The History and Importance of Correct Intrinsic Value Calculation
During the first half of the 20th century, Columbia Business School professor and legendary investor Benjamin Graham taught his students how to calculate the intrinsic value of a business, measured per share.
Graham's system had already proven successful when a student of his named Warren Buffett applied the formula and continually discovered businesses that were severely undervalued.
In the book The Snowball: Warren Buffett and the Business of Life, author Alice Schroeder provides sensational recount of Buffett's amazing performance, often beating the market by over 100% in a single year during his early days when he was still of small enough quantity to move his money seamlessly.
Besides Buffett, many other Graham disciples made fortunes in the market utilizing the aforementioned prescription, as well as thousands of Buffett students that he mentored over the course of his career.
Buffett modified the formula slightly to reflect changes of market intricacy over time, but the basic tenants which have proven so accurate for nearly a century remain.
Of course, calculating the intrinsic value of a business is not the only component to decipher when analyzing potential investment, but it is a major factor and indeed the first step of many a value investor.
In the 2006 New York Times best selling book Rule #1, author Phil Town unveiled the method of determining the intrinsic value of a business, finally allowing the layperson a peek behind the curtain of the well protected Graham-Buffett formula.
Never actually a secret, those privy were either taught directly by the masters, had the benefit of being taught by one of their students, or was somewhere on this network tree.
Although many market analysts' devised similar equations to assign target prices to securities, most deviated somewhere in hard number implementation and interjected too much personal opinion and other elements of subjectivity.
The Graham-Buffett calculation of intrinsic value is strictly objective and based on historical data which unveils patterns most likely to carry forward.
Subjectivity enters when analyzing the management of the business and overall sector viability, but numerical value determination utilizes only numbers.
Critics recite a repeated creed of past performance being an inaccurate predictor of future performance, but the investing records of Graham, Buffett, Town, and their followers prove otherwise.
It is true in the strictest sense that past numbers are not guaranteed predictors of future ones, but I offer the following analogy to capture the idea of why the formula is most often successful.
If you had the responsibility of putting together a baseball team and were evaluating potential players who were veterans of your league, which player would you put your money on as more likely to have an all-star season for you: the gold glove slugger who hits.
300 with 30 homers every year, or the career journeyman utility infielder who's a career.
250 hitter? Would you take Albert Pujols or Alex Cora? I doubt that anyone would debate that past performance has little to do with future prospects when you apply the analogy, especially when one keeps in mind that businesses are not affected by pulled hamstrings, torn ACL's, and slowed reflexes due to age that can knock out the all-star ballplayer.
Point being that yes, if both are healthy next season, Alex Cora could conceivably have a better year than Albert Pujols, but what are the odds of that happening? Accurate calculations of the value of a business use the empirical data of the businesses return on equity, analysts' composite estimations of growth, and historical price to earnings ratio baselines.
Intrinsic value has nothing to do with past or current share price, however the above stated realized figures prove accurate in determining future growth as well as how the market tends to assign a multiple of price to earnings of that business.
Obtaining an accurate estimation of future earnings per share, multiplied by an accurate estimation of earnings multiple (P/E), gives the accurate estimation of future share price.
In determining intrinsic value, a final element must be discussed which is a key ingredient to the success of the Graham-Buffett formula.
The calculation is done using several samples of the above mentioned figures, but the most conservative is always used in the final compute.
For example, the lowest rate of return on equity for the business over a one, three, and five year period is assumed going forward, which assures that the intrinsic value calculation can in no way be inflated.
In essence, it is better to get it low than get it right, because a determination of undervaluation when using the most conservative figures adds of level of protection; weeding out any businesses on the fence of undervaluation and leaving the definitive ones.
Graham's system had already proven successful when a student of his named Warren Buffett applied the formula and continually discovered businesses that were severely undervalued.
In the book The Snowball: Warren Buffett and the Business of Life, author Alice Schroeder provides sensational recount of Buffett's amazing performance, often beating the market by over 100% in a single year during his early days when he was still of small enough quantity to move his money seamlessly.
Besides Buffett, many other Graham disciples made fortunes in the market utilizing the aforementioned prescription, as well as thousands of Buffett students that he mentored over the course of his career.
Buffett modified the formula slightly to reflect changes of market intricacy over time, but the basic tenants which have proven so accurate for nearly a century remain.
Of course, calculating the intrinsic value of a business is not the only component to decipher when analyzing potential investment, but it is a major factor and indeed the first step of many a value investor.
In the 2006 New York Times best selling book Rule #1, author Phil Town unveiled the method of determining the intrinsic value of a business, finally allowing the layperson a peek behind the curtain of the well protected Graham-Buffett formula.
Never actually a secret, those privy were either taught directly by the masters, had the benefit of being taught by one of their students, or was somewhere on this network tree.
Although many market analysts' devised similar equations to assign target prices to securities, most deviated somewhere in hard number implementation and interjected too much personal opinion and other elements of subjectivity.
The Graham-Buffett calculation of intrinsic value is strictly objective and based on historical data which unveils patterns most likely to carry forward.
Subjectivity enters when analyzing the management of the business and overall sector viability, but numerical value determination utilizes only numbers.
Critics recite a repeated creed of past performance being an inaccurate predictor of future performance, but the investing records of Graham, Buffett, Town, and their followers prove otherwise.
It is true in the strictest sense that past numbers are not guaranteed predictors of future ones, but I offer the following analogy to capture the idea of why the formula is most often successful.
If you had the responsibility of putting together a baseball team and were evaluating potential players who were veterans of your league, which player would you put your money on as more likely to have an all-star season for you: the gold glove slugger who hits.
300 with 30 homers every year, or the career journeyman utility infielder who's a career.
250 hitter? Would you take Albert Pujols or Alex Cora? I doubt that anyone would debate that past performance has little to do with future prospects when you apply the analogy, especially when one keeps in mind that businesses are not affected by pulled hamstrings, torn ACL's, and slowed reflexes due to age that can knock out the all-star ballplayer.
Point being that yes, if both are healthy next season, Alex Cora could conceivably have a better year than Albert Pujols, but what are the odds of that happening? Accurate calculations of the value of a business use the empirical data of the businesses return on equity, analysts' composite estimations of growth, and historical price to earnings ratio baselines.
Intrinsic value has nothing to do with past or current share price, however the above stated realized figures prove accurate in determining future growth as well as how the market tends to assign a multiple of price to earnings of that business.
Obtaining an accurate estimation of future earnings per share, multiplied by an accurate estimation of earnings multiple (P/E), gives the accurate estimation of future share price.
In determining intrinsic value, a final element must be discussed which is a key ingredient to the success of the Graham-Buffett formula.
The calculation is done using several samples of the above mentioned figures, but the most conservative is always used in the final compute.
For example, the lowest rate of return on equity for the business over a one, three, and five year period is assumed going forward, which assures that the intrinsic value calculation can in no way be inflated.
In essence, it is better to get it low than get it right, because a determination of undervaluation when using the most conservative figures adds of level of protection; weeding out any businesses on the fence of undervaluation and leaving the definitive ones.