Value Investing

Intrinsic value of stock is a company’s realistic value per share at any given moment. Intrinsic value is not book value; it is the most likely dollar amount a reasonable person would pay for the underlying net assets. In most cases, an investor would include some value for the near-term future earnings of the investment; but the core amount in determining the intrinsic value of a share of stock is tied to the net assets at fair market value.

The intrinsic value formula is different for every sector of the economy and for the respective industries within that sector. Equity based real estate investment trusts (REITs) consist of six different types. One of the types of REITs are apartment complex based operations. In effect, they are apartment rentals. With real estate, specifically those in the home rental industry which includes apartments, condos, townhomes and traditional individual homes, intrinsic value is strongly tied to the fair market value of the rental properties less the assigned associated debt (mortgage). In addition, some value is included for future near-term earnings and the other assets on the balance sheet. It is really no different than how your traditional home rental operation would value their investment.

With Essex Property Trust, this REIT has been around for almost 30 years. It owns 246 apartment complexes with 60,272 units. There are an additional 1,853 units under construction. To determine intrinsic value, one would simply appraise all 246 complexes, determine the full fair market value and then deduct the total debt to get net assets value. Add to this value, the other assets on the books, get a full net assets value at fair market value. In addition, you would simply add about three years of profits. With this cumulative sum, divide by the number of shares and determine an approximate intrinsic value per share.

This appears relatively simple. For Essex, assume each unit can be sold for $350,000; seems like a reasonable value per unit. Total fair market value would approximate $21.1 Billion. The other assets on the books are equal to around $900 Million, thus total assets at fair market value would approximate $22 Billion. Total debt and current liabilities on the books are approximately $7.2 Billion. Once the liabilities are satisfied upon the sale of the units, the net remaining amount available to all shareholders results in $14.8 Billion. There are 67.5 Million shares outstanding. Thus, each share has a net worth of about $219 tied to net assets value at fair market value.

Currently, the company’s net operating income is just a little over $8 per share. Using three years of net income, the investor would add about $24 to the net assets value outcome to get total intrinsic value. Three years of net income is used as this would be a reasonable and normal time period to dispose of all the complexes, i.e. it would be the time period to negotiate an arm’s length transaction (fair and normal). Thus, Essex Property Trust’s intrinsic value is approximately $243 per share. 

Of course, there is more to it than this simple approach. But the core idea is there; the intrinsic value should be in the neighborhood of $243 per share. As a value investor, you should anticipate that the intrinsic value isn’t going to deviate greatly from this simple quick calculation. In effect, a value investor would expect the actual outcome to end up within 20% of this quick calculation. Thus, the final intrinsic value should end up in between $195 per share (20% less) and $292 per share (20% more). From Lesson 7, there is no definitive intrinsic value calculation for any stock. Intrinsic value has a range; the key for value investors is to narrow this range as much as possible in order to determine a reasonable intrinsic value for any potential stock investment. Ideally, getting the range down to plus or minus 3% is the goal. In effect, the final intrinsic value calculation is somewhere between the two given outcomes and the value investor’s goal is to have a high level of confidence with the final outcome. 

What is important here is that if you end up with a really conservative outcome (tending towards $195/share), it is likely the market price will never dip this low (the last time was in November 2014) thus eliminating opportunities for the value investor. If the end result is too high (tending towards $292/share), you end up with more opportunities but the end result with the investment is less gains from the respective buy/sell turnovers and therefore the overall return for a value investor decreases. In effect, it defeats the purpose of value investing which is to buy low and sell high. Thus, it is extremely important to walk through the exercise of calculating a reasonable intrinsic value that results in reduced risk and adequate opportunities to make buy and sell transactions assuring an excellent return for the portfolio, i.e. the pool of similar investments.

Given this, how do you determine a REIT’s intrinsic value to plus or minus 3%?