In Chapter 1 we show how to value an asset using a discounted cash flow model and in Chapter 2 we use these tools to value a simple business. In Chapter 3 we show how to evaluate a company’s competitive advantage to properly value growth. We finish that discussion by converting the resulting business value to a single point estimate. At the risk of confusing the reader, we will show in this chapter that it is unrealistic to assume that one can derive a single-point estimate of value. Rather, it is better to think of a company’s intrinsic value as a range of values. However, we need to define intrinsic value before proceeding.

What is “Intrinsic Value”?

One might ask: “Isn’t the definition of intrinsic value simply the value of the business?” Yes and no. While Benjamin Graham and David Dodd introduce the term intrinsic value in their seminal work Security Analysis, first published in 1934, surprisingly, the authors never provide a specific definition.

Rather, they discuss the concept in more general terms. For instance, the first¹ mention of the phrase intrinsic value appears on page 16:

[In 1922] Wright Aeronautical Corporation stock was selling on the New York Stock Exchange at only $8, although it was paying a $1 dividend, had for some time been earning over $2 a share, and showed more than $8 per share in cash assets in the treasury. In this case analysis would readily have established that the intrinsic value of the issue was substantially above the market price [emphasis added].²

Why doesn’t Graham provide the reader with a clear definition? One could surmise that this decision was intentional as it is likely Graham wanted to force the reader to develop the concept in their own minds.³ Therefore, instead of offering a precise definition, Graham discusses intrinsic value more abstractly:

The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish either that the value is adequate—e.g., to protect a bond or to justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his exact weight [emphasis added].⁴

Graham also emphasizes that it is not easy to calculate intrinsic value:

We must recognize, however, that intrinsic value is an elusive concept. In general terms it is understood to be that value which is justified by the facts, e.g., the assets, earnings, dividends, [and the company’s] definite prospects . . . and that, it is a great mistake to imagine that intrinsic value is as definite and as determinable as is the market price.⁵

Like so many things in life, after the more than 80 years since Security Analysis was written, nuance has been lost in the retelling. We can infer that Graham never intended for intrinsic value to be thought of as a single-point estimate of value. Rather, he thought of it as more of a concept of value. In fact, on page 19 of Security Analysis he discusses the “flexibility of the concept of intrinsic value” as “a very hypothetical ‘range of approximate value,’ which would grow wider as the uncertainty of the picture increased [emphasis added].”⁶

Seth Klarman, in his book Margin of Safety, similarly explains the challenge of finding a precise intrinsic value estimate, although in a slightly different manner:

Many investors insist on affixing exact values to their investment, seeking precision in an imprecise world, but business value cannot be precisely determined.⁷

Graham’s most famous student, Warren Buffett, echoes the same observations in Berkshire’s Owner’s Manual:

The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover—and this would apply even to Charlie and me—will almost inevitably come up with at least slightly different intrinsic value figures [emphasis added].⁸

And in Berkshire Hathaway’s 2014 letter to shareholders Buffett alludes to the difficulty of arriving at a single number:

As much as Charlie and I talk about intrinsic business value, we cannot tell you precisely what that number is for Berkshire shares (nor, in fact, for any other stock).⁹

It is clear from these statements that:

1. Graham never intended for intrinsic value to be thought of as a single number; rather it was meant as a concept of value.
2. Business values cannot be precisely determined.¹⁰
3. Since value cannot be determined precisely it is unrealistic to attempt to derive a single-point estimate of intrinsic value. Rather, the goal is to estimate a range of approximate values.

We have two choices at this point. We can either keep the definition of intrinsic value intentionally vague or forge ahead with the goal of getting closer to a working/practical definition. We chose the second opinion. However, before providing a specific definition, we want to review comments by Buffett, Klarman, and Murray.

Buffett provides a succinct definition of intrinsic value in his 1999 Owner’s Manual:

Let’s start with intrinsic value, an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.¹¹

Klarman makes a parallel statement in Margin of Safety:

While a great many methods of business valuation exist, there are only three that I found useful. The first is an analysis of the going-concern value, known as net present value (NPV) analysis. NPV is the discounted value of all future cash flows that a business is expected to generate.¹²

Roger Murray¹³ discusses intrinsic value in a similar, although intriguingly different way, during a lecture hosted by Mario Gabelli at the Museum of Television & Radio¹⁴ in New York City in 1993:

What we are talking about when we use the term intrinsic value is this is our estimate of the economic value of a company . . . intrinsic value is a magnet in a rational world . . . that is constantly pulling market prices towards it. And, if you prefer, you can call it towards intrinsic value or you can call it regression to the mean, which implies, to some extent at least, that the intrinsic value is the true, underlying, central tendency in the valuation of an enterprise . . .

