June 2, 2009                                      Quick discussion on Intrinsic Value

One day  in the middle of March 2009, a buddy and I were running the trails. We often talk about the economy and investing. Today we had a debate of value. In very raw and quick terms, he thinks value is what something will sell for. Where I think value is really based on what something is worth, based on future cash flows and reasonable expectations. Again, not getting to far into it. My buddy graduated with an MBA from University of Chicago. 

Here is a copy of an email I sent him. Thought I would share here.

Here is the best definition I have ever read on the meaning of intrinsic value. As I write this, I recall that most value investors are not believers of EMT (efficient market theory). Yet, if I recall EMT was developed at University of Chicago. Hence, we might have 2 biases towards each of our opinions.

The following was written by the editors of The Analysts Journal April 1945...

"By Intrinsic Value we mean the real or true value of a security or group of securities. It is the amount which a willing and able buyer would pay if the buyer was well informed of the assets, liabilities, financial condition and business possibilities of the company issuing such a security, were well acquainted with the territory of which the company operated, and were not pressed for immediate return on his investments. This is the same with the seller. Intrinsic Value does not mean market value at any given time."

Benjamin Graham wrote in Security analysis on page 708 of 6th edition.

”Purchase of securities selling well below intrinsic value. Intrinsic Value takes into account not only past earnings and liquid asset values but also future earning power, conservatively estimated – in other words, qualitative as well as quantitative elements. We think that since a large percentage of all issues nowadays are relatively unpopular, there must be many cases in which the market goes clearly and crassly astray, thus creating real opportunities for the discriminating student.”

Here are notes I posted from Buffett's recent discussion at Emory

http://www.rbcpa.com/WEB_Emory_20090226.html

"Emory:

How do you think about value?

Buffett:

The formula for value was handed down from 600 BC by a guy named Aesop. A bird in the hand is worth two in the bush. Investing is about laying out a bird now to get two or more out of the bush. The keys are to only look at the bushes you like and identify how long it will take to get them out. When interest rates are 20%, you need to get it out right now. When rates are 1%, you have 10 years. Think about what the asset will produce. Look at the asset, not the beta. I don’t really care about volatility. Stock price is not that important to me, it just gives you the opportunity to buy at a great price. I don’t care if they close the NYSE for 5 years. I care more about the business than I do about events. I care about if there’s price flexibility and whether the company can gain more market share. I care about people drinking more Coke.

I bought a farm from the FDIC 20 years ago for $600 per acre. Now I don’t know anything about farming but my son does. I asked him, how much it cost to buy corn, plow the field, harvest, how much an acre will yield, what price to expect. I haven’t gotten a quote on that farm in 20 years.

If I were running a business school I would only have 2 courses. The first would obviously be an investing class about how to value a business. The second would be how to think about the stock market and how to deal with the volatility. The stock market is funny. You have no compulsion to act and a bunch of silly people setting prices all the time, it is great odds. I want the market to be like a manic depressive drunk. Graham’s Ch. 8, in the book Intelligent Investor, on Mr. Market is the most important thing I have ever read. Now think about the NYSE. You have thousands of companies to choose from. For me, that universe has shrunk because I need to put large dollar amounts to work. Attitude is much more important than IQ. You can really get into trouble with a high IQ, i.e. Long-Term Capital. You need to have the right philosophical temperament."