Thursday, July 15, 2010

What Is Intrinsic Value? – 3rd Level Calculations

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

I use a three level hierarchy to test each stock. In previous posts I explained the 1st Level and 2nd Level analysis. In my recent post I reviewed the 3rd Level Data; Now, I’ll take up the 3rd Level calculations & decision criteria.

The essence of the 3rd Level analysis is a deeper look at the company’s financial data and including it in the resolution of the Meta-Parameter introduced in the 2nd Level analysis.

The Meta-Parameter is adjusted by the additional data but the same decision criteria are applied to the revised value.

All 3rd Level data discussed in the previous post are involved in the revision of the Meta-Parameter as are the following elements.

“Cash Flow per EPS” is a simple ratio and equals “Cash Flow per Share” divided by “Earnings per Share” (EPS).

“Inverse Cash Flow Payout Ratio” is similar and equals “Cash Flow per Share” divided by “Annual Dividend”.

Financial Score:
The “Financial Score” aggregates all 3rd Level data elements from the previous post with the two elements above. It’s calculated by:

First, testing the “Business Model” data element; If the value of “Business Model” is less than zero the Financial Score is assigned a value of negative one hundred (-100). If “Business Model” is greater than or equals zero then the calculation continues.

Second, the value of the data element “Inverse Current Ratio” is subtracted from an initial value of zero.

Third, two times the “Debt to Equity” value is subtracted from the interim value.

Fourth, “Cash Flow per EPS” is added to the interim value.

Fifth, “Inverse Cash Flow Payout Ratio” is added to the interim value.

Sixth, “Return on Equity” is added to the interim value.

Seventh, Two times the “Return on Assets” is added to the interim value.

Eighth, “Insider Owners” is added to the interim value.

Ninth, “Competitive Advantage” is added to the interim value producing the final value of the “Financial Score”.

The above calculations are performed on a tab separate from the 2nd Level Analysis tab. The value of the “Financial Score” element is then brought over to the 2nd Level Analysis Tab.

Meta-Parameter Revision:
When 3rd Level Analysis data is available an additional parameter, the “Financial Score Parameter”, is activated in the calculation of the Meta-Parameter value.

“Financial Score Parameter” = 0 if the value of “Financial Score” is less than zero; = 1 if the value of “Financial Score” is greater than or equal to zero; = 2 if the value of “Financial Score” is greater than 2.

The pre-existing Meta-Parameter value is multiplied by the new “Financial Score Parameter”. It's clear that a zero value of “Financial Score Parameter” will drive the Meta-Parameter to zero; a value of one will leave it unchanged and a value of two will double it.

The decision criteria remain the same, so if the revised Meta-Parameter value is greater than or equal to 16 (an arbitrary cut off) the stock passes the 3rd Level Analysis test.

My stock analysis for the buy decision is, for me, a very complicated algorithm. Working through it has helped me refine it, correct some mistakes, and understand it better.

Next, I’ll try to develop a way to summarize it so I can clearly communicate the concepts behind it.

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

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