Friday, April 23, 2010

What Is Intrinsic Value? – Business Model I Understand

My definition of intrinsic value boils down to “a wonderful company fairly valued”. By judging 14 value elements I’ll determine if a company deserves this description. It’s my intention to select and buy stocks based on their intrinsic value and to thereby get rich slowly; rich enough, at least, to fund my retirement.

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) Reliable Long Term Dividend Income Stream
(13) Increasing Annual Dividends Faster than Inflation
(14) Expect at least a 9% Total Return Compounded Annually

(9) A Business Model I Understand
Value element number (9) is borrowed from Warren Buffett’s list. At its root, “A Business Model I Understand” means staying within my circle of competence – those industries and technologies that I “grok”. If I intuitively grasp the product or service and the framework of how the business makes a profit – then I can say the company has a business model I understand.

If, on the other hand, in my mind the products or services are best be represented by a “black box” and I haven’t a clue how the black box makes a profit – then, clearly, I don’t understand the business model. This is a subjective evaluation. Only I can decide whether or nor I “get” a particular business. And, I ether get it – or I don’t. So, I will score value element (9) as either a “-1” (for businesses I don’t understand) or “+1” for those I do.

Since a blank field in Excel is interpreted as a zero in most calculations, a “0” rating for value element (9) will mean I haven’t yet assigned a value.

Research and learning will sometimes change a company’s score for this value element. In 2007, I thought I understood the business model of American banks. In 2008, I discovered that I didn’t. In 2006, I knew I didn’t understand the energy business very well but, after a fair amount of reading, I understand it much better in 2010.

Thinking through this simple mechanism helped me clarify exactly what I mean by “A Business Model I Understand” and now I see how to incorporate this value element into my overall analysis of a stock.

Next, I’ll tackle value element (10) “A Durable Competitive Advantage”.

Link to Other Topics in the Get Rich Slowly Report: What Is Intrinsic Value?

No comments:

Post a Comment