I do not care whether we are talking about a real estate equity or I am talking about a company, the same elements that give that physical asset value in financial terms have to be the same. We are talking about the level at which the asset generates returns and the characteristics of that stream of returns across future periods.

The part of Murray’s talk that intrigues us is his metaphor of a magnet pulling the market price toward its intrinsic value, which we discuss in greater detail in Chapter 7.

Buffett’s, Murray’s, and Klarman’s comments are consistent with the definition we provide in the previous chapters:

The estimated value of any asset is the sum of the cash flows expected to be produced by that asset, over its useful life, discounted for the time value of money and the uncertainty of receiving those cash flows.

To arrive at a working/practical definition of intrinsic value that we can use going forward, we simply add the word “intrinsic” to the earlier definition of the value of an asset:

The estimated intrinsic value of any asset is the sum of the cash flows expected to be produced by that asset, over its useful life, discounted for the time value of money and the uncertainty of receiving those cash flows.

Thinking of Intrinsic Value as a Range of Values

Although the definition we provide implies that the asset’s intrinsic value is a single-point number, we believe firmly that the goal is to determine a “range of approximate value.”

As we discuss in Chapter 1, assets with more predictable cash flows are preferable to assets with less predictable ones. Echoing Graham’s comment that intrinsic value is “a very hypothetical ‘range of approximate value,’ which would grow wider as the uncertainty of the picture increased,” it would logically follow that a business with less predictable (more uncertain) cash flows will have a wider distribution of estimated intrinsic value than will a business with more predictable cash flows, as shown in Figures 4.1A and 4.1B.¹⁵

To deal with an inherently uncertain future, the analyst needs to consider various possible scenarios when forecasting the company’s future cash flows and calculating its intrinsic value. He can produce a range of potential intrinsic values by performing a sensitivity analysis in which the assumption about one or more of the future cash flow components varies over time. Each scenario will produce a different discrete present value estimate that the analyst can use to create a range of possible intrinsic values.

For instance, we calculate seven different scenarios for Zoe’s Lemonade Stand in Chapter 3, and show in that analysis that each scenario produces a different intrinsic value estimate. In Table 4.1, we show the present value of three of the scenarios and divide by 150 shares outstanding¹⁶ to arrive at a value per share figure.

The intrinsic value for Zoe’s Lemonade Stand from Scenario 1 is presented as a single-point estimate in Figure 4.2

We can begin to create a range of estimated potential intrinsic values by adding the two-other single-point estimates from Table 4.1, Scenario 5 and Scenario 7 to the initial single-point estimate, as shown in Figure 4.3.

The analyst can produce additional possible intrinsic values by running a sensitivity analysis based on other growth scenarios. Different intrinsic values calculated using this method are shown in Table 4.2¹⁷

Adding the intrinsic value estimates for each of the different growth scenarios calculated in Table 4.2 to the chart in Figure 4.3 produces an even wider range of possible intrinsic values, as shown in Figure 4.4. As a reminder, the analyst calculates a range of possible intrinsic values because he is uncertain which of the scenarios will prove to be the actual outcome, although it is important to note that he will not know the true value of Zoe’s Lemonade Stand until the actual future unfolds.

The values closest to the central point represent the estimates that the analyst believes have the highest likelihood (probability) of being the company’s true intrinsic value, while the estimated values toward each of the tails are the scenarios the analyst believes are less likely to occur. The vertical distance away from the horizontal axis represents the analyst’s confidence in each estimate’s relative likelihood of unfolding. For instance, the graph shows that the analyst believes the most likely scenario for the lemonade stand results in an intrinsic value estimate of $9.41 per share, which is based on a no growth scenario.

We can use a simple example to illustrate how the range of distributions (and the shape of the distribution curve) can differ. Assume that a company has as its sole asset a $1,000 face value 10-year U.S. Treasury Note, which currently trades at $995.31. The best estimate of the company’s intrinsic value is also $995.31, which is the note’s current value.

It is relatively easy to estimate the company’s current intrinsic value in this example. The only information we need is the price of the Treasury Note¹⁸ since this is the company’s only asset. The chart in Figure 4.5 also includes a range of other possible intrinsic values to show that a change in interest rates would impact the value of the Treasury Note and, in turn, the company’s intrinsic value. However, the distribution is narrow because it is unlikely that interest rates will change much in a short span of time.

