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“You must never delude yourself into thinking you’re investing when you’re speculating” – Benjamin Graham (Father of Value Investing)
There is no distinctive cross-over point between investing and gambling. Both have elements of speculation involved. Speculation refers to ‘Guessing’. To guess, one relies on their gut feeling. What is interesting is that the gut feeling is directly tied to availability of good information and one’s experience gained from speculating in the past. The latter, most folks refer to as ‘An Educated Guess’. Speculating is more commonly inferred with gambling than with investing; but in reality, it exists in both to certain degrees. It is speculation that incorporates risk. In effect, speculation and risk are somewhat synonymous to each other. As you rely more on guessing, the risk factor also increases.
To illustrate, games of chance such as flipping a coin, rolling die or roulette have certain mathematical chances of winning for their respective outcomes. There is really no speculation here because guessing is eliminated by the fact that chance is predetermined; the information is maximum because it is well known what the chances are for the respective outcomes. However, if you step up into a greater level of risk in the gambling zone such as playing Blackjack or Poker, the player has less information input because the information available is based on the cards that have been played or discarded. This information allows the player to evaluate the chances of winning; as such, the player has to add speculation. Risk increases from pure chance games of flipping a coin or dice. With pure chance, the house has an automatic percentage of winning; whereas with the next level of gambling, the house has increased risk of losing because the table players have an opportunity to incorporate speculation and take ‘An Educated Guess’ at the most probably outcome. With greater speculation, comes greater risk.
This is also true with investing. At the extreme with investing is the most conservative investment such as the purchase of a Federal Treasury Note. Similar to the extreme with gambling (games of pure chance), it has a hint of risk involved. The information about the bond is boundless. However, there is a remote possibility the U.S. Government will fail to honor their obligations. But since this minute risk is so negligible, there isn’t any real speculation involved with this highly conservative investment.
In between these two extreme points of the gambling/investment spectrum lie all forms of risks which are often dictated by the level of good information available to the gamer/investor.
Speculating is the act of taking risk in exchange for sizable returns with investing resources. The greater the reliance on speculation, the more likely the increase in the reward. The key is this: the more reliable information available, the less speculation involved. As information dissipates, speculation increases as the gambler/investor must rely more on their ‘Gut Feeling’ than on information available.
Pure speculation does exist. Speculation peaks at around 90% of the decision related to certain types of gambling/investing. At this level, it is pretty much pure speculation with maximum risk involved. The perfect example is a crypto investment. There is very little reliable information about crypto, but it does exist and many folks call this investing. The reality is that it absurd to spend sums of money in hopes that the market price will continue to rise and at some point you exit this particular so-called security (technically, it is not a security). This is about as much ‘Gut Feeling’ as anyone can get related to investing or gambling. The nearest historical similarity is the ‘Great Dutch Tulip Craze‘ from back in the 1630’s. The author DOES NOT endorse readers even considering risking their money with crypto or non-fungical tokens (NFT’s).
This article explores the various levels of speculation with both gambling and investing. The key element is information; is it available and reliable? Both forms of risking money are similar when comparing risk/speculation. However, there is one key difference between the two venues. With gambling, the risk of loss is pure, i.e. one loses all of one’s money put up to get involved. With investing, it is rare to lose of all one’s invested monies. Typically, the investment takes longer to come to fruition or the level of return is diminished due to either unrealistic expectations or market/management factors that lowered the final outcomes.
Finally, the article explores why value investing practically eliminates risk and assures an investor of a reasonably good return because speculation is almost eliminated. Note how it is stated that ‘speculation is almost eliminated’. This is because there will always be some hint of speculation with investing. Just as with government bonds, there are no such investments that ‘GUARANTEE‘ a return.
Speculation with Investing – Gambling/Investing Spectrum
Speculation exists in both gambling and with investing. Many novice investors believe speculation only exists with gambling. This is not true. Speculation refers to guessing. Even with investing, there is some guessing going on. The key is the degree of guessing. To reduce risk, which is one of the primary principles of value investing, the degree of guessing is reduced by only utilizing companies with extensive available information; especially those that report production on a regular basis. As an example, all the Class I railways report their weekly loads hauled. This allows an investor to monitor the trend towards revenue generation and ultimately the expected profitability at quarter’s end.
This graph/depiction below illustrates the various levels of speculation for both gambling and investing. Take note, speculation peaks with with certain types of gambling and with certain types of investments. The absolute worse level is with crypto and NFT’s (non-fungical tokens). With these types of investments/gambling venues, there are no underlying assets, no reliable information and neither pays dividends or even have formal audits to validate their existence.
With gambling, it is known upfront that this risk adventure is for entertainment purposes and is not a legitimate form of methodical investment to grow a portfolio of securities. As gambling begins to shift from pure chance to information based decision making, think of sports betting, the risk/reward relationship begins to take on a new dynamic. In this case, speculating begins to create a greater emphasis and as such, there can be some unusual outcomes. However, these infrequent explosive returns do not constitute investing; they still tend towards gambling than legitimate well thought out risk reward transactions.
Moving along the spectrum towards investing is another form of gambling but it is perceived by many as investing. This involves crypto. Just because something is publicly traded doesn’t make it investing.
As the graphical line moves more towards investing, investment opportunities begin to have good information available. But in many cases, the information is inadequate or unreliable and thus, speculation is required in order to guess at the return. Great examples include new start-ups, penny stocks and day trading. Information exists, but either the method of investing or the information is unreliable; thus, speculation is required.
Moving further down the graph line, speculation begins to dissipate rapidly especially as you move towards highly reliable and more secure forms of securities. The underlying companies are more forthcoming because they are stable and highly reputable operations. Value investors thrive in this zone. Information is plentiful, accurate and reliable. In addition, these companies are run by some of the best and brightest managers available. They rarely disappoint with their financial results. When a value investor buys in this zone, the odds that the investment’s value will decline further or in an extreme downturn is remote. Speculation is practically eliminated.
It is important to note that there is some element of speculation even with good quality investments. The level of speculation is so low with high quality investments, for all intents and purposes it is considered irrelevant with one’s decision model; but, it still exists. It is possible for the company to have a series of setbacks or have an accident which greatly affects value; think of Exxon Valdez oil spill or Enron. Value investors look to eliminate as much risk or speculative element as possible when considering investments. Act on Knowledge.
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PUT options are an excellent tool to leverage the realized return for a value investment based portfolio of securities. In general, options are very risky financial derivatives and are not recommended for unsophisticated investors. In laymen terms, options are classed as mildly speculative instruments in the world of investing. The key to proper use is to eliminate the risk aspect by only utilizing PUTs in a very restrictive set of circumstances. When properly applying restrictions, PUT options can add between four and ten percent of a value investment fund’s annual realized earnings. This marginal improvement is how a value investment fund outperforms even the best performing index based funds.
This particular lesson lays out how to properly use PUT options to leverage higher the performance of an investment fund. First, options are introduced and why only a particular position with PUT options is utilized. Secondly, a set of highly restrictive conditions are provided that must be followed in order to practically eliminate the risk options carry for traders of such speculative financial instruments. With this knowledge of restrictive conditions required to use PUT options, the next section explains how they are utilized in a value investment fund portfolio. Finally, several examples are presented to assist the reader with proper application along with a set of most likely outcomes from employing PUT options.
As with any sophisticated financial tool, an introduction is required.
PUT Options – Introduction to Options and Their Risk Factors
If you ever watched a sporting event, it is common to see folks involved in ‘Side Bets’. The actual event has it own set of winnings or prestige for whoever triumphs. But spectators often create their own friendly bets with others. Thus, the ‘Side Bets’ have nothing to do with the actual event itself. The best way to describe options is to think of them as ‘Side Bets’.
Options are considered financial derivatives. Basically, they are not a financial security (notes, bonds, convertibles, preferred and common stock) issued by a company. They are outside of a company’s financial makeup. Thus, the connection to the principle of a ‘Side Bet’. However, they are monitored and regulated by the Securities and Exchange Commission and the Commodity Futures Trading Commission. In effect, they are regulated and derive their value directly from the financial information provided by the respective companies they are tied to in the market.
With financial securities, the issuing company backs the security by providing different rights or collateral depending on the nature of the security. Naturally, common stock has the least amount of rights or collateral in comparison to secured notes or secured bonds. With common stock, the holder has three key rights.
- First, the holder has a right to their share of dividends.
- Secondly, a shareholder has the right to vote when it comes time to determine board leadership and for certain changes to the charter or policies.
- Finally, a shareholder has the right to sell their security if they want to get out of the financial relationship.
With options, all these rights are nonexistent or highly restricted. Options provide no financial reward from the company; literally, the company doesn’t care about your side bet. Secondly, options provide no rights to vote. As for the third aspect, in some situations you are indeed allowed to sell your option and get out of the financial deal. Typically though, this costs money and unlike securities where the seller receives money, with options, if one wants out of the deal, one has to pay money.
Notice immediately the much higher exposure an options trader places their investment into when dealing with this type of financial instrument. Simply stated, options categorizes one in a much riskier situation in comparison to directly buying and selling issued financial securities. These ‘Side Bets’ can get you into a lot of financial trouble. Thus, CAUTION is warranted. This lesson is designed to teach the reader that only a certain kind of option is utilized with value investing. In addition, this particular kind of option should only be used under highly restrictive conditions. The key is ‘Risk Reduction’.
With this mindset of caution, it is time to introduce the two types of options (CALLs and PUTs) and their respective purposes.
Introduction to Options
CALL Options – this particular side bet is designed to give a buyer a right to purchase a particular stock at a preset price (strike price) no matter what the market price is for the respective stock. It is designed to allow the buyer (holder of the CALL contract) to purchase from the seller of the CALL the stock. Realistically this would only occur when the market price of the stock suddenly jumps much higher than the strike price. The owner of the call, i.e. the buyer, would naturally elect to exercise this right and purchase the stock for the agreed upon strike price. In turn, they would sell the stock at the current higher market price and pocket the difference as profit. The seller of the CALL, this so called side bet, is gambling that the current and future market price will stay the same or go down and as such will have cash earned from the sale of this call option as additional margin while holding this stock. Take note of the risk involved with the two respective positions of the buyer and seller:
Buyer – Pays a sum of money for a RIGHT to buy this stock at a preset price (strike price) before a certain date (expiration date) from the seller of this CALL. The seller typically owns the particular stock but doesn’t have to own, they must be willing to buy it at the current market price and sell it to the buyer at the strike price if the buyer exercises the CALL. For the buyer, the risk is that the market price will not surpass the strike price by the expiration date. If the market price does not increase, the buyer’s financial risk is the premium they paid for this right.
Seller – Sells a right to someone to buy a certain stock from the seller at a certain strike price in the future but before an expiration date. For the seller of this CALL, they firmly believe that the market price will not reach this strike price by the expiration date. The seller’s risk is that the market price for this particular stock soars past the CALL’s strike price and they are forced to sell the stock at the strike price to the current owner (buyer) of the CALL.
Example – Seller (‘S’) owns 100 shares of Coca-Cola stock. The current market price is $62 per share. ‘S’ firmly believes that Coke’s market price will dip or stay at or lower than the current market price for the next three months. ‘S’ sells a CALL option (contract) to anyone for a strike price of $68 per share on Coke for $3 per share, i.e. 100 shares at $3 each or $300. The strike price is $68 per share and the expiration date is three months out. A Buyer (‘B’) firmly believes that Coke will hit $74 per share within three months. ‘B’ pays $300 to have a right to buy Coke at $68 per share and is willing to wait the three months to see what unfolds. During this three month period, Coke’s share price fluctuates from $59 per share to as high as $66 per share. There are now two weeks remaining to the expiration date. This CALL option has dropped in value to 50 cents per share and the current market price is $66 per share. ‘B’ can continue to wait it out or elect to sell this contract for $50 (100 shares at 50 cents each) and just end up losing $250 in total. ‘B’ elects to get out of the option contract and proceeds to sell it for $50 (50 cents/share). The new buyer (‘B2’) now has a contract with the original seller with two weeks remaining. Suddenly the market price for Coke soars to $77 in less than three days. ‘B2’ knows a good thing when it happens and proceeds to exercise the option and purchases from the seller 100 shares of Coke for $6,800 (100 shares at $68/each). ‘B2’s total investment into Coke is $6,850 ($6,800 paid for the stock and $50 for the option). The current market price is $7,700; ‘B2’ immediately sells the 100 shares of Coke and realizes an $850 profit from the overall deal. ‘S’ did earn $6,800 from the sale of shares of Coke and also earned $300 from the sale of the CALL option for a total amount of $7,100. ‘B’ lost $250. ‘B’ took a risk and lost some money, ‘S’ also took some risk associated with the difference between $7,100 and the final market price of $7,700. ‘S’ lost out on $600 had they waited it out. However, ‘S’ is risk averse and preferred to get their $6,800 plus a $300 premium for selling the CALL option.
The graph below depicts the overall financial relationship for the two parties. The strike price is the core ‘win’ or ‘lose’ crossover point. On the left of this crossover point of the market price, the seller of the CALL wins the bet outright as long as the market price does not crossover the strike price point. The area between the strike price and where the net payoff line cross at the market price point is the ‘marginal’ exchange range. Using the example above, this is that $3 range between the strike price of $68 and the value the seller earns of a marginal $3 ($71 market price for the stock). If the buyer exercises the CALL option when the market price is $69.25, the seller earns $68 for the sale of the stock plus $3 for the sale of the CALL. In this $3 zone, the seller is technically the winner of the ‘side bet’. As the market price transitions past $69.50 per share, the buyer of the CALL now begins to gain a better overall financial situation, the buyer is still paying more overall in this transition zone as the total cost of $71 still exceeds the market price value. But once that market price exceeds $71 per share, the buyer of the CALL is in a superior financial position and is now winning the bet.
One final pertinent part of this overall situation. The exercising of the option only occurs if the buyer is going to sell the security to a third party to reap the reward between their cost of $71 (the price paid for the stock and the option). It is rare for the buyer to exercise the option and then just hold the security. They can do this, especially if there is some significant dividend announcement during this time frame. While the market price is in that ‘marginal’ zone, the buyer’s risk is elevated as it becomes difficult to decide the best course of action; does the buyer wait or act? This is where adequate information as to what is happening not only in the market, but within the industry and at the company level comes into play. In most cases, unless there is a sudden dramatic price increase in the securities market price, buyers opt to wait it out. Time benefits them. As the price transitions through this ‘marginal’ zone, if the expiration date is not close, waiting is prudent. After all, this is what the buyer desired when paying for this option.
“Option Pricing Theory and Models” – Chapter 5
Neither ‘B’ nor ‘B2’ are obligated to buy the shares from ‘S’; the option contract is a RIGHT to buy them. ‘B’ or ‘B2’ could at any time, no matter what the market price is, elect to buy the shares at $68 each. Even if the market price is $66 per share, the buyer can elect to buy the stock right then. Of course, a prudent money manager would not do that; but, they still own the right.
The one party at most risk of financial loss is of course the seller of the CALL option. They may be force to sell that stock and lose out on all that upper market price range (the area exceeding $71 per share in value in the graph above). Thus, sellers of CALLs risk significant POTENTIAL reward if market price jumps. In effect, a seller is exchanging potential high reward for a more secure financial position, in this case $68 per share. Both buyers, ‘B’ and ‘B2’, risked the market price decreasing and as such only risked their investment into the option contract; i.e. their maximum financial risk is the amount paid to buy the CALL. Think of it this way, they are leveraging their bet with a little money that the particular stock will suddenly soar in value (win the game and hopefully win big) and get a high return on their overall small investment. Remember, they will have to put out money to buy the shares; but immediately, they would turn around and resell those shares at this current high market price.
PUT Options – With CALL options, the primary driver of value is the overall belief in the market price increasing for the underlying security. The price of a call goes up as market price for the underlying security goes up. This is the opposite for PUT options. PUT values are driven by a decreasing market value.
With PUT options, the typical buyer already owns the stock and is fearful the stock’s market price will decline over time and therefore wants to force another party to buy this stock from them at some floor value; a value they are willing to tolerate. This strike price guarantees the holder of the PUT a minimum market price in case of a sudden or slow market decline for the respective stock. For the seller of a PUT option contract, they firmly believe the market price is currently stable or will recover for the respective stock and as such are gambling that the buyer of the PUT will not exercise the contract and force the seller of the PUT to purchase the stock from the buyer (current contract holder). Review the positions and thought process of the two respective bettors:
Buyer – Owns stock in a particular company and wishes to eliminate their downside risk; i.e. the stock’s market price will drop dramatically or slowly decline over an extended period of time. As such, the buyer of a PUT option contract is willing to pay some kind of premium to minimize their respective potential losses. The closest comparable financial instrument is insurance. With insurance, the asset owner (auto or home as an example) fear that the value will suddenly drop due to some unforeseen accident and as such is willing to pay for insurance to protect that potential value loss. With a financial security, the asset owner is buying a PUT option, a form of insurance, to protect against a sudden or extended market price decline for the asset they own. Note that with typical insurance, insurance protects against acts of God or acts of physical mistakes (auto accidents). Insurance does not protect against declines in market value for a home or auto. PUT options are designed to act as insurance against value decline for the underlying security instrument.
Seller – Firmly believes the market price for a particular security will not decrease but either stabilize or improve over time and is willing to sell an option in order to earn some money. The seller sets the strike price well below intrinsic value of the underlying security involved. This reduces the chance the particular security will continue to decline in value over time. As an example, look at this pricing structure for a PUT option on The Walt Disney Company. The intrinsic value is estimated at $116 per share, the current market price is at $100 per share; thus, the market price is already 14% less than intrinsic value. The chances the share price for The Walt Disney Company continues decreasing are remote. Naturally, there is a greater chance it will decrease to $95 per share than to $90 per share. Thus, the price for a PUT option is more expensive at $95 per share due to the risk it will be exercised at $95 than $90 per share.
Notice how even at $60 per share strike price with a three month expiration date, there is some interest (161 buyers have indicated a desire to buy a contract) to buy a PUT option in the market. These buyers have indicated that they are willing to pay 32 cents per share to have insurance that their Disney stock could be sold to someone if that market price goes below $60 per share. The key to this chart is that there is less and less risk of Disney’s share price continuing to drop further and further as first, the open interest in insurance wanes and the price buyers are willing to pay drops dramatically too.
Example – Seller (‘S’) is convinced Disney has hit rock bottom in market price due to several underlying reasons. First, it is a rock solid company and is traded as a DOW Industrials member. Secondly, the company’s revenue and net profits are significant and have improved over the last three years. Third, the real driver of this current decline is the overall mindset in the market which is experiencing declines. ‘S’ is highly confident that the market price will not dip below $90 per share and as such is willing to sell a PUT option contract for 100 shares at $4 per share or $400 for the entire contract. There are currently 2,486 buyers interested in purchasing a contract to force the seller to buy Disney at $90 per share. One of them enters into this arrangement. The buyer (‘B’) purchases from ‘S’ this PUT option. The strike price is $90 per share with an expiration date of 09/16/2022.
Over the next month, Disney’s stock price waivers, ebbing and flowing, and begins to creep back up towards $110 per share. In late July, Disney releases their financial results and to everyone’s surprise they didn’t perform as well as they predicted. The market price dips to $89 per share. At this point, ‘B’ has the right to force ‘S’ to buy the stock from ‘B’. ‘B’ decides to wait a little longer, after all, ‘B’ has until September 16th to force the ‘S’ to oblige the terms of the contract. ‘S’ isn’t nervous yet because ‘S’ is convinced this is a temporary setback. In early August, Disney releases a new Pixar movie and it becomes the number one summer hit and earns more than $200 Million in one weekend. On Monday morning, Disney’s stock price improves due to this batch of good news and goes back up to $95 per share. The price continues to improve as more good news comes out of Disney’s information center that their subscriptions to the their Disney+ channel are exceeding their expectations. The price of Disney’s stock soars to $112 per share and never looks back as the expiration date finally expires. ‘S’ did indeed earn $400 and was only truly at risk for a few days. ‘B’ paid $400 to protect his investment in Disney and at one point could have forced ‘S’ to buy the stock from ‘B’.
Take note of the financial relationship with PUT options. The seller’s risk only exists if the market price goes below the strike price. Even then, that risk doesn’t actually exist until the market price drops below the strike price less the sales price of the PUT option. In the above example, ‘S’ isn’t really at risk until the price drops below $86 per share. At that point, if ‘B’ exercises the option, ‘S’ has to pay $90 per share and own Disney. Thus, the total amount out of pocket for ‘S’ is $86 per share ($90 per share paid to own the stock less $4 per share for the option sold). If the market price continues to slide further lower, ‘S’ will experience an unrealized loss for the difference. This is important, ‘S’ has yet to realize an actual loss because in order to realize an actual loss, ‘S’ would have to sell the stock at a price lower than ‘S’s basis which is currently $86 per share. ‘S’ can simply wait it out and hope the market price will recover in a short period of time.
