In order to make any intelligent investment decision we must first understand what the value of that investment is to us. We call this the “Intrinsic Value”; the objective, inherent value of the business.
“Intrinsic value is the number that if you were all knowing about the future, and you could predict all the cash that a business (or investment) would give you between now and judgement day, discounted at the proper (opportunity) discount rate, that number is what the intrinsic value of the business (investment) is.” – Warren Buffett
Let’s include a reminder here that the ‘discount’ or ‘opportunity’ rate, is the rate of return you want from your investments, and you use that rate to calculate the intrinsic value of all your comparable investments.
If this sounds complex or confusing, rest assured, it’s not. In fact, it’s a simple concept. But simple is not the same as easy. I’ll try to explain.
Many of you will be familiar with a bond, GIC or CD. Each of these are similar investments so for our purposes, we will simply call them all a bond going forward.
With each bond, you know that you will pay or deposit some money now. This is also known as your principal or investment capital. You then expect to get paid interest on your capital at the prescribed rate over the term of the bond, plus you expect to get your principal paid back at the end of the term.
So for each bond with a one year term you will get your principal and interest back by the end of that year. If your term is longer than one year then you will likely get interest payments throughout the term of your agreement plus you would then get your principal paid back at the end of the term (also called the maturity); or you get both the interest and your principle at the end. With me so far? Take your time and reread that that last bit if your not there yet; we can wait. Understanding new things takes time, so take the time you need.
Let’s use an example to illustrate. You buy a one year bond with a 5% coupon or interest rate. Since most bonds are sold in face value increments of $1,000, you will pay your $1,000 now and one year later, the company who sold you the bond, pays you $50 in interest plus your $1,000 of principle. You now have $1,050. Well done.
So now we are going to turn that around and ask the question; what is the intrinsic value of the bond in the above example? Well, we know the cash it will produce for the investor over its term is $50 and we know the term (life) of the investment is one year.
Based on our example, we know that if we discount the bond at 5%, the bond is worth $1,000. That’s the intrinsic value of the bond.
But what happens if we have a higher opportunity rate? That means we need or expect a bigger rate of return from that same bond versus the rate printed on the bond. Since we already know the term of the bond and the cash it will generate for you (those items are fixed), you will quickly realize that you will have to pay something less than the $1,000 face value of the bond in order to get a higher return than the 5% promised by the bond. And the converse is true, that if you used an opportunity rate of less than the 5% promised by the bond you could pay more for the bond than the $1,000 face value to get your desired rate of return.
Let’s use some examples in tables to help illustrate.
| Intrinsic Value / Investment | Opportunity / Discount Rate | Future Value (1 Yr) |
| $ 1,000.00 | 20.00% | $ 1,200.00 |
| $ 1,043.48 | 15.00% | $ 1,200.00 |
| $ 1,090.91 | 10.00% | $ 1,200.00 |
| $ 1,142.86 | 5.00% | $ 1,200.00 |
| Intrinsic Value / Investment | Opportunity / Discount Rate | Future Value (1 Yr) |
| $ 1,000.00 | 20.00% | $ 1,200.00 |
| $ 1,000.00 | 15.00% | $ 1,150.00 |
| $ 1,000.00 | 10.00% | $ 1,100.00 |
| $ 1,000.00 | 5.00% | $ 1,050.00 |
Take a little time to review those tables just to properly understand the relationships of the change in Intrinsic Value and Future Value given a specific Opportunity Rate.
So how does this apply to common stock investments?
To start with, we want to think of common stocks like an ‘equity bond’. Yes an ‘equity bond’. Go long with it for now because it will make sense in time. This equity bond (common stock) will generate cash for the investor over its lifetime, just like a regular bond does as we described above. So if we take the same approach with common stocks or ‘equity bonds’ as we do for traditional bonds we will need to know (or assess) the term or life of the ‘equity bond’ and the ‘coupons’ or cash generated for the investor (otherwise known as Owner’s Earnings).
I know you see the challenge already. With a traditional bond we know the term or life of the bond (normally in years) and we know the amount of cash generated (interest payment) for the investor over that life…because this information is printed on the bond!
But for an equity bond (common stock) we don’t know any of these details. You are right of course and that lack of detail poses a big challenge for the investor. Filling in those big important blanks is a big part of the work of the investor.
So once an investor assess the term of an investment (business) and the expected cash generated from that investment for the investor (Owner’s Earnings), we then need to discount those values back to today, using our Opportunity Rate, to calculate our opinion of the Intrinsic Value for that investment. The math is not complicate but the process is not easy as you can start to see.
By the way, Owner’s Earnings is a term that comes from Warren Buffett and other successful and revered investors, to accurately describe the earnings of a company that accrue for the benefit of its owners, the shareholders. These earnings are notably different than accounting earnings presented on financial statements and require intelligent analysis to determine.
Even when the investor really knows a company well, including the industry that the company operates in, it is still extremely difficult (more like impossible) to assess these missing pieces of information with any high degree of accuracy. Despite these pitfalls and hurdles this is the work we must do in order to makes intelligent investment assessments and decisions.
And how do we mitigate the risks of being so inaccurate with our assessment information? We use the principle of a Margin of Safety. We’ll talk about that topic another time.
Cheers.
