![\"Intrinsic](\"https:\/\/businessecon.org\/wp-content\/uploads\/Dutch-Tulips.jpg\")
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It’s a bubble. It has to have intrinsic value. You have to really stretch your imagination to infer what the intrinsic value of Bitcoin is. I haven’t been able to do it. Maybe somebody else can. <\/span><\/strong><\/em>Alan Greenspan<\/span><\/p>\n With stocks<\/span><\/strong><\/a>, what exactly are you buying? There are four commonly accepted responses to this question:<\/span><\/p>\n<\/div>\n The sections below cover each one of these responses and how they independently tie to intrinsic value. The final section puts all of them together to provide an overall understanding of intrinsic value related to stocks, specifically related to high quality companies which is advocated with value investing<\/span><\/strong><\/a>.<\/span><\/p>\n This particular valuation concept is tied to a similar concept known as an annuity. With an annuity, a buyer pays a lump sum and receives cash payments in return over an extended period of time. Similarly, with stock, the stock buy price is the initial capital outlay and in return you receive dividends and any net earnings remaining will increase the retained earnings position in the equity section<\/span><\/strong><\/a> of the balance sheet.<\/span><\/p>\n Cash flow<\/span><\/strong><\/a> in business often refers to what is commonly known as ‘Free Cash Flow’ which is merely the net profit earned reduced by investment requirements. Almost all of the top 2,000 companies, which are the value investors target group, earn more than $1 Billion per year in net profit after taxes. These earnings are then in turn used to reduce debt by making principal payments or buying back bonds; purchasing new fixed or intangible assets; making dividend payments to shareholders; and\/or increasing the equity position of the company. In every case, it is customary to use free cash flow to do a combination of all four uses of net earnings. Take note, two of the uses benefit the shareholder directly; whereas, the other two benefit the company’s financial position. The reality is that all four actually do benefit the shareholder, any investment use (debt reduction or the purchase of new assets) indirectly benefits the shareholder in the future with additional net income.<\/span><\/p>\n With this form of intrinsic value calculation, specifically the future cash flows valuation, the formula incorporates all four of the above uses of net cash flow. Some conservative investors only count the dividend portion of the future cash flows in their formula. This is understandable. For value investors, using such a strict interpretation reduces the intrinsic value point; thus, practically eliminating opportunities for investment. An illustration is best here to explain this point.<\/span><\/p>\n Assume XYZ, Inc. earns $1 Billion per year after taxes. The governing board agrees to distribute 30% of the earnings to their shareholders each year. Therefore, $300 Million is distributed each year. The company has no growth, nor decline; it simply earns $1 Billion per year. If there are 150 million shares outstanding, then each shareholder earns $2 per share. Assume a conservative investor uses a discount rate of 5%. Using the financial formula of discounted cash flow, the stock to the conservative investor is worth about $32 per share.<\/span><\/p>\n Thus, the conservative buyer earns $2 per year on a $32 investment equating to an annual return of 6.25%.<\/span><\/p>\n However, investors at the other end of this concept state that all $1 Billion improves the shareholder’s position. Here, the earnings are the actual per share amount of $6.66 ($1 Billion\/150 Million Shares). Using the same 5% discount rate, a more liberal investor will say the stock is worth closer to $98 per share. This position is defendable because each dollar of earnings is used in some way to improve the overall financial position of the company and\/or shareholder. Remember the concept of book value, use of earnings include reducing debt, purchasing assets or simply retaining cash. This improves the book value of the respective company; thus, improving the book value per share for shareholders. For help with this understanding, review Lesson 6<\/span><\/strong><\/a> in this series.<\/span><\/p>\n With the above two extreme opposing interpretations of future cash flow to determine stock price, the results are at opposite ends of a spectrum of stock value. Remember, if the determination is too low, ‘conservative approach’, it is unlikely the market price for the respective stock will dip to this extreme, especially for such a consistent performing company. In Lesson 6<\/span><\/strong><\/a>, stability of earnings<\/span><\/strong><\/a> is the most prized value determinate with stock investments. Therefore, any dip to this extreme low value for a share of stock is unlikely with high quality stocks. Therefore, there are no opportunities to buy low and then sell high.<\/span><\/p>\n If the determination is too high, the result is that value investors will buy at an unreasonably high price defeating the purpose of the buy low, sell high tenet of business; review Lesson 5<\/span><\/strong><\/a>. In effect, they will not make a good return on their investment. Therefore, the answer lies somewhere in between these two extremes.<\/span><\/p>\n Notice how with this example, the company earns exactly the same amount each year and the governing body imposes the exact same use of funds. There are several flaws here and therefore, it is important to compare and contrast the differences between the above easy model and of course, the real world.