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The Search For Intrinsic Value: Some Selected Moments in the History of DPV
The Search For Intrinsic Value: Some Selected Moments in the History of DPV
Professor Eric Kirzner June 2006
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Security Valuation Security Valuation
What people are willing to pay for it
Risk contribution to a portfolio
The consensus of the crowd
Discounted present value of future dividends
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Intrinsic Value Price = Value Intrinsic Value Price = Value
1. Efficient Market?
Security prices reflect all available information
Security prices efficiently adjust to new information
1/ jttjt rEr
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Random walk
The Famous Drunk
Intrinsic Value Price = Value Intrinsic Value Price = Value
X
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Intrinsic Value: Security Analysis Intrinsic Value: Security Analysis
2. Fundamental: the Search for Intrinsic Value
Prices and value can diverge: search for intrinsic value: compare to actual price
Asset based; cash flow (earnings-based)
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Intrinsic Value: Security Analysis Intrinsic Value: Security Analysis
Accounting Oriented Long history
Ratios and relative valuation
Value school
Growth oriented Evidence re models
back to 16th century
Projecting Future cash values
Search k and g
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Security Analysis Security Analysis
3. Technical Analysis Prices reflect all available information Analysis of price and volume trading
history used to predict future price directions
Charts and patterns: momentum Dow Theory 1895 Edwards and Magee “Technical Analysis
of Stock Trends:, 1952
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Intrinsic Value Intrinsic Value
The holy grail of investing is the search for intrinsic value
From Roman Times to the present
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Discounted Present Values Discounted Present Values
DPV concept at least over 2000 years old “Annua” traced back to ancient Rome
Annual stipends In return for a lump sum payment, these
contracts promised to pay the buyers a fixed yearly payment for life, or sometimes for a specified period of term.
Often bequests to non first-borns Life annuities!
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Annuities! Annuities!
1600s and 1700’s: governments in several nations, including
England and Holland, sold annuities in lieu of government bonds
lifetime annuities purchased with a single premium became a popular method of funding the nearly constant wars that characterized that period.
See Charles Dickens and Jane Austen annuities were “all the rage” in European high
society.
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Tontines! Tontines! Named for Lorenzo Tonti who first recommended a
tontine form of government financing in 1652 special annuity pools: In return for an initial lump-
sum payment, purchasers of tontines received life annuities.
amount of the annuity was increased each year for the survivors who received the payouts that would otherwise have gone to those who died.
When the last participant in a tontine pool died, the sole survivor received the entire remaining principal.
The tontine thus combined insurance with an element of lottery-style gambling.
First Option pricing model!
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Abraham de Moivre (1667-1754)Abraham de Moivre (1667-1754)
Mathematician (analytic geometry), physicist
Friend of Newton, Halley Published “Treatise on Annuities
on Lives” (1725)Valuation of joint annuities on
several lives; pricing tontines
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Johan de Witt 1625-1672Johan de Witt 1625-1672
Lawyer, mathematician ( analytic geometry), politician (political leader of Holland 1653; settled two wars with England)
“The Value of Life Annuities In Proportion to Redeemable Annuities” (1671) Derived a model for valuing a life annuity Crude approximation formula re how many
people out of a group would die each year Calculated present value of each annuity and
then priced it based on arithmetic average of all annuities
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Edmond Halley (1656-1742) Edmond Halley (1656-1742)
Astronomer, mathematician Paid for
publication of Sir Isaac Newton’s “Principia Mathematica”
1695 predicted that comet of 1531, 1607 and 1682 was periodic
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Edmond Halley (1656-1742)Edmond Halley (1656-1742)
Mortality tables based on five years of data: city of Breslau 1693 One of first to
relate mortality and age in a population
A step re production of actuarial tables
Edmond Halley “ Of Compound Interest” (1761) Formula for present
value of a regular annuity
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Early 1900’s Early 1900’s
Accounting book values widely used re valuation
Stock market crashDCF gains popularity re valuation approach Irving Fisher, John Burr WilliamsHowever not until 1951 that NPV accepted
as model for in capital expenditure decision Joel Dean, “Capital Budgeting” 1951.
