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Estimating a share’s intrinsic value 101

In my previous article on thinking rationally about shares, I outlined the case for buying quality companies at a discount to intrinsic value. But what is that? The basic formula for estimating intrinsic value, using an approach called excess returns, is simple arithmetic. It compares the return generated by the business’s equity to the return that an investor should reasonably expect from a share market investment and uses the result to determine what premium to pay for the equity. The formula is:

(Return on Equity / Required Return) X Equity = Intrinsic Value Estimate

To obtain intrinsic value per share, divide the result by the number of shares on issue.

While the division and multiplication are simple, producing a straight line model with its own set of limitations and determining the inputs requires some thought. It’s a case of garbage in, garbage out. When Berkshire’s Charlie Munger was asked what made him such a successful investor, he responded by offering “My guesses are better than yours.”

Applying the formula

By way of example, let’s examine Wesfarmers’ purchase of Coles many years ago. At the time, Coles’ Equity was $4.3 billion, Return on Equity was 25%, and for this example only, adopt a Required Return of 13% – half the Return on Equity being produced at the time. The valuation formula, assuming all earnings are taken out as dividends, would be:

(25% / 13%) X $4.3 billion which equals $8.3 billion

A word of warning: don’t apply this formula to a company that retains profits. If the company retains profits and generates a return on its equity that is lower than your required return, the above formula will overstate the value of the company. If the company you are examining retains profits and generates a return that is higher than your required return, the above formula will understate the value of the company.

In my book Value.able, I demonstrate a set of steps to follow to provide an estimated value for any company, anywhere in the world, not just those that pay out all the earnings as a dividend. You might also like to read Warren Buffett’s 1981 letter to Berkshire Hathaway shareholders. You can click here to download it.

Quite simply, when the prices of shares trade below an estimate of their value, they become candidates for inclusion into your portfolio, investing no more than 3 to 7% of your portfolio in any one of these opportunities. And this is where the rubber hits the road. When investors forego the opportunity to buy shares in wonderful businesses because of short-term concerns about the economy or because of fears that falling prices mean risks have increased, a major opportunity may be missed.

This includes businesses which the market quickly marks down in response to negative news. Having bought shares in Sirtex recently below $19 ($29 at time of writing) after divergent expectations appeared following the release of trial results, and McMillan Shakespeare below $7.50 ($12.50 now), after proposals for damaging legislation, my view is that you should take advantage of other people’s fears rather than listen to them. Volatility in shares prices, especially if you are a net buyer over the years, represents an opportunity rather than risk.

Buy now and receive more later

‘Investing’ is the laying out of money today to receive more in the future - nothing more, nothing less. The safest way to do that in the stock market is to buy shares in sound businesses when they are cheap.

Shares in extraordinary businesses are cheap when they are at a discount to the appropriate multiple of equity based on the profitability of that equity. High dividend yields or low price to earnings (PE) ratios may exist, but these are not a pre-requisite to a bargain. Indeed, the way I have demonstrated the calculation of intrinsic value, a company’s shares could display a high PE ratio and a low dividend yield and still be a bargain. Indeed, we hold stocks with PE ratios ranging from 14 times to 29 times and they are still regarded as good value.

The rest of your time should be spent thinking about the competitive landscape a business is in to determine what pressure may be leveled against its future profitability. More than perhaps anything else, you need to understand the future return on equity.

Gradual portfolio construction is important

Finally, turn your mind to the mechanics of portfolio construction.

Wouldn’t it be nice if the market knew you were going to be investing millions tomorrow, so fell by an appropriately substantial amount to accommodate your purchase, then returned to today’s level? Unfortunately it never works out that way, yet some advisers might go ahead and invest all your money, all at once, as if it just did.

The reality is that you will likely take many months, if not years, to fill your portfolio with wonderful businesses, purchased at discounts to intrinsic value. But don’t lose patience and don’t think about stocks. If you think about stocks you’ll be tempted to chase them higher and pay too much. Instead think of stocks as slices of businesses. Business performance changes slowly. So fill your portfolio with a selection of great businesses, like CSL, Challenger, CBA and REA, buying them only when they are below intrinsic values.

Put together a portfolio of great businesses, purchased at fair prices, whose earnings you are confident will be materially higher in 5 or 10 years, and you will do well over the very long run.

 

Roger Montgomery is the Chief Investment Officer of The Montgomery Fund. This article is for general education purposes and does not address the specific circumstances of any individual.

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8 Comments

Dean Tipping

June 24, 2015

Another great piece of information afforded by Roger. Never tire of reading his material or following his thoughts in other areas of the media, which are always so rational and logical. Please keep that sort of stuff coming. Thank you Roger.

Graham Hand

June 20, 2015

Thanks for the questions on Roger's articles. He is away at the moment, we will try to find answers from someone else or may need to wait for his return.

