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?