Thursday, April 1, 2010

What Is Intrinsic Value? – Profitability & Return on Equity

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.

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

(5) Profitability
I’ll measure the fifth of my fourteen value elements, Profitability, in three ways. First, I’ll pick up the “Earnings/Share” field from the MSN Money web site in the upper right corner of the “Quotes” page. The “Earnings/Share” or EPS as recorded on this screen for Abbott Laboratories (ABT) before the market opening on April 1st, 2010 was 3.69 - an annualized $3.69 of earnings per share of common stock posted by ABT in the previous fiscal quarter. Regardless of share price or industry the EPS of a wonderful company will be greater than zero.

Second, the “five year net income growth ratio” that I described in my post "What Is Intrinsic Value? - Cash Flow & Earnings Growth" must be a positive number. And, when I pick up the two end point net income figures I’ll note whether or not the intervening three years are all in the black. I will, depending on what I see, use one of the more recent year net incomes as the starting point for the ratio. For example, if the net income of the fifth year back was negative but the next four years were all positive, showing an increasing trend, I may use the fourth year back as the starting point of the ratio and force the ratio positive. However, if the fifth year was positive and the most recent year was also positive but the three years in the middle were all negative, I may use the fourth year back as the starting point to force the ratio negative.

Third, from The Motley Fool - Stats Tab I’ll record the “Return on Assets” metric. The Return on Assets for ABT after the market closed on April 1st, 2010 was displayed as 11.00 or 11.00%. Return on Assets is a metric with different norms depending on the industry. I won’t try to keep track of industry norms but I’ll reward a company with higher regard - proportionate with its higher Return on Assets.

(7) Good Returns on Equity
My seventh value element, “Good Returns on Equity”, I’ll measure by collecting the “Return on Equity” from the same Motley Fool web site – in fact Return on Equity is located immediately above Return on Assets. Once again, instead of targeting a specific number for Return on Equity – even though I prefer this measure to be greater than 15% - I’ll reward a company with higher regard proportionate with higher Return on Equity.

For the curious, ABT’s Return on Equity was 25.1% after the market closed on April 1st, 2010.

My next post will tackle “The Formula” – Ben Graham’s recommended calculation of intrinsic value from The Intelligent Investor: The Classic Text on Value Investing.

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

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