<\/span><\/p>\n This is why many value investors compromise between the two extremes as illustrated above with XYZ, Inc. Value investors will often simply use the free cash flow value as the basis of their formula. A common tool is to assume a reasonable growth rate (one of the dampening factors explained above), discount rate and a set short-range time period to determine intrinsic value utilizing future cash flows. For this purpose, an illustration is helpful:<\/span><\/p>\n Assuming XYZ, Inc. has historically had a growth rate of 1% greater than the economic growth rate; and value investors like a conservative discount rate of 6%; what is the intrinsic value of XYZ’s stock. XYZ’s free cash flow is $650,000,000 per year (the board uses $350,000,000 per year to reduce debt and purchase additional fixed assets to replace worn out assets and improve processes).<\/span><\/p>\n The economy grows at around 2.3% per year; therefore, XYZ’s growth is 3.3% per year and all of this falls to the bottom line. Thus, in Year 1, net earnings is $1 Billion, in Year 2, net earnings improve to $1,003,300,000. Therefore, free cash flow in Year 2 improves to $653,300,000. What is the present value of this free cash flow assuming this pattern continues?<\/span><\/p>\n This makes the company worth approximately $13.1 Billion (the formulas for this are provided during Phase 2 of this program). With 150 Million shares outstanding, each share is worth approximately $88. Notice how this falls between the two extremes identified above ($32 and $98)? Why did this tend towards the higher end though? The answer is due to the fact that the company is able to maintain its relative position to the economy as a whole. Let’s change it slightly to illustrate. Assume that it only grows at the economic rate of 2.3%. What is the stock’s intrinsic value based on cash flows? The answer: $81. Therefore, the ability to maintain its economic position or a slight improvement can affect a stock’s value about 8 to 9%.<\/span><\/p>\n A higher discount rate by the value investor lowers the share price. A simple 1% increase in discount reduces the share price $6 for XYZ, Inc.<\/span><\/p>\n For value investors, they only work with the top 2,000 investment opportunities and are selective within this group to only those that have stable earnings and can maintain or slightly improve their economic position within the overall group of 2,000. The intrinsic value outcome is going to tend towards the more liberal outcome as illustrated in the XYZ, Inc. example at the beginning of this section. Value investors should expect the share price to be within 15 to 20% (lower) of the more liberal interpretation of how much future cash flows are worth.<\/span><\/p>\n This concept is covered in more detail during Phase Two of this program and is incorporated into the spreadsheets provided. For the reader, it should make sense. Notice how it is reasonable in business to have results somewhere between the extremes but tend towards the full value of future cash flows and not the ultra conservative outcome that pure dividend only conservative investors rely on for their determination of value? If you only use the discounted dividends formula, even assuming growth with dividends over time, the outcome for intrinsic value is too low.<\/span><\/p>\n Because dividends are only one of the uses of the earnings, the other uses also add value to the discounted dividends only formula with higher quality stocks. Lower quality stocks have increased risk of poorly investing the unused portion of net earnings after payment of dividends. One of these additional uses is the amount the unused earnings add to the book value of stock.<\/span><\/p>\n A second popular intrinsic value definition is that stock is worth the company’s book value. Book value<\/span><\/strong><\/a> is merely all assets, less all liabilities. It is also referred to as the equity section of the balance sheet. However, with large corporations, the equity section can get a bit complicated. Often, there are three owners, each with certain rights. The first group of owners are preferred shareholders or preferred stockholders. In effect, they get paid first before traditional common stockholders. The second group of owners are what is referred to as minority shareholders. Here, when a large corporation exists, it often owns subsidiary corporations. But, it doesn’t own 100% of these smaller corporations; thus the other owners of these other corporations are known as minority interests. Lastly, are of course the traditional common shareholders. Thus, the term here, book value, refers to the common shareholders, i.e. the publicly traded shares.<\/span><\/p>\n The formula is simple, it is this part of the equity section of the balance sheet<\/span><\/strong><\/a> divided by the number of outstanding shares. Many of the popular brokerage sites include this value in a company’s snapshot of financial metrics.<\/span><\/p>\n Many so called value investors use this particular dollar amount as the perceived purchase point with stock. As explained in other lessons and reiterated here; top quality stocks rarely sell at book value. You find book value prices commonly with small-caps and penny stocks<\/span><\/strong><\/a>. Thus, book value is NOT<\/strong> the target price for high quality stocks nor large-caps. The book value concept is applicable with other stock tiers. This is why when you read about value investing from other sites, they claim intrinsic value equals book value. This is not true with high quality stocks.