Thursday, March 25, 2010

What Is Intrinsic Value? – Cash Flow & Earnings Growth

My definition of intrinsic value boils down to “a wonderful company fairly valued”. I’ll determine if a company deserves this description by judging 14 value elements.

14 Elements in My Definition of Intrinsic Value
(1) Strong Cash Flow
(2) Strong Earnings Growth
(3) Dividend Consistency
(4) Consistent Dividend Increases
(5) Profitability
(6) The Formula: E(2R+8.5)*Y/4 = Intrinsic Value per share
(7) Good returns on equity
(8) Little or no debt
(9) A business model I understand
(10) A durable competitive advantage
(11) Measure Risk
(12) Providing reliable long term dividend income streams
(13) Increasing annual dividends faster than the inflation rate
(14) Expect to generate at least a 9% total return compounded annually

(1) Strong Cash Flow
I’ll directly measure cash flow per share using the figure published by The Motley Fool in the Caps Community tab; selecting “Stocks” from the options at the top of the screen and “Stats” from the selections below the graphical comparison to the S&P 500 (SPY).

A wonderful company will have positive cash flow per share regardless of share price or industry. And, I’ll regard companies more highly in proportion to the ratio of their Cash Flow per Share to Earnings per Share (CF/EPS).

I’ll also use proxies for cash flow. I’ll require positive earnings per share (EPS) and a dividend payout ratio to EPS greater than 0% and less than 100%. MSN Money displays the annualized dividend payment (Dividend & Yield) and most recent annualized earnings per share (Earnings/Share) in the upper right hand corner of the screen after you enter the ticker symbol and press the “Get Quote” button. Dividing the stated dividend by the earning per share produces the dividend payout ration.

(2) Strong Earnings Growth
Wonderful companies will demonstrate the ability to make money over time by showing positive and growing net income over the past five years.

On the left side center of the same MSN Money screen select “Financial Results” and then “Statements” to see the company’s Income Statements for the most recent five years. The “Net Income” line is about 2/3 down from the top of the screen. Dividing the most recent net income by the net income from five years prior will produce a growth ratio.

If the growth in revenue over the five year period is less than the growth in net income I’ll assume the earnings growth is unsustainable and use the five year revenue growth ratio (calculated in a similar manner) as a proxy for the net income growth.

A wonderful company will have a five year net income growth ratio greater than 1.0 and will get extra credit if the ratio is greater than 2.0.

So far I’ve defined measurements for value elements (1), (2), (3), & (4) – more to come.

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

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