In the previous article, we discussed the first task for investors to complete to survive under a bear market: identifying high-quality businesses in their portfolio. In this article, we will discuss task two, calculating the intrinsic value of businesses that can allow investors to make better buy and hold decisions.
After identifying the high-quality businesses in their portfolio, investors should start determining the intrinsic value of the companies they own. Especially in the present day, with high inflation and sour markets, it is crucial to find a company’s intrinsic value. A company’s intrinsic value is key to surviving a bear market and making more intelligent buying, holding, or selling decisions.
The intrinsic value of businesses is the present value of all expected future cash flows generated from business activities which are then discounted at an appropriate discount rate. The intrinsic value of a business differs from the market price because it is reached through objective calculations rather than the animal spirits of the markets on any given day.
Credit: Market Business News
Such a difference is shown in the graph above. As the graph shows, the stock market is efficient over the long run yet inefficient over the short run. The market value of a company can fluctuate significantly in any direction during the short run; however, the long-term movement will eventually reflect a business' intrinsic value. Company ABC, with an intrinsic value of $10 billion, can have a market cap of $16 billion when the market sentiment is optimistic and drop to $3 billion when it is pessimistic. However, this company will eventually arrive at its intrinsic value of $10 billion.
There is one way that investors can go about calculating this value through qualitative and quantitative techniques. Qualitative as the name implies is everything outside of the numbers including the ethics and intangible characteristics of the business. While the quantitative side includes factors such as the numbers on the statement sheets and exact cash flows of the company. Take the company ABC, for example. ABC'S intrinsic value is derived from using a DCF model, which for inputs requires factors such as growth rate and projected cash flow. To find the values of these factors, a qualitative analysis must be deployed. Using qualitative analysis, investors are looking for factors such as competition, business demand, operating infrastructure, and other factors, which determine ABC’s growth and profits. Therefore, Investors have to take both quantitative and qualitative factors into account to calculate the intrinsic value of companies.
Credit: Corporate Finance Institute
Take a McDonald's store, for example. The qualitative and quantitative analysis must be used to value this McDonald's store.
This McDonald's store has experienced an average of 500 customers daily, and the average profit from each order is around $5.5. Since the store opens daily, we can roughly estimate that it generates $1,000,000 in profits yearly. Furthermore, there are only two fast food restaurants within a five-mile radius of the store, and no new restaurants have opened up in the past year. The neighborhood where the store is located is expected to have a 5% population growth, and the store is looking to hike its price by 5% annually. Lastly, the owner is looking to close the store and sell its equipment and real estate at the end of year five, yielding a $1,000,000 income or the terminal cash flow. Therefore, we can assume that this store's terminal value will be $1,000,000, and its profit will grow by 10% over the next five years due to low competition, customer growth, and price increase.
Investors can find the intrinsic value of the McDonald's store by using the above formula.The idea behind this formula is to discount all the future cash flows from this McDonald's using a rate that represents your opportunity cost. A typical discount or interest rate that investors can use is 10%, which is the long-term average return from investing in equities. Using this formula, investors can find the intrinsic value of the McDonald's store, given that the growth, which is 10%, remains steady for the next five years.
Through valuation using conservative assumptions, investors can find that the McDonald’s store’s intrinsic value is around $5.1 million. Investors can use such methods to figure out the value of most equities. However, the key is buying the equity at much less than its intrinsic value, which will both reduce risk and improve return at once. In the following newsletter, we will discuss the importance of having margin of safety in your investments is key to surviving a bear market.
By: Siddharth Singhai, Yang Peng, and Jake Glatz
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