The intrinsic value of Amazon when Jeff Bezos worked in his garage swell up to today’s value.
. . .
The price of the asset – whether it is stock, commodity, or bond – is subjective. Thus, the investor calculates Intrinsic value to set a “standard” whether certain assets are overvalued, undervalued, or at a fair price. Problem is, the calculation of the intrinsic value itself is subjective – it varies from investor to investor. So, we have a subjective asset price that is measured by another subjective (less subjective by the way) method. Could we solve this dilemma?
Intrinsic Value. In This Issue
What We Should Focus On? Using DCF to Determine Intrinsic Value?
To make $100 you just need a piece of paper and ink the printed properties. It may cost you around 16 cents – we don’t know the detail figure but one thing, it is far below $100. If someone asks you, is that 16 cents printed note with Benjamin Franklin face overvalued? None will nod his head.
We have two things here.
The first is the number, the quantity things: $100, and 16 cents.
And we have quality things – the unseen – intangible one: government regulation, Federal Reserve authority. The consensus, the public acceptance of that value.
See? The Intangible – the invisible – is the one that dictates the value.
The lesson we learn is when determining a certain asset – it is the quality that drives the price of that asset in the long, long run. Like our $100 example.
Earnings, Revenue, Free Cash Flow, is quantity things – in some industries, it is volatile. Even when we take the most stable business like retailers, the expectation of that number sometimes miss. Discounted Cash Flow, is a valuation method using those quantity things. A slight difference in expectation (versus reality), can lead DCF calculation to go significantly wrong.
Competitive Advantage: The Quality
So we have to move our focus on another element – the quality things. In the case of $100, the quality things are the regulation, the public acceptance. Weird question, what is the competitive advantage or economic moat of that $100? We would say, the regulation back up is the economic moat – it enjoys monopolistic “business”. None – on this planet – can print and distribute that greenbacks but The Federal Reserve.
Could we extend this lesson to riskier assets like stock?
To obtain, or to calculate the intrinsic value of the company – or stock, we need to focus on the quality things. To be more precise, we need to pay more attention to its competitive advantages. The first question we need to ask before we invest our money is – do this company could maintain its earning (or even grow) in the upcoming years? Is there any threat from other parties, whether it is regulation, the industrial revolution, or competitor existence? What is the company’s competitive advantage? Could it last? How long?
The quality things dictate the quantity. Quality things are more robust, accurate, and less volatile than the quantity.
Valuation
Let get more serious.
Imagine we are ready to make our most popular method – the discounted cash flow – to make valuation for, let say, Microsoft. Suppose the Redmond-based company generates 10 Billion in earnings last year and has a 10% CAGR. You want to know its intrinsic value 10 years later – then you do the legendary DCF. You use that 10 Billion as the initial value and 10% as the rate. Question – How can you be so sure?
If I change the company – from Microsoft to Vale, does the calculation change? What about ExxonMobil? Intuitively, you will say that it would be much different. By the way, you could change the DCF with the P/E ratio, or any number or ratio you like. Or if you don’t like using earning as valuation, you could change it with free cash flow, margin, or whatever.
The things are the quality, the economic moat that makes differences.
A company with a strong economic moat has more predictability – Apple has intangible assets as an economic moat, so it can cast higher prices for their devices, something that other vendors can’t replicate. Amazon, Facebook, Google, enjoy network effects, the more people join to use their product, the stronger they are – Like Apple, this is difficult to be replicated.
Quality things, the economic moat give us predictability of the quantity, the number.
The rest is up to you – whether you use P/E multiple, DCF, you name it.
What To Do. Algorithm Calculating Intrinsic Value
Practically, here is the guide.
- The first thing to do is understand the business model. You can’t value something if you don’t know how it makes money. Try to identify the segment contribution to earning and revenue. Make an analysis, do this business model is prone to competition? In investingdeck.com we make several examples of business models, you can refer to here.
- Once you understand the business model – how the company operates and makes money, usually you will get an insight into its competitive advantage or economic moat. How unique the product? How its position in the market? Simply said, an economic moat is something that prevents the company’s market share from taken by the competitor or any other parties. If you don’t know how to perform it, try threat analysis in SWOT analysis – it is simple but will help a lot, as we did here for Visa.
- Analyze the management. Does the Board of Directors creating value for shareholders or destroy it? For a more complete guide, you could refer to here.
- The better the business and management, the more confident you use the number – for instance, the 5 years CAGR. When we calculate an intrinsic value for Visa – given its strong economic moat and management – we could straightforwardly use discounted cash flow. Consequently, the lower quality of those factors, you should make the proper adjustments. ExxonMobil, the oil producer company may have a 15% CAGR for the last 5 years, but you need to take the worst case when making a valuation for that kind of business.
Another Approach
Reverse your logic and find this beautiful mind – Charlie Munger.
I like Munger’s approach not because he is a genius. It is because he is very simple. Regarding investing, Munger said that he has advantages not because he trying to become smart – invest in the most sophisticated business which then becomes a phenomenon. Instead, he trying not to become stupid.
We could extend this method to deal with intrinsic value.
Instead of involving the herculean task of getting the precise number, we can just try to assess whether it is too much or overlooked.
Listen.
You can say whether someone is overweight or underweight just by looking at her1.
You can assess if Tesla is overvalued or not just by understanding its business model and economic moat – then do accordingly. Right now, Tesla is at 680 P/E multiples and Amazon at 67. Yes, we know that Tesla enjoys the growth – but once another vendor joins the competition, the growth will be ephemeral. Amazon has more solid business, great network effect, and economies of scale as an economic moat. But Tesla’s valuation is ten times Amazon’s. I would like to pick Amazon than Tesla – it is overvalued. Thanks for booing us, but no, Tesla could make another all-time high this year, next year, but we won’t join.
We hate the risk more than we love the gain.
This method is called Mental Model by Munger – just reverse the logic.
Takeaway
- Quality things matter. Earnings, Revenue, Cash Flow, Margin, Growth are products of business, scale, economic moat, management excellence.
- Sometimes we don’t need to be accurate, just make a simple comparison with a logical framework will help a lot.
- All valuation method is based on an assumption – making this assumption is the difficult ones.
Have a great investing.
- yay, because you know the concept, the quality [↩]