What Is Intrinsic Value? – Competitive Advantage

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

(10) A Durable Competitive Advantage
Value element number (10) is taken from Benjamin Graham and Warren Buffet. They’ve frequently called it an “economic moat” or more often just a “moat”. The idea is that some companies have developed an unassailable position in their industry and markets. The advantage might come from brand loyalty as with Coca Cola and Altria (Marlboro Brand). It could derive from infrastructure as with WalMart and Burlington Northern or from a culture of innovation like Apple or Google. It could come from anything, but wherever it comes from and whatever it is, it gives a company a dominant competitive advantage. Berkshire-Hathaway’s competitive advantage is having Warren Buffet and Charlie Munger running the company.

Because the Moat, if it exists, could be anything it must be found through analysis and judgment. Since it can be intangible it can’t be calculated nor can the degree of advantage be easily calculated. So, I’ll assign a subjective integer score from 0 to 3 with a “3” meaning a maximum competitive advantage and a “0” meaning no competitive advantage exists.

I’ll rely on my research, my experience, and my judgment to assign the competitive advantage score knowing it’s an imprecise estimate and I’ll sometimes be wrong. I hope to err to the low side of the scale. That is, unless a competitive advantage seems obvious to me I’ll assume there’s none.

In my investment analysis I’ll prefer companies with higher scores but I won’t exclude companies solely because their score is low.

Next, I’ll measure risk; value element number (11),

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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”.

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What Is Intrinsic Value? – Little Or No Debt

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

(8) Little or no debt
Wonderful companies have little debt. This ensures that in difficult times they can service their debt without endangering their survival. I’ll measure my eighth value element, “Little or no debt”, by picking up a company’s “Current Ratio” and its “Total Debt / Equity” ratio from The Motley Fool - Stats Tab after logging into the site.

“Current Ratio” is defined as current assets divided by current liabilities from the company’s balance sheet. I prefer to use the inverse of the current ratio (current liabilities divided by current assets. So, when I pick up the “Current Ratio” from The Motley Fool - Stats Tab I’ll divide it into “1.0” to get the inverse.

On April 14th, 2010 the “Current Ratio” for Abbott Laboratories (ABT) was “1.80”. The inverse then is 1/1.80 = 0.56. In my analysis I’ll penalize companies for relatively higher Inverse Current Ratios.

I’ll use the “Total Debt / Equity” ratio exactly as shown on The Motley Fool - Stats Tab. And, I’ll also penalize companies for relatively higher “Total Debt / Equity” ratios.

Eight value elements are defined leaving six more to go.

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What Is Intrinsic Value? – The Ben Graham Formula

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

(6) The Formula: E(2R+8.5)*Y/4 = Intrinsic Value per share
Benjamin Graham offered this formula for intrinsic value in his book for individual investors, The Intelligent Investor: The Classic Text on Value Investing.

The three formula parameters are:
E – Current earnings per share
R - The expected earnings growth rate
Y - The current yield on AAA rated corporate bonds

Benjamin Graham’s definition of intrinsic value is not mine. I’m not really a “value investor” in the pure sense – perhaps not in any sense. I’m not trying to buy deeply discounted stocks with the intention of selling them when they rise to their intrinsic value. My intention is to buy growing companies that pay growing dividends and to hold them for as long as they continue doing both.

Of course, I’ll be happy to buy them at a deep discount but that’s not the reason Ben Graham’s formula is one of my value elements. I’m willing to pay fair value for a stock that’s likely to meet my financial objectives - but I want to avoid paying too much.

So, I’ll calculate Benjamin Graham’s intrinsic value (GIV) and compare it to the current stock price. If the stock price is less than the GIV it’ll pass my filter. If it also passes Graham’s 20% margin of safety rule I’ll give it extra credit.

I need the values of his three parameters in order to calculate GIV. Here’s how I’ll get them.

E – Current earnings per share
I’m already picking up the earnings per share (EPS) as part of value element (1) Strong Cash Flow so I’ll simply use that value for E.

R - The expected earnings growth rate
I calculate an historical earnings growth ratio as part of element (2) Strong Earnings Growth. I’ll use that value for R.

Y - The current yield on AAA rated corporate bonds
I’ve not been interested in the yield on AAA corporate bonds so far. Fortunately, this parameter isn’t dependent on each company’s performance. I can check it periodically and use the value in all of the GIV calculations.

I’ve found a reasonable source for this figure at the Yahoo! Finance Bond Center. The average yield for ten year AAA rated corporate bonds on April 7th, 2010 was 3.78%. This will be my value for Y. I’ll refresh the parameter at least monthly.

With the parameters defined and sourced I can simply plug them into the Benjamin Graham GIV formula recreated in an Excel workbook and calculate GIV for each stock I analyze.

With this I’ve defined exactly half of my fourteen value elements. Some of the rest will be harder I think.

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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.

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