What Is Intrinsic Value? – Cash Flow & Earnings Growth

My definition of intrinsic value boils down to “a wonderful company fairly valued”. I’ll determine if a company deserves this description by judging 14 value elements.

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

(1) Strong Cash Flow
I’ll directly measure cash flow per share using the figure published by The Motley Fool in the Caps Community tab; selecting “Stocks” from the options at the top of the screen and “Stats” from the selections below the graphical comparison to the S&P 500 (SPY).

A wonderful company will have positive cash flow per share regardless of share price or industry. And, I’ll regard companies more highly in proportion to the ratio of their Cash Flow per Share to Earnings per Share (CF/EPS).

I’ll also use proxies for cash flow. I’ll require positive earnings per share (EPS) and a dividend payout ratio to EPS greater than 0% and less than 100%. MSN Money displays the annualized dividend payment (Dividend & Yield) and most recent annualized earnings per share (Earnings/Share) in the upper right hand corner of the screen after you enter the ticker symbol and press the “Get Quote” button. Dividing the stated dividend by the earning per share produces the dividend payout ration.

(2) Strong Earnings Growth
Wonderful companies will demonstrate the ability to make money over time by showing positive and growing net income over the past five years.

On the left side center of the same MSN Money screen select “Financial Results” and then “Statements” to see the company’s Income Statements for the most recent five years. The “Net Income” line is about 2/3 down from the top of the screen. Dividing the most recent net income by the net income from five years prior will produce a growth ratio.

If the growth in revenue over the five year period is less than the growth in net income I’ll assume the earnings growth is unsustainable and use the five year revenue growth ratio (calculated in a similar manner) as a proxy for the net income growth.

A wonderful company will have a five year net income growth ratio greater than 1.0 and will get extra credit if the ratio is greater than 2.0.

So far I’ve defined measurements for value elements (1), (2), (3), & (4) – more to come.

Link to Other Topics in the Special Report: "What Is Intrinsic Value?"

Investing Library

Link to other Book Reviews

A Selection of Books From My Investing Library:

Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street - Book Review

Yes, You Can Still Retire Comfortably!: The Baby-Boom Retirement Crisis and How to Beat It

Yes, You Can Time the Market!

Yes, You Can Be A Successful, Income Investor: Reaching for Yield in Today's Market

Relative Dividend Yield: Common Stock Investing for Income and Appreciation, 2nd Edition

The Dividend Growth Investment Strategy: How to Keep Your Retirement Income Doubling Every Five Years

Beating the S&P with Dividends: How to Build a Superior Portfolio of Dividend Yielding Stocks

The Dividend Rich Investor: Building Wealth with High-Quality, Dividend-Paying Stocks

All About Dividend Investing, Second Edition (All About Series)

What Is Intrinsic Value? – A Consolidated List

By combining value elements advocated by Benjamin Graham, Warren Buffet, Charlie Munger, and Peter O’Shea & Jonathon Worrall with my own investment goals, I’ve arrived at something I think is my definition of intrinsic value.

It’s mine because the combination meshes with how my actual investing behavior evolved over the past five years. I started out following Jim Cramer and thinking that a month was a reasonable investing time horizon. I gradually learned that such a short horizon was trading and speculating – not investing.

I read a lot and tried things and found that some things worked better for me than others. I found that Warren Buffet’s “forever” holding period works very well with my basically long range “turtle” approach to life in general. And I realized that if “forever” was indeed my preferred holding period dividends were required, otherwise stock certificates may as well be used as wall paper.

So I began my search for a personal definition of intrinsic value. It’s resulted in the following 14 value elements.

