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Parable of a Bird in the Bush: Study of Risk, Reward and Valuation
INTRINSIC VALUE
"How do you determine the economic value of an asset or decide the attractiveness of all possible use of capital?"
When my daughter, an English major, recently ask me this question and wanted a simple explanation, I turned to the master, Warren Buffet, who typically articulates an answer that even the lay person can understand. This was my response to her:
Dear Lauren,
Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn't smart enough to know it was 600 B.C.).
The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was "a bird in the hand is worth two in the bush". To expand this principle, you must answer only three questions:
(1) How certain are you that there are indeed birds in the bush?
(2) When will they emerge and how many will there be?
(3) What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)?
If you can answer these three questions, you will know the maximum value of the bush-and the maximum number of the birds you now possess that should be offered for it. And, of course, don't literally think birds. Think dollars.
Aesop's investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota--nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.
Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to "growth" and "value" styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component-usually a plus, sometimes a minus-in the value equation.
Alas, though Aesop's proposition and the third variable-that is, interest rates-are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.
Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let's call this phenomenon the IBT-Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance or blinding insights.
At the other extreme, there are many times when the most brilliant of investors can't muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.
Let me try to explain Intrinsic Value a different way to further help explain the above. Intrinsic value is 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. This is why I say constantly, "Growth is one of the components of value", or "Growth is value--they are joined at the hip." When evaluating intrinsic value, I suggest you always consider the sustainable competitive advantage of the business and capital allocation skills of management. Additionally, it takes the skills of a detective to completely understand a business, estimate the growth of the free cash flow/conversion of the business and, most difficult, evaluate management".
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, furthermore, will almost inevitably come up with at least slightly different intrinsic value figures.
Additionally, since intrinsic value of a business is never precise and can change, it is important to always have a substantial "margin of safety"when buying and thus buy at a significant discount and sell when the gap narrows (i.e. 90% price to value).
Good luck in computing intrinsic value or estimating the "birds in the bush". And by the way, always have a "margin of safety"!
Love, Dad January 31, 2003