- The market is irrational and can’t be used as the only measure of investment performance.
- Imagine if all the businesses you own suddenly delisted, you’d look at their value in a different way.
- Intrinsic value is based on the business owner perspective which is essential for reaching healthy long term returns.
This past Tuesday was a bad day for stocks with both the Dow and the S&P 500 falling more than 1%. This isn’t very significant for now, apart from the fact that it broke the longest run the S&P 500 has ever seen without a 1% decline (64 days in comparison to 34 days in August 1995). However, it’s an excellent introduction to today’s topic on how we measure investment performance.
I find it hard to measure investment performance by using an irrational assessor like the market. Nothing happened on Tuesday that could justify a 1.24% decline in the S&P 500, the American economy didn’t suddenly go into a recession nor did we all lose 1.24% of our tangible wealth or 1.24% of our disposable income. What’s funny is that the market, in its irrational and erratic moves, is the common measure for investment performance. Another measure for investment performance is intrinsic value, which eliminates irrational behavior and gives an owner-like perspective.
Why Market Measured Performance Isn’t Always The Best Measure
A great example of how the market can be irrational in valuing a stock is mining giant Rio Tinto (NYSE: RIO).
Mining is a cyclical business swinging around its long term balance. When commodity prices are high due to higher demand, investments increase and in a few years, commodity prices fall due to increased supply. Low commodity prices stall investments, and lower long term supply, but as global demand for metals grows alongside global economic growth and mines eventually get depleted, supply falls below demand and pushes prices back up. And so the cycle continues.
As RIO is one of the biggest global suppliers of essential metals, its stock price should be relatively stable as owning such a company means owning a business that has a low cost competitive advantage and is large enough to weather cyclical downturns. However, the reality is far from stability.
Figure 1: RIO’s stock price is extremely volatile and related to temporary swings in commodity prices. Source: Yahoo Finance.
However, RIO has been very consistent in paying out nice dividends over time and its long term return including dividends is a healthy 8%. The 2008 and 2011 spikes, or the 2009 and 2016 declines, are clearly irrational if you look at the business from an owner’s perspective, i.e. if you look at RIO from what its intrinsic value is or long term expected cash flows are.
If you think RIO is a stretched example, let me use the S&P 500.
Figure 2: S&P 500 since 1989. Source: Yahoo Finance.
I simply don’t see the S&P 500 being a rational measure of investment performance because it should represent the American economy, but the economy doesn’t swing like the chart above.
A measure that doesn’t care about what the market says is intrinsic value.
Buffett defines intrinsic value as (Berkshire Hathaway—NYSE: BRK.A, BRK.B—2013 annual report, page 107) “the discounted value of the cash that can be taken out of a business during its remaining life,” and considers it the only logical approach to evaluating the relative attractiveness of investments and businesses.
Intrinsic value is different than book value. Book value is easy to calculate and gives a limited perspective on the company as it doesn’t tell anything about its future. But the change in book value in one year tells you how much the intrinsic value of the business has increased as the current increase isn’t discounted. With a realistic growth rate including economic and sector cyclicality, you can accurately estimate the value of future cash flows.
Intrinsic value is an estimate that depends on the accuracy in predicting future cash flows and interest rates. However, if you use always the same methodology in predicting what the businesses you own or plan to own will deliver, you will have a great comparison to make investment decisions on.
In the long term, market values eventually catch up with intrinsic values. What’s essential is how much the book value increases each year and by how much the cash flows increase. The yearly change in book value is much more stable than the market’s irrational valuation. Berkshire has seen its book value decline only twice in the last 52 years while its market value has declined 11 times.
Figure 3: Berkshire’s annual percentage change in book value and market value. Source: Berkshire.
If you think like an owner, the only thing you care about is the change in book value, and if you know you own a great business, you don’t care about what the market has to say except for when the market goes in panic mode and then you buy more of what you already own.
Measuring Intrinsic Value
Intrinsic value isn’t difficult to measure.
The first component of intrinsic value is the value of the investments an organization has made. This can be seen by looking at its book value. If the sector is in trouble, like oil is right now, then these investments should be impaired or cautiously analyzed. If the company has lots of investments accounted at cost while their current value is much higher, this should be reflected in the company’s earnings which are the second component of measuring intrinsic value.
Earnings are the oxygen of a business and should be the metric for its evaluation. If you own a business and have no intention of selling it, the only thing you care about is how much money you made this year.
The third component is the expected future return on retained earnings which is the most subjective component of the three. A good approximation is to use the past returns on capital the management has achieved. The better the management, the higher the intrinsic value.
By combining all the three components, you should end up with a number that represents the intrinsic value of the company for you, the owner. This is the number you would use if you were the sole owner of the company and the company wasn’t quoted anywhere.
Imagine if you owned stock in Mars Inc., the family owned private confectionery producer that isn’t listed. If there is no intention to sell the complete business, you would never even think about what the market value of your stake would be, what you would think about is how much cash will the company make this and the following years.
A similar approach should also be used with stock investments, but the constant real-time quotes that you can follow on your phone, television, laptop, and practically any other device make it hard to remember that the only thing a business owner cares about is where the highest future cash flows will come from in order to make the best capital allocation decisions.
Intrinsic value is just another futile method if not used with an ownership approach. If you invest as a business owner, you are happy when stock prices go down as you can use your capital from dividends to buy more businesses. When stock prices are far above the intrinsic value of what you own, you rebalance and buy cheaper businesses.
What an investor never does is invest in a stock just because it’s supposed to go up. An investor, by looking an intrinsic value, buys a part of a business and is happy about the parts of the future cash flows that they will receive.
I personally own very volatile stocks, mostly in emerging markets. I need to use intrinsic value as it’s the only metric that tells me the real value of what I own and lets me sleep well at night because I know the real value of the businesses I own. This allows me to buy more when stock prices decline and to sell the stocks, i.e. businesses, when market prices are clearly above intrinsic values. Due to their inherent volatility, these businesses can be bought at extremely low valuations which will bring me above average returns in the long term.