From Benjamin Graham, Peter O’Shea and Jonathon Worrall I’ve taken:

(1) Strong Cash Flow
(2) Strong Earnings Growth
(3) Dividend Consistency
(4) Consistent Dividend Increases

From Benjamin Graham I’ve adopted:

(5) Profitability
(6) The Formula: E(2R+8.5)*Y/4 = Intrinsic Value per share

From Warren Buffet:

(7) Good returns on equity
(8) Little or no debt
(9) A business model I understand
(10) A durable competitive advantage

From Charlie Munger:

(11) Measure Risk

And I want my investments to have a relatively high probability of achieving my goals of:

(12) Providing reliable long term dividend income streams
(13) Increasing annual dividends faster than the inflation rate
(14) Expected to generate at least a 9% total return compounded annually

In my previous post I described how I would measure

(3) Dividend Consistency
(4) Consistent Dividend Increases

Next I’ll determine how I’ll measure the other 12 of the 14 chosen value elements.

14 Value 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

Link to Other Topics in the Special Report: What Is Intrinsic Value?

What Is Intrinsic Value? – Dividends

Two of Benjamin Graham’s value elements I’ve incorporated into my personal definition of intrinsic value are (1) the consistent payment of dividends and (2) consistent increases in dividend payments.

These elements are important to me for the following reasons:

a. Consistent dividend payments mean I can hold the stock throughout my retirement deriving income without selling shares.

b. Consistently increasing dividend payments mean the dividend income stream will offset inflation in whole or in part.

c. Consistently increasing dividend payments communicate that corporate management is managing cash flow and has confidence in the future of the business.

I’ve chosen two methods of measuring dividend consistency and increase. First, I record the current annual dividend payment and the annual payment from five years previous. I then compare the two as a ratio of current/prior and require the ratio be greater than 1.0; higher is better of course but I’ll assume an increase greater than the rate of revenue increase is unsustainable.

Second, there are two indexes that screen stock for these dividend characteristics. The Indxis Dividend Achievers are, “companies that have increased annual regular cash dividends for at least the past 10 consecutive years and have met specific liquidity screening criteria. Dividend Achievers are typically companies with strong cash reserves, a solid balance sheet and a proven record of consistent earnings growth.”

320 companies qualified for the January 2010 Dividend Achievers list from all over the world. The companies on the Achievers list get some form of “extra credit”

The S&P 500® Dividend Aristocrats has even more stringent criteria it, “measures the performance of large cap, blue chip companies within the S&P 500 that have followed a policy of increasing dividends every year for at least 25 consecutive years.”

43 companies qualified for the most recent Dividend Aristocrats list and they get extra “extra” credit in my calculation.

Link to Other Topics in the Special Report: What Is Intrinsic Value?

What Is Intrinsic Value? – Dividend Growth

I’m convinced that the dividend growth investment strategy is best suited to my investment goals and my temperament. Even so, I still need to actually pick stocks for my portfolio and I don’t want to overpay for them. Therefore, I’m on a quest; searching for my own personal definition of “intrinsic value” – my own method of selecting investments for their dividends, their value, and their price appreciation.

I’ve learned some things from Warren Buffet, from Charlie Munger, and from Benjamin Graham. And, I’ve combined what I’ve learned from them with what I have learned over the years about myself and about what I have been able to make work.

I’m getting close to a working definition of “intrinsic value”.

A couple of books on dividend investing have aided my quest; the most useful was “Beating the S&P with Dividends: How to Build a Superior Portfolio of Dividend Yielding Stocks”.

Beating the S&P with Dividends: How to Build a Superior Portfolio of Dividend Yielding Stocks

In this excellent reference book, Peter O’Shea and Jonathan Worrall outline the characteristics of superior dividend stocks. They recommend selecting dividend stocks for:

(1) Strong Cash Flow
(2) Strong Earnings Growth
(3) Dividend Consistency
(4) Consistent Dividend Increases

These characteristics are a subset of those recommended by Warren Buffet and Benjamin Graham. But I’m gratified for this confirmation of what I’ve already learned.

Next, I must reduce what I’ve learned to a set of actionable criteria I can use to identify “wonderful” companies that are “fairly” valued.

Link to Other Topics in the Special Report: What Is Intrinsic Value?

What Is Intrinsic Value? – Benjamin Graham’s View

Even a cursory examination of Warren Buffet’s writings will quickly turn up references to his teacher and mentor Benjamin Graham.