<\/span><\/p>\n There are actually two uses of book value when used with determining intrinsic value for a company. First, it is often the floor value of the stock. It is encouraged that value investors understand this floor value because as the price for a quality stock decreases towards the floor value, the stock becomes an obvious target for purchase by value investors and a multitude of other types of investors (institutional, market funds, pensions etc.). A second use of book value is with the business ratio of price to book<\/span><\/strong><\/a>. This ratio is customarily a trend line to compare current price to book to the historical average with a goal of discovering opportunities to buy. Rarely will value investors pay more than three to one for a stock unless this particular company is a standard bearer in their respective industry. To illustrate, look at Coca-Cola’s price to book over the last five Coca-Cola<\/span><\/strong><\/a> is considered one the best company’s out there in the market; it is a DOW company. This company is more than 100 years old and rarely records quarterly losses. It is simply one of the best companies in the world. Thus, the most recent history rarely finds a price to book at the end of any quarter less than 3:1.\u00a0<\/span><\/p>\n When the price does drop towards 3:1, it becomes enticing for buyers given its record of stable earnings since 1919, the year the company went public.<\/span><\/p>\n *Notice in the first quarter of 2018 how the price to book dropped to 3:1? Well, it actually is due to the tax code change in December of 2017. Coca-Cola went ahead and recaptured historical off-shore income and paid federal income taxes at a lower rate. In that respective quarter, Coca-Cola lost $2.2 Billion and many ill-informed investors fled the stock lowering its price (see the stock price in the upper section of the three graphs). This was an opportunity to buy and make a lot of money as the tax payment had no impact on market share, processes, or the management team. Look at how fast it recovered? This is what value investors understand and calculate with their models.\u00a0<\/span><\/em><\/p>\n This particular chart is on the quarterly basis. If this particular stock is included within a pool of investments containing the various non-alcohol beverage companies, it would be the standard bearer. In addition, the price to book trend line would be weekly so upwards and downward trends can greatly assist the value investor with the decision model.<\/span><\/p>\n Most of the quality investments used in the respective industry pools will have a standard bearer with a high price to book ratio and the others will have ratios ranging from 1.5:1 (stated as ‘1.5 to 1) upwards to 2.5:1.\u00a0<\/span><\/p>\n Remember, the reason price to book ratios are higher with this program is because the pool is composed of low risk, highly stable, profitable companies. Therefore, the stock price will rarely if ever dip down to pure book value. It doesn’t mean it can’t happen, it would take extenuating economic wide circumstances along with industry issues to depress the market price towards book price with these types of companies.<\/span><\/p>\n Many folks get a tad confused with book value by equating it to net assets value. Technically, they are one and the same. The textbook definition of book value is assets less liabilities which equals net assets. This next section will explain how reality is far different than a textbook answer.<\/span><\/p>\n ‘Net assets’ means all assets less all liabilities. This is also referred to as ‘Book Value’. Be careful here, in this case, book value refers to the entire equity section of the balance sheet as net assets less liabilities refers to all remaining book value of assets. Thus, common stockholders may not have rights to all of the net assets. Those equity holders in a higher position, think of preferred and minority shareholders, have greater rights to net assets than common shareholders. Thus, true net assets really equals:<\/span><\/p>\n Net Assets for Common Stock Holders = All Assets Less All Liabilities Less Apportioned Value for Preferred and Minority Shareholders<\/strong><\/span><\/p>\n As will be stated multiple times throughout this series of lessons, textbook definitions and actual application are two different outcomes, especially when dealing with value investing.<\/span><\/p>\n Thus, net assets with value investing means the net assets’ dollar amount apportioned to common stock. This net asset amount is then divided by the number of common stock shares outstanding to determine net assets’ value per share. This mirrors the definition of book value as explained in the section above. So why do we need to understand the difference between net assets and book value if they are the same?<\/span><\/p>\n Book value as stated above assumes that the entity is an ongoing operation and the dollar amount refers to the accrual basis value of the company in its current state of existence. Net assets are slightly different. With value investing, net assets actually means the value of the assets if the company ceases to exist and disposes of the assets into the market. Therefore, net assets really means all assets at fair market value<\/span><\/strong><\/a> less liabilities less apportioned amounts of equity to minority interests ending with an acquired value that is then allocated per share to the existing common stock shareholders. To put this in another way, think of net assets as equal to the liquidation value less payment of all liabilities and apportioned amounts to senior equity stakeholders.