Columns AI – AK – Intrinsic Value #2

Cameron : The next column, AI, is intrinsic value number two. Again, it’s a formula, but in this case, we take the future EPS and we divide it by a different hurdle rate, the market hurdle rate. And this is one that I think tricks a lot of people up. In fact, when we first did our getting started episodes, I screwed up the way I explained it. Can you explain the second hurdle rate, the IV #2 hurdle rate?

Tony : Yeah. So, IV #2 hurdle rate uses what’s often called the market hurdle rate. It’s a norm in accounting to use a risk premium for stocks of 6% and then to add in the long-term interest rate, which at the moment is 0.1%. I think there’s some science behind it, way back, maybe a hundred years ago, someone said, look, if I’m going to buy stocks rather than bonds, I want to pay less for the stocks and the bonds. And that risk premium has been calculated as 6% for a long time. So most fund managers in the market will be using 6% plus the long-term interest rate. So, 6.1% is the current hurdle rate, which is commonly used.

Cameron : So let’s explain the long-term interest rate. This is the RBA (Reserve Bank of Australia) cash rate?

Tony : It is. Yes, that’s right. The cash rate is the interest rate on unsecured overnight loans between banks.

Cameron : Right. So that’s what I could get for a bond, a very low-risk investment. And if I’m going to take the risk of investing in stocks, I want to get at least 6% better than that.

Tony : That’s right.

Cameron : Column AJ asks if the share price is below IV #2. If the answer is yes, it gets a one; if it’s no, it gets a zero. In some cases IV #2 will be blank because the Future EPS (FEPS) will be blank. We can’t find one. I find this is quite often with smaller companies that don’t have analysts looking at it.

Tony : Correct. Yes. And that can be a good thing for us because if we found a company which the analysts haven’t found yet, because it’s too small, as it grows, they start to report it, which in turn leads to more investors buying it and that drives the share price up.

Cameron : Yeah. So not having a FEPS is not necessarily a bad thing.

Tony : Correct.

Cameron : Column AK asks the question is IV #2 more than twice the current share price. If it’s yes, it gets a one. If it’s not, it gets a zero, and if the FEPS is a blank, it gets a blank. Why do we have this question in there, Tony ?

Tony : Again, it’s an example of a company selling with a price which is extreme value. For example, if the company is trading at one dollar per share, but our IV says that it’s worth TWO dollars per share, then it’s an indicator of being very undervalued.