This is an important aspect as a seller of PUT options. As a seller you only realize losses IF you sell the stock you were forced to buy at a price lower than the net realized basis in your investment ($86 in the above example). Look at this graphical depiction to help clear up this viewpoint:
Payoff on a PUT Option
The risk for the buyer is the area to the right of the Strike Price. As for the seller, the risk factor starts when the market price for the security is less than the Strike Price. As the market price crosses over the net realized value (strike price less the value derived from the sale of the PUT – $86 from the above example), the seller’s risk begins to increase financially from zero to the difference between the net realized amount (strike price less sale’s price of PUT options) and the current market price because the current owner of the option may force the ‘S’ to buy the shares at the Strike Price. The further the decline in market price, the more likely the buyer of the option will exercise the agreement and force the seller to pay the strike price.
Remember, the buyer has until the expiration date to force the hand of the seller. It is possible and often common for the market price to dip well below the strike price and the buyer continues to wait it out. The buyer has time on their side in this set of conditions. Their risk of financial loss is practically zero in this situation and often they will just wait to see what happens.
Options and Respective Risk Factors
Both types of options are technically side bets in the market. However, unlike a traditional side bet which utilizes a strong position of speculation due to limited information, options are directly relatable to the underlying asset, i.e. the company in question. Therefore, the speculation element in the decision matrix will match the speculation spectrum of the company under review. Thus, options on large caps and DOW companies are less speculative than options tied to small caps or start-ups. The general consensus among unsophisticated investors is that options are highly speculative and therefore dramatically riskier.
In general, options are riskier due to the fact that the buyer and seller are not trading an actual security. This by itself moves this particular financial instrument into a riskier territory of investments. But, the risk factor for this aspect is tied more to the required knowledge to understand the forces that drive an options current market price. Not only must an investor understand the underlying securities financial matrix, the investor must also incorporate the forces that move an option’s market price. An investor must be more sophisticated with these forces of deriving value.
In addition, each of the four possible option positions have their own distinct risk factors. With CALL options, a buyer’s financial risk is strictly limited to the cost paid to purchase the CALL. In most cases, the price of the underlying stock doesn’t soar above the strike price and therefore the buyer only loses out on the cash paid to buy the CALL. The seller of the call carries a greater financial risk in that if the stock’s price does suddenly soar in value, the seller can’t reap those dramatic gains. They are limited to the strike price for the particular stock investment. PUT options also have distinct risk factors for each of two positions. Seller’s are at the most risk because the price could keep falling and of course they will have to pay the strike price for stock that the market now deems dramatically less in value. Buyers of PUT options only risk the initial premium paid to own the right to force the seller of the PUT to buy the stock from them.
Thus, both sellers of CALL options and PUT options are at the greatest risk with their respective options. But of course, this makes sense; after all, they are also earning some money from the sale of the respective option and as such should have the greatest exposure to risk.
PUT Options – Value Investing Risk Factors
A value investor’s mantra is tied directly to the business tenet of ‘buy low, sell high’. This tenet is focused on four key principles of exercising risk reduction, understanding intrinsic value, conducting financial analysis to sell high, and having patience to allow time to achieve both aspects of buying low and selling high. The primary key driver of realizing good returns with any investment is the ability to buy low. When a value investor determines intrinsic value and then sets a buy price that creates a strong margin of security such as 15% or more, buying low creates tremendous wealth as time will drive the value of the security higher. The key is to buy well below intrinsic value.
Only as a seller of PUT options can a value investor realize earnings and gain an additional opportunity to buy low. However, this should only be done under the following restrictive conditions:
- The particular PUT option is sold tied to one of the opportunities within a Value Investment Fund portfolio. In effect, this particular investment complies with the risk reduction tools commonly used as criteria for investment opportunities:
- A top 2,000 company;
- Company must be financially stable;
- Company demonstrates good growth beyond inflationary growth.
- The option pricing structure has marginal decreases for significant step downs in strike price points.
- The underlying company is not currently involved in an intensive stock buyback program.
These restrictive conditions mimic the criteria customarily used with purchasing traditional stock in a value investment portfolio. However, there are couple additional restrictions involved:
Pricing Structure Has Marginal Decreases for Significant Step Down in Strike Price Points
This restrictive condition refers to the marginal loss of revenue from the sale of an option for a decrease in strike price point. Here is that same chart for Disney’s PUT options from above:
Notice the price for a PUT option is $5.60 for a marginal change in the market price of the stock from $99.40 to $95.00 or $4.40. However, the next $5.00 of market price reduction only costs the seller of the PUT a mere $1.60. To go from $95 to $85 strike price, the marginal reduction in the PUT option price dropped $2.86 (from $5.60 to $2.74). Thus, an additional $5.00 of savings from $90 to $85 only cost the Seller another $1.26. The first additional $5 of savings costs $1.60, the next $5.00 of protection costs $1.26; from there it continues.
This pattern is common with all PUT options for their sales price. Each incremental price reduction costs less and less in terms of the sales price reduction for the option.
For value investors, the secret is to find significant strike price reductions for a very low overall decrease in the PUT option’s price. As an example, look at this schedule for Norfolk Southern Corporation, one of the five publicly traded Class I Railways in North America. Its current intrinsic value is approximately $197 per share. A value investor could achieve a margin of safety of 15% by selling a PUT option at $165 strike price for $2.75 each. Thus, 100 shares PUT option contract will earn the value investor $275 and an opportunity to own a high quality company paying $5 per year in dividends, earning more than $11 per year on average over the last five years AND is tracking for $12 of earnings in 2022. The current market price is $220 per share.
At $165 per share, there is a 16.25 % margin of safety over intrinsic value, a $64 margin of safety from the current market value ($229/Share) which exists in a depressed market (Norfolk Southern was trading at a peak of $299 a mere six months ago).
The primary key point here is to notice two distinctly different value points. A seller could sell the option at $175 strike price which is $5 lower and make 10 cents more per share! For a marginal reduction of 65 cents per share ($3.40 to $2.75), a value investor can acquire an additional $15 of safety margin. What is really more important is that a typical ‘BUY’ point for Norfolk Southern is only 9% safety margin. Thus, this sites’ Railroad’s Pool has Norfolk Southern as a ‘BUY’ at $180 per share!
Imagine the value acquired if a value investor could own this company at $165 per share? It is $15 lower than the set ‘BUY’ price and at $165, the margin of safety far exceeds the required amount. The likelihood of Norfolk Southern’s market price dropping to $165 per share is so remote that this type of opportunity is simply unheard of with investing. Again, the key is the marginal cost (reduction in the form of PUT option sell price) for dramatic strike price changes; this is what a value investor seeks as a risk reduction tool for PUT options.
What a value investor desires with PUT options is a good return with as little risk as possible. If a value investor is forced to buy the security, at least it is purchased at LESS THAN what is determined to be the preset ‘BUY’ point for that security. This just adds additional protection against further security market price reductions.
Who wouldn’t want to own a top 2,000 company with a 3% dividend yield ($5/YR on a purchase price of $165/Share) earning more than $11 per year with a prior peak market price of $299 per share? This is a solid company.
No Intensive Stock Buy-Back Program
The third restrictive condition for risk reduction with PUT options is the underlying company’s stock buy-back program. Stock buy back programs typical work against intrinsic value determination. Intrinsic value determines the in-house value of the company. Think of it as the value that would exist in the equity section of the balance sheet and would equal the book value of the company’s stock. If a company participates in a buy back program and pays more per share to buy stock back off the market (Treasury Stock), the company is literally taking existing book value from the remaining shares and giving it away to those whose shares are being purchased. It is an intrinsic value killer. Rarely do highly stable companies trade in the market for less than intrinsic value. Think about it for a moment, this is why value investors set intrinsic value in order to determine the real worth of the stock. Value investors are not in the business of buying securities for more than they are worth.
If a company has a stock buy back program and the company is one of these highly stable operations and included in the value investment portfolio, it means that the intrinsic value is going to go down depending on how much value is shifting out of the company to buy back the stock. Most treasury stock programs are small and a company is trying to buy back two to four percent of the whole portfolio of outstanding shares in a three year period. At this level of a buy-back program, the reduction in intrinsic value is relatively low (maybe a net effect of seven to nine percent overall reduction), but it still affects the calculation related to PUT options due to the leveraging concept. Thus, look for programs whereby the stock buy-back is less than two percent of the total outstanding number of shares. If greater, the value investor must look at the impact over the period to the expiration date; how much value will shift out of the company during this time frame?
Continuing with the example above, Norfolk Southern’s buy-back program allows for the repurchase of up to 6 million shares by December 31, 2022 including the six months remaining. The current number of shares outstanding as of March 31, 2022 is 238 Million; thus if all 6 million shares are repurchased as treasury stock, the company’s intrinsic value would thin down approximately 2.6% assuming share are repurchased at more than $220 per share. This means, intrinsic value COULD decrease to $192 per share by December 31, 2022 which covers the open period of this option. In effect, Norfolk Southern’s stock buy-back program (repurchase program) should not impact the decision model related to selling the PUT options with a strike price of $165 per share.
As long as a value investor adheres to the three required restrictions for selling PUT options, the risk factors tied to PUT options can be dramatically reduced or eliminated. The other three remaining positions do not have this ability to utilize restrictions to reduce this risk and in general, are counter intuitive to what value investor is about. With this information, how can a value investor properly apply a system of utilizing PUT options to increase a portfolio’s annual return?
PUT Options – Proper Application in a Value Investment Portfolio
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The key to understanding intrinsic value is grasping the fundamentals of the balance sheet. The balance sheet reflects the lifetime to date accrued net worth of that business entity. For the value investor, understanding how a balance sheet is laid out, works and how it reports net worth takes the investor to the next level of confidence with their buy/sell model for any potential investment. Simply stated, understanding the balance sheet places the value investor ahead of other types of investors. Knowledge about the balance sheet for your investment can provide all the necessary confidence you need to make good decisions when setting buy and sell points for that company’s securities.
In essence, the balance sheet is a scale. Accounting ensures the scale always stays in balance. It is laid out with two sides; on one side of the scale are all the existing assets of the company. The other side informs the reader how those assets are funded. More mature or well managed companies fund assets with the lifetime earnings to date that are retained. Some companies borrow the money to pay for the assets. As an example, most people don’t realize this, but McDonalds funds the entire asset side of the scale with borrowed money and then some. Yet, McDonalds is one of the top 30 companies in the world. Thus, how can McDonalds have any intrinsic value when they actually owe more money to creditors than they have in assets?
This is why value investors must have a good fundamental understanding of how the balance sheet works.
In addition, the balance sheet acts as a report. It informs the reader what kind of assets the company owns and it details how those assets were funded. Understanding this fundamental reporting format allows the value investor the ability to quickly get to the core reason the company has value. In many cases, understanding this reporting format allows the reader to easily determine a viable range of expected outcomes for intrinsic value.
Understanding the balance sheet fundamentals allows investors to not only determine the core value of a company but its also assists the investor with determining which particular intrinsic value formula is the most reliable to use. You must understand these fundamental balance sheet relationships to assist with determining the best intrinsic value formula. In most cases, the balance sheet will provide the intrinsic value (subsequent articles) for the company. But without this knowledge, an investor can’t possible have a high level of confidence with intrinsic value formulas. It all starts with understanding the fundamentals of the balance sheet.
Fundamental understanding of the balance sheet starts out with keying in on the concept of balance. Once this core principle of balance is comprehended, an investor then must understand that THERE IS NO UNIVERSALLY ACCEPTED PRESENTATION FORMAT. There is a simple balance sheet presentation format that is ingrained into formal education of accountants; but, at the public securities level, industries have set how a balance sheet is presented. What is important here is that although the industry’s balance sheet format is different, it is still easy to comprehend this alternative presentation format and how it ties back to the basic presentation format.
Finally, after grasping how a balance sheet is laid out and works; a value investor begins to appreciate each industry’s presentation format. Now it is time to key in on the real reason all this is so important; matching the most important asset on the balance sheet to how this entity makes its money. What is the one or two most important assets and how they are presented aids the investor with determining value. How does a value investor discover this asset and how does one determines its value?
Each section below goes into this set of core fundamentals of a balance sheet. When done, the reader should be able to break any company’s balance sheet out into the core groupings and quickly ascertain the proper format for the company one wishes to invest. From there, a value investor will quickly key in the most important asset that makes this company go; what is the one single most important asset that provides all that wealth? With this understanding, a value investor can more easily derive intrinsic value and have extreme confidence with the intrinsic value outcome.
Intrinsic Value – The Balance Sheet
The balance sheet is one of the five key financial reports. It is a required presentation with the company’s annual 10K report filed with the Security and Exchange Commission. Most publicly traded companies also include the report with their quarterly releases. The balance sheet identifies existing assets along with the sources of funds to finance the company. Sources of funds include liabilities, loans and money fronted by the shareholders and other equity stakeholders. Generally Accepted Accounting Principles (GAAP) and the accounting profession’s dual entry accounting system forces the balance sheet to exist in a state of equilibrium, thus the expression, ‘the balance sheet’.
As an investor, it is important to understand the primary purpose of the balance sheet; the balance sheet reflects the lifetime to date financial position of the company. The income statement only reflects the accounting year, whereas the balance sheet is just a snapshot of a single moment in time which is identified by the date of the report. The balance sheet states the book value of all assets and the book value of all debt (current and long-term) along with the resulting aggregated position of all stakeholders (Preferred Stock, Minority/Joint Owners, Treasury Stock and Shareholders). It starts out with a very simple equation:
ASSETS = SOURCES OF FUNDS (the core balance sheet)
This is then broaden out to reflect the two major sources of funds which have different risk levels:
ASSETS = LIABILITIES (preferred rights, less risk)
plus
. EQUITY (subordinate position to liabilities, greater risk)
In effect, the balance sheet is a three part formula. Part One reflects assets such as cash in the bank, receivables, fixed and other assets. Some of these assets are funded by short-term liabilities while others are funded with long-term loans (notes). Subsequently, liabilities are Part Two of the formula. The final part is of course equity. Equity in a simple state refers to what the shareholders have invested in the company. This investment is the initial purchase price paid to start the company plus the lifetime to date earnings referred to as ‘retained earnings’. Recall, each year as the company earns a profit, any profit not used to pay dividends or buy back stock (treasury stock) is then accumulated in an account called retained earnings. The end result is:
ASSETS = LIABILITIES + EQUITY
An easy observation is that this formula can be rearranged to state the value from the perspective of just the shareholders:
ASSETS minus LIABILITIES = EQUITY
This presentation format is not referred as the balance sheet, but as ‘Net Assets’. It is important for the reader to understand that there is a naming difference involved as often different wording is used to identify the various presentation formats of the balance sheet. The balance sheet refers to the core formula of assets equals liabilities plus equity. When referring to assets minus liabilities equals equity, accountants and finance folks refer to this as ‘Net Assets’. Notice how net assets equals assets minus liabilities. Thus:
NET ASSETS (assets minus liabilities) = EQUITY
This is key, value investors more often use the term ‘Net Assets’ when talking about value than the alternative term of ‘Balance Sheet’. Mathematically though, the two terms are referring to same financial equation; specifically, what is the value of the equity position of the company. An illustration will assist the reader in understanding this relationship:
This is the balance sheet for a real estate investment trust (REIT), American Homes 4 Rent, Inc. This company owns 56,400 homes throughout the United States. This is their balance sheet at 12/31/2021.
Notice the three highlighted summation amounts? The first is assets at $10.962 Billion. Liabilities equals $4.224 Billion and Equity equals $6.738 Billion.
Thus, the balance sheet formula (accountant’s perspective) is:
ASSETS = LIABILITIES plus EQUITY (sources of funds)
$10.962 B = $4.224 B + $6.738 B
Whereas, value investors will state that the net assets are $6.738 Billion.
ASSETS – LIABILITIES = EQUITY
$10.962 B – $4.224 B = $6.738 B
Notice also the very bottom financial value is referred to as ‘Total liabilities and Equity’. This value equals total assets. This goes back to the primary goal of the balance sheet, the two sides must be in balance, they must match.
ASSETS = SOURCES OF FUNDS
$10.962 Billion = $10.962 Billion
Again, this is extremely important, accountants use the term ‘Balance Sheet’ whereas investors, specifically value investors will use the term ‘Net Assets’. Please remember, they are saying the same thing, but just from a different perspective.
Intrinsic Value – Balance Sheet Presentation
When accountants go through their undergraduate studies, they are taught the balance sheet has a certain presentation format. Of course the primary form matches the core formula of assets equals liabilities plus equity, the two sides of the balance sheet. The core model used in studies is the traditional retail model. Here the model breaks out each side of the balance sheet into three subsections as follows:
ASSETS
. Current Assets $ZZZ
. Fixed Assets Z,ZZZ
. Non-Current Assets ZZ
. Total Assets $ZZ,ZZZ
LIABILITIES
. Current Liabilities $ZZZ
. Long-Term Liabilities Z,ZZZ
. Total Liabilities Z,ZZZ
EQUITY Z,ZZZ
. Total Liabilities & Equity $ZZ,ZZZ
Notice how this model fits perfectly to the core concept of the balance sheet structure explained above, ASSETS = LIABILITIES + EQUITY.
In general, most companies try to mimic this presentation model as best they can; but each industry utilizes their own presentation format. Overall, the format each industry utilizes matches the core formula, it’s just that they may present it differently. Go back to the REIT above. American Homes 4 Rent uses a slightly modified model. In their case, they focus on fixed assets as the primary asset. Notice how total real estate dominates the value of total assets. This is their basic presentation format:
ASSETS
. Total Real Estate $10.245 Billion
. Current Assets .597 Billion (cash, receivables, deposits, investments)
. Non-Current Assets .120 Billion (goodwill)
. Total Assets $10.962 Billion
On the liabilities side, preference in hierarchy is given to secured notes over unsecured notes. In the traditional presentation format, unsecured liabilities are listed first and then secured loans are listed based on inverse seniority.
Again, each industry presents their balance sheet in their own format. As a value investor, it is so important to understand this presentation format in order to better grasp value when it comes time to determine intrinsic value.
There is another aspect of the presentation format that is important for value investors to understand and appreciate. Large companies, those in the top 2,000 in the United States tend to report the most important assets first along with their prioritized liabilities. Look at the REIT’s presentation above. Almost all REITs present in a similar format, they list their net real estate book value (cost basis less depreciation taken to date) as the first asset on the books. Whereas banks, list their cash available, then their portfolio of securities they own and loans they’ve made. Look at Bank of America’s format:
For Bank of America, the presentation format goes like this:
ASSETS
. Cash $348.221 Billion
. Federal Funds/Trading Accounts/Derivatives 540.288 Billion
. Debt Securities 982.627 Billion
. Loans Made 966.737 Billion
. Other Assets (fixed, goodwill, other) 331.622 Billion
. Total Assets $3,169.495 Billion
($3.169 Trillion)
With banks, they generally list their assets based on liquidity from the most liquid to the group that will take extended to time liquefy in case of termination of operations. For banks, the government grades the quality of a bank based on its ability to liquidate its assets; thus, the balance sheet reflects this governmental compliance format.
The liabilities section is similar, it is presented in the format of priority to repay. Existing customer deposits are first at $2.1 Trillion and then the remaining forms of liabilities based on their time windows.
All the banks follow this pattern with their balance sheet. Again, the presentation format is tied to the core concept of balance first; assets in the upper half and liabilities and equity in the bottom half.
Each industry’s presentation format actually assists value investors with determining intrinsic value. When you understand what the industry presents as the most important asset over others and why, it helps to focus in on what matters the most to that particular industry.
With REITs, it is real estate that is the most important asset and as such, it gets reported first. With banking, it is liquidity; because it is required by law. Thus, banks want the readers to see that they have adequate cash and other easily liquifiable assets (government bonds and debt securities) in their portfolio to cover any ‘run’ on the bank.
For value investors it is so important to understand this relationship of what it is that the company does and how their key assets allow it to generate revenue. The company wants the balance sheet to reflect, by prioritizing, those key assets first.
Intrinsic Value – Matching the Balance Sheet Against the Company’s Purpose
A key fundamental of value investing is understanding how the balance sheet presents the priority of the particular company within a certain industry. Each industry is different and as such, there is an asset allocation or alignment that matches that industry’s purpose. Look at the difference in presentation format just between the two industries above:
REIT’s Banks
Net Real Estate >92% Cash 10 to 15%
Cash 3% Federal Notes/Securities >50%
Other 4% Loans 30%
Other <10%
Look at what the company does, REIT’s collect rents; thus, real estate as an asset is the most important asset to own. It is difficult to collect rent on cash. Whereas a bank’s primary purpose is to generate net interest income. Interest comes off of debt securities (bonds) and loans. In their case, they want to maximize how much of their assets are lent out to debtors. The only reason they list cash first is because they have to meet a minimum cash position (liquidity) in relation to the total assets to be in compliance with the license they are granted by the Federal Reserve and other federal agencies. But immediately after reporting this cash position, the primary asset is listed, securities and loans that make the bank money via interest payments as their revenue.
As a value investor, key in on this concept and it will help you to gain a better perspective of overall intrinsic value for a company. At this point an in-depth illustration will assist the reader with a better understanding of this fundamental principle of determining intrinsic value.
The financial sector of the economy is divided into several industries. One of those industries is insurance. Insurance is further segmented into different types. Some companies focus strictly on life products, others health insurance. But there is one that all of us understand and recognize, property and casualty. Customarily referred to as the P&C arm of insurance.
