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Understanding Intrinsic Value: Part I

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With so much information floating in the internet these days, it’s hard for people to know what’s the best investment source for them.

It is even more difficult for normal salary worker to trust the so-called “experts” when all they really care about is to profit from your hard-earned money rather than telling you the truth.

I think we can relate to this; one moment some insurance guy pops up and says I have the “best financial plan available in the market”.

The other moment when we think we are safe; they pay you a visit while engrossed in our youtube videos, using nifty emotional selling words like:” own a house, it’s an investment that will never go wrong.”

There’s too much noise in the market, it is almost like there is no commonality among all different investment ideas. Every course claims to be the best, we are no different.

But if we were to think about it, all actions we do to earn money have 3 undeniable factors.

  1. Profitability
  2. Probability
  3. Duration.

Either way if we were to neglect one of the factors, we will most likely have either subpar or negative returns.

Scenario 1

If I were to tell you that you would definitely make a million dollars, you will be elated to hear such a deal! But to add on that you will only make that million with 100 years of investment time, I doubt anyone would be that turned on about it.

Thus this million-dollar deal has Profitability and probability but lack duration.

Scenario 1 resembles closely to CPF investment account where you could enjoy a 3-4% assured compounding effect on your retirement account but only to withdraw it at the age of 65 – 70 depending on your current age.


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Scenario 2

If I were to tell you would definitely get these 10 cents by the end of the day, every day, you would tell me to keep the change, get a real job and walk off. This 10 cents deal has Probability and Duration but is a waste of time.

Scenario 2 is similar to banks saving account, Insurance saving bond or even Singapore Savings bond, which offers meagre but assured interest on your total savings.

Scenario 3

And the last scenario is very reminiscent to all, if this deal is quick and profitable but has no certainty, most people would be strangely happy to take this deal.

Why? Because it resembled closely to gambling or speculating, that’s why Singapore pools and Casinos are earning truckloads of money. Everyone loves the idea of the get rich quick scheme!

The point I’m trying to make is there is the best stocks, courses or even jobs provides the highest amount of Profitability, Probability and Duration. Period. You need nothing else to decide.

Aesop of Babylon, the richest businessman of ancient times would say:” how many birds in your hand would you trade-in for the birds in the bush and how long would it take for those birds to come out?”

Buffet understood the principle and kept it simpler: ”how much are you going to get, when are you going to get it and how sure are you?”

(Intrinsic value speech – Skip to 2:13 for his reference and 4:10 for Aesop speech reference.)

The 3 factors are very much like karma, the more we neglect it, the more it will come back to kick us in the ass.

Intrinsic Calculation

To be a great Investor you need to know what is the highest optimisation of those 3 factors, Profitability, Probability and Duration or in other words people commonly refer to this mouthful of words I used as “Intrinsic Value”.

This word is often attached to a stock to determine over or under valuation, just like how people would know if a piece of new real estate at Bishan is under priced or over priced based on many merits.

And how a 500ml bottle of Pokka Jasmine green tea should be price around 1 dollar to 1.60 but somehow the same stuff is selling at 60 cents a bottle.

Thus the basic calculation of Intrinsic value = Profitability (x) Probability (x) Duration.

For if any factor is non-existent or worth zero, intrinsic value is worth nothing.

Example: Probability 0% x Profitability 100% x duration 80% = 0%

No matter how well other factors perform, if there’s a 0 in the equation, the whole damn thing is worthless.

Furthermore to add to the equation is that

  • Profitability can go up to an infinite amount in percentage; We can earn 5, 10, 50, 100 baggers ( One bagger means 100% in investment terms).
  • Probability is capped at below 100%; We can only be relatively right most of the time.
  • You must understand that probability is way more important than duration and profitability factors. We need to protect our capital. So we should only invest in stocks with higher probabilities of making money. In other words, only investments which we are more confident in. Buffett once said if you don’t want to own a stock for 5 years, don’t even own it for 5 minutes. This is a good question to ask yourself when it comes to how confident you are in a business’s long term prospects.
  • And last to add, the thing which plagues most value investors is duration, because duration is a beast, hard to be tamed by value investors. Most value investors focus on Profitability and probability with a strategy to diversify in order to address the issue of calculating duration.

You wouldn’t know when will market psychology persists in valuing things insanely or not and macroeconomic factors is hard to predict.

As such maximum duration represents 70 –80% but rarely 100%. It would take a special situation such as cigar butting/liquidating or even spin-off/arbitration of a company to know the exact duration.

But even if that’s the case, you must have truckloads of money to cigar butt the company – and such action will bring you infamy.

To add on there will be several intricacies involved to liquidate the business to get the maximum value out of it. Most certainly management will not sit idly by to watch you burn their jobs to the ground.

Advance Interpretation

Also to add on an advance interpretation of intrinsic value is the discounted cash flow of a company at present value until it collapses minus current interest rates.

The price of the stock I pay will affect our personal stock performance. Can company ABC I purchased, be able to pay me more than risk-free yielding assets like Singapore savings bond, which yields 2.8%  per annum currently in all-knowing when the company files for bankruptcy?

i.e. I buy a 5 room HDB for 100k SGD instead of 500k, with a 99-year lease  and rent it out at a modest 40k per annum. It would only take 2 year 6 months to break even instead of 12 and half years.

Compared to buying risk-free government bonds which are yielding 2.8% annum and pays back principal upon maturity of the bond, a HDB flat rented out will only start yielding 40% per annum after 2 years 6 months of repayment on the principal until the 99 years lease is up. (Presuming the government does not repurchase your house).

