Columns AF – AH – Intrinsic Value #1

Cameron : Okay, so column AF – intrinsic value (IV) number one. This is where we get down to brass tacks. We mentioned earlier that discounted cashflow (DCF) is something that Buffett and use to determine what they think the value of a company is. And we’ve talked about the fact that you have this calculation called an intrinsic value. We do two of them actually, it’s sort of an estimation or a shortcut or heuristic to achieve sort of the same thing as doing a full DCF calculation. To calculate our IV #1, we take the current earnings per share and divide it by 19.5%, which is one of the hurdle rates that we look at. This took me a long time to get my head around. Can you explain what a hurdle rate is?

Tony : Yeah, sure. So when we’re talking about discounted cash flows, the hurdle rate is the discounting factor. It’s basically saying that if I’m going to buy the coffee shop, and I’m going to project out into the future what its currently earning, I’m going to discount that future cashflow for two reasons. One – because there’s risk. And two – because the money in the future is not worth what the money is now due to inflation. If I agreed to give you a thousand dollars in 10 years’ time, how much would you pay for that contract now? And you can take into account the risk of me not being around in 10 years’ time or having a thousand dollars to pay you. And also, the fact that a thousand dollars in 10 years’ time might be worth $700 now, or $600 or $500 or whatever. And so again, we’re trying to put some science around it, and the hurdle rate is what we use to discount the future cash flows. I use 19.5% in this first IVF calculation because that’s what my long-term return has been in the market. So, I’m looking to add stocks which are getting better than that hurdle rate. It’s a very small sample set, but if they do achieve that sort of metric, they’re really worthwhile looking at.

Cameron : And I’ve noticed that, quite often, the current share price will be above our IV #1 figure, but we may still end up buying it because, as you’ve explained earlier, this is just one metric. It’s not necessarily a go / no go, like the sentiment is, it’s not the be all and end all. It’s just one more data point that we’re looking at. Ideally, we would like to be able to buy the share for what our intrinsic value is or less, but if it’s above that today, that’s not necessarily a deal breaker.

Tony : That’s right. It’s partly because, particularly IV#1, it is a very, very high bar, just counting the earnings per share into the future by a high hurdle rate means it’s got to be in deep value before you buy it. And that’s great if it happens, but we don’t want to necessarily roll companies out that don’t quite meet that hurdle rate.

Cameron : Right. So in my spreadsheet, the next column AG is just the current share price copied over from earlier, just for easy reference, because column AH asks the question: is today’s price below IV number one? If it’s a yes, it gets a one. If it’s a no, it gets a zero. So not the end of the world if it is below the IV, but it gets a score if it does, and that just all adds up at the end of the day.

Tony : Correct.