable price, we much prefer the latter. What really gets our attention, however, is a comfortable business at a comfortable price." Buffett apparently would choose business quality over cheap valuation, but like any reasonable person, would prefer to have it all.

But most value investors would probably be happy with at least a decent business at a good price -- a satisfactory discount to intrinsic value, your margin of safety. That's the criterion for the value investing part of my portfolio allocation, the subject of my last two columns, this one, and the next two:

  • Dividend-paying stocks, large dominant companies still growing, a low-expense S&P 500 index fund, and cash waiting to be invested. This "sleep at night" section comprises about 40%-50% of my stock portfolio. Please read last week's column, Dividends Plus Growth, for more about it.
  • Value investments, mostly small caps. Bought at a discount to low estimate of intrinsic value, usually sold at some point at or above high estimate of intrinsic value. About 30% of portfolio. This week's subject.
  • Informed speculations, leaders in emerging industries (Rule Breakers), unprofitable development-stage companies, shorts, options. High risk, 20%-30% of portfolio. The next two columns will look at this section of the portfolio.

But what the heck is a good price, a "discount to intrinsic value"? How do you determine intrinsic value, anyway?

In A Buy and Two Sells (Using Valuation to Buy and Sell), I explained my two-part approach to determining value, or valuation. Today I'll use to the first of them -- discounted cash flow analysis -- for my four current value holdings, medical practice software company Quality Systems (NASDAQ:QSII), retailer Sportsman's Guide (NASDAQ:SGDE), Breathe Right Snore Relief king CNS (NASDAQ:CNXS), and medical diagnostics and recombinant DNA manufacturer Meridian Bioscience (NASDAQ:VIVO). Side note: Meridian straddles the value category and the first one because it pays a nice dividend -- over 4% when I bought it and now 3.7% after the stock's (and the market's) run-up since March.

What the heck is intrinsic value?
You've heard that the value of a business is the sum of its future cash flows, discounted to present value. To perform a discounted cash flow (DCF) analysis is easier said than done, of course, because you have to make so many estimates about things that are impossible to predict with any certainty. What will be your measure of cash flows -- GAAP earnings, net cash from operations, free cash flow? And for how long? Some people use 20 years and then an estimate for a terminal period -- or some number thrown out there for "the rest of its life." But not all publicly traded companies live for five years, let alone 10, 20, or 50. So remember that it's quite a stretch to look this far out, even if DCF analysis is still one useful tool in the valuation bag.

Discount rate
And then that discount rate. Choosing a rate at which to discount future cash means basically saying that this is the compound annual growth rate you require to compensate you for your risk. It's the extra premium you demand from a stock investment because of the risk that a business may fail. I choose 15% or higher for riskier stocks (the third group of informed speculations), and 11% or lower for less risky and more stable businesses. The 11% makes more sense when you consider the historical long-term return from stocks of 10% to 11%, depending on your source, or about 7% after inflation. Remember that the higher the discount rate, the lower the present value of future cash, and the lower the discount rate, the higher that present value.

It's useful to have low and high estimates of intrinsic value assuming less and more optimistic rates of growth, and to build in a bad year here and there -- speedbumps -- to take away some of our tendency to see investments in the most positive light.

Some results
Here's how the current four value investments stack up using an 11% discount rate, an average of the last three years' annual net shareholder dilution from stock option grants (net = grants minus cancellations), and low and high estimates of growth in free cash flow. For each company, you can see how the low and high estimates compare with my purchase price and the stock's current price.

                              QSII   SGDE    CNS   VIVO
       IV* Low              $27.80 $11.74 $ 9.57 $ 8.72IV High               63.28  16.55  14.90  16.32Purchase Price       $21.02 $ 6.80 $ 7.77 $ 7.97 Discount to IV Low    24%     42%    19%     9% Discount to IV High   67%     59%    48%    51% Upside to IV Low      32%     73%    23%    10% Upside to IV High    198%    143%    92%   106%Current Price        $30.45 $10.40 $ 8.70 $ 9.85 Upside to IV Low     -9%      13%    10%   -12% Upside to IV High   108%      59%    71%    66%*IV = intrinsic value

Sportsman's Guide was the biggest bargain when I bought it, with a 42% discount to low estimated intrinsic value, and all but Meridian Bioscience provided a substantial discount. Those discounts provided a margin of safety should things not go at all according to those estimates of business performance. Meridian at $7.97 a share provided only a 9% discount to low estimated intrinsic value, but its new recombinant DNA manufacturing business and reorganized diagnostics operations appeared to reduce the risk and increase the odds of outperformance. These possibilities for growth led to a high estimate of intrinsic value providing 106% upside.

All four are still quite shy of high estimates, so unless quarterly financial results cause these estimates to change or other screaming values appear -- the reason I sold Integrity Media (NASDAQ:ITGR) earlier this year --I'm holding for more appreciation and may add more shares on pullbacks if all continues well with the businesses.

Parting notes
A closing note on Meridian Bioscience: Introducing the company a few weeks ago, I wrote that it had just signed its first customer for the new recombinant DNA manufacturing business. Soon thereafter, it snagged a second. We'll watch this progress in the company's coming quarterly reports to see whether this new arena does indeed bring greater growth than the company's diagnostics business -- and rewards for shareholders.

And thanks to all who last week requested the free spreadsheet on internal rate of return for the three dividend paying stocks. Now back from vacation, I'm starting to send them out. If you did not request one already and would like one, please email me at tcjmail@cs.com, with "spreadsheet" in the subject line. If you already requested one last week, trust me, it's coming, you don't have to request again, and thanks for your patience.

Please feel free to share ideas about value investing on our Fool on the Hill discussion board, and have a most Foolish week!

Writer and Senior Analyst Tom Jacobs's (TMF Tom9) is pleased to report the good news that his car battery dies all the time because he doesn't drive enough, not because it needs a gazillion dollars of electrical work. Phew. He owns shares of all companies mentioned here (except Integrity Media) as well as other companies listed in his profile . Motley Fool writers are investors writing for investors .