Unlike the other forms of insurance which have a steady pattern of benefit pay outs; P&C does experience some peak payouts at certain times throughout the year for natural events (tornados, hurricanes, flooding, wind and hail). Thus, this type of company must have reserves that can be easily cashed and cashed without undue additional costs. Look at their assets section of the balance sheet:
Notice the very first grouping of assets are investments. Three-fourths of all assets are investments. Within this investment group, more than two-thirds are fixed income securities (bonds). The bonds are a key source of cash from the interest income (see articles within the Insurance Pool explaining this). Bonds are the key asset of a P&C company.
Look at the cash position, it is a measly $377 Million (.3%) out of the $126 Billion of assets. Insurance companies don’t need to hold cash, they just need access to cash. Bond and equity securities are an excellent easily convertible source of cash.
A property and casualty insurance company’s asset arrangement is strictly about the ability to convert assets into cash to meet forecasted catastrophic events. Think about this from the perspective of intrinsic value. Recall, intrinsic value is tied to the core value of a company. In this case, for a P&C operation, intrinsic value is strongly aligned with the quality of the liquifiable assets.
There is some additional value related to earnings; but, the balance sheet identifies the real intrinsic value of insurance operations. To validate this value, look at Allstate’s liabilities:
The first line is the standard P&C expected obligation of Allstate; they believe that in the upcoming year of 2021 and in the future tied to longer term P&C policies, Allstate will need to pay out about $27.6 Billion to settle damage claims. Since most P&C insurance companies are not pure P&C, most do also sell life insurance, the second line is the projected lifetime amount they will pay out for existing life insurance contracts. The third line ties to their annuity products.
The fourth line is the standard arrangement with their customers. When you purchase insurance, you agree to a certain ‘Annual’ premium and customers prepay for the upcoming year. In this case, almost $16 Billion has been paid and not amortized to the revenue section of the income statement at year-end. Most of these policies are for P&C policies for corporate size accounts and not necessarily at the individual levels. At the individual level, customers agree to pay the premium in the near future and this in turn is an asset on the balance sheet; thus, look at the line ‘Premium Installment Receivables, Net’ for $6.5 Billion in the asset section above.
Then there is a line for claims made but not disbursed yet, deferred taxes and other common forms of corporate liabilities (payables, notes, etc.). Altogether, Allstate estimates it owes about $95.8 Billion, of which most of this will be settled within a few years.
The key relationship is this, Allstate’s core investments plus existing cash plus receivables due from customers equals $101.1 Billion; its expected obligations are about $95.8 Billion; thus, there is a $5.3 Billion delta to the positive here.
In the aggregate, Allstate’s assets less liabilities are an estimated net assets position (remember from above, investors use the term ‘net assets’) of about $30.2 Billion.
There are 304 Million shares outstanding (trading) in the market on 12/31/2020 plus another 26 Million assigned to a benefit package for employees. This means each share on a fully diluted basis has a book value of $91.50.
However, book value DOES NOT equal intrinsic value. With P&C operations, intrinsic value is commonly within .9 to 1.4 times book value. Rarely, if ever, will intrinsic value exceed 1.5 times book value. The reason is straight forward, P&C operations use actuarial science and know within a few million dollars their full obligations related to the various policies they carry. Thus, given the risk of dramatic catastrophic losses (imagine seven or eight hurricanes, a large forest fire, several hailstorms in one year), it is quite possible to have to utilize net asset value to cover these unforeseen events; this in turn limits the upper range of intrinsic value for an insurance company.
Any unusual activity will quickly diminish intrinsic value of a P&C insurance company. Therefore, intrinsic value is merely the book value plus a few years of net earnings from the income statement. The extenuating risk factors associated with catastrophic events in excess of expected volume will dramatically impact intrinsic value. Therefore, intrinsic value will never exceed 1.5 times book value for P&C insurance companies.
For the reader, this site’s facilitator estimates intrinsic value for Allstate at $102 per share with a buy price of $81 per share.
The key is this, the balance sheet is customarily formatted to facilitate a better financial understanding of the company related to the industry in which they operate. Understanding these core fundamentals of how a balance sheet is laid out, formatted, reported and presented assists the investor with determining intrinsic value.
Summary Intrinsic Value – Balance Sheet Fundamentals
Novice and unsophisticated investors place greater reliance on net profits over the balance sheet to determine intrinsic value. However, most so-called experts forget what intrinsic value means; intrinsic value refers to the universally accepted core value of a company. In many cases, this can be easily derived from the balance sheet. If not derived from the balance sheet, the balance sheet can act as additional assurance that certain intrinsic value formulas are superior and best suited given the balance sheet information.
Understanding how a balance sheet is laid out, works and reports this information greatly assists value investors with determining intrinsic value. Gaining knowledge about balance sheet fundamentals takes a value investor to the next level of comprehension of value investing. Act on Knowledge.
This is the second part in a series about intrinsic value. It is the first in a four-part series about the balance sheet and different intrinsic value formulas that are tied to the balance sheet. The next lesson in this balance sheet series delves deep into analysis of asset matrixes and proper interpretation of that information. It also includes how to tie the asset matrix to the liability layout. Understanding this relationship allows the value investor to apply certain intrinsic value formulas which are explained and illustrated.
For those of you that have not, it is a good idea to read the first part of this series. In addition, there are some other articles to assist with a more comprehensive understanding of the balance sheet.
- Intrinsic Value – Definition and Introduction
- How to Read a Balance Sheet – Simple Format
- How to Read a Balance Sheet – Equity Section Simple Format
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Intrinsic value’s definition has several different meanings when used in the business context. The word intrinsic refers to ‘innate’ or ‘inherent’. Whereas value refers to the exchange mindset between two or more parties. Thus, intrinsic value refers to the core understanding between parties of the worth of something. Bread is the perfect example. At its core concept, bread is a food we consume as a starch; we eat it due to its relatively inexpensive cost to fill our bellies. When you go to purchase bread at the grocer, there is already a preconceived price range for bread. Different flavors, packaging, size and type determines the final price within this predictable range. It is easy to spot prices that are too high or for some reason well below expectations.
Intrinsic value works the same way. When looking at the market price for a security, having knowledge of the intrinsic value prevents over paying for an investment. The key is determining this price range for the security. The primary rule for intrinsic value is straight forward; it is a RANGE and not an exact dollar value. Just as with the bakery section of the grocery store, bread is priced within a range. With value investing, the goal is to narrow this range to a set of values that are REASONABLE and OBJECTIVELY verified. Therefore, rule number two, intrinsic value must be reasonable and objectively determined. Finally, all users of intrinsic value must understand and appreciate that intrinsic value is not static. It changes every day and for highly stable companies, it should improve every day in a predictable manner with a high level of confidence.
The following sections cover these three rules tied to intrinsic value. The first section explains how intrinsic value is a RANGE of values and never a definitive amount. The second section discusses the importance of arriving at this price range in an OBJECTIVE manner and that the price range is REASONABLE given various ratios and performance indicators for the particular company. The third section below covers how intrinsic value is FLUID in business; it changes regularly and with highly respectable, stable operations, it is constantly improving.
Intrinsic Value – A Range of Monetary Outcomes
Determining intrinsic value is not an exact science. Intrinsic value is a range of values determined from many different variables collected, collated and exercised in several formulas to derive results. In many cases, these results are extreme with their respective outcomes. For value investors, the idea is to acquire as many different results as possible over at least five and ideally eight or more different standard formulas. From these results, a range is extrapolated. As is typical with many derived results, highs and lows are tossed due to their extreme nature. Those that remain set the boundaries of the possible outcome. The goal is finding common ground from among the remaining outcomes. Narrowing this outcome to a common acceptable monetary range determines intrinsic value.
An illustration is appropriate. In this case, a simple well documented company is used to determine intrinsic value – Coca-Cola.
Typically, the first step involved with determining intrinsic value is to collect pertinent data. For the purpose of brevity, the following data was collected on Coca-Cola.
Data Point 2021 2020 2019 2018 4 Year Weighted Average*
Revenue $38.6B $33.0B $37.3B $31.9B $36.3B
Gross Profit $23.3B $19.6B $22.6B $20.1B $21.9B
GP Margin 60.3% 59.4% 60.6% 63.0% 60.4%
Net Profit $9.8B $7.8B $8.9B $6.4B $8.8B
# of Shares Trading 4.3B 4.3B 4.3B 4.3B 4.3B
Earnings/Share $2.28 $1.81 $2.09 $1.51 $2.06
Dividends/Share $1.67 $1.64 $1.59 $1.56 $1.64
Book Value/Share $5.31 $4.48 $4.43 $3.98 $4.84
Operating Cash Flow $12.6B $9.8B $10.5B $7.6B $11.1B
Free Cash Flow $11.3B $8.7B $8.4B $6.3B $9.7B
Growth Rate 3.7%
Discount Rate 7.75%
Average Market Price $56 $55 $52 $47
Dividend Yield 2.98% 2.98% 3.05% 3.32%
Price to Earnings Ratio 24.5 30.4 24.9 31.1
* Weighting is as follows: 2021 – 50%; 2020 – 25%; 2019 – 15%; 2018 – 10%.
Over time, Coke’s market price continues to increase reflecting the constantly increasing earnings per share. This is a DOW Jones Industrial member and as such, this company is highly stable and experiences a good growth rate for such a well established company (they been publicly traded for 103 years). Excellence is their standard. As such, the market price to earnings ratio will always be strong (>20:1 ratio). In effect, it is a great company to buy when the price suddenly dips more than 25% below the most recent peak price. However, recall, market price is NOT intrinsic value. Intrinsic value reflects a fair and reasonable dollar amount that mirrors a general agreement among parties as to the worth of a security. The difference between the two prices (market and intrinsic) is the speculative risk many investors take believing the market price will continue to increase.
For any stock based security, a fair and reasonable value is measured utilizing a discount rate. This is the rate an owner of this particular security desires for the risk they assume. For a high quality company like this, a discount rate of 5% is very fair. Coca-Cola has very little risk but risk still exists. It isn’t government grade risk (1 – 3%); nor is at the high quality bond risk rates of 3.5% to 5%. However, it is still a super high quality stock investment risk which typically starts at around 5%. Thus, as an investor with this type of high quality stock, a five percent return on your investment is considered fair and acceptable.
Therefore, the very first intrinsic value formula commonly used is the dividend yield tied to the stock based discount rate. In this case, the average dividend is $1.64 and with a discount rate of 5%; the stock is worth around $33 per share. Coke is highly stable, returns a dividend to the shareholder and, at greater than 60%, has one of the strongest gross profit margins for any company. It is a super quality company to own. It would appear on the face of values that $33 per share for intrinsic value is low. Thus, more intrinsic value formulas are required.
Intrinsic value formulas are commonly grouped by financial data. Historically, a very well respected formula advocated by Benjamin Graham and David Dodd (the Fathers of Value Investing) is a formula tied to earnings. Their popular formula is:
Value = Earnings times ((8.5 plus (2 times a reasonable growth rate))
With Coke, this would equal:
Earnings of $2.06/Share times ((8.5 + (2X3.7));
$2.06 X (8.5 + 7.4);
$2.06 X 15.9;
$32.75/Share
Take note how close this is to the dividend discounted result from above. However, a value investor should never rely on just two results. More are required.
A third and quite common approach is to use the discounted earnings formula. This formula is a income statement based formula and assumes earnings are normal and not inclusive of unusual or infrequent events. However, Coke, just like every other company, did experience an unusual event starting in March of 2020. COVID affected all companies across the board. With Coke, it definitely caused a decrease in sales in the amount of $4.3 Billion; thus, net profit was most likely reduced around $1.2B which in turn reduced earnings per share that year approximately 28 cents per share. In the overall scheme of things, this probably impacted the average earnings per share about 6 cents (due to the weighting effect of the 4 year average). The question here is this, should a value investor use the historical recorded average of $2.06 per share or adjust this for the COVID situation?
Surprisingly, the answer is to NOT adjust the average. The key is the average. Since 2019’s value is only weighted 25%, the net impact is slightly higher than 6 cents in the overall result. This aggregated 3% difference (6 cents divided by $2.06) isn’t going to dramatically affect the end result (with business, dramatic refers to a change of more than 5%) with the discounted earnings formula, or for that matter any long-term time derived result (discounted formulas customarily utilize 20 plus years to derive a result). Discounted future values are grounded in the near future over the extended future. The first seven years typically are worth more than 30% of the end result.
In this case, using a discounted earnings tool, Coke’s intrinsic value is estimated at $36.03 over the next 30 years assuming a discount rate of 7.75% and a growth rate of 3.7%.
A Side Note
The discount rate used with the discounted earnings formula here is different than the discount rate used in the dividend yield formula. In the dividend yield formula, the discount rate reflects a much improved overall risk position because it is dividends and not earnings. Dividends are a direct payment to the shareholder; whereas earnings doesn’t guarantee all of it going in the shareholder’s pocket as dividends. Thus, the discount rate for earnings includes not only the portion tied to equity ownership (the 5% desired rate used with the dividend yield formula), but also the ‘no risk’ desired discount (usually around 2%), the size premium and the specific risk (is there a market for Coke’s securities). Thus, the discount rate for the discounted earnings and cash flow formulas is always higher than the discount rate for dividend yield.
Notice how this result is slightly higher than than the first two results? Often, value investors adjust the variables in the formula around the earnings. The two variables are the growth rate and the discount rate. Let’s assume a more conservative approach and increase the discount rate to 8.25% and reduce the growth rate to 2.9%; again, the idea is to be more conservative with the outcome. Using these factors, the intrinsic value shrinks to $30.96 per share.
A more aggressive approach might be to reduce the discount rate to 7.25% and leave the growth rate as is, 3.7% (it is very difficult for companies that are fully mature, in this case Coke has been in business for over 130 years, to have strong growth rates greater than 4% per year). Using this more liberal approach, the discounted earnings approach values the shares at around $38.25.
A user of this formula could extend the number of years with discounting future earnings and go to 40 years; this will add anywhere from $3 to $5 per share depending on whether the value investor incorporates conservative or liberal values for the two variables.
Notice already, the RANGE that is beginning to develop. To this point, the following results exist:
- Dividend Yield with a Desired Discount Rate of 5% $33/Share
- Graham & Dodd Formula $33/Share
- Discounted Earnings (7.75%, 3.7% Growth, 30 Years) $36/Share
- Discounted Earnings (7.75%, 3.7% Growth, 40 Years) $41/Share
- Discounted Earnings Conservative Approach (8.25%, 2.9% Growth, 30 Years) $31/Share
- Discounted Earnings Conservative Approach (8.25%, 2.9% Growth, 40 Years) $34/Share
- Discounted Earnings Liberal Approach (7.25%, 3.7% Growth, 30 Years) $38/Share
- Discounted Earnings Liberal Approach (7.25%, 3.7% Growth, 40 Years) $45/Share
This pattern results in a RANGE of a low $31 per share (conservative approach, 30 years) to a high of $45 per share (liberal approach, 40 years). There are still more intrinsic value formulas an investor could use. Many investors like to resort to cash flow as a more reliable indicator than earnings. In general, there are two sets of cash flow values to use. The first is purely the operating cash flow. This is basically earnings adjusted for non-cash expenditures such as depreciation and amortization. Coke has a very strong amortization deduction each year related to the years of growth when they purchased many rights to own certain brands, formulas, distribution venues etc. over the last 40 years.
From the schedule above, operating cash flows exceed earnings by approximately $2.3 Billion per year, or around 53 cents per year per share. In effect, the discounted formula uses $2.59 per share as the substitution value over $2.06 of earnings average per year. This additional 53 cents per year, increases the overall intrinsic value result about $9 per share. With the more conservative approach, the additional 53 cents per year increases the result around $8 per share.
The key question here is, which is better? Should a value investor use discounted earnings or should an investor use discounted operating cash flows? The answer is is highly dependent on the investor’s belief system related to how cash flow is utilized. Most investors believe that it is important for the cash to be used to reward shareholders with dividends, reduce the overall risk of the company (paying down debt) and investing cash for future growth or to maintain the current growth rate.
Think about this for a moment, if Coke doesn’t take their cash and invest some of this money as capital expenditures, the growth rate of Coke will drop over the next 10 years and it is possible, that without this reinvestment into new products, geographical expansion and developing expanded distribution systems, the company could begin to retrench as the competition will take advantage of this non-growth position. Since, most of the values derived above are heavily reliant on a moderate to strong growth rate, a good portion of the operating cash must be used to maintain the company’s market share and overall position in this industry. In effect, Coke must reinvest some of this $2.4 Billion per year to maintain their overall position. Reviewing the cash flows statement identifies that Coke reinvests around $1.5 Billion per year.
The end result is that most of the 53 cents per share from cash flow is reinvested to maintain the company’s overall market position. Thus, a value investor can use operating cash flow as the basis in the discounted formula; but, the investor must adjust this for the required investment to maintain the company’s overall market position. This is known as ‘Free Cash Flow’ (Operating Cash Flow less Capital Reinvestment).
With Coke, once you adjust the cash flow for maintenance requirements, it effectively ends up just slightly more than purely earnings, around $2.24 per share as the basis for discounted formula. This adds about $3 more per share with the end results and not $9 per share utilizing nothing but operating cash flow. Now the results are as follows:
- Dividend Yield with a Desired Discount Rate of 5% $33/Share
- Graham & Dodd Formula $33/Share
- Discounted Earnings (7.75%, 3.7% Growth, 30 Years) $36/Share
- Discounted Earnings (7.75%, 3.7% Growth, 40 Years) $41/Share
- Discounted Earnings Conservative Approach (8.25%, 2.9% Growth, 30 Years) $31/Share
- Discounted Earnings Conservative Approach (8.25%, 2.9% Growth, 40 Years) $34/Share
- Discounted Earnings Liberal Approach (7.25%, 3.7% Growth, 30 Years) $38/Share
- Discounted Earnings Liberal Approach (7.25%, 3.7% Growth, 40 Years) $45/Share
- Discounted Free Cash Flow (7.75%, 3.7% Growth, 30 Years) $39/Share
- Discounted Free Cash Flow Liberal Approach (7.25%, 3.7% Growth, 40 Years) $48/Share
Again, the overall range of values expands slightly to a high of $48 per share. The range is now a low of $31 to a high of $48. Statistical analysis states to toss the extremes of $31 and $48 and now the range becomes a low of $33/share, Dividend Yield, to as much as $45/share, Discounted Earnings Liberal Approach.
Most of the results are from $36/share to $41/share. A RANGE of values is now set. The next step is to narrow this RANGE to something REASONABLE and OBJECTIVE.
A Side Note
The more stable the company, the more reliable the discounted formula becomes. Mid-Cap companies require additional supplemental formulas to assess intrinsic value in addition to the discounted method. Use fair market valuations for fixed assets; incorporate business ratios; and utilize the company’s notes to the financials to identify critical key performance indicators. As the company moves through its life span and improves, the discount rate also improves (decreases). For Mid-Caps, discount rates of 11% and higher are necessary to account for the additional risks associated with these companies. For those that are improving within the Mid-Cap level of companies, the discount rate tends towards 11% from 12%; for those companies unable to improve or demonstrate sound financial results year after year, the discount rate must increase to compensate for this additional risk. Value Investors SHOULD NEVER consider Small-Caps, Penny stocks or even Over-The-Counter investments. For those types of companies, additional tools are required to determine intrinsic value and the associated risk of deriving a reliable result is magnified dramatically. This is why value investors should only consider the top 2,000 companies and within this pool of potential investments, only those that demonstrate continuous growth and performance during recessions or unusual events.
Intrinsic Value – A Reasonable and Objective Outcome
Is an intrinsic value of $36 to $41 reasonable and objective? How can you tell? Well, there are several tools available to value investors to confirm or independently verify that this is a good range of values. The most commonly used tool is the price to earnings ratio.
Price to Earnings
If you look at the history of Coke, the price to earnings ratio, i.e. the market price against the earnings hovers in the 20’s. The market price to earnings rarely dips below 20:1. This chart illustrates Coke’s PE ratio over the last five years. The sudden high PE ration in 2018 is a direct reflection of Coca-Cola taking advantage of the new tax law in December 2017 and paying a dramatic amount in taxes reducing their overall net earnings. Since the average market investor is aware of this, they are not going to suddenly reduce the market price for Coke. Thus, if the market price remains stable and the earnings drops dramatically, the ratio inversely changes. In effect, 2018 is an anomaly. By the way, this is one of the flaws of the PE ratio and is explained in detail in the lesson about price to earnings in the Business Ratios section of Value Investing on this website.
From above, the market is willing to spend at least 20 times earnings to own this stock. Current earnings plus some excess cash flow totals around $2.24 per share. At a PE of 20, that makes Coke’s market value approximately $45 per share. Value investors don’t want to buy stock at commonly accepted market prices, it just means that you will only earn dividends and although the yield will be good, value investors desire strong overall returns. To achieve this, the buy price, which is set below intrinsic value, must be dramatically (> 5%) less than intrinsic value. With Coke, given the unusual quality this company provides to its shareholders, a price differential including the additional 5% for margin of safety must exceed 25% in order to justify the risk associated with the holding period. An illustration is warranted here.
