Intrinsic value

We spend the great majority of our time working to understand the value of each of our investments and avoid trying to guess what each stock price will do.  While many managers speak of intrinsic value, our observations are that precious few actually take the time to really think about it; instead, relying upon relative valuations to provide them with a view of value.  Of course, the problem with comparing the prices of a company with its competitors is that it doesn't really help you if a sector is either overvalued or undervalued.  Just ask technology investors from the late 90s how effective comparable analysis worked for them.

So how do we arrive at our estimates of intrinsic value?  We start by assessing the risks and opportunities available to each company and then incorporate those assessments into a financial model.  We think about the factors that will determine a company's future cashflows:  its revenue growth, margin opportunities and threats, operating expense requirements, tax rates, capital expenditures and working capital requirements to name a few.  We look at returns on capital and operating margins as sanity checks.  Using this model, we discount the company’s future cashflows to arrive at a current value.  This value roughly coincides with the price a buyer would pay for the entire entity.  The real value of doing all the work to build a model is that it consolidates a great wealth of historical information and forces us to think long and hard about all the factors that will affect the future of the business.  It forces us to explicitly consider all crucial assumptions and is a guard against untested speculation and optimism.

While developing a view of intrinsic value requires a great deal of effort, it prepares us for the events that inevitably occur (either market related or specific to the company) that cause meaningful changes in share prices.  The grounding that we have from our extensive work to arrive at a view of fundamental value allows us to react during these times.  Buying more of a company when its share price has fallen sharply isn’t that difficult to do if you truly understand the company’s value.  The truth is that most investors do not understand value and so are not comfortable ‘stepping-up’ at the times they should.