“You should always buy the stock of a good company.” In isolation, this seems a very valid statement.
But look at this – “You should always buy the stock of a good company, whatever the price.”
Now, this is a highly dangerous advice to give to someone.
A great company can translate into a great investment. But all great companies do not translate into great investments.
Confused? Well let me clarify.
There is a business behind a company. And there is a great business behind a great company – one that has all the ingredients of success, enjoys pricing power, generates a lot of free cash flow, is not much troubled by competition, and has a very good management team at helm.
So this business has a great value. But it will make a great investment only if it is bought at a reasonable price.
“But how do you know what is a reasonable price?” you may ask.
Well, you just need to identify the ‘value’ of a business and match it with the price at which its stock trades in the stock market.
So if the ‘value’ of a business is Rs 100 per share and its share is trading in the stock market at Rs 50 per share, would you buy it or not? Of course, you would lap it up. Who wouldn’t like to buy something at a 50% discount to its value?
But now the question is – how do you calculate the ‘value’ of a business? How do you give a number to what a business is worth?
Intrinsic value, in simple terms, is the fundamental value of a business.
As per the legendary investor Warren Buffett, “Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses.”
Buffett defines intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life.
As we have discussed on Safal Niveshak in the past, a good business is one that generates lots of free cash flow year after year. This is the money that is left over after paying taxes and interest on borrowings, after spending for new expansion, and after adjusting for the money that is required in the day to day running of the business (also known as ‘working capital’).
A good business is one that is able to generate some excess cash after taking care of all this. A bad business is one that eats into its cash due to these things and has lesser cash at its disposal at the end of the year than what it started the year with.
Coming back to Buffett’s definition of intrinsic value, it is nothing but the ‘present value’ of the excess cash (also known as ‘free cash flow’) that a business can generate over a period of next 10-20 years.
Now the question you may have is – what does ‘present value’ stand for and what is its relevance?
Let me take you through a simple explanation.
You would agree that money has a value when lent over a period of time. So if you lend someone Rs 100 for a period of one year and ask for an interest of 10%, the total money that you will receive after one year would be Rs 110 (Rs 100 of original capital plus Rs 10 of interest).
In other words, the ‘future’ value of Rs 100 1-year down the line is Rs 110.
Alternatively, the ‘present’ value of this Rs 110 that you will receive after 1 year is Rs 100 as of now. Simple, isn’t it?
Similarly, to calculate the intrinsic value of a business (what it is worth ‘today’), we need to calculate the present value of cash that it will generate after 1 year, 2 years, 3 years, and so on.
Apart from this method of discounting cash flows, there are a few other methods that you can use to calculate the intrinsic value of a stock. We will discuss them over the course of next few weeks.
But for now, just understand that ‘intrinsic value’ is one of the most important concepts you must learn in your life as an investor.
This is because without knowing the intrinsic value of a stock, it’s impossible to know whether you are paying the right price for it or not.
And you know that the price you pay is the most important thing when it comes to succeeding as an investor.
If you pay a cheap enough price, you can make money in even the worst businesses. If you pay an expensive price, you can lose money for long periods of time in even the best businesses.
Here is an illustration of the relationship between intrinsic value of a stock and its market price. As the chart suggests, if you know the intrinsic value, you can make out when the stock is underpriced (and therefore good for buying) and when it is overpriced (thus ripe for selling).
A correct value…or just a guess?
Despite its usefulness, Buffett warns that the calculation of intrinsic value of a business will mostly throw up a highly subjective figure. And this figure will change as estimates of future cash flows are revised (given that the future is unknown).
Anyways, despite its subjective nature, intrinsic value remains an all-important and the most logical way to evaluate a company’s true business value, which helps us to identify the attractiveness of a stock.
It is important to understand that even when a company is good, it is important to see whether the stock’s valuations justify its purchase. As Buffett says, he invests only when he can find:
- Businesses he can understand;
- With favourable long-term prospects;
- Operated by honest and competent people; and
- Priced very attractively.
He then adds, “We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action.”
So there you are. Even if a business passes all tests of quality, its stock must be avoided if its valuations are not attractive in relation to its intrinsic value.