Final Basic Equation

As such to summarise, intrinsic value:

  • Intrinsic Value= Probability (min 0% – max100%) x Profitability (min 0% max %) x duration (min 0% – max100%)
  • Intrinsic Value = Discounted cash flow at present value till fore closure of company minus current interest rate
  • Probability (min 0% – max100%) x Profitability (min 0% max %) x duration (min 0% – max100%) = Discounted cash flow at present value till fore closure of company minus current interest rate

Difference

So why 2 equations? The difference is that (1) most of the time is used for an investment with a short time horizon of around 1 to 5 years, to cash out as a shareholder. It is commonly used for bargain stocks as intrinsic generally gravitates towards book value of a company. This equation is more quantitative as duration factor is taking a less active role.

Whereas (2) thinks more of a long-term businessman with a mindset of growing earnings over time with shareholder cash. It is expecting the stock to do better at fair value or even bargain value. It has predictive/qualitative nature to it as duration must be something that investors pretty certain about.

(1) and (2) are closely similar but not exactly the same. So how can I say that they are numerically equal when they have different variables?

It is because Intrinsic value is a price range not an absolute number. The more you can grasp the 3 factors clearly, the smaller the price range is. The more uncertain you are about the 3, the wider the gap becomes. (1) and (2) still falls in the price range of the intrinsic value of the company.

As more information is received from future quarterly or annual reports, Intrinsic value will adjust up or down. You can judge if a person is overweight or underweight, old or young based on his appearances, the same principle is also applied to investing.

Tips & Tricks

But what I absolutely love about this is it that I always think of it as like a primary school problem sum. The goal of this problem sum is to find the intrinsic value of the company and solve the problem.

But if we do not know how to figure out the intrinsic using the equation or it starts to look more like rocket science, we can always skip it without getting penalised at all. We only get penalised if we answer it wrongly.

Personally, when I read financial reports, 80% of the time I could not arrive at an intrinsic value because of various factors I couldn’t grasp. But there are tens of thousands of stocks out there, why fret just when we just need to answer 10 – 15 stock questions right to be filthy rich?

The best investors are not the one who knows everything, the best investors are not the one who says yes to any “opportunity” or stocks but said no to many and agrees to a few of the best ideas, and that’s what we personally want to achieve.

Intrinsic has no strict mathematical equation

I know what you are thinking; you are actually trying to search for a precise mathematical formula to calculate to the exact value of a company.

 *The above model is made by Ben Graham; the father of value investing. There are also multiple derivatives made by other value investor base on this equation.*

Even Benjamin Graham warned about using absolute numbers and mathematical equations for intrinsic calculation as it is mostly used as a guide not an answer.

Furthermore to add Ben’s equation is out-dated as it only encompasses company base from the late 19th century to the 20th century, there are assumptions made about growth (2g) and EPS that must be addressed properly.

If it was so easy as to input numbers then I guess office clerks with good excel sheet skill and a reliable stock screener will be billionaires. Even Sun Tzu’s military book was not called the science or maths of war but the art of war.

Investing is very much art because it merges quantitative maths with qualitative business values, it takes a seasoned person to know how to balance it.

To be rich is to understand the essence/concept of investing, not the form of it, just like Sun Tzu’s book; the ideas in his book are not hard and fast, it is flexible in circumstances. 

The idea might be simple, but the 3 factors are the key foundations for incredible investing. Abandoning one because the other 2 offers the best performance is emotionally tempting but it is courting for disaster. 

Chasing low yielding factors because of the fear of the unknown is what provides investors with subpar results. Fear of the unknown is what makes people L.O.V.E renting out their houses, buying dividend stocks, REITs or signing up for real estate courses since the 3 factors are almost certain, it almost similar to an 8-5 job salary.

A B C D E F G, Buy low sell high, than dua lui (earn a lot of money in teochew)”. 

See? Eazy peezy lemon squeezy.

But since I’m so sure that the 3 points (probability, profitability, duration) are what makes people super-rich, how do we calculate it? The 3 factors equation is still too abstract, obviously, we can’t arrive at a price range or intrinsic with it.

How do we quantify how much is probability, profitability and duration to get a rough gauge of intrinsic value? And when we attain intrinsic value, what do we do with it?

That’s where the hard part lies ahead, understanding different tools and knowing when to use those tools is what pays us, big fat money. I’ll talk more about that in my next article. But dwelling on these 3 factors should provide enough of a framework for investors new to the game to make better decisions.

Editor’s Note: I’ve always been somewhat fascinated by mental models. Concepts, models, rules are how the world is shaped and understanding this allows us to understand and benefit from it just as how observable, repeatable patterns can be understood and benefitted from in the market by quantitative investors.

The trouble most people have is that when they choose to invest, most are lost. They have no guiding framework. No concept. No model. No idea where to even look. In essence, these new investors are essenceless. This article aims to address that by at least providing a framework for thinking.

Only after you dwell for some time on the concept of probability, profitability, and duration can you truly understand how to make better decisions. This is because it forces you as the investor to answer some tough questions (which I previously believed fell under the common sense territory – I have since learned common sense is uncommon).

If you’d like to find out more about how we invest for ourselves, you can register for a seat here, or check out our guide here.

1 thought on “Understanding Intrinsic Value: Part I”

  1. A minor point here, would be good if the article could be proof-read beforehand to catch the grammar errors and missing punctuation marks – these distract the reader from the key ideas that the article is trying to convey. Thanks

    Reply

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