Ben Graham practically invented the securities analysis profession. He literally wrote their book, “Security Analysis” first published in 1934 and still in print after multiple updates.

Graham’s even more popular book, “The Intelligent Investor” brought the value investing concept to the individual investor. In this work Graham popularized terms that remain core to value investing; “intrinsic value”, “margin of safety”, and “Mr. Market”.

Since Ben Graham effectively invented the term “intrinsic value” I need to know what he meant by it. In pursuit of that goal I recently read, “Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street”, a biography written by Janet Lowe.

In the biography Ms Lowe quotes from Graham’s books, “Security Analysis”, “The Intelligent Investor”, and a third volume Graham authored, “The Interpretation of Financial Statements”.

“Statements” defines intrinsic value broadly as the real value of a company. This value may be very different from the company’s market price or its book value. It “approximates the price the whole company would bring if it were sold to a private buyer”. This definition isn’t very helpful to my quest. However, in other places Ben Graham fleshed it out with several concepts he used in real life practice.

Net Current Asset Value
Net Current Asset Value (NCAV) is defined as “current assets” less “current liabilities”. Roughly “current assets” is the sum of cash, marketable securities, inventory, and receivables. “Current liabilities” is roughly the sum of accounts payable and short term debt. All of these can be found on the company’s balance sheet.

Graham used NCAV as a screen. Stocks selling for less than NCAV per share he considered interesting but, “that factor alone was not conclusive evidence that the stock was undervalued.”

Graham frequently traded with short term objectives and arbitrage situations. However, he, “invariably advised individual investors to buy for the long term…” In “The Intelligent Investor” he introduced “six essential business factors” for individual investors to evaluate company performance.

Six Essential Business Factors
(1) Profitability: the ratio of operating income to sales (both found on the company income statement)

(2) Stability: the earnings per share trend over ten years; steady growth with no declines is perfect

(3) Growth: earnings per share trend compared to the market as a whole; Graham used the Dow Jones Industrial Average as the measure

(4) Financial Position: the ratio of current liabilities over current assets; Graham looked for this ration to be 0.5 or less.

(5) Dividends: a long and uninterrupted history of paying dividends; preferably with a trend of increasing dividends in proportion to increasing earnings per share

(6) Price History: a long term trend of share price appreciation in proportion to increasing earnings per share

Ben Graham also created a formula for individual investors to determine if a stock is undervalued:

The Formula: E(2R+8.5)*Y/4 = Intrinsic Value per share
where
E is defined as earnings per share
R is defined as the expected earnings growth rate
Y is defined as the current yield on AAA rated corporate bonds

The 8.5 was Ben Graham’s target price to earnings ratio (P/E) for a company with little or no growth.

Plug in the appropriate values for E, R, and Y and then do the arithmetic to determine Graham’s estimate of the intrinsic value per share of a company’s stock.

For Benjamin Graham to consider the stock a "buy" the stock price needed to be at least 20% less than the intrinsic value as calculated by the formula. And, the company needed to pass the test defined by the “Six Essential Business Factors”.

These criteria are as objective as they can be given the general reliability of published corporate financial results. I understand how to use them.

I’m not ready to declare victory in my quest, however. I’m looking for my personal definition of intrinsic value although Ben Graham’s definition is a pretty good base to work from.

Link to Other Topics in the Special Report: What Is Intrinsic Value?

Links to Books Referenced Above:
Security Analysis: Sixth Edition, Foreword by Warren Buffett (Security Analysis Prior Editions)
The Intelligent Investor: The Classic Text on Value Investing
The Interpretation of Financial Statements (1955 Revised Edition)
Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street

What Is Intrinsic Value? – Charlie Munger’s Checklist

Charlie Munger is Warren Buffet’s long time partner in running Berkshire-Hathaway. He is also a multibillionaire and a successful CEO in his own right. The Motley Fool (http://www.fool.com/) discusses Charlie Munger’s “Investing Principles Checklist” in the February 8th, 2010 article, "Charlie Munger on How to Become Rich", by Morgan Housel.

