We seek to buy high quality businesses at a discount to our assessment of intrinsic value. That surely sounds sensible. But what is intrinsic value? And is there a trade-off between business quality and the discount to intrinsic value you need to make money? Furthermore, is there ever an argument to buy a business at a price that is above intrinsic value?
These are some of the questions we have recently been asked by some of our clients and they are really good ones that are worth exploring.
First on intrinsic value, what we are talking about is our own assessment of what we think a business is worth. Equity research analysts can calculate the value of a business by forecasting out the future sales, profit margins, capital requirements and resulting cash flows over time into the future. A standard mathematical technique, known as “discounting cash flows”, can be applied to convert a series of future cash flows into one number today that represents their present value. This number can then be adjusted for excess net assets on the balance sheet and the result is an estimate of the intrinsic value of the business.
This is what intrinsic value means. It is essentially a single-number representation of our expectations for future cash flows generated by the business.
Business quality feeds into one’s assessment of intrinsic value – and the higher the quality of a business, the higher its intrinsic value. A high quality business is more likely to generate high returns on invested capital over time, resulting in higher earnings and higher ultimate dividends to shareholders. This results in a higher intrinsic value, all else being equal.
Note that intrinsic value is not what the market thinks the business is worth on any given day. The premise of value investing is that price and intrinsic value are two different things. Without this premise, there is no value investing. The idea is: buy when price is below intrinsic value; and sell when price is above intrinsic value.
This all sounds reasonable. But what if we had a situation in which an extraordinarily high quality business was trading in the market at a level that was slightly above its intrinsic value. Is there a case to buy it?
The short answer is “no”; and the longer answer is “perhaps”. To understand why, we begin by considering a hypothetical world in which you can predict the future perfectly.
In this hypothetical world, you know for sure the precise intrinsic value of every business listed on the stock market. After all, you know the dollar amount of every company’s future revenues, costs, capital investments and dividends for the rest of time.
In this world, you could only ever achieve above-market equity returns if you bought stocks that were explicitly trading at a discount to intrinsic value – irrespective of their business quality. (Indeed, in this hypothetical world you would rapidly accumulate a large share of global equity capital profits, so you would likely retire pretty quickly and not worry too much about the nuances of intrinsic value).
This is an important point and is worthy of some further explanation. To illustrate the point, it is worth considering the purchase of two very different, but fairly priced, businesses. We describe the quality of each business below:
- High quality business: generates 20% returns on equity; reinvests 40% of earnings and pays out the remaining 60% in dividends; earnings growth of 8% per annum.
- Low quality business: generates only 5% returns on equity; reinvests 40% of earnings and pays out the remaining 60% in dividends; earnings growth of 2% per annum.
We can see from the tables below that the high quality business is clearly superior. After just five years both earnings and equity have increased by a third compared to where they were initially. Conversely, the earnings and equity have barely increased at all after five years in the low quality business.Now, in this example, imagine again you can predict the future perfectly and can therefore determine the true intrinsic value of these businesses. You value the businesses as follows:
- High quality business: 4.6x book, or 23x forward NPAT.
- Low quality business: 0.4x book, or just 8x forward NPAT.
This seems reasonable: the higher quality business attracts a much higher valuation. But look what happens if you buy each of them at a cost of $100. What happens to your investment after five years (including accumulated dividends)? In both cases, they grow to exactly $161 which reflects precisely a 10% per annum return.
How can this be? Well, the business quality – both good and bad – was already reflected in the price you paid. So the ultimate return you achieve on your investment is the same and reflects a general equity market return.
A corollary of this example is as follows: if you want to achieve returns on your investment greater than 10%, then you need to either:
- Buy the high quality business at less than 4.6x book, or the low quality business at less than 0.4x book; or
- You need believe that, in both cases, business quality is actually higher than what we have presented here.
It should now be clear that buying a stock at a price above its intrinsic value cannot result in above-market returns, assuming you know for sure what the intrinsic value truly is (which of course, no one does).
Which brings us back to the real world in which no one can predict the future perfectly. We can think of three valid reasons why investors might buy a stock when price is above its estimate intrinsic value.
- Intrinsic value is a distribution of possible outcomes, not a single point-estimate
Given we cannot predict the future perfectly, it is helpful to think about intrinsic value in a range, or distribution. By thinking about various combinations of high and low scenarios for revenue growth, profit margins, capital requirements, etcetera; we can arrive at a distribution of outcomes around some central estimate of intrinsic value.
It follows therefore, that it may actually make sense for you to own a high quality business at a price above your central estimate for intrinsic value. There is still upside potential from owning such a stock to the extent price is still below your high case intrinsic value scenario. (Of course, as the stock price approaches your high case intrinsic value, downside risk is implicitly building and you should think about trimming the size of your position).
- Analysts are perhaps more likely to underestimate the intrinsic value of a high quality business
In the same way that analysts and investors tend to underestimate the extent of a business in decline; there is perhaps an argument to be made that analysts will underestimate the intrinsic value of a very high quality business. To the extent this may be the case, there is an argument to own a stock at a price slightly above intrinsic value. (The assumption here is that the stock is still trading at a discount to intrinsic value – so we have not violated any of the logic described above).
- High quality businesses likely protect the downside better for investors, which is highly valued
Investors are humans and humans feel pain more than they feel equivalent gains. (This is not rational but has been clearly demonstrated to be true). That is why most investors – particularly older investors – value downside-protection above chasing every last basis point of upside return. In this sense, there is perhaps an argument for investors to own a high quality business at a price slightly higher than intrinsic value to limit negative surprises.
High quality businesses arguably come with inherently more downside protection. This stems from the very attributes that drive quality: a privileged competitive position in an attractive industry, demonstrably strong cash earnings, a clean balance sheet and strong financial flexibility. All of these attributes serve to minimize the probability of a sudden impairment to intrinsic value.
We believe owning high quality businesses helps us avoid landmines which helps our investors sleep soundly at night. Our objective is to buy such businesses at a discount to our assessment of intrinsic value. If we do this consistently, we should generate above market returns over the medium term while also providing our clients with a level of downside protection.