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

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

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

Random walk

The Famous Drunk

Intrinsic Value Price = Value Intrinsic Value Price = Value

X

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)

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

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

Intrinsic Value Intrinsic Value

The holy grail of investing is the search for intrinsic value

From Roman Times to the present

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!

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.

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!

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

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

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

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

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.

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

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

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.

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

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

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

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

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.

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

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

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

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

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

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

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.”

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

Models1. Perpetuity CaseModels1. Perpetuity Case

k

CfV

g

N

t

o

0

Models2. Constant growth: Williams, Gordon Model

Models2. Constant growth: Williams, Gordon Model

brkbEo

gkCf

V

nT

t

o

)1(

DerivationDerivation

Basic Cash flow

N

No

k

Cf

k

Cf

k

Cf

k

CfV

)1(...

)1()1(1 3

3

2

21

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

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

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

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

Current IssuesCurrent Issues

Factors affecting valueRisk re expected cash flowsSelecting appropriate discount rateAdverse selection and moral hazard

The Key To Long Horizon InvestingThe Key To Long Horizon Investing

Estimating k and g

brk

bE

gk

DivP

oo

)1(1

Present value modelsPresent value models

Present value of dividends Need to calculate growth rate and

discount rate

)*(

)1(1

bROEk

bEo

gk

DPo

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!

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