In my previous article on thinking rationally about shares, I outlined the case for buying quality companies at a discount to intrinsic value. But what is that? The basic formula for estimating intrinsic value, using an approach called excess returns, is simple arithmetic. It compares the return generated by the business’s equity to the return that an investor should reasonably expect from a share market investment and uses the result to determine what premium to pay for the equity. The formula is:
(Return on Equity / Required Return) X Equity = Intrinsic Value Estimate
To obtain intrinsic value per share, divide the result by the number of shares on issue.
While the division and multiplication are simple, producing a straight line model with its own set of limitations and determining the inputs requires some thought. It’s a case of garbage in, garbage out. When Berkshire’s Charlie Munger was asked what made him such a successful investor, he responded by offering “My guesses are better than yours.”
Applying the formula
By way of example, let’s examine Wesfarmers’ purchase of Coles many years ago. At the time, Coles’ Equity was $4.3 billion, Return on Equity was 25%, and for this example only, adopt a Required Return of 13% – half the Return on Equity being produced at the time. The valuation formula, assuming all earnings are taken out as dividends, would be:
(25% / 13%) X $4.3 billion which equals $8.3 billion
A word of warning: don’t apply this formula to a company that retains profits. If the company retains profits and generates a return on its equity that is lower than your required return, the above formula will overstate the value of the company. If the company you are examining retains profits and generates a return that is higher than your required return, the above formula will understate the value of the company.
In my book Value.able, I demonstrate a set of steps to follow to provide an estimated value for any company, anywhere in the world, not just those that pay out all the earnings as a dividend. You might also like to read Warren Buffett’s 1981 letter to Berkshire Hathaway shareholders. You can click here to download it.
Quite simply, when the prices of shares trade below an estimate of their value, they become candidates for inclusion into your portfolio, investing no more than 3 to 7% of your portfolio in any one of these opportunities. And this is where the rubber hits the road. When investors forego the opportunity to buy shares in wonderful businesses because of short-term concerns about the economy or because of fears that falling prices mean risks have increased, a major opportunity may be missed.
This includes businesses which the market quickly marks down in response to negative news. Having bought shares in Sirtex recently below $19 ($29 at time of writing) after divergent expectations appeared following the release of trial results, and McMillan Shakespeare below $7.50 ($12.50 now), after proposals for damaging legislation, my view is that you should take advantage of other people’s fears rather than listen to them. Volatility in shares prices, especially if you are a net buyer over the years, represents an opportunity rather than risk.
Buy now and receive more later
‘Investing’ is the laying out of money today to receive more in the future – nothing more, nothing less. The safest way to do that in the stock market is to buy shares in sound businesses when they are cheap.
Shares in extraordinary businesses are cheap when they are at a discount to the appropriate multiple of equity based on the profitability of that equity. High dividend yields or low price to earnings (PE) ratios may exist, but these are not a pre-requisite to a bargain. Indeed, the way I have demonstrated the calculation of intrinsic value, a company’s shares could display a high PE ratio and a low dividend yield and still be a bargain. Indeed, we hold stocks with PE ratios ranging from 14 times to 29 times and they are still regarded as good value.
The rest of your time should be spent thinking about the competitive landscape a business is in to determine what pressure may be leveled against its future profitability. More than perhaps anything else, you need to understand the future return on equity.
Gradual portfolio construction is important
Finally, turn your mind to the mechanics of portfolio construction.
Wouldn’t it be nice if the market knew you were going to be investing millions tomorrow, so fell by an appropriately substantial amount to accommodate your purchase, then returned to today’s level? Unfortunately it never works out that way, yet some advisers might go ahead and invest all your money, all at once, as if it just did.
The reality is that you will likely take many months, if not years, to fill your portfolio with wonderful businesses, purchased at discounts to intrinsic value. But don’t lose patience and don’t think about stocks. If you think about stocks you’ll be tempted to chase them higher and pay too much. Instead think of stocks as slices of businesses. Business performance changes slowly. So fill your portfolio with a selection of great businesses, like CSL, Challenger, CBA and REA, buying them only when they are below intrinsic values.
Put together a portfolio of great businesses, purchased at fair prices, whose earnings you are confident will be materially higher in 5 or 10 years, and you will do well over the very long run.
Roger Montgomery is the Chief Investment Officer of The Montgomery Fund. This article is for general education purposes and does not address the specific circumstances of any individual.