Assume that a fair market price is $45 per share based on a minimum 20:1 PE ratio. Given the risk of time to recover to a fair market price, a 25% discount is required to buy the stock. 25% of $45 is $11.25. Thus, to buy this stock, the value investor sets the buy point at $33.75 per share. This buy point is at least 5% less than intrinsic value. This makes intrinsic value approximately $35 to $36 per share. Take note how this is at the low end of the range established in the prior section.
Thus, using PE ratios as a barometer of value, discounting the minimum average PE ratio 25% from the most recent look back period of five years can provide some insight to intrinsic value. If the minimum PE ratio increases to 25:1, the fair market price increases to $56 per share. A 25% discount puts the buy point at $42 per share. If this is at least 5% below intrinsic value, then intrinsic value is estimated at $44 per share. Notice how this estimate is well above the expected intrinsic value range of $36 to $41. However, it is within the overall range calculated in the prior section (Discounted Earnings Liberal Approach Price).
A Side Note
Please take notice of something interesting here, the discount explained above is different than the discount used with the Discounted Earnings/Cash Flow method in the prior section. Some readers will ask, why is it that this discount in this section is almost four times greater than the discount used in the prior section (discounted earnings/cash flow). There is an outright difference between the two uses of the term ‘discount’. In the prior section, discount is tied to multiple risk factors AND extrapolated over an extended perid of time. Whereas, in this section, the discount is instantaneous and is driven by a limited set of factors that can impact its value. In this case, the value investor’s risk is a very short period of time (six or less months) and the value investor needs to have dramatic change in a very short period of time. In the prior section, the different variables of growth and earnings are addressed over a very long time frame, 30 or more years. The end result is this, as time decreases, the discount rate must adjust accordingly, i.e. increase.
Using a 25% discount of a minimum expected market PE ratio is just one tool to provide additional confidence of the resultant values from the various intrinsic value formulas used when determining an intrinsic value range. Think of it as a quick objective outcome.
Market Appraisal
Another objective tool is to ‘Appraise’ the company. Naturally, appraising Coca-Cola would take several years. Thus, to conduct a quick appraisal, one must use reasonable expectations related to determining fair market value of Coke’s assets. A quick look at Coke’s assets identifies the following on 12/31/21:
Current Assets $22.5B
Investments $18.4B
Fixed Assets $9.9B
Intangibles $41.3B
Most of the intangibles are Trademarks and Goodwill. Basically, Coke purchased these rights over the last 70 years to gain market share for non-alcohol beverages. Fixed assets reflect manufacturing, distribution and office facilities. Investments are mostly equity positions in other beverage companies, geographical territories and distribution venues. Since assets are recorded at cost under Generally Accepted Accounting Principles, their step-up in value to fair market value is not done and not reported on the balance sheet.
The step-up to fair market value is very effective with fixed asset intensive businesses like real estate, utilities, shipyards etc. Coca-Cola’s balance sheet relies intensively on intangibles. There is a very involved process to appraise intangibles. Thus, using this appraisal tool isn’t going to work with evaluating Coke’s overall asset position at fair market value less its liabilities to determine net aggregated value which is one way of measuring intrinsic value. A good illustration of how market appraisal effecitively calculates intrinsic value is with a REIT, please read Intrinsic Value of Essex Property Trust to learn more.
Another alternative is required.
Price to Book Ratio
A third objective tool is an old method called ‘Price to Book Ratio‘. This is a valuation ratio that emphasizes the importance of the book value for a company. It has many flaws and can be easily misinterpreted. But in general, it is more effective with highly stable operations, ones with an extremely extended history of exceptional performance.
Book value reflects the net equity position of the company divided by the number of shares in the market. For Coke, it slowly improves from year to year. Coca-Cola generally prefers to distribute earnings and not reduce debt or improve the overall financial position of the company. It has such an outstanding history with sales and a top rated (if not one of the best among all companies) gross margin, which exceeds 60% of revenue. Thus, the company will perform very well year after year. Coke doesn’t take its earnings to improve its financial position, it pays out 80% of what it earns in the form of dividends. Thus, very little is used to improve the book value per share (retained earnings improvement).
This does however produce a highly reliable market measure with the price to book ratio. With this stable market measure, a value investor can preset a discount to buy. This is no different than how a house flipper will determine the maximum amount they are willing to pay for a piece of property given the market value of similar property. For a value investor, a net cumulative 40% discount is considered reasonable and necessary to make a good return on an investment. Thus, if the current price to book ratio is 12, a value investor is interested in buying when the price to boot ratio drops 40% or to around 7.2 price to book ratio. Again, think about a house flipper’s business dynamics. It costs extra money to purchase and sell the investment, secondly, the house flipper’s real risk is time. How long will it take to sell this home? In addition, he has to invest some money to improve the property. For most house flippers, they buy distress property at about 40 cents on the dollar and invest another 20 cents on the dollar to get the property ready for sale. Then it is just a matter of time to get it sold. Their total investment is around 60 cents on the dollar. So, just like a house flipper, a value investor considers buying the current investment with a 40% discount (paying 60 cents on the dollar).
During the first quarter of 2022, Coke’s price to book ratio is around 11.2; a 40% discount means that Coke’s intrinsic value is about a 6.72 of price to book ratio. The current book value is $5.78. Thus, intrinsic value will approximate $5.78 X 6.72 or $38.85.
Reasonable and Objective
Overall, two separate objective and reasonable approaches were used to validate the intrinsic value range established in the prior section. The first involved discounting the market price to earnings ratio at least 25%. Again, higher stable operations such as Coke, warrant a minimum market price discount of at least 20% in order for a value investor to take the risk and tie up capital for an unknown period of time while they wait for the market price to recover to the long-term price to earnings ratio. The more stable and less volatile the entity, the deeper the discount the value investor should consider when determining intrinsic value tied to price to earnings.
The second tool used is similar; but this tool is tied to the book value. Review the company’s price to book value, look at the history of the book value. For entities with very strong dividend payouts, the book value rises slowly over time. In contradiction to this are entities that limit their dividend payouts to under 30% like Disney. The retention of the difference forces the book value to step up significantly from one year to the next. In their case, their market price to book value hovers from 1:1 to as high as 4:1. Whereas Coke pays out almost all its earnings as dividends, their price to book value rarely goes below 7:1. Look at Coke’s price to book history over the last 10 years:
During the recession time period of 2008 through 2011, the price to book was low. Then it slowly rises to today’s 11 to 1 ratio.
Notice how it hasn’t gone below a 7:1 ratio since back in 2016 to 2017 time frame. Thus, buying this stock at a 6 or 7 to 1 price to book ratio is considered an excellent buy assuming earnings have not decreased.
Both independent tools indicate that intrinsic value in the upper 30’s to low 40’s is REASONABLE and OBJECTIVE. This matches the RANGE of intrinsic value covered in the prior section. The key is to get a warm fuzzy that the intrinsic value range determined withstands many separate tests and although the tests may indicate values just outside the range, the delta involved isn’t unusual or dramatic. Therefore, it is with a strong degree of certainty that Coca-Cola’s intrinsic value is indeed between $36 and $41 per share. Thus, buying at about 5% discount to intrinsic value to provide some margin of safety is acceptable and pretty much guarantees the investor a good return on their investment. A buy price between $34 and $39 per share is going to reward the investor well. The market will return to high price to earnings at some point for this stock and when it does, the value investor is going to be rewarded well.
The real value is the fact that Coca-Cola keeps earning money from one year to the next, even during a recession or some unusual event, like COVID. This continuous earnings means that the intrinsic value is constantly improving. This tells any investor that intrinsic value is FLUID.
Intrinsic Value – Fluid with Time
One of the top 30 companies in the world is McDonalds. McDonald’s average net profit percentage is in the low 20’s. Thus, it is a top notch producer of profit for its shareholders. Each quarter, McDonalds generates about $2.50 per share. Therefore, over a 92 day period, it is netting 2.7 cents per day for each share. Intrinsic value is tied to the 2.7 cents per day. The current intrinsic value assumes earnings of 2.7 cents per day. When McDonalds adds a new location, it earns a little bit more for that share each day. Over time, the earnings per day per share improve to 2.8 cents. Thus, each day, the intrinsic value is constantly changing. With high quality companies, it generally tends to improve over time.
This fluid state requires the value investor to modify the intrinsic value on a regular basis. Customarily, it is done each year when the annual report is released. With some companies, this intrinsic value changes slowly. Coke is one of them. Since Coca-Cola pays out almost of its earnings as dividends, what is earned as profit has limited reinvestment utility; as such, future growth is slow and sometimes feels lethargic for a shareholder. A value investor must be aware of this and recognize that intrinsic value will improve, but very slowly over time.
This ties to the market price too. The market price doesn’t fluctuate dramatically for Coke. Look at Coke’s market price over the last ten years:
Coke’s market price has improved from $25 a share to $60 a share over 10 years. This is a direct reflection of its ability to earn a profit. The key is volatility; it just simply does not exist with this company.
Yes, it is true Coke’s stock price dropped more than 25% in March of 2020. However, every publicly traded company saw their share price drop from mid February through March due to the COVID pandemic. Coke’s market price dropped more than 30%. But at no other point along this graphical time line has Coke’s market price changed more than 15% in a short time period, or for that matter even over long time frames. It has continuously improved (with the noted exception). Intrinsic value follows the same curve line over the same time frame. When Coke’s price dropped suddenly due to COVID, intrinsic value did not suddenly drop. Intrinsic value is tied to the long-term picture; market price is a today value.
This is just another example of why highly stable operations are coveted by all investors. Value investors have to recognize that opportunities to buy low with highly stable operations are few and far between these market price points. This brings into play core principle number four, patience.
With Coke, intrinsic value is constantly improving; slowly but surely over time. Intrinsic value is FLUID.
With some companies, intrinsic value can have severe changes in value from one year to the next. As an example, Union Pacific bought back some of its stock during 2021. It paid much more than intrinsic value to buy back this stock. In effect, the company used cash, $7.3 Billion, to buy back stock. Aggregated intrinsic value decreased $20 Billion from $120 Billion to $100 Billion. This outflow of assets shifts existing value off the balance sheet. This in turn reduces intrinsic value to existing shareholders, resulting in increased risk too.
Value investors must be aware of the various activities that can increase and decrease intrinsic value. These actions affect intrinsic value from one quarter to the next, one year to the next. Thus, intrinsic value is FLUID.
Intrinsic Value – Summary
There are three rules with intrinsic value. First, intrinsic value is a range of values. Different elements of the various intrinsic value formulas can vary the outcome from relatively conservative estimates to high outcomes with more liberal element application. The key here is to narrow the range to a reasonable zone. This is where rule number two comes into play. That range of value should be reasonable and objectively verified. It is important to utilize other tests and tools to ensure that the range is reasonable and not extreme. Extreme results will result in either no opportunities to invest in the particular security, or when one does invest, it will not result in a good return. The more tests an investor can apply against the intrinsic value range, the more objective the outcome gets and the more confident the value investor is with the range.
Finally, a third rule exists. Intrinsic value is in a constant state of change; it is fluid in price. The mere fact the company operates each day changes the value incrementally each day. As profits improve, intrinsic value goes up. In some cases, the governing body of the company can make decisions that dramatically affect intrinsic value. Readers of financial statements must be on the look-out for these intrinsic value impact factors.
Most importantly, intrinsic value exists within a RANGE of values; it should be REASONABLE and OBJECTIVELY verified; in addition, it exists in a FLUID state and can instantly change.
This is the first article in a series on intrinsic value. The series continues with the balance sheet approach to calculate intrinsic value. In addition, there is another article which covers income statement intrinsic value formulas. After that article is another explaining how to determine intrinsic value using cash flow. There are still others, they include utilizing business ratios and determining intrinsic value utilizing key performance indicators. The final article sums all this up. For the reader, the key is that there is NO SINGLE UNIVERSAL INTRINSIC VALUE FORMULA. Value investors must apply several formulas and test the results to gain a high confidence that the intrinsic value range is valid. ACT ON KNOWLEDGE.
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]]>The post Value Investing – Industry Principles and Standards (Lesson 25) first appeared on ValueInvestingNow.com.
]]>Shifting from economic wide factors that impact market price to industry wide standards is essential with understanding and creating decision models for investment with a pool of similar companies. Industry standards are a part of the spectrum of business principles. This spectrum starts with tenets, universal rules that can not be broken by anyone in business. With value investing, the focus is on the primary business tenet of buying low and selling high. It is an undeniable requirement to increase one’s wealth. The spectrum moves towards core business principles that sometimes are not universally applicable. The final set are industry standards. Each industry has its own unique set of principles it must follow to be successful. Some are a function of law, others are driven by consumer expectations or the culture of the industry. For value investors, understanding this dynamic set of standards for each industry drives the holistic thinking of effective investing.
Value Investing – Industry Standards, A Pyramid of Principles
There is no universal finite set of business principles. In the aggregate, there are over several hundred of them. Many of them are not applicable to every industry; on the contrary, many are specific to a unique business or industry. The best approach to understanding business principles is to look at this in a holistic manner, i.e. overall doctrine down to a few rules specifically designed for that one business.
In effect, think of business principles as an inverted pyramid. The base of the pyramid consists of business tenets, common universal principles. Tenets support the next level, fundamentals. Fundamentals are the more common thoughts that most business managers use to govern their operation. However, some of these fundamentals are not applicable to all corporate operations. At this level, there begins separation of the tenets of business based on multiple variables including markets, business sectors and the underlying industries, customers, employees and vendors. In many cases, this level of the pyramid is impacted by law based on the various levels of our government system. The final tier supported by fundamentals is called standards. This level of principles involve customs, guidelines, rules and procedures.
Look at this depiction:
Notice that tenets are relatively few, again they are universal in nature and applicable across all industries. Fundamentals are the bulk of principles that exist. The reason for this is that many fundamentals are set by economic restrictions and law. The final upper tier is industry and business specific principles and are uniquely defined by the sector and industry.
This article is merely an introduction to the pyramid, other articles on this site go in-depth related to each of the tenets of business and of course fundamentals. Many of the standards are located in the pool of investments of this site and often include the respective accounting processes and operational issues the industry uses to implement the fundamentals.
To illustrate, a tenet of business is cited. The fundamentals of its importance are compared and contrasted using two different business operations. The comparison does not cover all the standards for each of the two business operations but just identifies one or two standards they each may use to comply with their respective fundamentals.
Tenets
Principles that are universal to all businesses are tenets of business. If any single business or industry can operate without this tenet or can break this principle, then this principle is really a fundamental and not a tenet. The principle must be applicable to all industries, all sectors, all aspects of operations and dealings with employees, customers and vendors.
As example, there is one tenet that all corporations must follow.
Efficiency and Effectiveness
Efficiency and effectiveness are the yin and yang of business. When one of these two elements is given more credence then the other element falters. The key is to balance them appropriately. This balancing act is different for every industry and is customarily driven by the respective purpose.
Efficiency refers to utilizing the least amount of resources to deliver the product or service. Intuitively, many companies focus on efficiency as this reduces the overall cost allowing for a profit on the bottom line. Effectiveness refers to delivering the correct product or service. Without it, the customer is highly unlikely to purchase again in the future. Every company must weigh these two elements in delivering the product or service. Use poor quality parts or resources to reduce costs (increasing efficiency) and the company increases the risk of being ineffective with delivering the product or service.
Remember though, certain industries will place more value on one element over the other as the other element may not be as valuable to the customer. For example, think of a medical surgeon. Undoubtedly, a surgeon needs to be effective, many people will say no matter the cost. However, this isn’t true. You see, the surgeon is bound by the hospital’s need to exercise efficiency to keep costs down in order to comply with insurance company restrictions. Furthermore, many families simply cannot afford to pay an open-ended arrangement to be effective with the surgery no matter the cost. As the importance of one element increases the other can give but there are limits.
On the flip side are businesses that place a lot of emphasis on efficiency and less on effectiveness. However, they must still deliver the product or service the customer demands.
A good example is the electric utilities business. Efficiency, both scientific and administrative are necessary to keep costs under control. For them, every step of the process requires efficiency to reduce costs. For the consumer, they are only interested in having the source of energy at 120 volts, 60 Hertz. Thus, it is easy for an electric utility company to be effective, but difficult to maintain efficiency. Thus, the emphasis is with efficiency over effectiveness.
This efficiency/effectiveness tenet exists across all business sectors and industries. However, the fundamentals will be different tied to the respective sector and industry.
Fundamentals
Fundamental principles are not always universal. For some industries, certain principles are solely theirs. That same principle may not be applicable to another industry. For example, there is a principle with business known as the range of production. It’s basic definition states that a business should produce products at the maximum point of production (think of a manufacturing plant) to maximize profits. This principle assumes all products produced will be sold in the market.
The range of production is a key business principle used with many business sectors and industries. The mere fact that the principle has a restriction, ‘… assumes all products produced will be sold…’, makes it a fundamental principle and not a tenet.
This principle is utilized with the following industries:
- Consumer Products Manufacturing
- Food Production
- Service Sector
However, this principle is not applicable with some businesses.
As stated earlier, one of the common restrictions related to fundamentals is government regulation. A good example is the new marijuana industry. Although demand exists, state governments (specifically California, Colorado and Massachusetts) have set limits for production and restrictions to operate retail stores. Thus, this fundamental is not applicable to this particular industry. Since the range of production principle is not universal, it is considered a fundamental principle and not a tenet.
Going back to the two businesses used above for the efficiency and effectiveness principle, the fundamentals related to this tenet are going to be different. For the utility company, since efficiency carries greater regard, their business fundamental principles are focused on this tenet. For example, their efficiency issues will be science driven with production of electricity and distribution to the end-user.
As for the surgical business, their fundamental principles are focused on effectiveness. Some of their business principles may cover:
- Proper Diagnosis (Hiring of Qualified Staff)
- Acquisition of Lab Results in a Timely Manner
- Patient Evaluation (Good Timing and Potential for Best Results)
Don’t misunderstand, the doctor’s office still has to practice some efficiencies in order to control costs and ultimately generate profits for the medical partners. But the overall business principles they use will defer to effectiveness over efficiency.
What is really fascinating is that each business will create their own standards, most often mimicking other similar businesses. These standards are not as encompassing as fundamentals, they are focused on one or two elements of the overall operation. Since most operations have hundreds, sometimes thousands of different elements to conduct business, standards can and are often voluminous with business operations. Think of all the manuals some companies follow in order to conduct business.
Standards
Many industry standards are tied directly to higher level fundamentals and a few are generated as a direct result of a business tenet.
Think of the surgery practice, their standards are oriented towards effectiveness in helping their patients get healthier. The clinical staff must have appropriate credentials, all operational practices are designed to maximize effectiveness from proper specimen draws to cleanliness. It’s about being effective.
Whereas with the utility supplier, standards are focused on efficiency. Something as simple as safety reduces downtime for the utility operation. Thus, standards are put in place to create uniformity and consistency across the entire organization to maximize uptime with production of electricity.
Even their financial standards are set against the industry standards for just about every aspect of production. Think about:
- Raw Resources Consumption and Energy Output
- Distribution Systems and Maintenance
- Business Ratios
- Proper Debt Financing
The financial standards used with utility operations are significantly different from those for the medical practice. One is a conglomerate whereas the surgical operation is most likely a partnership. Their legal structures, operating management team and insurance principles will be completely different.
Summary – Industry Principles and Standards
Every form of business operates under different standards. However, many businesses still utilize similar fundamentals but one industry or sector may exercise more fundamentals or different ones depending on the various forces that guide them. But there is one set of universal principles known as tenets. Here, all businesses have to follow these tenets as no one is exempt. With this understanding of the various levels of the pyramid of business principles the reader can begin to understand that there are hundreds of business principles out there. Use the above as guidance to help you understand your respective pool of investments. ACT ON KNOWLEDGE.
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Value Investing – Market Forces
- Choice – Every buyer and seller is given the choice to exchange their resources for a product or service. With value investing, choices are focused on the buy and sell points for investments.
- Opportunity Cost – When a transaction is completed, each party has lost at an opportunity to sell it higher or buy it lower. It also refers to an alternative buy or sell which may have better risk or reward.
- Supply and Demand – Defined as the willingness to buy or sell a product/service.
- Market – Centers where suppliers and buyers meet to negotiate the equilibrium of value.
- Equilibrium – The final net exchange price between a willing buyer and seller.
- Price – The exchange rate between two parties.
- Competition – Many sellers and buyers vying for resources.
- Macro/Micro – See above.
All eight of these will come into play as a value investor. Throughout these lessons, anytime one of these affects the principle or particular situation, it will be noted and identified to the member. The key is that it is so important to be on the alert for these economic concepts and their respective impact on a business financial model.
In addition to the impact economics plays on a financial model, there is another equally impactful aspect of value investing. This is the business model.
Value Investing – Business Model
In business there are four distinct business models. Just about any business can be identified with one of the four. The following are the four types of business models:
- Low-Volume, Hi-Margin
- Hi-Volume, Hi-Margin
- Low-Volume, Low-Margin
- Hi-Volume, Low-Margin
No single model is the best nor the worse. Each works within their respective industries. In general, the models exist by default and it is highly improbable that the model can move into another one of the types without changing the particular business sector/industry. An illustration is appropriate.
