How To Calculate Intrinsic Value & Why You Need To

October 25, 2017

How To Calculate Intrinsic Value & Why You Need To

  • Calculating the intrinsic value of a stock is essential for making any kind of buy or sell decision.
  • However, intrinsic value is different for everyone and depends on what you expect from the market.
  • Attaching a margin of safety to intrinsic value is all you need for low risk high return investments.



Introduction

99% of the what’s discussed about stocks is whether a stock is undervalued or overvalued and where will it go as you wouldn’t be a proper analyst without a price target on every stock you discuss.

This is completely the wrong way to approach investing, but we as analysts will continue to deliver what the market wants.

In today’s article, I’ll discuss what my soul says and elaborate on the most important measure for investors, intrinsic value.

What Is Intrinsic Value?

As an investor, you should care about the money you can get out of a business.

If you are a restaurant owner, you don’t care about the valuation of your restaurant, about the EBTIDA, ROI, ROC, and other metrics, but rather, what you care about most is how much cash can you take out of your business at year end so that the business continues to thrive.

This should be the case for investors as well, but due to media and the attractiveness of watching stock prices go up and down on a daily basis, many quickly forget about intrinsic value and focus on target prices and about what the FED or Trump will do next.

(Note: The free cash flow can also be reinvested into new business ventures, it doesn’t have to be returned to an investor in the form of a dividend to be taken into consideration in calculating intrinsic value.)

So the definition of intrinsic value is simple: It is the discounted value of the cash that can be taken out of a business during its remaining life.

Therefore, to determine the intrinsic value of a business, we have to take a look at future cash flows. Of course, it’s impossible to correctly estimate future cash flows, but the important thing is that your estimation is a bit better than the market’s estimation.

How To Estimate Future Cash Flows

What most do to determine future cash flows is to look at what happened in the past and project that into the future. This is why metrics like EBITDA, PE ratios, ROI, ROC, debt to EBITDA, and many other are so famous. However, to estimate future cash flows, you have to know the company, understand the business and sector, and knowing all this will allow you to estimate future revenues, earnings, and cash flows.

The best way to explain why calculating your own intrinsic value matters is to use an example.

A stock that I’m following and recommended as a buy a few months ago, is Skechers (NYSE: SKX). Investors were extremely positive about SKX’s growth two years ago, and they clearly overestimated its intrinsic value. However, in relation to the turmoil in the U.S. retail environment and SKX not meeting the unrealistic expected growth rates, the stock price got hammered. At one point, the company lost more than 65% of its market capitalization. Such erratic and volatile behavior is clearly irrational and a consequence of not calculating intrinsic values, but rather trying to chase profits by following trends (thus, looking in the rear-view mirror).

Figure 1: SKX’s stock price in the last 3 years. Source: NASDAQ.



Nevertheless, the rational investor could easily see that the company was more an Asian growth company than a declining U.S. retail company. Therefore, the thing to do was to look at revenues and earnings, apply the worst possible outcome to U.S. sales and global growth, just to be conservative, and then estimate future cash flows.

SKX’s margins have been improving over the last year and the growth in Asia has been staggering. The company changed their JV business model in Korea which postponed some sales which analysts didn’t like and the stock fell below $20. At that level, I saw a company that has been growing at a rate of at least 15% over the past few years and thanks to Asia, was supposed to continue to grow. I estimated that this growth of around 15% would also increase earnings and that earnings would grow from $1.5 to above $2 in less than two years. Given the market environment, I found SKX trading at any price below $22 as extremely cheap and gave it a target price of over $40.

Figure 2: SKX’s financials. Source: Morningstar.

So my intrinsic value was deduced by my expectations that earnings would soon hit $2 per share.

Therefore, for intrinsic value, you have to estimate future earnings. You do that by looking at current earnings and then by calculating what will happen to margins and revenue in relation to what is going on in the sector and what the company is doing. This is complicated for companies with volatile sales, but relatively easy for stable companies and especially for companies selling commodities.

When you have estimated future earnings, then you can calculate the intrinsic value but that depends on your investing preferences. My investing preference is that an investment is overvalued when it has a yield below 7.5%, but your level could be much lower given that the current S&P 500 yield is 4%. If you look for undervalued investments, you can certainly find them. For example, even Berkshire is undervalued when compared to the S&P 500 as it has a better earnings yield.



To conclude, to calculate the intrinsic value of a stock, you have to put your estimated future earnings in a table, let’s say 10 years based on your knowledge of the company, and then you can discount them to the present value or simply attach a valuation to the future value, compare it to the current stock price, and see if you would be happy with the return from now to that point in time.

This isn’t that difficult. You just need to understand the business, the potential it has, and estimate where earnings will go in relation to the current profit the company is making. After that, if you want to invest with less risk, then you have to look for a margin of safety which we discussed in our margin of safety article.

Combining intrinsic value and a margin of safety is all you need for low risk, high return investing.