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Early 1900s: Two Paths to Security Analysis Early 1900s: Two Paths to Security Analysis
Value Investing and the accounting approach
Growth Models and The DPV approach
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1929: The Great Crash: Dow drops by 90% from high to low
Benjamin Graham (1894-1976) 1926 founded Graham-Newman corp. 1928 taught course on security analysis at Columbia Observes Great Crash focuses on crunching numbers not on qualitative
factors Techniques that could be universally applied Available from publicly available sources price-to-earnings (P/E) ratios, debt-to-equity ratios,
dividend records, net current assets, book values, and earnings growth.
Value approach: 1920’s-Value approach: 1920’s-1930s1930s
Value approach: 1920’s-Value approach: 1920’s-1930s1930s
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Benjamin Graham Benjamin Graham
“Many common stocks do involve risks of deterioration. But it is our thesis that a properly executed investment in common stocks does not carry any substantial risk of this sort and that therefore it should not be termed “risky’ merely because of the element of price fluctuation.”
The Intelligent Investor pp.121-122.
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What Value Investing Is: Three characteristics according to Graham and Dodd
What Value Investing Is: Three characteristics according to Graham and Dodd
1. Prices of securities subject to significant and capricious movements Mr. Market -the Graham personification- willing
to buy and sell every day Prices gyrate randomly: Current price will
diverge from intrinsic value2. (Many) securities have fundamental economic
value values that are stable, measurable
Disciplined investor using metrics Price and value rarely equal in short term
Market a voting machine in short term
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What Value Investing Is:Three characteristics according to Graham and Dodd
What Value Investing Is:Three characteristics according to Graham and Dodd
3. Appropriate investment strategy is to buy good companies but only when…
market price is significantly below calculated intrinsic value
This is margin of safety
Ideally should be 50% discount and not less than 33% discount
Intrinsic value is $10.00 Want to buy at $5.00; no more than $6.67
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Value Investing: The Bright LineValue Investing: The Bright Line
Margin of safety! Graham and Dodd
If price established by Mr. Market is lower than intrinsic value by a sufficient margin of safety stock is a buy for the value investor!Price
Intrinsic
Value
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Value InvestingValue Investing
Why the growth skepticism? View that in many
instances growth not worth anything at all!
In a competitive environment all of the value of future growth may be consumed by additional capital necessary to fund the growth
Profitable growth is that that produces returns in excess of excess capital needed
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Value InvestingValue Investing
Why the growth skepticism?
Profitable growth is that which produces returns in excess of excess capital needed
True growth companies generally have barriers to entry that restrict competition and constrain pure competition from developing
Growth primarily valuable in a protected franchise
Hence value investors focus on strategic position of company and how sustainable the franchise is.
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1950s 1950s
Chairman Sen. William Fulbright Fulbright Q: “What causes a cheap
stock to find its value?”
Graham A: “That is one of the mysteries of our
business, and it is a mystery to me as well as to everyone else. But we know from experience that eventually the market catches up with value.”
Benjamin Graham testimony to the Committee on Banking and Commerce, 1955
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T. Rowe Price ( 1930’s) (1) high quality R & D; (2) limited competition; (3) few government regulations; (4) well-paid employees but low
labor costs; (5) a strong possibility of high return
on invested capital and (6) superior growth in earnings per
share.
Growth Approach 1920’s-Growth Approach 1920’s-1930s1930s
Growth Approach 1920’s-Growth Approach 1920’s-1930s1930s
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NPV’s: Irving Fisher NPV’s: Irving Fisher
Fisher defined capital as any asset that produces a flow of income over time.
A flow of income, said Fisher, was distinct from the stock of capital that generated it. “ Separation of production and financing
decision” Capital and income are linked by the interest rate.
Specifically, the value of capital is the present value of the flow of (net) income that the asset generates.
