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Buffett Principles: Intrinsic Value

Value investor with a deep passion for understanding and a desire to improve results over time.


Price Is What You Pay

Price is what you pay. Value is what you get.

To the surprise of very few, Warren Buffett's 2008 letter to shareholders contains a lot of relevant wisdom for investors looking for comfort or clarity. Since the Global Financial Crisis had begun to come to fruition, shareholders and investors had begun to realize that they were in the midst of an historic bear market, the likes of which had not been seen in seven decades, well outside of the memory of most investors and traders on Wall Street.

Buffett grew up during the Great Depression, and of course, he was able to offer words of comfort to anyone who felt like the last person on the Titanic to realize there weren't enough lifeboats to go around. He also offered some very practical advice: how to invest in order to avoid being in such a disastrous situation in the first place, at least insofar as your personal portfolio goes.

One of the main principles outlined over the years, and not just in 2008, has been to think of a stock as a share in a business, not an abstract number on a screen (or digits on a ticker tape, if you're of Buffett's generation).

Don't Look at Price

Buffett, true to his reputation of being half preacher, half professor, defines intrinsic value effectively and very simply:

Intrinsic value is the number that you’d have if you could know everything about the future, predict all the cash that a business can give you between now and judgment day, and discount it to today at the proper discount rate.

This is technically true, and it gives an eager pupil all the inputs they need in order to calculate what any investment is worth. If you're thinking that Pandora's box has just been opened, you are not wrong. It's pretty clear that knowing everything about the future, such as macroeconomic conditions, isn't in the cards for any humans alive today.

It's also obvious that you can't know how much a business will earn in the future, and various types of businesses will be more or less predictable than others because of this. Finally, you can't really know what your discount rate should be, although you can take some steps to make a reasonable guess.

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Think of a Stock as a Business

What does thinking of the stock as a business really imply? First, it means taking a hard look at the actual underlying financial measures of the underlying business and then analyzing it to determine at what price you'd consider buying. This means entirely disregarding the price the market assigns to the stock, not assuming it's "right" or "close" or anything of the sort.

A stock price and a business can often diverge widely, even to the point where a company is worth more than double what the market thinks (the price it assigns), or less than half, especially during times of crisis. Isn't the stock market efficient? Yes and no, but the market isn't you, and it's looking for all sorts of things you might not be looking for from a stock.

3M's stock chart since 2002

3M's stock chart since 2002

A Quick Example

Take a look at the above chart. This is 3M's stock chart since 2002, immediately after the recession following the Dot Com Crash. The black line on the chart is price, and the blue line represents the normal P/E ratio at which the stock trades. It's important to note that whenever the stock price (black line) drops below the normal P/E ratio, it tends to go back up eventually, and if it trades above the blue line, it tends to come back down.

Owner's Earnings and Tencap

Paraphrasing Buffett, “in the short-run, the market is a voting machine, but in the long-run, the market is a weighing machine.” If you have a 20-year history of a stock, you can see how the market weighs a particular stock. Twenty years is probably long enough to shake out the voting elements, but this is just one way to measure intrinsic value.

Another really simple method Buffett likes to use is called a "tencap." Buffett likes to take a company's operating cash flow (found on a business's 10K or cashflow worksheet, available for free for all publicly traded companies), and subtract what Buffett refers to as "maintenance capital expenditures." This would be capex that doesn't fall into the category of growing the company, but instead is necessary capital expenditures that need to be spent in order to run the business, like replacing a broken machine.

Once you have OCF (Operating Cash Flow) minus the maintenance capex, just multiply that number by ten, and then compare to the market capitalization of the company (available nearly everywhere the ticker price appears). The Tencap method works well for more stable investments, but if you have a business with major growth prospects, you might consider using a different method.

True North: Intrinsic Value

It's important to keep in mind that the intrinsic value is your true north, at least if you're a value investor. This means that you want to buy whenever your stock price is selling for way below what you think it's worth, and then you should consider selling whenever a stock goes way above your intrinsic value. Keep in mind that Mr. Market could possibly offer you the deal of a lifetime one day but then hike the price up into absurdity the next.

Try to separate yourself from the herd of investors who will inevitably perform poorly over the years. Think first about intrinsic value, and then only consider buying (with a margin of safety) whenever your stock is on sale, and only consider selling whenever its price is so high that it seems dumb not to sell. Buffett would be proud.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2022 Andrew Smith

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