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

1 comment:

  1. Great article, Neko.

    Ben Graham's influence on fundamental investors like me is incalculable.

    Finding great companies trading at attractive margins of safety to their intrinsic value has never failed!