Andre

June 19, 2015

Hi Roger,

Thanks for this great article. It makes a lot of sense and explains why we often see the likes of Warren Buffet buying when everyone else is selling. Could you please clarify 3 points for me?

I too am looking for clarification via an example as per below.
EXAMPLE Using RCG (I use Lincoln Indicators data for ROE, mkt cap & shares on issue)
(The ROE is 31.26% / my choice of required return say 15%) x market cap $316.72m = RCG intrinsic value $660.04m / number shares outstanding 268.41m = intrinsic value per share is $2.46 (compared to current market price of $1.18) This suggests RCG is a great buy!

However, if we use the one year forecast (ROE of 10.85% / 15% RR) x mkt cap $316.72m = RCG intrinsic value $229.09m / # shares on issue 268.41m = intrinsic value per share is $0.85. Suddenly RCG is a sell!

Which should I use from the above calculation the current or forecast ROE? Does the forecast ROE in this case suggest that RCG's earnings are expected to fall over the next year?

I also would like clarification around what the "required return" is.Is it simply a figure I choose and what if I choose too low or too high a figure? This seems very arbitrary or is there a method to arrive at this?

I also would appreciate clarification around your word of warning in applying the formula. You suggest that, if the company retains profits and generates a lower ROE than my required return, this will overstate the value of the company. Using the RCG example
(assume ROE is 10% / required return 15%) x mkt cap $316.72m = intrinsic value $211.1m which is lower not higher than the above value. Is this simply a matter that you may have incorrectly reversed the meaning in the article i.e. the article should have read where a company retains profits it generates a lower ROE, which would UNDERSTATE the value of the company, not overstate it? Additionally the required return could create a lower or higher intrinsic value also, so thast number again becomes very important, so what is the correct number to use for "required return" and how is it arrived at?

Thanks,
Andre

Roger Montgomery

June 23, 2015

Hi Andre,

The correct formula is ROE / RR * Equity.

Basically this is a bond-valuation formula which assumes all of the companies earnings (ROE) are paid out.

Unfortunately you have used ROE / RR * Market Cap (which unfortunately is incorrect).

Using this basic formula, the correct inputs (ballpark and based on 2016 forecasts) would be;

NPAT $26.6m / Shareholders Equity $222m = 12% ROE

If you require a 10% return and believe that RCG will not grow much from here, formula becomes 12%/10%*$222m = $266.4m. $266.4m / 450.6m shares on issue = 59c.

A word of warning, dont apply this formula to a company that retains profits - for if retains capital, its likely to grow earnings in the future and this model will underrate the companies valuation.

RCG likely fits that description as its growing earnings at a compound rate of 23.5 per cent per annum since 2005.

tohoku

June 19, 2015

Dear Roger,
Thank you for the article above.

Using a different example, because Coles is no longer listed on the ASX and these numbers are not available. I have been tracking SIP for 1 year now, and I would like to apply your strategy.

9.1% (RoE) / 10% (RR) x 814.6million (MrkCap) = 757578000$

If that is correct, than what does the 757million tell me?

Thanks for either writing an article about how to interpret the figure or for letting me know directly.

Sincerely,
Tohoku

Roger Montgomery

June 23, 2015

Hi Tohoku,

In the stock market, my requirement is a minimum 10 per cent return after tax. The risk in the stock market is simply too high to accept a lower rate.

That compensates me for longer-term bond rates of 5% and an equity risk premium of a further 5%. I may be prepared to lower that (Equity risk premium) to 3% for the very best companies, buts not often the case.

What does the $757m figure tell you? Not much given you have calculated it incorrectly. The correct formula is ROE / RR * Shareholders Equity. Basically this is a bond-valuation formula which assumes all of the companies earnings (ROE) are paid out.

If a company is generating 9.1% ROE, pays all of that out as a dividend and you require a 10% return and has $573m in equity (which SIP has presently on their balance sheet) - the max you should pay for the business is $521.43m (.091/.1*573).

E.g. 573m equity at 9.1% ROE = $52.1m after tax profits. If I pay $521.43m, then if the business continues to generate $52.1m and pay that all out as a dividend, my return is $521.43/$52.1m = 10%

SIP has a current market cap of $836m so investors are either accepting a lower return, OR, are of the view that the businesses earnings are likely to grow in the future (not pay all their earnings out as a dividend).

tohoku

June 19, 2015

Dear Roger,

You did not explicitly state where the number for "required return" comes from. You simply stated, if I understand correctly, that this number is determined by the buyer.

So, if I want a 10% return on my investment, I should use that number, is that correct?

Using this logic someone who wants to use 15% return, should use that number. If that is the case, does this actually affect the true actual value of a company? because it becomes subjective to the investor's needs and not market fundamentals.

Thank you for clarifying this.
Sincerely,
Tohoku

Rod Shepherd

October 22, 2018

mmm...

This is why I leave the details to the Montgomery Fund in which I invest.

Rod


 

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