Friday, February 26, 2010

What Is Intrinsic Value? – Benjamin Graham’s View

Even a cursory examination of Warren Buffet’s writings will quickly turn up references to his teacher and mentor Benjamin Graham.

Ben Graham practically invented the securities analysis profession. He literally wrote their book, “Security Analysis” first published in 1934 and still in print after multiple updates.

Graham’s even more popular book, “The Intelligent Investor” brought the value investing concept to the individual investor. In this work Graham popularized terms that remain core to value investing; “intrinsic value”, “margin of safety”, and “Mr. Market”.

Since Ben Graham effectively invented the term “intrinsic value” I need to know what he meant by it. In pursuit of that goal I recently read, “Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street”, a biography written by Janet Lowe.

In the biography Ms Lowe quotes from Graham’s books, “Security Analysis”, “The Intelligent Investor”, and a third volume Graham authored, “The Interpretation of Financial Statements”.

“Statements” defines intrinsic value broadly as the real value of a company. This value may be very different from the company’s market price or its book value. It “approximates the price the whole company would bring if it were sold to a private buyer”. This definition isn’t very helpful to my quest. However, in other places Ben Graham fleshed it out with several concepts he used in real life practice.

Net Current Asset Value
Net Current Asset Value (NCAV) is defined as “current assets” less “current liabilities”. Roughly “current assets” is the sum of cash, marketable securities, inventory, and receivables. “Current liabilities” is roughly the sum of accounts payable and short term debt. All of these can be found on the company’s balance sheet.

Graham used NCAV as a screen. Stocks selling for less than NCAV per share he considered interesting but, “that factor alone was not conclusive evidence that the stock was undervalued.”

Graham frequently traded with short term objectives and arbitrage situations. However, he, “invariably advised individual investors to buy for the long term…” In “The Intelligent Investor” he introduced “six essential business factors” for individual investors to evaluate company performance.

Six Essential Business Factors
(1) Profitability: the ratio of operating income to sales (both found on the company income statement)

(2) Stability: the earnings per share trend over ten years; steady growth with no declines is perfect

(3) Growth: earnings per share trend compared to the market as a whole; Graham used the Dow Jones Industrial Average as the measure

(4) Financial Position: the ratio of current liabilities over current assets; Graham looked for this ration to be 0.5 or less.

(5) Dividends: a long and uninterrupted history of paying dividends; preferably with a trend of increasing dividends in proportion to increasing earnings per share

(6) Price History: a long term trend of share price appreciation in proportion to increasing earnings per share

Ben Graham also created a formula for individual investors to determine if a stock is undervalued:

The Formula: E(2R+8.5)*Y/4 = Intrinsic Value per share
E is defined as earnings per share
R is defined as the expected earnings growth rate
Y is defined as the current yield on AAA rated corporate bonds

The 8.5 was Ben Graham’s target price to earnings ratio (P/E) for a company with little or no growth.

Plug in the appropriate values for E, R, and Y and then do the arithmetic to determine Graham’s estimate of the intrinsic value per share of a company’s stock.

For Benjamin Graham to consider the stock a "buy" the stock price needed to be at least 20% less than the intrinsic value as calculated by the formula. And, the company needed to pass the test defined by the “Six Essential Business Factors”.

These criteria are as objective as they can be given the general reliability of published corporate financial results. I understand how to use them.

I’m not ready to declare victory in my quest, however. I’m looking for my personal definition of intrinsic value although Ben Graham’s definition is a pretty good base to work from.

Link to Other Topics in the Special Report: What Is Intrinsic Value?

Links to Books Referenced Above:
Security Analysis: Sixth Edition, Foreword by Warren Buffett (Security Analysis Prior Editions)
The Intelligent Investor: The Classic Text on Value Investing
The Interpretation of Financial Statements (1955 Revised Edition)
Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street

Friday, February 19, 2010

What Is Intrinsic Value? – Charlie Munger’s Checklist

Charlie Munger is Warren Buffet’s long time partner in running Berkshire-Hathaway. He is also a multibillionaire and a successful CEO in his own right. The Motley Fool ( discusses Charlie Munger’s “Investing Principles Checklist” in the February 8th, 2010 article, "Charlie Munger on How to Become Rich", by Morgan Housel.

The Investing Principles Checklist is a high level summary of recommended investor traits and behaviors. It’s not specifically about intrinsic value. However, four of Charlie Munger’s ten investing principles struck me as pertinent to my developing definition intrinsic value. First, the ten principles:

(1) Measure Risk
(2) Be Independent
(3) Prepare Ahead
(4) Have Intellectual Humility
(5) Analyze Rigorously
(6) Allocate Assets Wisely
(7) Have Patience
(8) Be Decisive
(9) Be ready for Change
(10) Stay Focused

Of the ten, these four struck a chord with me; (1) Measure Risk, (5) Analyze Rigorously, (6) Allocate Assets Wisely, and (7) Have Patience.

Under (1) Measure Risk, the objective is to assess how risky the proposed investment is. Does the business have a “moat” – an important competitive advantage? Is the investment overvalued?

For (5) Analyze Rigorously, the objective is to understand the potential investment – do your homework – and apply your research to whatever rules you’ve developed.

(6) Allocate Assets Wisely is about having and using an asset allocation plan. It also made me think that in order to take advantage of an opportunity you must have some cash available - or you’ll have to sell something. Having available cash – “keeping your powder dry” - seems like the better path. That means having a cash reserve for the purpose of taking advantage of investing opportunities.