Wal-Mart is by far the most significant retail player in the world-wide market. They control about more than 11% of all retail. They definitely follow the Hi-Volume, Low-Margin model mostly out of default. All of their competition uses the same model. It is impossible for Wal-Mart to shift their model to Hi-Volume, Hi-Margin format. Their customer retention would fall dramatically if they raised their prices. But, this model works well with the retail industry.
At the other corner sits Boeing. Here, it is low-volume with a hi-margin. Nobody is going to mass produce huge airplanes; it literally takes several years from start to finish constructing an airplane. Quality control is a cornerstone of their business and even a little error can cause huge repercussions. They could go to the low-volume low-margin section but the overhead costs would cause the company to lose money. If this happens, they would go out of business. Out of necessity, this type of industry exists using this model.
Some businesses lean more towards one of the four but may have elements of two of the business models within its structure. It isn’t as if every business has to fall distinctively within one of these four types. But some bleeding over exists between two of the types is rare not the rule.
The following sections below explain the four types of business models and provide examples of businesses that use this model. In addition, this article elaborates as why the model is successful in the respective industries and that no single model is absolutely the best.
Low-Volume, High-Margin Business Activity
An extreme example of this type of business is a shipyard. Imagine how long it takes to build an aircraft carrier. In reality, it takes a little over 8 years from start to finish. Prior to laying the keel, there are several years of engineering and material requisition requirements to build the carrier in an efficient manner. Then there is the construction period and the testing period before final delivery is made to the Navy. In effect, one product taking 8 years employing several thousand workers has to cover its share of the overhead and profit for the company. To do this, the final product may have hard costs of materials and labor that is half of the final price charged to the Navy. The bulk of the sales price has to cover all the equipment used, facility costs, general overhead, licensing (the government just doesn’t let anyone handle nuclear material), taxes, and a host of other costs to run a shipyard.
The following are more examples of low-volume, hi-margin businesses:
Large Companies
- Aircraft manufacturing – Boeing
- Heavy Equipment manufacturing – Caterpillar, Komatsu, Hitachi & Volvo
- Military Equipment manufacturing
- Large Industrial/Commercial Contractors – Bechtel, Fluor & Kiewit
Small Business
- Engineering Design/Build Companies
- Metal Fabrication
- Marine Fabrication/Construction
- Home Construction/Remodelers/Renovators
There are certain business attributes that force the industry to exercise this model. They are:
- Significant initial capitalization (financial, perseverance, and knowledge);
- Almost all work is project based and requires extended time periods to complete;
- Highly complex interactions and resource management;
- Little competition
Notice that in this model, although it is a low volume company, the term reflects the physical quantity, not the dollar value. Go back to the shipyard, an aircraft carrier is ONE item (low volume) but the sales price is nearly $8,000,000,000. That’s billions of dollars.
In small business, it is really the same concept. For construction, it is ONE house, but it is an expensive item. It is the only way that a company can cover the indirect and overhead costs associated with running a construction company.
Now on the flip side of this are industries that have high volume and high margins.
High-Volume, High-Margin Business Activities
Absolutely this is the preferred type of business model to have due to the contribution value both extremes bring to the company. But these types of companies are not as common and often have significant capital barriers to start operations. Mostly they are in the professional services industry such as law, accounting, engineering, and in some of the medical specialties. In general, the margins are in the 40 to 50% range. This is mostly attributable to variable costs as the primary cost driver. The following are some other examples of these types of businesses:
- Coffee Retail/Coffee Supply
- Software Manufacturing
- Entertainment (Music Albums, Movies, Videos, Games)
- Hospitality Based Businesses (Hotels, Motels, Golf Courses etc.)
An example of a large company with a high margin and a high volume is Apple. The I-Phones costs less than $450 to manufacture and get to market. Retail prices run in excess of $1,000 for the device. Apple sells nearly 100 million units per year. This is a rare business model that has driven the stock price off the charts.
This type of business model is ideal. Typically in these types of business models, the overhead and capitalization costs are higher than other models. This is mostly attributable to the development of manufacturing facilities, distribution systems and reliance on technology. In addition, competition is keen as others seeking to enter this type of business model seek the same high margins this model provides. In effect, lucrative returns create competition.
Another factor necessitating the high-margin requirements relates to higher than normal fixed costs. In many of these types of operations, fixed costs are recorded in the overhead section of the profit and loss report and therefore are not a function of cost of sales.
High-Volume, Low-Margin Business Activities
This type of business model is traditionally seen in the retail and other consumer based product businesses. The following is a list of businesses that use this model:
- Convenience Stores
- Gas Stations
- Grocery Stores
- Fast Food Restaurants
- Retail Outlets
- Transportation (Bus Lines, Distribution, Taxis, etc.)
- Service Based Operations in More Discretionary Income Dependent Areas of Business
- Nail Salons
- Hair Salons
- Massage Parlors
An interesting business attribute is the low capitalization threshold to enter the market.
One last interesting fact about these types of businesses; this is most common form of business in our consumer based society. This reflects several business attributes:
- Easy entry for small business;
- Low capitalization barriers;
- Low knowledge thresholds;
- Many support systems;
- Limited government compliance requirements.
In this type of model, the gross margin in absolute dollars is a direct reflection on volume. Competition is significantly keen. The best example of this are gas stations. In general, most gas retailers only have about an 18 cent contribution margin per gallon of gas sold. When the station down the street has his price 10 cents lower, he is really trying to garner market share that week.
By the way, the number one company in the world using this business model. You guessed it: Wal-Mart.
Based on this, you would think that it would really be tuff in your low-volume, low-margin business activity. Why would anyone get involved in that type of business model? Let’s find out.
Low-Volume, Low-Margin Business Activities
This one is the most interesting of all the business types. With low-volume low-margin operations the reader would wonder how on earth you would make a profit. Well, it turns out that there is another way to look at the equation. Less experienced business entrepreneurs always think in terms of margin as a percentage of sales. Experience and a little more sophistication teaches us that it is really about the absolute dollars. Which would you rather have?
- Sales of 200 units in one day at 18% margin or
- One unit at 13%?
Answer: It depends on the sales price. Assume that in A, the sales price is $7 per unit which means that we have sales of $1,400 and the dollar contribution margin is $252 (this is your high-volume, low-margin business model). OR in B, the sales price is $14,000 with a contribution margin of 13% which is $1,820.
$1,820 is superior to $252. What industries fall into the type of model? Typically your household goods and high ticket items follow this model:
- Auto Retail
- RV Dealerships
- Marine Dealerships
- Appliance Sales
- Jewelry and Luxury Goods Retail
These industries typically have higher overhead costs and compliance related costs. Since buyers of the product are rare, advertising becomes a significant portion of overhead costs. Just watch TV for half an hour and about a 1/3 of your commercials relate to the local auto dealerships trying to convince you they are the best.
The negative attribute of this model is the higher than normal risk associated with acquiring customers. Any reduction in market share can wreak havoc with the financial profitability of the business.
Summary – Types of Business Models
Some businesses will fall in the marginal areas of one or more of the models above. A good example is a furniture retailer. In general, furniture has a high margin with low volume. But many furniture outlets try to shift their model towards higher volume with lower margins; thus the constant bombardment of advertising from them with their endless sales.
Overall, each of the models described above works for particular industries. The shear nature of the industry forces their hand into the respective model. When you think about your pool of investments, which model is utilized? Combining economic wide forces with the respective business model allows the value investor and opportunity to appreciate the particular pool’s business characteristics and it sets the stage for calculating intrinsic value and the corresponding buy/sell points. In the next lesson, it is essential that value investors understand the number one force affecting investments – the Federal Reserve. Act on Knowledge.
The post Value Investing – Concepts of Economics and Business Models (Lesson 19) first appeared on ValueInvestingNow.com.
]]>The ideal method to maximize return is buying low and selling high at the right time with investments that have quick recovery time frames. Ideally, all the cash proceeds from a sale should be immediately reinvested into new opportunities. Often, this is not the case. When the respective markets such as the DOW, S&P 500 or the S&P Composite 1500 experience highs, it is difficult to find good quality investments at low prices. This is further hampered when a value investment fund has limited options. In order to provide ample opportunities for reinvestment of cash, value investment funds require at least five pools of industries and a minimum of 40 stocks. The ideal fund will have around eight pools of potential investments with no less than 60 potential securities.
The post Value Investing – Churning (Lesson 18) first appeared on ValueInvestingNow.com.
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Fast is fine, but accuracy is everything. – Wyatt Earp
Churning refers to agitating. It is commonly used with the dairy industry to refer to the process of turning liquid cream into butter. The churning process breaks down the fat membranes allowing the fats to join together. In effect, churning means to work the liquid into a solid. With investing, churning has two different connotations. The first is the more common negative connection to brokers getting their clients to buy and sell frequently in order to increase overall commissions for the brokerage. The positive connotation is rarely used and it refers to working one’s portfolio of investments to maximize overall return. That is what this lesson is about. How does a value investor work their portfolio to maximize overall portfolio return?
The ideal method to maximize return is buying low and selling high at the right time with investments that have quick recovery time frames. Ideally, all the cash proceeds from a sale should be immediately reinvested into new opportunities. Often, this is not the case. When the respective markets such as the DOW, S&P 500 or the S&P Composite 1500 experience highs, it is difficult to find good quality investments at low prices. This is further hampered when a value investment fund has limited options. In order to provide ample opportunities for reinvestment of cash, value investment funds require at least five pools of industries and a minimum of 40 stocks. The ideal fund will have around eight pools of potential investments with no less than 60 potential securities.
The current Value Investment Fund on this site has the following pools and respective stock selections within each pool:
. Real Estate Investment Trusts Insurance
Railways (Residential Rentals) Banks Fast Food Non-Health Care Military Contractors
Union Pacific Essex Property Trust Comerica Bank McDonalds Travelers Huntington Ingalls Industries
CSX UDR (United Dominion Realty) Bank of America Restaurant Brands AllState Lockheed Martin Corp.
Canadian National Equity Residential Wells Fargo Starbucks Progressive Raytheon Technologies
Canadian Pacific Avalonbay Communities JP Morgan Chase Jack In The Box Cincinnati Insurance Northrup Grumman
Kansas City Southern Mid-America Apartment Communities Fifth Third Bank YUM Brands Old Republic General Dynamics
Norfolk Southern Corporation American Homes 4Rent CI A Bank of New York Wendy’s L3Harris Technologies
. Dominos Pizza
. Shake Shake
This particular investment fund has six pools with 37 various stock selections. Even with this many selections, the Fund still has times where it holds large amounts of cash for extended periods because all of the respective opportunities are priced in excess of intrinsic value. The key is to have a large enough selection so that at any given time, one or more of the opportunities has a market price below intrinsic value allowing an investor to reinvest cash earned from the sale of securities. In effect, the cash is always invested and working to improve the overall fund’s return.
There are two key requirements to successfully churn an investment fund. The first is selection; i.e. ensure a diverse portfolio of opportunities such that at any given moment there are always opportunities to buy. Secondly, understanding how timing impacts returns on investment. When an investor understands how these two requirements interact with each other, an investor can take advantage of this knowledge and successfully manage and churn a good return (remember a good return means annual returns above 30%).
As always, a reminder is required here. Value investing is not about getting rich quickly, it is about creating a methodical buy/sell program that generates good returns year after year with very little, if any, risk associated with the capital invested.
Pools of Potential Investments – Selection
A common risk reduction tool with securities management is diversification. Here, the professionals discuss specific types of risk associated with actually owning the respective securities. The goal is to reduce volatility and correlation risks such that no one single investment will expose the owner to a significant loss. The results are interesting, with at least 18 different security positions, a portfolio manager reduces this risk by 90%. Having 30 different positions, improves risk reduction to 99%.
However, with value investing, the goal isn’t really volatility. After all, value investors are buying the the respective security at less than intrinsic value; therefore, the chance the particular investment will go lower and stay low for an extended period of time has already been practically eliminated. The risk value investors are seeking to eliminate is that with a portfolio of securities to choose among, that all the respective opportunities are all above intrinsic value. In effect, there are no opportunities to buy low. Value investors need one or more of these potential opportunities to drop below intrinsic value and acquire some margin of safety such that a purchase can be made to utilize excess cash. Thus, how many stocks must exist within the selection pool such that there will always be opportunities to buy and therefore the portfolio rarely has cash which earns a pittance return in comparison to capital gains.
Simply stated, how many different securities must exist in the overall portfolio such that there is ALWAYS an opportunity to buy low. Thus, when a sale of an investment is made, the cash proceeds are immediately reinvested in a new opportunity.
Furthermore, the ideal situation provides more than just one or two opportunities to buy. Value investors want to see several potential investments below intrinsic value such that one or more of the securities provides a greater margin of safety when purchased. Then the value investor reinvests with the security with the greatest potential to recover quickly and earn an outstanding return on the investment. The end result is constant agitating of the portfolio to maximize overall return for the portfolio.
So how many potential investments must exist to always have continuous opportunities to buy? Remember, value investors are only interested in the top 2000 publicly traded companies and all of them must have good histories of operations and earnings. With top corporate operations, the market rarely allows the securities’ price to drop below intrinsic value. Thus, these attributes make it difficult to find opportunities to buy low.
If a value investor could, obviously having two thousand plus opportunities is ideal. This would indeed provide continuous occasions to buy low such that the cash will always be at work. However, it is unrealistic. It takes about 20 to 30 hours of work during the initial phase to learn about an industry and then another eight to 10 hours to analyze each potential member within that pool. Once the initial work is completed, it takes about four to eight hours per year to maintain the analysis for a pool of five to eight members. In effect, it requires about five hours on average per year for each potential investment to conduct initial analysis and then maintain that analysis. If a value investor has a pool of 50 possible individual securities, then on an annual basis, this investor would need to spend around 250 hours of work to maintain the analysis necessary for intrinsic value, margin of safety and of course market recovery price.
To make matters worse, 50 possible individual securities would mean about seven to nine pools of investments (six to ten potential stocks in each pool). Learning about and understanding seven to nine industries will add another 200 hours of work per year.
The end result is that it is ideal to have several hundred potential investments with their respective value points (intrinsic, buy and sell); but, it is unrealistic to think that any single individual can realistically expend the resources necessary to develop and maintain such a diverse portfolio of pools of industries and of course each pool’s individual members.
What is the minimum required?
Based on experience and some supporting input from Graham and Dodd (Security Analysis), a value investor needs at least 60 potential investments spread over no less than eight pools of industries. The only possible way to have such a diverse portfolio is if the value investor participates in a club whereby each member establishes and monitors a single pool industry and provides the information to fellow club members. This in turn, allows all members access to a diverse portfolio of pools of industries and a broad base of potential investments.
Churning with value investing is the ability to maximize returns to the maximum extent possible. This requires a large pool of potential investments. Not only is a wide selection pool required, the investor must select those available investments that have faster recovery time frames over those with longer recovery periods.
Churning – Timing of Investments
Churning refers to continuous utilization of cash into investments with the best recovery cycle such that the entire investment portfolio is growing at the fastest rate possible. In order for this to be possible, a value investor must be able to time the purchase at a low point below intrinsic value. In addition, preference must be given to those investments with faster recovery time frames over investments with slower or extended recovery periods. Thus, timing involves buying at a low price and giving preference to those potential investments with faster recovery cycles. Each of these two attributes are explained further.
Buying Low
Value investing uses the term ‘Margin of Safety’ to refer to buying the security at a good price. Margin of safety is typically a percentage of value below intrinsic value. Of course, intrinsic value is the securities’ real value, i.e. the maximum value which a reasonable investor would pay to own the respective rights the security provides. In effect, intrinsic value is a ‘Fair Value‘ for the investment. When a value investor purchases this investment for less than intrinsic value, it affords additional risk protection that the particular investment’s market price will go lower and/or stay below this price for an extended period of time. Think of margin of safety as an insurance policy.
Margins of safety are calculated depending on several attributes. Companies with strong current asset weighted balance sheets have a lower margin of safety because of the liquidity afforded current assets over fixed assets. Liquidity refers to the ability to unwind the business in a reasonable time frame. Whereas fixed asset intensive operations require deeper margins of safety due the market’s understanding of fixed assets and the unease of turning a fixed asset into cash. In effect, it takes much longer to liquidate fixed assets over current assets which in turn requires a greater margin of safety when buying fixed asset intensive companies.
There are other contributing factors affecting margin of safety, they include:
- The Respective Industry
- The Industry’s Financial Model
- Economic Factors (Inflation, Interest Rates, Unemployment, GDP, Growth, etc.)
- Federal Compliance and/or Restrictions
With this site’s Value Investing Fund, the following pools have these respective margin of safety ranges:
. Pool Balance Sheet Margins of Safety Range
Railways Fixed Asset Intensive 9% to 19%
Fast-Food Mixed 5% to 35%
Banking Current Asset Intensive 4% to 14%
P&C Insurance Current Asset Intensive 3% to 8%
REITs Fixed Asset Intensive 8% to 18%
Military Contractors Fixed/Intangible Intensive 5% to 12%
Overall, current asset intensive pools start with lower margins of safety and tend to top out with a margin of safety that will rarely exceed 15% to intrinsic value. Whereas, fixed asset intensive models start out higher and top out at more extremes to intrinsic value. This reflects risk associated with liquidation of assets. The greater the risk to liquidate in a shorter window of time, the more important it is to reduce this risk by increasing the margin of safety.
Thus, when buying low, the value investor should wait until the margin of safety price is reached by the market prior to purchasing the security. As an example, Union Pacific’s intrinsic value is currently $197, the Railways Pool has determined that an appropriate margin of safety for Union Pacific is 9% or about $18 against intrinsic value. Therefore, Union Pacific’s current buy price is $179 per share. The risk the price will drop lower than $179 exists, but as the price continues to drop, other forces kick in to minimize its continued downward spiral. For example, the dividend yield at $165 per share is 2.85% which is extremely strong. At $150 per share, the dividend yield increases to a rarely found 3.15%. Furthermore, the deep selloff of Union Pacific during the mid February to late March 2020 driven by the COVID pandemic identified a maximum market price reduction for this company of around 37% against its prior peak market price. Again, this sudden price drop was against current market price which had just recently reached the highest ever recorded for Union Pacific just prior to this drop. Thus, buying Union Pacific at a 9% discount against an intrinsic value which is commonly much lower than the market value provides adequate protection against a market price that will continue to drop dramatically lower than this preset buy price and acts as a very defensive position that this deep discount price will stay low for an extended period of time.
The idea of buying at such a low price is one of the four principles of value investing. The buying low is the best risk reduction tool available to any investor. In addition, buying low generates greater returns once the security is finally sold. To create great disparity between the buy price and the sale price begins with buying low. The lower the buy price against intrinsic value, the greater the absolute return on the investment once it is sold.
One last note related to buying the security below intrinsic value. With a typical portfolio of 60 to 80 potential investments, only about two to three investments will be at these low prices. Remember who we are talking about here. These are top 2,000 companies with very stable history of earnings and performance. There may be other driving forces that may have more than three out of 80 potential investments whereby the current market price is dramatically lower than their respective intrinsic values. These include economic recessions/depressions, industry wide issues (new federal compliance requirements, resource availability, consumer attitude towards the industry’s product/service, and/or competition). But the more common scenario is only two to three out of 80 potential investments. Thus, which one does the investor choose to buy low?
Recovery Time Frames
The second attribute of timing related to churning of one’s portfolio of investments is the recovery time period. This is the common time frame for a company to have its securities’ market price recover to a prior peak price. Obviously, the shorter the time recovery period, the greater the annual return on the investment. This is key for any churning function of any portfolio. Ideal recovery time frames are three to six months. Some investments will have longer recovery time frames, in some cases up to three years.
Thus, preference is given to those potential investments with shorter recovery time frames allowing the investor to sell upon recovery and begin the churning process all over again with this new inflow of cash into the portfolio.
As an example, here is the Banking Index over the last three years. Notice the time period from one peak to the next. Once the stock is purchased as some point within that cycle at a deep discount to intrinsic value, the recovery time frame is anywhere from two months to nine months. As an example, if an investor bought banking during March of 2020, they would have and to wait until early February of 2021 to sell their investment and reap their reward. This was eleven months, which is slightly longer than the expected nine months maximum. It doesn’t change the absolute dollars earned, it only changes the annual return on the investment due to the longer time frame to complete the recovery cycle.
Other industries take much longer to recover. Look at military contractors:
With military contractors, recovery time frames are much longer; short time frames are about one year and extended time frames are just longer than two years.
As a value investor, each investment will have its own recovery time frame. Give preference when buying to the investment that has shorter recovery time periods over those with longer recovery time frames.
In the sophistication phase of this program, the value investor learns about how to calculate the various inclines found with a security’s market price. Those investments with steeper price declines and recovery periods are given greater preference over those with shallow inclines.
The reality for the attribute of recovery is that as value investor, you will rarely have to address this as a part of your decision model. Odds are that you will only have one potential investment in your portfolio of investments to invest excess cash. Without a large portfolio of at least 60 or more potential investments, most likely you will not have anything available when you have excess cash to churn. If your portfolio of potential investments is less than 30, it is very likely you will have to sit on cash for extended periods of time while waiting on the market or a particular industry to falter providing the value investor with an opportunity to buy low. Remember, value investing’s fourth principle, patience.
