The concept of intrinsic value (the true worth of a share) has been developed over decades with the intellectual rigour of some of the world’s most successful investors most notably Walter Schloss, Charlie Munger and Warren Buffet. Value investing centres on the calculation of intrinsic value. Intrinsic value is not a range of values, rather it is a precise assessment of a company’s worth based on its’ performance and a view of its’ prospective sustainable profitability.
There are several components of the intrinsic value formula:
There are many components to a share’s true worth and all these must be accounted for. Shares may have regular pay outs (share dividends) paid by their respective company to shareholders based on the profits and reserves of the company. There is also income of a corporation that is retained by the corporation, excluding that which is distributed to shareholders as dividends. The reserves at the disposal of a company may also fluctuate (e.g. the rise and fall of foreign currency gains). As you might know already, all Australian investors benefit from receiving franking credits at tax time in offsetting assessable tax or being refunded by the Australian Tax Office. This too needs to be accounted. And, one off abnormalities such as the gains or losses associated with asset sales must too be accounted. When these factors are calculated we get a Normalised Earnings value.
Normalised Return on Equity:
Next, we need to calculate the Normalised Return on Equity (NROE). Often investors put too much focus on a company’s value in the way of profits and dividends rather than focusing on the capital that has gone into a company to produce the profits. The key; consider both via the Normalised Return on Equity measure of true profitability. Normalised Return on Equity is calculated as a proportion of the Normalised Earnings of a company based on its equity past and present.
Reinvestment Strategies and use of Capital of the Company:
We also need to reward companies that have high NROE and can retain capital and reinvest it to compound it at attractive rates. Conversely we need to punish businesses that have low NROE and decide to retain capital at sub-par rates of return. This is where the Payout Ratio comes into play.
Recognition of Future Growth Potential and Profitability:
Our approach recognises that there is also both a bond and growth characteristic within each company. We account for this via the Equity Multiplier.
Once the Equity Multiplier has been calculated, the final step is to apply this to the equity per applicable share. The product of this calculation is the ‘Intrinsic Value’. Thus through the Value Investing methodology you arrive at a mathematical equation to calculate the intrinsic value of a share.
Intrinsic Value Equation:
Intrinsic value = Equity Multiplier x Equity Per Share