Although we use a normal distribution to depict the range of possible intrinsic values in figure 4.5, we do not mean to imply that this or any other distribution will be normally distributed. We use the chart for illustrative purposes only.¹⁹

We can use Tesla, a company using a new technology to manufacture electric cars, to illustrate the importance of determining the range of instrinsic value. Although Tesla operates in an established industry, the company’s outlook is highly uncertain because it is a relatively small auto manufacturer, selling cars based on new and completely different technologies. The car’s price, features, and reliability will dramatically affect its demand and, in turn, the company’s future revenue and cash flow. Not surprisingly, analyst estimates for the company’s intrinsic value vary greatly.

The uncertainty in the company’s prospects is evident by the wide range of price targets (estimates of intrinsic value)²⁰ for Tesla from the 15 sell side analysts who have published forecasts, as shown in Figure 4.6. The estimates range from a low of $178 per share to a high of $400 per share, with an average estimated one year price target of $293 (which represents the consensus). The stock traded at $245 at the time these estimates were published, in August 2015.

The wide range of estimates results from the fact that the timing, duration, magnitude, and growth of Tesla’s cash flows are highly uncertain. The range of estimates shows that the analysts have significantly different views for Tesla’s prospects, as they each have analyzed the available data differently in calculating their estimate of the company’s intrinsic value. As Buffett observed, “Two people looking at the same set of facts . . . will almost inevitably come up with at least slightly different intrinsic value figures.” The wide distribution also shows that the likelihood that any single estimate will be close to the actual intrinsic value is low and the possibility that the intrinsic value will be significantly higher or lower than the average (consensus) estimate is high.

Instead of comparing Tesla to a fictitious company whose sole asset is a Treasury Note, it is more instructive to compare it to another operating company. We chose McCormick, a company founded over 125 years ago that sells a wide range of kitchen spices. Compared to Tesla, given the nature of its business, McCormick’s future cash flows should be significantly more consistent and predictable, as we see in the distribution of estimates in Figure 4.7.

This difference between the three different distributions becomes evident when they are superimposed, as illustrated in Figure 4.8.

The distribution of analyst price targets for McCormick more closely resembles the distribution for the estimated value for the Treasury Note than it does to the distribution for Tesla, as the chart in Figure 4.8 demonstrates.

McCormick sells hundreds of different products to millions of customers, which makes the business more stable and its cash flows more predictable than Tesla’s. People use spices such as cinnamon and nutmeg on a regular basis, and most people buy more when they run out of a spice. While they might buy fewer spices during a recession, demand for the company’s products will not change much from year to year and McCormick’s operating income should not vary much over time. Consequently, the range of possible estimates for the company’s intrinsic value is relatively narrow. As such, the likelihood of McCormick stock increasing dramatically from the price at which it traded in January 2017 of $95 per share to $140 per share in a short period of time is highly unlikely.

On the other hand, unlike McCormick, Tesla could see a significant increase or decrease in its financial performance because of the high degree of unpredictability in demand for the company’s electric cars. As a result, the price of Tesla’s stock increasing or decreasing by 50% in any given year is not beyond the realm of possibility.

We calculate the sources of value for McCormick at the end of the previous chapter, which we replicate in Table 4.3.

We superimpose the range of analysts’ estimates from Figure 4.7 onto the range of values from Table 4.3 to create the combined graph in Figure 4.9.

This chart shows that the range of analysts’ estimates for McCormick’s value falls in the value of growth area for the company, which highlights that all the analysts expect the company to grow in the future and only differ in their views by the rate at which they expect the company to grow, as shown in the chart.

Gems:

• We can distill the comments from Buffett, Murray, and Klarman into a list of important factors that we need to keep in mind when estimating a company’s intrinsic value:
  • Intrinsic value is more of a conceptual framework than a precise calculation.
  • Intrinsic value is ultimately the discounted cash flow the asset will produce, as we discuss throughout the book.
  • The intrinsic value must be justified by facts—assets, earnings, and the company’s future prospects.
  • Intrinsic value is best expressed as a range of approximate values rather than a single-point estimate.
  • The range of possible intrinsic values grows wider as uncertainty increases.
• Intrinsic value is defined as follows: The intrinsic value of an asset is the sum of the cash flows produced by that asset, over its useful life, discounted for the time value of money and the uncertainty of receiving those cash flows.