Summary – Churning
With value investing, churning refers to maximizing the use of cash in the portfolio. To properly churn the investment portfolio, the value investor must always have one or two investments waiting for the cash investment. In order to to do this, the portfolio of potential investments must be vast and diverse. A typical portfolio of 60 or more potential investments will customarily provide two to three opportunities to buy low. If this exists, the value investor will always prefer the investment with the shorter recovery period for market price recovery. The key is to maximize the overall return of the portfolio by having as much cash invested as possible and optimizing the portfolio by selecting securities with faster recovery time frames. Remember the primary tenet of business, buy low, sell high. Act on Knowledge.
The post Value Investing – Churning (Lesson 18) first appeared on ValueInvestingNow.com.
]]>The post Value Investing – Monitoring Performance (Lesson 17) first appeared on ValueInvestingNow.com.
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I think it is an immutable law in business that words are words, explanations are explanations, promises are promises – but only performance is reality. – Harold Geneen
Monitoring performance is the single best tool to ensure success with value investing. Comparing results against expectations provides the basis for good decisions. In business, this is known as the feedback loop. In effect, a variable input is changed, results are recorded, compiled and reported in a understandable format. Any unexpected results are analyzed and input changes are implemented. The pattern is repeated. The end goal is to generate continuous improvement. With business, improvement is stated in the form of profit; with investment funds, it is stated in the form of percentage of return on the overall invested capital. Thus, managing an investment fund is just like operating a business; the goal is to improve overall performance.
Throughout this series of lessons in Phase One of the program, it has been stated and reiterated several times. The goal of value investing is to generate returns that far exceed the returns of several indices. A value investor should expect at least a return on their investment in the mid-twenties as a percentage per year. The real goal is to generate 30% plus with returns. If the investor does their research properly and adheres to the four principles of value investing, achieving 30% plus per year on average is doable. But without monitoring performance of the fund, an investor cannot make the necessary timely adjustments to achieve the annual goal.
There are three different levels of monitoring with an investment fund. The primary level includes the decisions and status of the respective buy and sell points for each transaction within the investment fund. Here, the goal is to ensure that each respective company level purchase is adhering to the respective parameters of their pool’s buy/sell model. How is each position performing? The next level is at the pool level. Similar to the respective investment level activity; at the pool level, the goal is to understand how the pool is performing against the initial conception for the upcoming period of activity. Is the pool of similar investments complying with or meeting the goals set at the beginning of the investment year?
The final level is for the fund as a whole. Here, the idea is to understand how each of the respective forms of realized earnings is performing against total earnings (realized and unrealized). Furthermore, it is important to break down progress against anticipated areas of anticipated revenues including dividends, options and finally gains from the sale of actual securities.
Throughout this lesson, the investor will refer to this spreadsheet to understand how this works. If you are a member of this site’s program, the spreadsheet is a simple download using your password. For those readers that are not members, you will have to refer to the screenshots provided along with some examples included here in the lesson. The key is that the formulas are built into the spreadsheet for members making it a lot easier for them to understand and to use this spreadsheet for their own personal purposes.
Monitoring Performance – Primary Level of Data
With value investing, it all starts out with creating the industry model. This table of information provides the basis for the buy and sell decisions an investor will set as the standard of performance. The model itself has it own set of building blocks which are covered in Phase Two of the membership program. Those building blocks have their own respective concepts, formulas and spreadsheets to use. Those resources are provided with their respective lessons.
The value investment industry model is the outcome. This is the guidance piece of the overall puzzle. To illustrate, here is the railways pool model. There are six publicly traded railways in North America. Each has their own current market price, book value, and intrinsic value. Review all six for these respective dollar amounts.
This fund model has several interesting key points.
- At the time of this lesson creation, every single one of the potential investments in the railways pool is at or near their historical peak price. This lesson was written in late March 2021, thus the Prior Peak Price column actually reflects current market prices for the individual companies. More interesting is that on Monday the 22nd of March, Kansas City Southern jumped another $25 per share do to an announcement by Canadian Pacific to buy and merge with Kansas City Southern. Even as a combined company, their volume of revenue ton miles will still be less than one-half of Union Pacific. This is why Union Pacific is marked as the standard bearer.
- Market price on 10/22/2020 indicates the market price as of the start of the fiscal year for this respective pool of potential investments. Prior peak price merely represents the most recent peak in price for the stock during the current fiscal year.
- Optimum buy price is the current year’s desired purchase trigger. The optimum buy price reflects the margin of safety desired from intrinsic value.
- Intrinsic value in the railways industry is calculated using a modified discounted cash flows formula (covered in Phase Two of the program).
The model is the most important part of the industry pool. When developing the model, the investor typically discovers patterns about the individual companies and uses those patterns to finesse the model. In this case, this particular pool of investments typically have excellent results. The problem is that having opportunities to purchase low occur infrequently. Over the last two years, a total of seven opportunities to buy low have existed. Each opportunity was recorded and every single one of them performed greater than than the model predicted.
To date, in Fiscal Year 2021, there have been two opportunities to buy low, both transactions generated outstanding gains. Look at the results:
Notice how the annualized return for Norfolk Southern far exceeded the expected annualized return the model sets. Norfolk Southern’s transaction far surpassed the expected due to its short turn around time of only 13 days. Union Pacific’s transaction almost hit the usual 90 day recovery and this is why its annualized return was only slightly better than what was projected at that time.
One last note, Norfolk Southern’s purchase at $202.49 per share was only at about 1% margin of safety and not the desired 10%. The investment pool manager decided to make the purchase just under intrinsic value because there were no holdings at all during this last week of October. The pool had not held a single investment in over a month. Once one of the potential investments finally had a share price below intrinsic value, the pool’s decision maker decided that owning Norfolk Southern for a smaller overall projected gain was worth the risk. Furthermore, four of the other potential investments were indicating recovery which meant that the likelihood of Norfolk Southern continuing to decline to the margin of safety buy price was unlikely. It turns out that Norfolk Southern’s share price only dipped to $198 before it rebounded and cleared its prior historical peak. Thus, intrinsic value is the worst case scenario to buy the respective potential investment.
With each full transaction (buy and sell), the pool’s overall value should begin to increase. In addition, any investment currently in a ‘hold’ status waiting on recovery after purchase requires monitoring. Thus, a second level of monitoring is required. This is the industry pool level.
Monitoring Performance – Industry Pool Level
At the pool level, monitoring performance is about tracking the status of the respective investments in that pool. The current status is compared against the goal. The idea is to understand how the pool stands in relation to the overall objective. When the investment is made for a particular member of that pool, it is then included in a current portfolio of investments and updated weekly to identify progress towards the projected recovery point.
To illustrate, here is the report for the Real Estate Investment Trust Pool of this site’s Value Investment Fund.
Take note of what this report reveals:
- The pool’s current cumulative value is well ahead of schedule, it is currently five months complete and all of the respective investments are either on schedule or ahead of schedule of their respective target earnings. For example, with four months to go, Equity Residential is tracking almost in-line with the desired outcomes. This is a reflection of the quarterly reports. There are two more quarterly reports to go before then end of July 2021. It is conceivable that the market price will hit the target price of $81 per share when the 1st quarter report for 2021 is posted at the end of April 2021. If that report identifies normal earnings, then the market price will soar. If tenant payments are still an issue tied to COVID, then the price will not hit that target price of $81 until after the 2nd quarter report.
- If all investments hit their respective targets by the respective goal dates, the respective return on investment will exceed 52% not counting dividend earnings during this period.
To augment the current status report, a second report is also included on the same page in the spreadsheet. Dividends earned and expected during the holding period are quantified and reported. This is an example of the report for the REITs Pool.
Take note, already fiscal year-to-date the REITs Pool has earned $666.66from dividends and is expected to earn another $1,711.96 if the respective investments are held through their respective anticipated recovery dates.
Add this cumulative $2,379 to the anticipated gains and this set of investments should earn a cumulative $39,224, a 56% return on the $70,000 basis. This is well in excess of reasonable return guidelines for value investors.
The pool is tracking very well towards it end goal. By Mid-April, the first quarter dividends will post, adding another $666.66 to realized returns.
Remember, dividends are not the primary purpose of value investing. It is about earning respectable gains within a reasonable period of time. Dividends are just icing on the cake. Overall, auxiliary sources of income such as dividends, interest and the sell of PUTs typically increase the return about 10% above gains. Thus, if a fund earns a total 35% return in one year, about 3.5% is sourced from these auxiliary sources. Gains will typically represent about 90% of the total return over time.
The final level of reports sums up all the respective pools onto one tab in a spreadsheet.
Monitoring Performance – Investment Fund Level
At the investment fund level, the format is a summary presentation of each of the individual pool’s current status tied to the existing investments. In addition, a second section reveals realized gains from each pool. A third section identifies the auxiliary forms of earnings fiscal year-to-date including dividends, sales of any options and interest. The summary line indicates total unrealized gains, realized gains and current balance of the investment fund. This section of the investment fund level will also identify the current positions along with any dividends receivable and cash balance.
The following is an illustration of how this site’s Value Investment Fund is presented to members for learning purposes.
VALUE INVESTMENT FUND
Status Report – 03/24/2021
Current FMV Unrealized
Industry Pool Investment Basis Net of Fees Gains/(Losses)
Railways -0- -0- -0-
REITs $70,000 $92,214 $22,214
Banking 40,000 41,889 1,889
Sub-Totals $110,000 $134,103 $24,103
Realized Gains
Railways $7,298
Banking 3,677 Realized
REITs -0- Earnings
Sub-Total $10,975
Dividends Earned
Railways 204
REITS 667
Banking 409
Sub-Total 1,280
Sale of PUTs
Railways 3,361
Sub-Total Realized Earnings Fiscal Year-To-Date $15,616
Receivables (Dividends/Broker Amounts) -0-
Cash Account 5,617
CURRENT DOLLAR BALANCE – VALUE INVESTMENT FUND $139,720
INITIAL INVESTMENT BASIS 10/22/2020 $100,000 $39,720 (Realized & Unrealized Gains)
When reading this report, remember, realized earnings are reinvested into other potential securities. In this, $10,000 of the earnings have been reinvested as the cost basis up in the industry pools section reveals a current cumulative investment of $110,000. The Fund started out with $100,000. The difference is in the form of cash; with most reports the difference will be in the form of receivables and cash.
Thus, this fund has increased in value by $39,720 through the first five months of activity.
Summary – Monitoring Performance
Monitoring performance of a value investment fund is essential for several reasons. First, it is important to compare results against the designed buy/sell model for each respective industry pool. Secondly, understanding the current fair market value of each industry pool and the dollar value of each holding within that pool allows the investor to understand how the respective investments are tracking against the goals set forth. Finally, an overall picture informs the investment fund manager about the current status of the fund overall, where it has earned its gains and other sources of net realized earnings. This allows the investor to compare the fund’s status against the respective goals set out at the beginning of the year. Act on Knowledge.
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“Money makes money. And the money that money makes, makes money.”– Benjamin Franklin
Every student of investing is taught the core principle of discounted cash flows. This business principle is also used with intrinsic value. Application of discounted cash flows assists value investors with determining intrinsic value. Academia, major investment brokerages and the majority of investment websites place unquestionable belief in this single formula to equate value for a security. The problem is that all of them forget or ignore the underlying requirements to use and then, rely on the outcome of the formula’s solution. In effect, with intrinsic value and the application of discounted cash flows, there is a very narrow set of highly defined parameters whereby this tool is applicable and useful. Used outside of this framework, the result’s reliability quickly drops to nearly zero, similar to how the bell curve moves from the most likely outcome in the center to extremes on either side.
Look at this bell curve. Application of discounted cash flows can produce an excellent solution contingent on NO or limited deviation from the norm (the highest point in the curve). This article starts out by identifying the highly restrictive requirements to apply discounted cash flows. There are at most 20% of all marketable securities where this formula succeeds in determining intrinsic value. Secondly, the formula is explained to the investor and why it is so important to apply it properly. There are several terms and values the user must include in the formula; this section explains them in layman’s words.
The third section below goes into the corporate financial matrix to explain how to determine cash flows. Furthermore, cash flows are just not the past year or years; it is really about future cash flows. How do you equate value from an unknown variable well into the future?
The final section puts it together when determining intrinsic value. Unlike what others state, intrinsic value is not a definitive value; it is a range. The job of the value investor is to narrow that range to a set of values that are reasonable and effective with generating gains with the value investor’s mindset of ‘buy low, sell high’.
The overall goal of value investing is to buy a security at less than intrinsic value, commonly referred to as creating a margin of safety; then waiting for the market price to recover to a reasonable high and then selling that security. The depiction here illustrates this concept well.
The most popular method to determine intrinsic value is the discounted cash flows method. Experts espouse this tool because it is advocated in the book Security Analysis written by Benjamin Graham and David Dodd, the fathers of value investing. However, most so called experts didn’t read the entire book. Graham and Dodd only used this method under certain conditions. The same conditions as explained in the first section below. They strongly encouraged calculating intrinsic value from the assets valuation perspective (balance sheet basis) and not as a function of earnings plus cash adjustments (cash flow). What so called intelligent professionals fail to recognize and embrace is that the discounted cash flows method is only used under a limited set of parameters. The discounted cash flows method is taught in every business major and is most commonly used with the finance (banking) degree. The bleed over into investing propelled this formula to the forefront of investment lingo because it appears to resolve several complex needs. The reality is utterly different. The following section goes into detail about this particular finance algorithm and the restrictive set of conditions with which to apply the formula.
Discounted Cash Flows – Highly Defined Set of Parameters
In the perfect world, there is no inflation, there is no cost of money and a particular investment would return the exact same amount of interest year after year without risk; without failure to continue; with constant demand by the market for the product and no deviations from performance. It is simply flawless. Here, one can easily determine the return on one’s investment; it is simply the cumulative sum of all future earnings in the form of cash less one’s investment.
As an example, a farmer is selling you a goose, yep, the one that lays a golden egg every day and the goose never dies. The farmer is just tired of watching the goose. You agree to buy it for $10,000. The market never changes, the egg weighs exactly one ounce and the goose produces one egg a day forever. Gold prices never change, gold is $10 an ounce. Thus, after one year, you earn exactly $3,650. Each year after, you earn another $3,650 and this goes on forever. As stated above, the conditions are perfect:
- The goose requires no maintenance;
- The goose will live forever (doesn’t get run over, doesn’t runaway, nor gets eaten by a predator);
- The goose is never stolen;
- The goose requires no food, no water; just sits there and lays an egg a day;
- Gold prices stay exactly the same, $10 for an ounce;
- There is no inflation;
- Every egg is exactly one ounce of pure gold;
- There is constant demand for gold;
- Life is good.
Well, this investment seems easy to calculate. After 3 years, you have earned $10,950 and you’ve gotten your original investment back plus some. Now, the investment will just continue to provide you with $10 a day for the rest of your life, your children and grandchildren’s lives. This is just too good to be true.
Notice how unrealistic this really is. First off there is inflation! Because inflation is the number one issue with lending money, an investor has to take this into consideration. Buying a security is very similar to lending money. Financial resources leave your pocket and in return you get a piece of paper with a promise to pay or some type of rights to control the outcome. This desired payment whether as interest on a bond or as a dividend for stock is the return on the investment you crave. This so called return will not happen immediately. You will receive these incremental payments over time. Thus, inflation decreases the value of each incremental payment. Assuming each incremental payment is equal and inflation is nominal, the payment received 30 years from now will be almost half in comparison to the first payment you will receive. A simple annual inflationary rate of 2% means that the payment received 30 years from now is only worth 55 cents on the dollar. If the inflationary rate is 4%, the value of that future payment drops to 31 cents on the dollar.
This is what the discounted cash flows is referring to when talking about making an investment. Again, all other parameters are perfect; its just inflation you need to consider.
This too is unrealistic. Other factors come into play. Now the formula starts to get more difficult to calculate. The most obvious is that the core formula assumes the cash payments are equal. The market doesn’t work that way. With bond payments, yes; with dividends, the answer is no. Dividends are constantly changing. Value investors only consider high quality, top 2,000 companies to invest with; these companies have continuously improving dividend payments. With most, dividend payments almost double every ten years. Now, there is a new dynamic brought into the formula. Not only do we have to discount the cash flows for inflation, but the cash flows are not even throughout the life of the investment.
For the discounted cash flows method of determining value to work well, it assumes a highly defined set of restrictions including:
- The discount rate is stable throughout the life of the investment;
- Cash inflows (periodic payments) are positive and predictable;
- There is a high degree of certainty for future cash inflows;
- The investment is pure, i.e. little to no chance of default (bankruptcy, insolvency etc.).
There are only so many publicly traded securities that meet this criteria. Immediately, any reasonable investor would automatically eliminate penny and small-cap investments. These types of investments are tied to young growing companies. It is highly unlikely that the discount rate will remain stable even in the short-term forecast (next three years). Any new product or service this company provides is unpredictable related to market acceptance and more importantly, competition. It is nearly impossible to state with a high degree of confidence that there will be future net positive cash inflows for this company. The simple truth of the investment is that companies that fall within this market capitalization spectrum have a much higher degree of default both in the form of bankruptcy and almost certainly at times, insolvency.
Middle capitalization companies are in a much better position than penny and small caps. However, they lack the one key element with exercising the discounted cash flows formula – stability of earnings. Only high quality, top 2,000 companies can demonstrate a long history of continuous positive earnings. It is from earnings that an investor begins the necessary adjustments to determine cash flows. This is explained further in the third section below. The key for the investor is that the discounted cash flows method to determine value is only effective with top notch corporations. The required attributes include:
- Large market capitalization based companies, in general, the top 2,000 companies; this supports the attribute of longevity of existence into the future (the goose will live forever).
- Highly stable history of positive earnings demonstrates the ability to produce cash; think of the goose laying the golden egg each day.
- The company produces goods/services that will remain in demand by consumers for the foreseeable future; this matches the attribute of demand for gold.
Even out the top 2,000 companies, a recognizable portion are unable to demonstrate these three required attributes to apply the discounted cash flows tool. A perfect example is Tesla. Tesla lacks history of earnings and secondly; Tesla has competition and therefore it is difficult to have a high level of confidence that there will be demand by consumers for its vehicles six to seven years from now. To further validate this, General Motors recently announced its intention to develop and sell electric autos starting in the mid part of this decade. This will eat into Tesla’s market share of the electric car market. The novelty of owning a Tesla has worn off.
The above attributes can be summed up as follows:
- Security – low risk companies
- Positive earnings
- Stable and desired product mix
For those of you that are savvy investors, the attributes mirror those attributes used with the dividend yield theory. The difference is that value investors are not buying solely for dividends, they are buying low to ultimately sell high in the near future, generally within two years. The dividend is just an additional benefit. The real value is the growth in the market price for the respective security.
If the attributes exist to apply this formula, then the investor needs to understand the formula’s two most important elements.
Discounted Cash Flows – Formula Analysis
The discounted cash flows formula is straightforward. How much is a certain set amount paid in a given period in the future worth today? If the payments are made as a stream over several periods of time, the net result is the cumulative sum of each individual period.
All the periodic payment periods are spaced equally apart, like a month, a quarter or a year. Each successive period has the discounted rate raised by the power of that period. Therefore, the formula is:
Discounted Cash Flow Value = Cash Flow Period 1 PLUS Cash Flow Period 2 PLUS Cash Flow Period 3 PLUS …
. (1 + Discount Rate)¹ Power of One (1 + Discount Rate)² Power of Two (1 + Discount Rate)³ Power of Three
The impact of time reduces the value of a future payment significantly. Look at the following table for a payment of $100 per year over 15 years given four different discount rates.
Period 2% 3% 5% 8%
1 $98.04 $97.09 $95.24 $92.59
2 96.12 94.26 90.70 85.73
3 94.23 91.51 86.38 79.38
4 92.38 88.85 82.27 73.50
5 90.57 86.26 78.35 68.06
6 88.80 83.75 74.62 63.02
7 87.06 81.31 71.07 58.35
8 85.35 78.94 67.68 54.03
9 83.68 76.64 64.46 50.02
10 82.03 74.41 61.39 46.32
11 80.43 72.24 58.47 42.89
12 78.85 70.14 55.68 39.71
13 77.30 68.10 53.03 36.77
14 75.79 66.11 50.51 34.05
15 74.30 64.19 48.10 31.52
Totals $1,285 $1,194 $1,040 $856
If you study the table and look at the graph, there are several important aspects of the discount rate that an investor must understand in order to give the discount rate its proper respect. First off, as the discount rate increases, the end results decreases. Furthermore, the longer the time frame involved, the lower the value each extending period out produces for the investment. In effect, what this table and graph illustrates is that a $100 per year cash inflow for 15 years will return $1,500. However, depending on the discount rate involved, the value of that $1,500 is going to be only effectively worth so much today.
To illustrate, assume a company proposes to sell its bond to you for exactly $1,000 of value. In exchange, you will receive exactly $100 per year for 15 years. There is no terminal payment; just a flat $1,500 in equal installments. Remember, this bond must meet all three ot the criteria to qualify to use the discounted cash flows method when evaluating an investment. First, it must be a secure investment (assume its a Walmart Bond). Secondly, the company must have a history of positive earnings; Walmart qualifies for this particular required attribute. And finally, the company provides a highly desired product mix; Walmart fits this attribute too. Thus, this investment offer meets all the required criteria as a solid investment.
