Calculating Intrinsic Value
“The concept of intrinsic value has been developed over decades with the intellectual rigour of some of the world’s most successful investors.”
Every business has an intrinsic value derived from its company’s fundamentals and its performance (historical and forecast). It is a company’s fundamentals, specifically its profitability and its inherent business or investment risk that creates the value.
First we need to ‘normalise’ the earnings of a company so as to create the economic picture an owner would see. This is akin to thinking of an investment in a company that is private. The owner receives dividends and determines the reinvestment of profit. Critically there is no public market for their shares.
In Australia, owner earnings must include the franking credits attached to dividends paid and this is defined as ‘grossed-up’ dividends. Franking credits are of immense value to investors and essential to be considered in a valuation. All Australian investors benefit from receiving franking credits at tax time in offsetting assessable tax or being refunded by the ATO.
Reported profits (earnings) need to be adjusted for non-recurrent items such as changes in reserves (e.g. foreign currency gains) and abnormal profits or losses (e.g. asset sales). It is the correct derivation of normalised earnings that is crucial for deriving profitability (i.e. return on owner’s equity).
Normalised Earnings consists of:
+ Retained Earnings
+ Change in Reserves
Once we have the correct picture of earnings we can calculate a key component of intrinsic value, Normalised Return on Equity (NROE). Often investors put too much focus on what comes out of a company in the way of profits and dividends rather than focusing on the capital that has gone into a company to produce the profits. The key is to consider both via the Normalised Return on Equity measure of profitability.
NROE consists of:
[Opening Equity + (new net ordinary equity/2)]
Next, we require an appropriate Payout Ratio (PR). The Payout Ratio is important as it rewards the intrinsic value of businesses that have high NROE and can retain and compound capital at attractive rates. Conversely it punishes businesses that have low NROE and decide to retain capital at subpar rates of return.
As many listed companies decide to pay dividends to their owners, we can determine the PR thus:
Once we have calculated our NROE and Payout Ratio we can make an assessment of the sustainability of both by considering the industry and the company position.
We now have the four variables that are the key to the valuation process.
- NROE: The profitability of the business.
- Dividends (D): The proportion of profitability paid to owners as dividends. (NROE x PR)
- Reinvested (RI): The proportion of profitability reinvested in the business to grow the business (NROE x (1 – PR)) or (NROE – D).
- Required Return (RR): The return we need to become owners of the business.
Our approach to intrinsic value uses the combined Buffett & Simmons methods. Businesses have both bond and growth characteristics. As such the intrinsic value of a company considers both of these characteristics of the business.
Recognising this, our valuation approach has two components that are separated by the payout ratio.
The component parts leading to intrinsic value are:
a. The Bond Component
b. The Growth Component
These two components are next modified and summed to produce the ‘Equity Multiplier‘.
|Bond component x payout ratio
Growth component x (1 – payout ratio)
Once the Equity Multiplier has been calculated, the final step is to multiply the Equity per Share for each share on issue by this multiplier.
The product of this calculation is the ‘Intrinsic Value’.
See a worked example using Blackmores Limited (ASX:BKL).
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Read more about Value Investing | Key factors when valuing a stock