(Maybe) first to propose that capital project should be evaluated by present value
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NPV’s: John Burr WilliamsNPV’s: John Burr Williams
Studied at Harvard Business School Security analyst
Found stock valuation elusive: disenchanted with accounting based measures
1932; enrolled in Ph.d program at Harvard
Joseph Schumpeter suggested intrinsic value focus for dissertation
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John Burr WilliamsJohn Burr Williams John Burr Williams, “ Theory of Investment value”
1938 (before completing thesis) One of first to interpret stock prices as worth
intrinsic value using discounted dividends Future dividends can be forecast by “algebraic
budgets” Estimates re earnings, growth, capital structure
Williams models General DCF; declining dividend discount
constant DDN, increasing DDM, sudden growth
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John Burr Williams John Burr Williams
Williams book contains the derivation of the constant growth model:
gk
DP
1
0
Gordon and Shapiro restated as
k= d1/p +g
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John Burr Williams John Burr Williams
“ The last word on the true worth of any security will never be said by anyone but men [sic] who have devoted their whole lives to a particular industry should be able to make a better appraisal of its securities than any outsider can.”
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Discounted Cash flowDiscounted Cash flow
Discounted cash flow…Value today of a series of two or
more future cash flows
P0 CfT
(1 k)TT1
N
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Models1. Perpetuity CaseModels1. Perpetuity Case
k
CfV
g
N
t
o
0
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Models2. Constant growth: Williams, Gordon Model
Models2. Constant growth: Williams, Gordon Model
brkbEo
gkCf
V
nT
t
o
)1(
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DerivationDerivation
Basic Cash flow
N
No
k
Cf
k
Cf
k
Cf
k
CfV
)1(...
)1()1(1 3
3
2
21
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Derivation Derivation
gk
Cf
kgkgCf
k
gCf
k
gCf
kgCf
k
gCf
)1
)1(1
1)1(
)1(
)1(...
)1(
)1(
)1()1(
1
)1(3
3
2
2
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Growing annuity Model Growing annuity Model
Williams: VALUATION MODEL
Gordon: DISCOUNT RATE MODEL
gP
Dk
gk
DP
s
s
+
0
1
1
0
DIVIDENDYIELD
LONG RUN CAPITAL
GAINSYIELD
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Models3. Variable growth:Models3. Variable growth:
R
RR
NTT
TN
TT
T
o kX
gk
gCf
k
gCf
k
gCfV
)1(
1)1(
)1(
)1(
)1(
)1(
3
3
1
2
1
1
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Models4. Variable growth with transition:Wells Fargo et al.
Models4. Variable growth with transition:Wells Fargo et al.
R
RN
NTT
TN
TT
T
o kX
gk
gCf
k
gCf
k
gCfV
)1(
1)1(
)1(
)1(
)1(
)1(
3
33
1
2
1
1
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Current IssuesCurrent Issues
Factors affecting valueRisk re expected cash flowsSelecting appropriate discount rateAdverse selection and moral hazard
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The Key To Long Horizon InvestingThe Key To Long Horizon Investing
Estimating k and g
brk
bE
gk
DivP
oo
)1(1
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Present value modelsPresent value models
Present value of dividends Need to calculate growth rate and
discount rate
)*(
)1(1
bROEk
bEo
gk
DPo
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Cash FlowsCash Flows
Free Cash Flow Net Income+ Non-cash revenue and expenses+
changes in net working capital+ capital expenditures – property dispositions
Recognizes that some investing and financing activities are critical to firm
These necessary expenditures must be made before firm can use cash flow for other purposes such as paying off debt or repurchasing equity
Key measure for valuation models such as free cash flow to firm and economic value added
Not a totally objective measure!
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Discounted Present Values Challenges
Discounted Present Values Challenges
ko How estimated? Forecaster’s k or estimated market k
(Keynes's beauty contest) Fixed or variable? Risk premium approach: stability?
f (risk-free rate?; expected inflation…)
Cft and growth how estimated? Short; long-term historic data? Reliability Growth: sustainable: protected franchise