The Investing Principles Checklist is a high level summary of recommended investor traits and behaviors. It’s not specifically about intrinsic value. However, four of Charlie Munger’s ten investing principles struck me as pertinent to my developing definition intrinsic value. First, the ten principles:

(1) Measure Risk
(2) Be Independent
(3) Prepare Ahead
(4) Have Intellectual Humility
(5) Analyze Rigorously
(6) Allocate Assets Wisely
(7) Have Patience
(8) Be Decisive
(9) Be ready for Change
(10) Stay Focused

Of the ten, these four struck a chord with me; (1) Measure Risk, (5) Analyze Rigorously, (6) Allocate Assets Wisely, and (7) Have Patience.

Under (1) Measure Risk, the objective is to assess how risky the proposed investment is. Does the business have a “moat” – an important competitive advantage? Is the investment overvalued?

For (5) Analyze Rigorously, the objective is to understand the potential investment – do your homework – and apply your research to whatever rules you’ve developed.

(6) Allocate Assets Wisely is about having and using an asset allocation plan. It also made me think that in order to take advantage of an opportunity you must have some cash available - or you’ll have to sell something. Having available cash – “keeping your powder dry” - seems like the better path. That means having a cash reserve for the purpose of taking advantage of investing opportunities.

(7) Have Patience means waiting for the right opportunity. It means waiting until others are fearful to become greedy; waiting until the price is right to provide the “margin of safety” that you want.

I’ve learned the following about intrinsic value from Charlie Munger’s “Investing Principles Checklist”:

(a) Intrinsic value includes the risk associated with the investment. I need to have a reasonable estimate of the reward and a reasonable estimate of the risk. And, knowing myself, I’ll need to analyze each separately.

(b) Intrinsic value may have nothing to do with maintaining a cash reserve for investment opportunities or with being patient until the price is right; but both behaviors enable an investment with the right intrinsic value - when I find it.

Link to Other Topics in the Special Report: What Is Intrinsic Value?

What Is Intrinsic Value?

Other Topics in the Special Report: What Is Intrinsic Value?

What Is Intrinsic Value? - Low Price?
What Is Intrinsic Value? - Buffet's Filter
What Is Intrinsic Value? - Charlie Munger's Checklist
What Is Intrinsic Value? - Benjamin Graham's View
What Is Intrinsic Value? - Dividend Growth
What Is Intrinsic Value? - Dividends
What Is Intrinsic Value? - A Consolidated List

What Is Intrinsic Value? - Cash Flow & Earnings Growth

What Is Intrinsic Value? - Profitability & Return on Equity

What Is Intrinsic Value? - The Ben Graham Formula

What Is Intrinsic Value? - Little Or No Debt

What Is Intrinsic Value? - Business Model I Understand

What Is Intrinsic Value? - Competitive Advantage

What Is Intrinsic Value? - Reliable Long Term Dividends

What Is Intrinsic Value? - Dividend Growth Greater Than Inflation

What Is Intrinsic Value? - 9% Minimum Total Return

What Is Intrinsic Value? - Reconsidering Value Elements

What Is Intrinsic Value? - 1st Level Analysis

What Is Intrinsic Value? - 2nd Level Analysis Data

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

What Is Intrinsic Value? - 2nd Level Calculations - Part 2

What Is Intrinsic Value? - 3rd Level Data

What Is Intrinsic Value? - 3rd Level Calculations

What Is Intrinsic Value? - Simplifying the Value Elements

When to Sell: Why Did I Sell?

What Is Intrinsic Value? - Buffet’s Filter

In my quest to determine what “intrinsic value” means to me in my own investment decisions it would be strange if I failed to consult the greatest living investor, Warren Buffet. His writings and quoted sayings are ubiquitous; but here are a few that resonate with me.

