The Problem With Intrinsic Value
The Truth About Value Investing and Stock Market Valuations
Understanding the Limitations of Value Investing
Many investors have been brainwashed by decades of smarter than thou finance participants telling them
value investing is the be-all and end-all of making money in stocks. I'm afraid to tell you that it is not so. Value is only one share price variable, and it's not a terribly good one. This is the standard stock valuation formula. Value is the sum of all future cash flows discounted back to today's date.
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There are a few variables in here, forecast earnings are one, the assumptions used to produce those earnings forecasts is another, and the most rubbery one of all, which is the discount rate. What discount rate do you use. Hmmm. There are text books on that.
Ultimately employing company valuations in the stock market decision to buy or sell has a number of weaknesses. Here are some of them:
- Value is only one element of a share price. If the bank sector can fall 56 per cent in the GFC and then recover 152 per cent then clearly there are a lot of other things at work in the stock market beyond ''value'' because the bank sector's value didn't change that much. In fact some might argue that it hardly changed at all in the GFC. If share prices of large, well understood, relatively easy to value, stocks, can move that much, inflict that much pain and present that much opportunity. Then there are clearly many forces at work on share prices besides value and if you want to exploit that then surely you should consider the other elements that drive a share price. Value is just one rather boring one. Consider how much more money you would make if you could time fear, greed, exuberance, stocks and the market. So shouldn't you try?
- Value is often presented as a ''quick shot'' stock view akin to the ''Target Price'' and ''Recommendation'' that everyone seems to live off these days. These snapshots are not the whole story but are there to dumb down the research and fulfil the commercial requisite for analysts to deliver their advisers and clients ''conclusions without the need for brains''. Just like the recommendation and target price, you can put too much value on a valuation if you don't actually understand ''why?''
- Value is calculated using consensus earnings forecasts. Need I say more? Forecasts change and the money is made not from the valuations that depend on them but on knowing when the forecasts are wrong and the valuations are wrong. The more accurate a valuation the more useless it is. What you really want is to know when everyone is wrong. When the intrinsic value calculation is flawed because the assumptions behind it are changing. That's much more useful.
- A single number, no matter how accurate, is of little use. This year's number, be it a PE, yield or intrinsic value overlooks the more important information, the trend in earnings, the trend in share price, the trend in sentiment, the sector, the market. Stating one data point is meaningless, it is the trend in intrinsic value, PE or ROE that is important. It is no good saying a stock is expensive on a 50 per cent premium to intrinsic value this year because if it is going to be at a 50 per cent discount in five years' time it's going up.
- The RRR - The required rate of return, a key component of the intrinsic value calculation, is a very rubbery assumption. This assumption would more appropriately be labelled the rubbery rate of return. It is central to an intrinsic value calculation, is often not disclosed, is subjective, but is the crucial assumption. You can't gloss over it because it is the core of the valuation. Tiny movements in an RRR can make a huge, literally huge, difference to a value calculation. Move your RRR on BHP by 1 per cent and the ''value'' of BHP changes $5 in both directions. If RRR is such a questionable variable then clearly there is no such thing as an ''exact'' valuation because you are dealing with opinion, not fact. The only way to bring order to value is to realise value calculations are a relative calculation between stocks rather than a definitive statement of fact or a statement of what the share price should be.
- If your time frame is shorter than value investing allows and you are financially impatient (all of us) it is not about ''what'' you buy, it is about ''when'' you buy. Investors who sat through the 54.5 per cent fall in the market in the global financial crisis being patient and faithful then needed to earn 113 per cent to get their money back. Being patient lost them 13 years. Value appears high brow, but it's not helpful when the market becomes volatile. You will never time the market or stocks, using value.
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In the end a more reliable, enduring, and desirous judgment on a stock in a safety-first investment environment would be a ''quality score''. The quality of a company's earnings would be a much more useful piece of information than any valuation calculation no matter how ''exact'' it looks, because there is no ''exact'' valuation if it is based on unreliable forecasts and a rubbery rate of return.
The Truth about valuation - Talk to any Corporate Finance analyst and they will tell you. It's all a bit of a game.
Valuation varies depending on whether you are the buyer or the seller. There is no exact valuation. Valuation is what somebody persuades you to pay. It is not fact, it is opinion which is a function of persuasion. He who argues best, and is believed, is right.
Intrinsic Value = The price a rational investor would pay and there is a lot of maths employed to persuade them what that is.
More about the author – Marcus Padley
is a highly-recognised stockbroker and business media personality. He founded the
Marcus Today Stock Market Newsletter in 1998. Over the years, the business has built a community of like-minded investors who want to survive and thrive in the stock market. This is achieved through a combination of daily stock market education, ideas and activities.
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