<\/span><\/p>\n If you spend some time on this thought process, older more mature and stable companies have fixed assets that are fully depreciated and thus on the books of record, have no or limited dollar value attached. For those of you unfamiliar with depreciation<\/span><\/strong><\/a> and its impact on the balance sheet, please read articles on this website related to depreciation (simply type in ‘depreciation’ in the search field on the home page). But in reality, these fixed assets<\/span><\/strong><\/a> have a fair market value that far exceed the book value. Younger companies, those still in the penny stock<\/span><\/strong><\/a> or small-caps tiers of stocks typically don’t have a large differential of value between what is recorded on the books and what is the true fair market value of the respective assets.<\/span><\/p>\n Since value investing only deals with the top 2,000 companies, most of these are mature and highly stable operations. Rarely will you find any one of these companies aged less than 30 years. Thus, their assets, including intangible assets<\/span><\/strong><\/a>, have a fair market value that often greatly exceeds their recorded value on the books of record. To illustrate, look at XYZ’s balance sheet values and of course the fair market value of the corresponding assets.<\/span><\/p>\n \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0XYZ, Inc.<\/span><\/strong><\/span> Take note, with the fair market value principle, the liabilities do not change, only the assets’ value changes. The fair market value of total assets for XYZ, Inc. adds another $7.22 of value per share for common stock.<\/span><\/p>\n This additional value greatly impacts the intrinsic value calculations value investors use to determine floor value of a stock’s market price. However, it is essential to understand this principle. It is more applicable to certain industries than other industries. For example, service based operations or high current assets based companies (banking, insurance and construction) generally have fair market values that match book values. Look at XYZ above. Its current assets at fair market value are slightly less than book value; this is due to the cost to liquidate those assets. This same liquidation cost is applicable to those companies with strong current asset based balance sheets.<\/span><\/p>\n However, for companies with strong fixed asset based balance sheets, the fair market value often exceeds the book value of the corresponding fixed assets. Good examples include real estate investment trusts – REIT’s<\/span><\/strong><\/a>. Many REIT’s have strong depreciation schedules for their fixed assets (buildings, improvements, etc.) but the actual fair market value customarily improves over time for real estate. Other examples of this principle include resorts, hotels, food service (think of the ever increasing value of the land where the restaurants sits) and manufacturing. Again, this is more common with mature companies, those in the top 2,000 companies worldwide.<\/span><\/p>\n
\nThis is considered the first market crash. Notice the key similar elements of a modern crash. First, lots of buyers, specifically inexperienced traders, enter the market. Secondly, the smarter and bigger players exit the market (they stop buying), effectively taking their gains. And third, and most importantly, buyers recognize that the price for the particular stock (in this case, flower bulbs) doesn’t match the real value of a flower bulb.<\/span><\/span><\/div>\n
\nThe lesson here is straight forward, intrinsic value is merely the real value of the respective asset you are buying. With tulip bulbs, it isn’t hard to figure it out. However, with a large institutional corporation like Walmart, it is a lot more difficult to fathom what you are buying.<\/span><\/p>\n\n
Intrinsic Value – Future Cash Flows<\/span><\/strong><\/h2>\n
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Intrinsic Value – Book Value<\/span><\/strong><\/h2>\n
![\"\"](\"https:\/\/businessecon.org\/wp-content\/uploads\/Coca-Cola-Book-Value-Last-Five-Years.png\")
<\/a> years.<\/span><\/p>\nIntrinsic Value – Net Assets at Fair Market Value<\/span><\/strong><\/h2>\n
\n.\u00a0<\/span> \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0Balance Sheet<\/span><\/strong>
\n.<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 12\/31\/2020<\/span><\/strong>
\n($000’s)\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Net Assets<\/strong><\/span>
\nASSETS\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 Book Value<\/span><\/strong>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0\u00a0Fair Market Value<\/span><\/strong><\/span>
\n.<\/span>\u00a0 Current Assets\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$2,435,000\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$2,418,000<\/span>
\n.<\/span>\u00a0 Fixed Assets\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 5,055,000\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a06,115,000<\/span>
\n.<\/span>\u00a0 Other Assets\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0410,000<\/span>\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 450,000<\/span><\/span>
\n.<\/span>\u00a0 Total Assets\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $7,900,000\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $8,983,000<\/span>
\nLIABILITIES\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a03,410,000\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 3,410,000<\/span>
\nEQUITY\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a04,490,000\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 5,573,000<\/span>
\n# of Shares\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 150,000\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0150,000<\/span>
\nValue\/Share\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 $29.93\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0$37.15<\/span><\/strong><\/p>\n