A Value Investing Toolkit (2): Intrinsic Value
Leading up to the International Value Investing Conference on October 23 and 24, Jos van Bommel, associate professor of Finance at the University of Luxembourg, will regularly share his insights on some basic tools and concepts relating to value investing.
In my previous blog I introduced the Enterprise Value (EV) as a value that is determined by Mr. Market. The EV can be interpreted as the market price for which you can purchase the underlying business, or enterprise, unencumbered by debt or other financial claims: If you buy all the shares of a company and repay all its interest-bearing debts, you own the firm’s business, and its excess cash (if there is any).
Value investors believe that a business also has an intrinsic value. They believe that if the intrinsic value is higher than the EV determined by Mr. Market, its stock may present a good investment opportunity. Cautious value investors will carefully look if there are no other claims on the business other than debt or equity, and then make sure that the intrinsic value surpasses the EV by a significant margin of safety, before investing. The key question is then: how can we estimate the intrinsic value of a business?
The most conservative and first approach is to look at the realizable value of the assets owned by the business. It is sometimes called the liquidation value or the break-up value. It is what you would get if you were to sell the firm’s tangible assets piecewise. The key to success of the first value investors was finding firms of which the break-up value of the assets was higher than Mr. Market’s EV.
Most firms’ assets can be classified in two key components. The first component is the Operating Working Capital (OWC), consisting of the operating cash, accounts receivable, inventory and other short-term liquid assets, minus the short term liabilities such as accounts receivable. The net value of these short term assets and liabilities are relatively easy to ascertain, and in the 1930s and 1940s, Ben Graham and other value investors were able to find stocks of which the EVs were trading below the value of their OWC. They called such opportunities “net-nets”. Although they did not buy entire firms and then liquidated them, they saw that over time EV
These days, it is extremely difficult to find firms with EV < OWC. If you find one, please let me know! I’ll be happy to bet with you that you either (i) underestimated the EV by overlooking a hidden claim on the firm’s assets (see last blog), or (ii) overestimated the value of the OWC, perhaps due to a large inventory of out of style left-foot shoes, booked at historical costs.
To identify investment opportunities we therefore also need to consider a firm’s long term assets (LTA): its machinery and equipment, land, buildings and other properties. Due to the long term nature of these assets, their book values can deviate significantly from their market values. This may be caused by excessive depreciation and amortization (possibly due to tax-optimization), or by the revaluation of buildings and land due to inflation or (expensed) modernization and investment. Some of the biggest success stories of value investors derive from the hidden assets that they discovered through careful “due diligence” and “forensic analysis” of the firm’s assets.
The sum of the OWC and LTA is often called the Invested Capital (IC), also known as Net Assets. And indeed, another popular screen used by value investors is to find stocks for which the market undervalues the invested capital, that is, of firms with EV < IC. Such firms are also quite rare (but less rare than EValso be good investment opportunities. However, we need to be careful because for EVvery few voluntary liquidations.
Firms with EV < IC tend to be out of favor by the market. After all, Mr. Market gives them low EV price tags. This may be due to bad management, bad past decisions, or just bad luck. Historically however, EVon average. One explanation for the historic outperformance of EVReturn on Invested Capital (ROIC), than it is for firms with EV > IC (“growth stocks”) to earn an above average ROIC (a.k.a. RONA, Return on Net Assets). I will get back to what a ‘fair’ ROIC is in a future blog entry.
Whereas a thorough analysis of the Invested Capital has historically been a very successful way to estimate the Intrinsic Value of a business, it is not the only way. Today’s value investor will most likely estimate the value of a business as a Going Concern that generates stream of future cashflows, rather than as a collection of assets making up the Invested Capital. In next week’s blog I will describe how we can estimate a firm’s intrinsic value from the expected future cashflows rather than from the past investments in net assets.