Friday, May 7, 2010

What Is Intrinsic Value? – Measure Risk

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) 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

(11) Measure Risk
Value element number (11) “Measure Risk” comes from Charlie Munger. However, it fits with Warren Buffet’s “Rule #1 – Never lose money.”

There are many sources of investment risk; some of them are:

Political risk – the risk that government action might harm a company’s business performance; for example withdrawing a previously granted oil drilling lease on government land (recently done in the United States by the Obama Administration) or even expropriating a company’s assets as was done to several oil companies by Venezuela.

Management risk – the risk that corporate management will do something stupid, like running a bank at more than 30:1 debt leverage aka Citibank in 2007. This is why Peter Lynch, the acclaimed former manager of the Fidelity Magellan Fund, said he wants to invest in companies that a monkey could run, because eventually one will.

Obsolescence risk – the risk that a company’s primary product or service may be replaced by an entirely different technology; this is the reason the New York Times hasn’t made a profit in years and why “Newsweek” seems to be for sale.

Economic cycle risk – the risk that a company’s revenue and earnings will be strongly affected by the business cycle; with profits in cycle peaks and losses at the bottom of recessions.

Business model risk – the risk that something intrinsic to the business might significantly damage the company’s performance, for example; Causality Insurers are subject to the risk of a serious natural disaster such as a major earthquake or hurricane. Airlines are subject to the risk of flight disruptions from weather and terrorism. Pharmaceuticals are at risk that they'll be unable to develop new drugs to replace revenue lost when a major drug patent expires.

There are probably many other risks, but this list is sufficient for me. Instead of trying to address each type of risk I’ll seek to invest it robust companies that can survive most risks.

To this end value elements (1) Strong Cash Flow, (8) Little or No Debt, (9) Business Model I Understand and (10) A Durable Competitive Advantage are very important. Scoring well in elements (1), (8) & (10) will allow a company to weather many storms.

Scoring poorly in (9) is a red flag warning me that I don’t know what the risks are with this company. I recently sold my positions in two Business Development Companies (BDC’s) as a result of measuring value element (9). I don’t understand the multitude of financial instruments used by BDC’s to invest in their portfolio companies. I find BDC annual reports baffling, so even though I sold them for nice profits I won’t buy them again unless I first learn how they make money.

Dividend Risk
Since I’m primarily a “Dividend Growth” investor I’m concerned with the safety of a company’s dividend payout. Therefore, I’ll measure the risk of a dividend cut with a “Dividend Payout Ratio”. This ratio will be calculated by dividing the annual dividend payout per share by the earnings per share (Div/EPS). I’m already collecting these values in order to measure other value elements. I won’t consider companies with negative payout ratios or ratios greater than 100%. I’ll prefer companies with payout ratios less than 50%.

I’ll also calculate a “Cash Flow Dividend Payout Ratio” by dividing cash flow per share by annual dividends per share (CF/Div). Cash flow per share (CF) is collected for value (1) Strong Cash Flow, so it’s already available. I’ll prefer companies with higher values of CF/Div

There’s no way to escape investment risk. However, by measuring risk (or perhaps lack of risk) and requiring companies I invest in to score well on the risk measurements including dividend risk; I hope to pursue Buffet’s Rule #1 – Never lose money.

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

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