“… buy stock in businesses that are so wonderful that an idiot can run them; Because sooner or later, one will.”
From a panel discussion in 2008

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Berkshire-Hathaway 1989 Letter to Shareholders

“Here’s what we’re looking for:
“(1) Large purchases (at least $10 million of after-tax earnings),
“(2) demonstrated consistent earning power (future projections are of little interest to us, nor are “turnaround” situations),
“(3) businesses earning good returns on equity while employing little or no debt,
“(4) management in place (we can’t supply it),
“(5) simple businesses (if there’s lots of technology, we won’t understand it),
“(6) an offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when the price is unknown).”
Berkshire-Hathaway 1989 Letter to Shareholders

“The key to investing is … determining the competitive advantage of any given company and, above all, the durability of that advantage.”
July 1999 at Herb Allen’s Sun Valley, Idaho Retreat

So, what exactly resonates in these Warren Buffet quotes?

First, I want to own only wonderful businesses. I’ve seen first hand how an idiot at the top can destroy an average business. I’ve also witnessed a good, but not wonderful, business muddle through with an idiot at the top.

Second, don’t pay too much, but its okay to pay a fairly valued price for a wonderful business. Microsoft, Cisco, Amazon, and eBay may be wonderful businesses and fairly priced today, but for the folks who bought them in 2000 it’s been a very long decade

Third, a wonderful business has (a) consistent earning power; (b) good returns on equity; (c) little or no debt; (d) good current management; (e) a business model I understand; and (f) a durable competitive advantage.

That’s a great list. However, every item needs a detailed definition before it becomes actionable. For example; what does “fairly valued” mean? What is consistent earning power? What is a good return on equity? How do you know the current management is good versus just lucky? What is a company’s competitive advantage and what would make it durable?

I’m making progress here. But I’ve still some way to go before I’ll know exactly what intrinsic value means to me

Link to Other Topics in the Special Report: What Is Intrinsic Value?

What Is Intrinsic Value? - Low Price?

“Price is what you pay; value is what you get.”
Benjamin Graham

As with most things, the momentary price of a stock is easy to determine. Today, delayed stock quotes are available from many on-line services and real time quotes can be had through most on-line brokerage houses including mine, USAA Investment Management Company.

As with most things, the value, or “intrinsic value”, of what you are about to buy is much harder to discern. John Templeton, one of history’s greatest investors seems to have equated value with low price. Or rather, he was certain that a basket of low priced stocks purchased during periods of market pessimism would perform well; with the good performers dominating the poor performers. He bet his life on this strategy at the beginning of his career as illustrated by the following quote from the web site http://www.sirjohntempleton.org/.

“While standard stock-buying advice is “buy low, sell high,” Templeton took the strategy to an extreme, picking nations, industries, and companies hitting rock-bottom, what he called “points of maximum pessimism.” When war began in Europe in 1939, he borrowed money to buy 100 shares each in 104 companies selling at one dollar per share or less, including 34 companies that were in bankruptcy. Only four turned out to be worthless, and he turned large profits on the others after holding each for an average of four years.”

At least in this case, John Templeton didn’t try to determine the intrinsic value of the 104 companies in his 1939 portfolio. He assumed that most of them were worth more than the price he paid. If 52 of the companies failed and the other 52 doubled he would have broken even.

In hindsight, his risk seems small and apparently it seemed so to him at the time. However, because he borrowed the money used to buy the 104 companies, at lot depends on the terms and conditions of his loan and the speed in which his portfolio would grow. We don’t know the terms of his loan, but obviously the deal seemed favorable.

Recently, this was a viable strategy again. Last spring one could have bought a basket of seriously depressed financial companies for under $10 per share. Those who pulled the trigger have done very well to date. I wasn’t one of them. And, despite the current much higher prices of financials, I have no desire to own any. My perception of their value is much lower than their current price.

The question is why do I think that? What does intrinsic value mean to me? I’m going to think this through over the next few posts.

I think more clearly when I write. And there is nothing like a posting deadline to force me to write.

Link to Other Topics in the Special Report: What Is Intrinsic Value?