(7) Have Patience means waiting for the right opportunity. It means waiting until others are fearful to become greedy; waiting until the price is right to provide the “margin of safety” that you want.

I’ve learned the following about intrinsic value from Charlie Munger’s “Investing Principles Checklist”:

(a) Intrinsic value includes the risk associated with the investment. I need to have a reasonable estimate of the reward and a reasonable estimate of the risk. And, knowing myself, I’ll need to analyze each separately.

(b) Intrinsic value may have nothing to do with maintaining a cash reserve for investment opportunities or with being patient until the price is right; but both behaviors enable an investment with the right intrinsic value - when I find it.

Link to Other Topics in the Special Report: What Is Intrinsic Value?

Friday, February 12, 2010

What Is Intrinsic Value?

Other Topics in the Special Report: What Is Intrinsic Value?

What Is Intrinsic Value? - Low Price?
What Is Intrinsic Value? - Buffet's Filter
What Is Intrinsic Value? - Charlie Munger's Checklist
What Is Intrinsic Value? - Benjamin Graham's View
What Is Intrinsic Value? - Dividend Growth
What Is Intrinsic Value? - Dividends
What Is Intrinsic Value? - A Consolidated List

What Is Intrinsic Value? - Buffet’s Filter

In my quest to determine what “intrinsic value” means to me in my own investment decisions it would be strange if I failed to consult the greatest living investor, Warren Buffet. His writings and quoted sayings are ubiquitous; but here are a few that resonate with me.

“… buy stock in businesses that are so wonderful that an idiot can run them; Because sooner or later, one will.”
From a panel discussion in 2008

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Berkshire-Hathaway 1989 Letter to Shareholders

“Here’s what we’re looking for:
“(1) Large purchases (at least $10 million of after-tax earnings),
“(2) demonstrated consistent earning power (future projections are of little interest to us, nor are “turnaround” situations),
“(3) businesses earning good returns on equity while employing little or no debt,
“(4) management in place (we can’t supply it),
“(5) simple businesses (if there’s lots of technology, we won’t understand it),
“(6) an offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when the price is unknown).”
Berkshire-Hathaway 1989 Letter to Shareholders

“The key to investing is … determining the competitive advantage of any given company and, above all, the durability of that advantage.”
July 1999 at Herb Allen’s Sun Valley, Idaho Retreat

So, what exactly resonates in these Warren Buffet quotes?

First, I want to own only wonderful businesses. I’ve seen first hand how an idiot at the top can destroy an average business. I’ve also witnessed a good, but not wonderful, business muddle through with an idiot at the top.

Second, don’t pay too much, but its okay to pay a fairly valued price for a wonderful business. Microsoft, Cisco, Amazon, and eBay may be wonderful businesses and fairly priced today, but for the folks who bought them in 2000 it’s been a very long decade

Third, a wonderful business has (a) consistent earning power; (b) good returns on equity; (c) little or no debt; (d) good current management; (e) a business model I understand; and (f) a durable competitive advantage.

That’s a great list. However, every item needs a detailed definition before it becomes actionable. For example; what does “fairly valued” mean? What is consistent earning power? What is a good return on equity? How do you know the current management is good versus just lucky? What is a company’s competitive advantage and what would make it durable?

I’m making progress here. But I’ve still some way to go before I’ll know exactly what intrinsic value means to me

Link to Other Topics in the Special Report: What Is Intrinsic Value?

Friday, February 5, 2010

What Is Intrinsic Value? - Low Price?

“Price is what you pay; value is what you get.”
Benjamin Graham

As with most things, the momentary price of a stock is easy to determine. Today, delayed stock quotes are available from many on-line services and real time quotes can be had through most on-line brokerage houses including mine, USAA Investment Management Company.

As with most things, the value, or “intrinsic value”, of what you are about to buy is much harder to discern. John Templeton, one of history’s greatest investors seems to have equated value with low price. Or rather, he was certain that a basket of low priced stocks purchased during periods of market pessimism would perform well; with the good performers dominating the poor performers. He bet his life on this strategy at the beginning of his career as illustrated by the following quote from the web site

“While standard stock-buying advice is “buy low, sell high,” Templeton took the strategy to an extreme, picking nations, industries, and companies hitting rock-bottom, what he called “points of maximum pessimism.” When war began in Europe in 1939, he borrowed money to buy 100 shares each in 104 companies selling at one dollar per share or less, including 34 companies that were in bankruptcy. Only four turned out to be worthless, and he turned large profits on the others after holding each for an average of four years.”

At least in this case, John Templeton didn’t try to determine the intrinsic value of the 104 companies in his 1939 portfolio. He assumed that most of them were worth more than the price he paid. If 52 of the companies failed and the other 52 doubled he would have broken even.

In hindsight, his risk seems small and apparently it seemed so to him at the time. However, because he borrowed the money used to buy the 104 companies, at lot depends on the terms and conditions of his loan and the speed in which his portfolio would grow. We don’t know the terms of his loan, but obviously the deal seemed favorable.

Recently, this was a viable strategy again. Last spring one could have bought a basket of seriously depressed financial companies for under $10 per share. Those who pulled the trigger have done very well to date. I wasn’t one of them. And, despite the current much higher prices of financials, I have no desire to own any. My perception of their value is much lower than their current price.

The question is why do I think that? What does intrinsic value mean to me? I’m going to think this through over the next few posts.

I think more clearly when I write. And there is nothing like a posting deadline to force me to write.

Link to Other Topics in the Special Report: What Is Intrinsic Value?