Now the question is – What is my discount rate? Looking at the table above, if you use 5% as the discount rate, it means you get $1,040 of value over the course of 15 years. Since you are paying $1,000 for the investment, you are technically increasing your wealth by $40 over this 15 year time period.
As an alternative, the bank is offering to pay you 4% interest per year on a $1,000 Certificate of Deposit. This means that over 15 years, you will receive $1,400 ($1,000 of principal and $400 of interest). Whereas with the bond, Walmart is willing to give you $1,500 over the same time period. Thus, the discount rate with the Walmart bond is slightly more than 5.5%.
The key for the investor is that the discount rate is your personal desire for a rate of return on an investment. If your personal rate is 6% return, then the bond isn’t worth $1,000 up front; you are forced to offer a lower value for the rights to receive $100 per year for the next 15 years. It turns out, at 6%, you are willing to pay $971.22 for the rights to the $100 annual payments. This doesn’t mean the seller, in this case Walmart, will accept that; what it means is that the two parties are close. Walmart is willing to pay 5.5% interest and the buyer wants 6% interest. If another investor is willing to accept a 5.5% return on their investment, then Walmart will sell to the other party. This is supply and demand.
This is the exact same relationship with any security in the market. How much are you, the buyer, willing to pay to own a certain set of rights? The most coveted right is a financial reward for your investment. With bonds, investors want interest and of course the original principal back. With stocks, investors want both dividends and an increase in value of the market price for that stock. The right to vote your shares have little to no value for the common stock trader.
In order for the market price to increase, other buyers in the market must be willing to pay more than you paid for the same stock certificate. There is only one way this is going to happen. The company must be growing which in turn creates desire with other investors. The industry is stable and the economy is not in a recession. Growth is defined as continuously increasing earnings.
Don’t forget, time with the discounted cash flows formula works against value. The further out the cash inflows are received, the lower the overall worth of that respective inflow. Go back to the table, look at the 8% column and go out 15 years. With a discount rate of 8%, the $100 payment is only worth about 32 cents on the dollar. Time is of the essence with the discounted cash flows formula.
For value investors, what they seek to do is to set a low buy price for a particular security. They also want some assurance the particular security’s market price will increase in a reasonable period of time in order to sell this security at a higher price and earn gains. The discounted cash flows formula is used with certain types of companies because it can effectively provide a comfortable buy price if the discount rate is tolerable by investors. The key is that the value investor’s discount rate must be higher than the market’s tolerated discount rate. This allows the value investor to buy the security at a lower price and then sell this security in a market that believes a lower discount rate is reasonable and acceptable. This part is explained in more detail in the final section below. For now, the investor wants to know how do you determine cash inflows? What exactly are cash inflows?
Discounted Cash Flows – Corporate Cash Flows
In the last section, emphasis was placed on both the discount rate and the period of the investment. But the formula has another essential element necessary to equate a final value – cash inflows. If you asked 20 professionals to define cash flows for the discounted cash flows formula, you will get 24 to 30 different responses. There is no single correct answer; there are good answers and poor responses.
At one end of the spectrum of responses, an investor will tell you that the only cash inflow that counts with the formula is the actual cash the investor receives, i.e. dividends and the proceeds from the final sale of the security. Is this the appropriate outcome for cash flows in the formula?
At the other end of the spectrum, a professional investor will state that cash inflows equals earnings net of taxes, plus depreciation/amortization and any other non-cash adjustments. This is commonly referred to as cash flow from operations. The thinking here is that this cash flow covers both reward to the shareholders and any remaining cash is used to maintain or expand the company’s operations which ultimately benefit shareholders as growth results in greater dividends in the future.
If you look at how profits are typically used, they are used for four different purposes:
- Pay dividends to shareholders (this is the preferred outcome for most stockholders);
- Expand operations by investing in new property, plant and equipment and/or research and development;
- Reduce debt; AND
- Set some money aside for adverse economic conditions that may arise in the future.
Other investors will take a more conservative approach than the extreme position of cash flow from operations and state that cash inflows equals cash flow from operations less the amount necessary to keep the company in the same economic position as it started at the beginning of the year. In effect, it equals cash flow from operations less investment in property, plant and equipment. This particular point along the cash inflows spectrum is referred to as ‘Free Cash Flow’.
The best answer the author has researched and agrees with is that cash flows equals actual value a shareholder will receive whether immediately in the form of dividends AND/OR via growth of the company in the future. The key is that growth is different for each industry. Some industries are expanding at phenomenal rates (think of geriatric care, home health and mining) and others are contracting, i.e. in decline (coal, paper information such as periodicals, newspapers etc.). Thus, any retention of profits to fund expansion has a different return on that investment depending on the industry’s position in the economy. Invariably, any dollar retained is not going to grow at a rate a dollar in the hands of the investor can earn via reinvestment. In effect, the discount rate for retained dollars must be higher than the discount rate an investor would use with actual cash received in the form of dividends or interest. The end result is a highly complex formula to derive a current value for cash inflows.
Fortunately, the very restrictive nature of the formula’s requirements eliminate industries in decline; remember, one of the required attributes to apply the discounted cash flows formula is a strong and desirable services/product mix for the investment under scrutiny. For the investor, growth from the respective retained earnings will never match the return on reinvestment from immediate cash returned to the investor (dividends and interest); thus, utilize a slightly higher discount rate to compensate for this dampening impact growth has with retained dollars.
Thus, a good answer to determine cash inflows is as follows.
Cash inflows equals net earnings adjusted for:
-
- Unusual or extraordinary events (most often losses) net of the respective tax effect from the event;
- Adding back depreciation/amortization;
- Less a reasonable reinvestment into existing property/plant/equipment to maintain the company’s respective position in its industry; AND
- Less a reasonable investment to expand the company’s position within its industry.
This formula almost mimics free cash flow as commonly defined by academia. It is different in that there is an additional deduction to fund growth. This additional dampening value reduces cash inflows with the formula and ultimately the net present value of those inflows. In most cases, this dampening value approximates 20% of average depreciation from the most recent three years.
The key to making this work is to use the average earnings adjusted for the respective four items above from the last seven years. If the company is growing, there will be an average growth determinant from this history. This growth rate is used for determining future inflows over the next five years. In addition, to keep the formula straight forward, the sixth iteration is the projected cash inflow for the sixth year times a factor of 20 discounted back to today’s dollars. This way, the investor doesn’t have to project out for another 20 years. The core intrinsic value outcome using the discounted cash flows method has marginal contribution beyond 25 years, go back to the table above, the results are dropping by more than 3% per year after 15 years. Thus, there is not much contribution from a value in the 26th year utilizing the discounted cash flows formula.
To illustrate this, look at the historical earnings and the adjusted earnings for Norfolk Southern Railroad.
Norfolk Southern Railroad
Values are in Millions of Dollars
Year Reported Earnings Unusual Items Depreciation/Amortization PPE Maint Growth Invest Adjusted Earnings
2014 $2,000 $281 $956 (1,219) (191) $1,827
2015 $1,550 $290 $1,059 (1,276) (212) $1,412
2016 $1,663 $181 $1,030 (1,309) (206) $1,359
2017 $5,400 ($3,001)* $1,059 (1,335) (212) $1,911
2018 $2,660 $2 $1,104 (1,368) (221) $2,177
2019 $2,717 $288 $1,139 (1,391) (228) $2,525
2020 $2,013 $484 $1,154 (1,379) (231) $2,041
Total $13,252
Average Earnings Per Year $1,893
Growth Rate (Approximate Value using Compounded Growth Rate) 5.6%
*This reflects adjustment for the tax rate change under the new law passed in December 2017.
This means the cash flows for the next six years including the sixth year as a multiplier of 20 equals:
2021 $2,002 Million
2022 $2,114 Million
2023 $2,233 Million
2024 $2,358 Million
2025 $2,490 Million
2026 $52,579 Million (Factor of 20 for sixth year result)
Reasonable discount rates are between 3.5% and 8% depending on the industry. The greater the stability of earnings, the lower the discount rate. The railways industry has six publicly traded companies, not a single one has lost money in any year in the last 20 years. Stability of earnings for this industy is highly reliable; railroads are a very secure investment. Thus, the discount rate for this industry is 4%. The discounted cash flows result at a 4% discount rate for the above inflows equals:
$51,481 Million
The number of shares outstanding today is 252.1 Million. Thus, each share’s intrinsic value using the discounted cash flows method at 4% equals $204. If the investor used a 3.5% discount rate which is not an unreasonable value, the value per share increases about $5 per share. Today’s market price (03/15/21) for Norfolk Southern is $261 per share and the entire industry’s market prices are at their all-time highs. This site’s value investment fund currently has its buy trigger set at $180 per share for Norfolk Southern; i.e. there is a 12% margin of safety against the intrinsic value. The 2022 intrinsic value reset is conducted at year end. All the above elements in the formula are updated and the algorithm is rerun to derive the updated intrinsic value based on discounted cash flows.
From this section with application of discounted cash flows, the reader learned that determining cash flows from the prior seven years is a derivative of adjusting earnings for unusual items, depreciation, investment back into property plant and equipment and finally a reasonable cash investment to fund growth. The outcomes are averaged and a growth rate is calculated. The final adjusted earnings average is then extrapolated out for the next five years and a terminal value is merely a factor of 20 for the sixth year of growth. All six final values are discounted based on a reasonable discount rate as determined by the industry’s performance. Some helpful guidelines are:
- Growth rates for top 2,000 companies RARELY exceed 8% per year, a more common growth rate is between three and six percent per year;
- Discount rates are from 3.5% to 8% depending on the nature of the industry and the economy as a whole;
- In most cases, the adjusted average earnings will always be less than the most recent reported traditional financial earnings due to reinvestment requirements;
- Do not apply a growth rate to any value beyond six years;
- Stability of earnings is the number one factor when determining the discount rate, the better the stability the lower the discount rate;
- Only use the discounted cash flows formula contingent on the respective entity meeting the restrictive attributes for application:
- Low risk companies (long and positive history of performance)
- Always positive earnings
- Service/Product mix desired by consumers
Discounted Cash Flows – Intrinsic Value Range
There is no such thing as a definitive dollar value for intrinsic value. Intrinsic value is constantly changing, just like the market price for stock. Each quarter, earnings are reported and the end result is a change to intrinsic value. When intrinsic value is less than $50 per share, it is important to get the result within plus or minus 5% (approximately $2.50 per share). As the intrinsic value increases towards $200 per share, the investor should be able to get the intrinsic value to within plus or minus 3% (up to $6 per share).
Thus, certain factors in the above formula drive accuracy with determining intrinsic value using the discounted cash flows method. Since the formula is only effective with highly stable and profitable companies, the formula user must accept that the outcome is going to be an estimate. Look at all the variables involved with determining an outcome:
- Determining Adjusted Earnings
- Calculating a Growth Rate
- Establish a Discount Rate
Which of the above variables has the greatest impact on the outcome for intrinsic value? Let’s explore.
Discount Rate
The discount rate has recognizable impact on the outcome. A mere 1% change in the discount rate changes the final intrinsic value output by $7 per share. This is just a little over 3%. Thus, it is important to have a proper discount rate. Remember, the higher the discount rate, the more conservative the intrinsic value result. For example, if the discount rate for the above Norfolk Southern Railroad were 5.5% and not 4%, the intrinsic value drops to $189 per share from $204.
Factors that impact the discount rate include:
-
- Current Inflation Rate
- Industry’s Position Within the Gross Domestic Product Algorithm – Is it improving? If no, an investor ups the discount rate about .5%; positive gain in the overall GDP does not impact the discount rate.
- Investor’s Cost of Capital – If an investor has to utilize borrowed funds to make the investment, the end results needs to be more conservative thus the discount rate must increase. Add 1.5% to the discount rate for every 1% interest an investor must pay beyond the current 15 year mortgage interest rate.
- Personal desire for risk, a higher discount rate reduces risk.
- The stability of earnings for the respective potential investment, the better and longer the history of stable earnings, the lower the rate.
These factors are covered in more detail during Phase Three of the membership program on this site.
Growth Rate
A company’s growth rate is driven by many variables. The most important is of course the management’s team decisions about the future of the company. How are they pursuing additional revenue streams, reducing costs, improving efficiencies? Most mature companies do not have high growth rates. If they are performing well and have introduced plans to make improvements or broaden the sources of revenue, growth for mature companies can hit as high as 8%. Realize that mature companies have already completed their respective fast growth periods in their life cycle. The respective industry can only garner a certain percentage of the economic sector they exist within. Thus, growth often comes at the expense of other members within their industry.
The growth rate includes the expanding economy. Thus, most companies have at least 1.5 to 2% annual growth as this is the growth rate for the entire economy. The industry may experience its own growth due to new products or shifting of consumer needs. Thus, for most large mature companies, growth rates of more than 4% require objective justification; in effect, the investor must provide substantial evidence of this growth.
For Norfolk Southern above, their growth was driven by several factors over this six year period. First, the company grew the volume of trainloads by more than 3%. In addition, it was able to reduce its operation ratio by almost 10% during this time period. This alone added more than 3% of the 5.6% growth rate used in the formula above. Therefore, these two factors along with economic wide growth is how this company ended up above 4% growth rate.
Growth comes from multiple sources. Broadening revenue streams is the most common growth impact factor. But some industries are already at their maximum revenue capture; thus, revenue growth can only occur by expanding market share or introducing new venues (with railroads, think of new lines or customer cooperation agreements). Other sources of growth include reducing costs of sales, reducing overhead costs or changing the product mix for a better margin.
With Norfolk Southern above, the 5.6% compounded rate reflects the continuously improving bottom line as a percentage of revenue. The result was derived using the compounded growth rate formula which is more conservative than the average growth rate formula.
The growth rate impacts the volume of earnings expected in the following year and then the compounding over the next five cycles for six full cycles. Since profits for highly stable top 2,000 companies are in the hundreds of millions of dollars, a single percentage change with growth can extrapolate out into about a couple of hundred million dollars with the cumulative absolute cash inflows determinate. The discount rate dampens the final value the growth rate generates. Thus, the growth rate can impact the final intrinsic value about one to two percent. It is important to pay attention to it; but in the overall equation, it has the least impact.
Adjusted Earnings
Adjusted earnings has the greatest impact on the intrinsic value formula. A mere $10 Million on average from the prior seven years will affect the intrinsic value by at least $1 per share. Thus, being off $100 million per year with a railroad formula can result with an outcome that is more than 3% off.
With the formula above, the averaging effect dampens any incorrect result from a single year. The key is to get the data straight from the annual financial reports. The investor must utilize all three of the primary reports – balance sheet, income statement and cash flows statement. Each of the respective elements are covered in great detail in Phase Three of this site’s membership program. For now, the above is just an introduction to the formula. Don’t forget, as stated above, often the formula is modified or adapted to every industry. The formula above doesn’t work as well with highly leveraged industries such as banking and insurance. It can work with real estate and the hospitality industry; but does require some slight modification. The adjusted earnings formula is customized for every industry.
The key is that intrinsic value is never a single dollar value. It is a range. The goal is to keep the range narrow by selecting the most appropriate values (discount, growth and earnings) that will shift this range higher or lower. Ideally, intrinsic value will have a range of plus or minus 3%. With an estimated $200 per share intrinsic value, the value investor’s range will be $194 to $206 with $200 as the most likely intrinsic value. With lower market price shares, getting to within plus or minus 5% is the target. The risk factor does increase with lower price shares, but an investor offsets this with a higher margin of safety such as 25% safety margins from the mid-point of the intrinsic range. Getting that range as narrow as possible is mostly impacted by determining adjusted earnings (cash inflows for the prior seven years). The discount and growth do have a bearing on the final result, but nowhere near the impact adjusted earnings has on the result.
Summary – Application of the Discounted Cash Flows to Determine Intrinsic Value
Discounted cash flows is a popular but highly misused investment formula. As it pertains to calculating intrinsic value, it is almost always improperly applied. The discounted cash flows formula is highly reliable within certain parameters. The respective security under scrutiny must be backed by a highly stable historically top 2,000 company in the market. There are three required conditions:
- Security – low risk companies
- Positive earnings
- Stable and desired product mix
If the conditions are met, the formula is viable. The formula is:
Discounted Cash Flow Value = Cash Flow Period 1 PLUS Cash Flow Period 2 PLUS Cash Flow Period 3 PLUS …
. (1 + Discount Rate)¹ Power of One (1 + Discount Rate)² Power of Two (1 + Discount Rate)³ Power of Three
This formula is merely stating the current value of future cash inflows. Cash inflows are a function of several factors that greatly affect the end result. In general, cash inflow equals net earnings adjusted for:
- Unusual or extraordinary events (most often losses) net of the respective tax effect from the event;
- Adding back depreciation/amortization;
- Less a reasonable reinvestment into existing property/plant/equipment to maintain the company’s respective position in its industry; AND
- Less a reasonable investment to expand the company’s position within its industry.
This adjusted earnings outcome is slightly modified for every industry. It is not purely applicable across the board. Investors must take into consideration several other factors depending on the industry considered for investment. This outcome, called adjusted earnings, has the greatest impact on the final intrinsic value result. Two other elements of the discounted cash flows formula also impact the outcome, but not to the degree as adjusted earnings. The discount rate can change the outcome a little more than 3% for every 1% change in the discount rate. The growth rate is the final element and has the least impact on the outcome. However, it is still important to ascertain the growth rate as it does assist in getting a more accurate intrinsic value result.
Finally, intrinsic value is never a single dollar value; it is a range. The goal is to get the final result to plus or minus three percent of a reasonable value. The greater the confidence with the formulas underlying values, the lower the margin of safety necessary when purchasing a security. Always increase your margin of safety percentage with lower market price stocks, i.e. less than $50 per share. ACT ON KNOWLEDGE.
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]]>The post Value Investing – Setting Buy and Sell Points (Lesson 16) first appeared on ValueInvestingNow.com.
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“The big money is not in the buying and selling … but in the waiting”. – Charlie Munger
Setting buy and sell points for any investment security determines the investment’s final return. If the buy is made too early while the security is falling in price, the value investor loses out on not only additional margin upon the sale of that security, but also reduces their margin of safety associated with the intrinsic value point. It is similar on the other side of intrinsic value. If sold too soon, the value investor leaves money on the table. Thus, setting the buy and sell points are important decisions for every investment.
There are tools available to determine these two values. In the simplest of statements, the easiest rule to follow is the Pareto Principle; commonly referred to as the old 80/20 rule. This rule basically states that roughly 80% of all outcomes are within 20% of a focal point. With security pricing, this principle is simply that 80% of the value changes will occur within 20% of intrinsic value. Therefore, if a security’s intrinsic value is $80, then the probability is that 80% of the maximum change in value will happen within 20% of the core value. Therefore, the buy is approximately $64 and the sell point is $96. Almost certainly, this rule isn’t pure with security investing. The conception is that if the end results are beyond this 20 percent under and over the intrinsic value point, the value investor must have additional financial support and a lot of history with the security to validate expanding the buy and sell points beyond 20% fluctuation. This does not mean that the buy and sell points are exactly 20% deviation from intrinsic value; it merely states that there is an 80% probability that the buy and sell trigger points are within 20% of intrinsic value. The key point here is that if you can find 20% deviation on both sides of intrinsic value with high quality securities, then you have an excellent potential for a good return.
This lesson first introduces a basic model to illustrate and reinforce setting the respective buy and sell points. This model emphasizes an important aspect of price change. The angle of change affects the return on the investment. The steeper the price change, the shorter the time period for the change. The shorter the holding period for any investment, the greater the return on the investment. This is illustrated with a chart in this section of the lesson.
Once the basic principle of the price angle is understood, it becomes straightforward with creating formulas to determine the preset buy and sell points. This lesson introduces three quick and simple tools to assist with setting these two points around intrinsic value. The first formula is the price to book ratio converted into dollars. The second tool is the adjusted prior dip or peak price point. The third, and highly restrictive, is the price to earnings ratio.
Lesson Three explains how fluctuations exist not only in the market as a whole, but with the economic sector, the industry group,and the respective investment securities of each company. Some companies experience wild fluctuations in bursts over extended time periods. Others have stable low variances.
A perfect example of a highly stable minimal variance security is Coca-Cola. Review Coke’s price fluctuations over the last ten years.
Other than the aberration circled in red driven by the sudden market decline in Feb/March of 2020 (COVID market decline), there is a steady incline with the market price for Coke’s stock. As the line moves along the time spectrum, there are lots of small peaks and valleys including some built-in high points to low points. For example, look at the middle of the 2014 – 2016 grid block. Right in the middle the price peaks to $37 and by around November of 2015, the price bottoms out at $32 a share.
It occurs again in early 2016 with a peak just above $40 and a dip to almost $35 by late 2016. Thus, in a nine month period, Coca-Cola’s share price deviated a total of $5 (approximately 7%) in a single direction. Without deep changes, at least 12% changes in a single direction, a value investor will find it very difficult to create enough delta with price deviation to justify the investment if a reasonable return is desired (more than 30%). Only during the sudden steep drop in March of 2020, where the price changes 35% is there an opportunity to earn a good return. Coca-Cola is just that high of a quality of stock. It is considered one of the top 10 stocks to own if you can buy it when there is a sudden and dramatic dip in its market price. The closet similar dip occurred back in 2008 – 2009 time period during the housing market collapse. Thus, Coke rarely has a significant price dip nor a dramatic increase in value.
