Unfortunately, when usually rational people turn to the stock market, many become afraid of cheaper prices, whilst enthusiastically snapping up on rising stocks. This is a buy high, sell low strategy and it makes absolutely no sense. Value investors such as myself understand that no business is worth an infinite price and that if you want to do well, you need to buy businesses below what they are actually worth. By purchasing stocks significantly below this 'intrinsic value', you give yourself a margin of safety in case things don't go according to plan, thus limiting your losses. Furthermore, if you are correct, the market will eventually recognise the mispricing, leaving you with a nice tidy profit.

Amongst value investors, there is much disagreement on how exactly to come up with this elusive intrinsic value - some use their own formula, the P/E ratio, P/B ratio, PEG ratio, EBITDA/EV ratio etc - but I will outline my own thoughts on how one should approach it. I'll start off with the basic principles and dig deeper into the finer points in subsequent posts.

To take an example, let's say I offered you a choice: I'll give you $100 cold hard cash today, or, you can have $105 dollars a year from now. Which one should you take? The answer depends on the interest rate. If interest rates are say, 7% then it would make sense to take the $100 now, stick it in the bank, and at the end of the year, you'll have $107. Conversely, if interest rates are only 3%, then waiting for the $105 is a better deal.

There is a mathematical process which tells you what is intuitive in the above example. It is essentially the compound interest formula rearranged into something called 'discounting'. Now, the value of the $100 today is worth just that, pretty simple. The value of $105 a year from now if interest rates are 3%: Value = 105/(1+3%)^1. This equates to $101.94. In other words, if you invest $101.94 for a year at 3%, you end up with $105. You can check it yourself. So if offered the choice between $101.94 today, and $105 a year from now, you wouldn't really care because you would end up with the same amount either way.

If interest rates are 7%, the value of the $105 a year from now is only $98.13. Unless I offered you less than $98.13 today, you'd take my $100 and run. This concept is known as the time value of money, which essentially states that a dollar today is worth more than a dollar in the future. This is because you can invest your money today and earn a return on it in the future (through interest, dividends, rent etc), and because in most countries inflation erodes the purchasing power of a currency over time. Aside from being interesting, the time value of money has many practical applications in daily life. All else being equal, it is preferable to receive money as soon as possible, whilst delaying payments as long as possible.

Hence, from the example above, we can see that the value of money in the future depends on how much you are offered, when, and what the interest rate is. Applied to a business, the money in the future is commonly referred to as 'cash flows', the interest rate as the 'discount rate' or 'required return', the intrinsic value as 'net present value' or just 'present value', and the whole process as 'discounted cash flow' analysis or DCF for short. It's a lot of jargon for a relatively simple concept. Instead of just one cash flow in my example, businesses have many future cash flows which occur at different times and in different amounts. As with all forecasts, estimating intrinsic value is difficult and imprecise, but nevertheless crucial for investors.

Hence, from the example above, we can see that the value of money in the future depends on how much you are offered, when, and what the interest rate is. Applied to a business, the money in the future is commonly referred to as 'cash flows', the interest rate as the 'discount rate' or 'required return', the intrinsic value as 'net present value' or just 'present value', and the whole process as 'discounted cash flow' analysis or DCF for short. It's a lot of jargon for a relatively simple concept. Instead of just one cash flow in my example, businesses have many future cash flows which occur at different times and in different amounts. As with all forecasts, estimating intrinsic value is difficult and imprecise, but nevertheless crucial for investors.

As Warren Buffett, arguably the authority on valuation says, 'Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised.'

And this DCF analysis isn't just some obscure mathematical trick only applied to the stock market, to steal some more words from the man: 'It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota — nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.'

To step up the DCF valuation up a notch with a more realistic example: suppose you were approached to buy a business that pays you $100,000 per year and could increase that forever at a rate of 3% per year. If interest rates are currently 7%, what would you pay for it? Now, you could set up a spreadsheet, calculate the cash flows each year for the next 100 years or so, discount them back to the present individually at 7%, and add them up to arrive at an intrinsic value, OR, you could use something called the Gordon growth model. Basically, Value = Cash flow in one year / (discount rate - growth rate). Hence in this case, Value = 100000/(7%-3%) = $2,500,000. This is just a shortcut DCF method as it gives you the exact same answer as doing it the long way, and can be useful for large, steady companies that are expected to grow at a certain rate. For most businesses however, it will be necessary to estimate each year's cash flows, taking into account important variables such as return on equity and the payout ratio. I'll explore how these factors affect intrinsic value a little more in my next post.

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