Thursday, June 24, 2010

What Is Intrinsic Value? – 2nd Level Calculations – Part 1

My definition of intrinsic value boils down to “a wonderful company fairly valued”. In previous posts I defined 14 value elements that describe what I mean by “a wonderful company fairly valued”. Now I’m looking for a better, simpler way to present the value elements & the way I use them.

The 14 Elements Value Elements Are:

(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

In each level of my three level stock analysis hierarchy I test potential stock investments against tougher standards. Each level requires additional data and additional calculations. Previous posts covered the data and calculations of 1st Level analysis and the data required for 2nd Level analysis.

The 2nd Level uses significantly more calculations than the 1st. Today’s post will begin to describe them.

2nd Level Calculations
The Excel workbook that is my stock analysis tool automatically recalculates whenever any formula value changes. So, in reality all calculations at the 2nd Level occur simultaneously. But I will describe them one at a time.

(1) “Dividend Yield” (Yield) as a percentage of the current share price is calculated by dividing the current annual dividend per share by the current share price. This is different from the dividend yield in the 1st Level in that I recalculate this yield each time I update the share price - for some stocks daily; for others it could be more than a year between updates.

(2) A numerical “Score” is calculated by multiplying the “Sales Growth Ratio” by the “Net Income Growth Ratio” & the “Dividend Growth Ratio”. The result is forced to zero if the “EPS Dividend Payout” is negative or greater than 100%. It’s also forced to zero if any of the growth ratios are negative. Exceptions are made for Funds and Limited Partnerships.

(3) An “Internal Rate of Return” (IRR) is calculated assuming that a share is purchased today at the current price and dividends are paid for seven years growing each year at an annualized growth rate (Dividend Growth Ratio/5) and then sold in year seven after appreciating at the same annualized growth rate. The IRR is calculated in a separate tab of the workbook and imported into the 2nd Level tab.

(4) In the same separate tab a “Net Present Value” (NPV) is calculated assuming a purchase at the current share price and the same seven annual dividend payments. A 9.0% Discount Rate is used with a zero salvage value; in other words, it assumes I don’t sell the stock in year seven. The NPV is also imported into the 2nd Level tab.

(5) "Intrinsic Value" is calculated using Benjamin Graham’s formula.

(6) A “Margin of Safety” results from subtracting the “Intrinsic Value” from the current share price.

(7) The “Revenue Constrained Net Income Growth Ratio” (Growth) is the “Net Income Growth Ratio” unless the “Revenue Growth Ratio” is smaller; in which case it’s the “Revenue Growth Ratio”.

(8) A rough “Compound Annual Growth Rate” (CAGR) calculation is imbedded in a formula for the “Total Annual Return” (Return). The Return is simply the sum of the CAGR & the current Dividend Yield.

The remainder of the 2nd Level calculations will be covered in the next post.

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

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