This illustration emphasizes the importance of understanding a security’s pattern. Two questions must be answered. First, are there frequent enough changes over time? Secondly, are these changes dramatic enough to warrant inclusion in an investment pool of funds? The first section below provides a model of price change and time period involved when developing potential investments.
Setting Buy and Sell Points – Basic Model Required
The ideal value investing model would have a straight line intrinsic value with a predictable security price fluctuation with at least a 20% change in both directions within a one-year time frame. This would allow for an above average annual return. Look at this stock’s price change over a course of a single year. 
On the first day of the year, both stock and intrinsic value start at the same point, $35. The determination to purchase and sell is 20% below and above the intrinsic value point. Thus, the buy is made at $28 per share and the sell occurs at $42 (120% of $35).
The price dips to $26 on 05/28/2021. However, it hits $28 around 04/23/2021. Since value investors use computer orders to buy and sell, the stock is purchased on 04/23/2021 at $28 share. At the same moment, a transaction fee is imposed of $1 per share. Thus, the total investment is $29.
Over the next month, the price continues to drop and reaches the low point on 05/28/2021 and begins to swing back towards intrinsic value. On 07/02/2021, the price crosses over the $28 dollar point and continues to climb to $35 on 07/30/2021. The model’s rule is to sell at 120% of intrinsic value, $42. It finally hits $42 on 09/17/2021. The computer generated order completes the sale and charges $1 for the transaction fee. Thus, the value investor nets $41 on the sale. The original investment is $29 (buy price of $28 plus $1 transaction fee). The gain on the sale is $12 ($41 minus $29). The original investment is $29, therefore the return on the investment is 41.3%. The holding period is 149 days, almost half of a year. The effective annual return is 101%.
This particular model is a ideal dream. The buy point is well below intrinsic value and the stock’s price recovered quickly from its low of $26.
A common concern/question raised by students of value investing is: ‘Why not buy the stock after it dips past $28?’ Their point is that, if the stock were purchased at $26, the return on the investment would be $14 on a $27 investment (buy price of $26 plus $1 transaction fee). The final return would equal 51.8%; the effective annual return would be dramatically greater than the 101% from the above example. There are two benefits from this; first, the financial gain is greater on a smaller investment and the time period to complete the full transaction is 35 days shorter. Therefore, the actual and annual return is greatly superior.
There are two problems with this thought. First, the student assumes that the price will continue to drop when there is a good chance that the price dips to $28 (recall the 80/20 rule) and then begins to swing upwards. The idea to continue waiting means a lost opportunity. Secondly, value investors exercise computer orders in order to reduce their time commitment with constantly monitoring the market. Imagine monitoring eight or ten different stocks waiting for a good price to buy. One of the benefits of value investing is reduced stress, a direct result of proper planning. Computer directives are a part of planning. Value investors adhere to the old adage: ‘Proper planning prevents poor performance’.
This is why this program teaches that value investors will earn good returns; in order to earn great returns, there must be dramatically more risk assumed and increased time invested with monitoring and research.
The above model is an example of an ideal potential investment opportunity. The perfect model would have greater dispersion from the intrinsic value point at higher frequency (more often). Imagine, having a model that allows for 30% deviation from intrinsic and the fluctuations occur within four months, i.e. the 30% dip to the 30% peak transition in four months. Thus, based on a $35 intrinsic value, the dip to $24.50 ($35 * 70%) would only take about 45 days; the buy is made for a total investment of $25.50. The market price recovery accelerates to $45.50 (130% of intrinsic value) in four months and the stock is then sold netting $44.50 ($45.50 less $1 for the transaction fee). Total gain is $19 on a $25.50 investment which equals a return of 74.5% or an annualized effective return of more than 220%.
Take note, steeper deviations along with shorter time frames dramatically increase the return on one’s investment. It isn’t a slight increase, it is substantial.
These types of models just simply don’t exist with highly stable top 2,000 companies. This is why it is explained in Lesson 14 to design at least three sets of pools that allows a value investor to create multiple models. From Lesson 3, market fluctuations are primarily driven by economic wide pressures, then industry wide factors. The goal is to have three or more industries (pools) with varying models such that the deviations are predictable. This then allows for easier setting of buy and sell points.
Go back to the core four principles of value investing. Principle number one is to seek risk reduction. Highly stable, top 2,000 companies practically eliminate risk associated with investment. Additional risk aversion is fulfilled by buying the security below intrinsic value. An investor can indeed find securities with dramatic deviations around intrinsic value and high frequency fluctuations. These are commonly found with small-cap investments. The trade-off with investing in this part of the market is significantly increased risk. Thus, value investors AVOID small-cap investments, a direct result of risk aversion. It is superior thinking to earn good returns with minimal risk than to increase risk dramatically for potentially a few more percentage points with gains.
When developing a model, try to find and use an industry wide model as the base for the pool. For example, this is the railways index published by Dow Jones and is comprised of all six North American railroad companies.
The least differential of extremes occurs with the center circled zone. On 04/28/2019 the index peaked at 2,512 and four months later on August 18, 2019 it dipped to 2,177, a 13.3% decrease. The key is that there is a pattern of differential values with railroad stocks. There appears to be an annual repetition with highs and lows of more than 13%.
For explanation purposes, assume the intrinsic value of the index fund is 2,300 in 2019. Thus, this would indicate a dip in this time period of approximately 5.4% and a recovery of approximately 109% of intrinsic value.
Many of you reading this will question why this would meet the suggested minimum differential of at least 20% of intrinsic value as the mean value. Therefore, based on this requirement, the only valid differential occurs in 2020 and there isn’t enough frequency to warrant inclusion of railroads as an industry pool of potential investments. The argument is reasonable. The response is really informative.
The index fund is comprised of six railroad investments. During the 2019 cycle period, each of the six had their own distinct cycles. To illustrate, here is a table of values, peaks and dips for each of the six railroads in this index fund.
. Time Period 04/28/2019 thru 08/18/2019
Name Peak Price Lowest Price Differential %
Union Pacific $179.20 $162.45 10.3%
Canadian Pacific $246.27 $216.73 13.6%
Kansas City Southern $125.34 $112.05 11.8%
Norfolk Southern $206.70 $169.85 21.7%
Canadian National $95.37 $88.59 7.6%
CSX $80.52 $64.41 25.0%
Within these six investments, both Norfolk Southern and CSX railroads drove the average price differential of the index fund. Thus, out of the six, two of the investments are potential value investment opportunities. Again, the respective intrinsic value for each investment is required in order to determine if indeed there is opportunity with that investment.
The point of the above exercise is that the industry index reveals cycles of ups and downs. Secondly, these differentials are for the industry as a whole. Reviewing the individual investments will identify actual opportunities.
With a core model developed for the industry and then with each member of the respective pool, the next step is to set the buy and sell points. A popular tool use is the price to book ratio.
Setting Buy and Sell Points With the Price to Book Ratio
The price to book ratio is one of the most popular value investor tools used to gain a quick understanding of any company’s financial market profile. As a company gains trust and proves its stability (remember, stability of earnings is considered the number one factor with valuation), its price to book ratio will begin to increase.
The price to book ratio is defined as the market price per share against the book value per share. The book value is the shareholder’s equity section divided by the number of shares outstanding (sold and held by shareholders). Thus, if the market price is greater than book value, the result is a positive relationship. It is not uncommon for market price to be less than book value and yet the company is still a great operation. In some instances, it is possible for the book value to be negative; yet the investment is considered high quality. A good example of this is McDonalds Corp. McDonalds book value is almost $9 negative per share; yet, it is one of the top 10 most stable companies in the world.
There are circumstances when book value is less than market price with high quality companies. But, in general, investors look for positive price to book values. The higher the ratio, the more likely it is time to dispose of the investment. In order to determine potential opportunity, the value investor must first recognize or determine the normal expected price to book ratio. Here is an example:
Essex Property Trust is a real estate investment trust with over 60,000 units along the west coast of the United States. In early 2021, its book value was approximately $98 per share. Its market price ranged from $240 per share to $265 per share during the first two months of 2021. Thus, its price to book value ranges from 2.45 to 2.70. The intrinsic value of Essex Property Trust is calculated to be $255 per share or approximately an intrinsic price to book value of 2.60:1. Thus, with this particular investment, it is expected and reasonable to have book values ranging from 2.1 to 3.1 (20% deviation from the intrinsic price to book ratio of 2.6).
This is not unreasonable with REITs. With banks, ratios greater than 1.5:1 are just unheard of with that industry. To illustrate, here is Bank of America’s price to book ratio for the last 14 years.
Not once in 14 years has Bank of America’s price to book ratio exceeded 1.5:1. Bank of America is considered one of the top five banks in the United States. It is a well respected and well run organization.
The point here is this, THERE IS NO UNIVERSALLY CORRECT PRICE TO BOOK RATIO STANDARD. Each industry is different and as a value investor, you must recognize this and accept it as a value investment standard to follow. If you ever hear someone say that the price to book ratio is high and that it is common to sell at 2 or 3 to one, that individual is not sophisticated when it comes to investments. THERE IS NO PRICE TO BOOK STANDARD. Price to book ratios have normal ranges within each industry.
This same principle exists with the buy side tied to price to book ratio. Many so called professional investors state that buying at less than book value is the same as value investing. IT IS NOT! It is not uncommon for the price to book ratio to be less than 1:1 with several different industries, for example, insurance companies. The Travelers Insurance Company have had eight of the last fourteen years with the price to book ratio at less than 1:1 and Traveler’s is a DOW Jones Index member.
The goal of this exercise is to first understand the industry’s normal price to book ratio range and then each member within your pool of potential investments within that industry. Keeping with Essex Property Trust, here is Essex’s price to book ratio over the last 14 years.
Notice that Essex’s price to book ratio dipped below 1:1 back in 2009. This is a direct relationship to the entire economic recession driven by the mortgage crisis that started in the 2nd half of 2008. The price to book goes over 3:1 in the middle of 2019 just prior to the COVID market collapse in February of 2020. With a 3.2:1 ratio and a book value back then of $94 per share, the market price was just over $300 per share.
Remember from above, intrinsic price to book is 2.6:1. Thus, looking at this graph, an excellent buy price is when the price to book drops to 2.4 or 2.3:1. If the current book value is $98, then a good buy price is $225 to $235 per share. Looking at the trend line, the sell point is 2.9 possibly as high as 3.0:1. Thus, a reasonable sell price if book value is $98 per share is $285 to $295 per share.
The key is to pay attention to current book value as it does improve from one quarter to the next. Remember, value investors only purchase high quality, top 2,000 companies. Since stability of earnings is essential to belong in this group, book values should increase quarter over quarter. There are exceptions to this rule; but in general, book value should improve with each quarter’s financial report for your investments. Since book values improve, the market price for the respective stock tied to price to book ratio should also improve quarter over quarter. Thus, the market price standard this quarter will most likely end up less than the desirable amount in the forthcoming quarter.
There is a lot of emphasis on book value in one of the lessons during Phase Two of this program. That lesson teaches the value investor on how to read the equity section of the balance sheet and derive book value. It also explains how share buy-back programs impact book value along with other circumstances that impact book value. Understanding book value and how to monitor this important pricing mechanism is essential as a value investor.
Another tool used to set buy and sell points with a particular investment is the prior peak price point of the security. This particular tool places emphasis on setting percentage changes in order to determine buy and sell points for stock.
Setting Buy and Sell Points Using Prior Peak Price
An alternative to the price to book ratio method is using the prior peak price tool. This approach is based on an assumption that the market price for high quality securities will always be on an upward incline, similar to the DOW Jones Industrial Average. Thus, if a particular company’s stock price hit a new peak, at some point in the future, it will surpass this peak price. In effect, buy at deep discount to the most recent peak price and then simply sell once the security’s price surpasses the prior peak price.
Thus, in order to to earn good gains, the value investor only needs to find securities with adequate differential between the peak prices and dips in market price within a short period of time. Here is an example with Norfolk Southern Railroad.
Norfolk Southern has a distinct incline. Within this incline are multiple points of peak price and a corresponding deep price discount. Here are the four obvious cycles:
- Jan 2018 – price peaks to $150.88 and dips to $135.78 in March of 2018 – 10% change
- Sept 2018 – price peaks to $180.50 and dips to $149.54 at the end of Dec 2018 – 17% change
- April 2019 – price peaks to $204 and dips to $174 in August of 2019 – 14.7% change
- Jan 2020 – price peaks to $208.21 and dips to $146 in March 2020 – 29.8% change
In a course of two years, there are four full cycles of at least a 9% decrease in value from a prior peak. This site’s investment fund took advantage of three of these distinct cycles to earn excellent gains. This site set the price decrease to 12% of the prior peak and the sell point to 103% of the prior peak and reaped good gains for each full cycle.
The key is that there is a definite pattern with this particular company and recovery from a trough point along the price spectrum is short in duration and always surpasses the prior peak market price. Why? This company is highly stable and provides weekly updates to its key performance indicators. In effect, it is highly stable and a well run company. Any negative deviations are simply the result of an industry wide issue or some kind of temporary falling out of favor from the market as a whole. This same pattern has existed for the last 20 years. With this site’s railways pool, this particular company is an automatic buy at a 12% dip in market price to prior market peak price and then sold at 103% of prior market peak price.
An important critical piece of the formula is the intrinsic value line. The line should have a similar incline as the market’s trend line over time. Do not allow the separation of the intrinsic value from the market’s trend to deviate more than 5%. A greater than 5% deviation will cause greater disparity with price fluctuations and will require a deeper discount with market price to protect against a protracted recovery period. In effect, deviation from normal warrants additional security to protect the investment and increase the final reward for this additional risk.
This particular method is only appropriate with investments that clearly demonstrate a pattern as Norfolk Southern’s share price illustrates. Furthermore, it is of the utmost importance to validate that the company is well managed and that it isn’t suddenly changing its operational standards or product/service lines. With railways, changing the model is difficult if not impossible. Thus, the highly stable pattern exists.
One last important note related to this particular method of buying and selling securities. Sometimes the prior peak is an anomaly. Be careful, look at the historical pattern, the prior peak should be on the incline path; in effect, it was predictable. If the prior peak is a spike that is more than 15% off the predicted high, gain an understanding of the underlying forces that cause this abrupt increase. If the underlying factors are permanent, it is possible that the market is elevating the entire industry due to a change in the industry or the economic sector. A good example are pharmaceuticals in late 2020. Worldwide governments started negotiating contracts with them to provide vaccines. There does not seem to be any reason to believe that this will not continue as new vaccines will be required each year to keep up with the variants of this virus. Thus, pharmaceuticals have been elevated to a higher tier of overall value in the eyes of the world economy.
To counter this, an example of stock that has had a sudden increase in market price is Tesla. There is no industry, company wide nor economic justification for this doubling of stock price in six months. In effect, Tesla’s $800 per share market peak in price is unjustifiable and quite simply, unreasonable to maintain or continue increasing along the same incline. It simply does not make sense.
A third method of setting the buy and sell points is to base the values on earnings per share.
Setting Buy and Sell Points Based on Earnings
Throughout Phase One of this program it has been reiterated many times in the lessons and in articles about particular investments that stability of earnings is the number one factor related to value for any company. Stability of earnings refers to three required characteristics of a company’s earnings.
First, the earnings must be positive for an extended period of time. The more history of positive earnings, the greater the reliance on the company to earn a profit in the future. An extended period of time does not mean five or even seven years. It means positive earnings for a complete economic cycle within the industry the company operates. For most industries, this means at least a dozen, possibly as many as twenty years of continuous positive earnings.
Secondly, the historical earnings pattern must be growing from one year to the next. A good example is Canadian National Railway. Here is Canadian National Railway’s earnings per share over the last fifteen years.
The increase in 2018 is a direct result of the change to the United States tax rate from 34% to 21%. The company elected to include deferred income into that year’s income and pay the tax at a much lower rate as allowed by law.
For this company, earnings per share per quarter are consistently on an incline over time. The last three quarters reflects the impact from COVID (quarters 2, 3, & 4 of 2020).
This graphical depiction validates stability of earnings. This is the ideal pattern for any publicly traded company.
Finally, the company must demonstrate positive earnings during a recession. Since stability of earnings is based on a full economic cycle for the respective industry, from the graph above, Canadian National demonstrates this twice in this fifteen year depiction. Back in 2008, which is depicted at the seventh and eight marker (notice the slight decrease with these two earnings per share indicators), a recession started in North America. A second recession exists during the last half of 2020 driven by COVID, notice the last two markers in the above graph. Canadian National continues to earn positive earnings per share during two distinct economic recessions.
Stability of earnings is the most critical factor in deriving value.
When setting a buy and sell point for any stock, earnings per share can be used to determine these two points. A popular ratio used to assist with this outcome is the price to earnings ratio. In theory, a company should hold steady with its price to earnings ratio (P/E). As its earnings increase, the market price per share should increase in a similar pattern as if the two units of measurement had a correlation rate of a natural price to earnings relationship. A good example of this is Amgen Inc. Amgen is a biotechnology company and a member of the DOW Jones Industrial Index. Take a look at its earnings, price per share and its P/E ratio.
Other than the anomaly in 2018 due to the tax code implications on earnings, the P/E ratio remains relatively stable even though the stock price increases. There is a good correlation between the increasing earnings and the stock price keeping the P/E ratio stable. Notice that even though the earnings dip due to the taxation recapture, the stock price did not drop in a similar pattern. This is because investors were well aware of the tax implications when Congress passed the Tax Act in December 2017. However, if the market price for a share remains stable and the earnings practically collapse, it does indeed impact the P/E ratio. The result was a tripling of the ratio outcome.
However, this isn’t true for all companies. Amgen is one of the few that actually adhere to the correlation theory for price and earnings. Other market forces including industry issues can cause the P/E to fluctuate even though the company continues to prove its ability to earn profits with consistency and improvement over an extended period of time. Take a look at Canadian National Railway’s P/E ratio over the same time period as the above earnings graph for Canadian National.
The P/E ratio fluctuates and its pattern is not level. This is how value investors can take advantage of the P/E ratio and set buy and sell points for a stock security.
How is this done?
To start, the value investor must know the intrinsic value. With this value, an intrinsic based price to earnings ratio can be calculated. As with all intrinsic formula calculations, use no less than five years look back to determine an average.
For Canadian National, the average annual earnings were $4.57 adjusted to exclude the tax benefit in 2018. The historical average P/E for the S&P 500 has been 15:1. With railways, an intrinsic price multiplier is 18:1. Using this ratio as the mean, Canadian National’s intrinsic average would be $82.26. Over the last five years, it has traded for a low of $48 and high of $116.
If an investor wants to add additional security with their investment, they would simply lower this ratio to 17:1. Thus, whatever the average five year earnings are, a buy is set for any price less than 17:1 and a sale is conducted at 23:1 or higher.
With Canadian National Railway, the current buy price using this method is $78 per share and the sell is set to $105. As of the writing of this lesson, the current market price for Canadian National is $108 (02/17/2021). During the past 12 months, the low has dipped to $66 per share and its high reached $116 per share.
Each quarter, this buy/sell trigger formula is recalculated to reflect the impact of the most recent earnings. However, the intrinsic value earning multiplier never changes; refer back to the correlation theory of market price to earnings.
* Caution
For those of you interested in reviewing Canadian National’s quarterly or annual financial reports, please be aware, their financial statements are in Canadian dollars, also known as the ‘Loonie’ named after the national bird, the loon. Thus, you must convert their financial information to US dollars in order to compare against other years or companies.
Summary – Setting Buy and Sell Points for Financial Securities
This lesson’s primary principles are as follows:
When setting up or designing buy and sell values for any financial security, a core industry model must be created and used as the standard to follow. Each industry will have a their own value differential around a core intrinsic amount. In addition, this model will identify a common frequency for these maximum and minimum price fluctuations. With this model in hand, the value investor can then proceed to create a unique buy/sell model for each potential investment within that pool of similar investments.
Value investors may use one or more of three very popular methods:
- Price to Book Ratio – as stated multiple times, each industry has their own average price to book ratio and a corresponding corridor of values tied to the price to book ratio. Remember, there is no universal standard for price to book ratio. In some industries, it is normal and acceptable to have price to book ratios less than 1:1.
- Prior Peak Price – highly stable, top 2,000 companies have a strong history of stable earnings; their respective securities price will also improve over time. A good method is to discount a prior peak price with a substantial discount, buy at this discounted price and then resell once the prior peak price is surpassed at a reasonable point, like 103% of prior peak.
- Price to Earnings Ratio – since the market typically prices stock tied to earnings, it uses a price to earnings ratio to determine value. A value investor determines the intrinsic value multiplier and uses the average of at least the last five years of earnings adjusted each quarter and then determine the current buy and the corresponding sell price based off this single multiplier number.
Good value investors will use all three tools to establish a limited range (corridor) of buy and sell points and adjust these two points each quarter as each company releases their respective financial updates. Act on Knowledge.
The post Value Investing – Setting Buy and Sell Points (Lesson 16) first appeared on ValueInvestingNow.com.
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