The Search For Intrinsic Value: Some Selected Moments in the History of DPV

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The Search For Intrinsic Value Some Selected
Moments in the History of DPV

• Professor Eric Kirzner
• June 2006

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Security Valuation

• What people are willing to pay for it
• Risk contribution to a portfolio
• The consensus of the crowd
• Discounted present value of future dividends

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Intrinsic Value
Price Value

• Efficient Market?
• Security prices reflect all available information
• Security prices efficiently adjust to new
  information

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Intrinsic Value
Price Value

• Random walk

The Famous Drunk
X
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Intrinsic Value
Security Analysis

• 2. Fundamental the Search for Intrinsic Value
• Prices and value can diverge search for
  intrinsic value compare to actual price
• Asset based cash flow (earnings-based)

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Intrinsic Value
Security Analysis

• Accounting Oriented
• Long history
• Ratios and relative valuation
• Value school

• Growth oriented
• Evidence re models back to 16th century
• Projecting Future cash values
• Search k and g

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Security Analysis

• 3. Technical Analysis
• Prices reflect all available information
• Analysis of price and volume trading history used
  to predict future price directions
• Charts and patterns momentum
• Dow Theory 1895
• Edwards and Magee Technical Analysis of Stock
  Trends, 1952

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Intrinsic Value

• The holy grail of investing is the search for
  intrinsic value
• From Roman Times to the present

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Discounted Present Values

• DPV concept at least over 2000 years old
• Annua traced back to ancient Rome
• Annual stipends
• In return for a lump sum payment, these contracts
  promised to pay the buyers a fixed yearly payment
  for life, or sometimes for a specified period of
  term.
• Often bequests to non first-borns
• Life annuities!

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Annuities!

• 1600s and 1700s
• governments in several nations, including England
  and Holland, sold annuities in lieu of government
  bonds
• lifetime annuities purchased with a single
  premium became a popular method of funding the
  nearly constant wars that characterized that
  period.
• See Charles Dickens and Jane Austen
• annuities were all the rage in European high
  society.

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Tontines!

• Named for Lorenzo Tonti who first recommended a
  tontine form of government financing in 1652
• special annuity pools In return for an initial
  lump-sum payment, purchasers of tontines received
  life annuities.
• amount of the annuity was increased each year for
  the survivors who received the payouts that would
  otherwise have gone to those who died.
• When the last participant in a tontine pool died,
  the sole survivor received the entire remaining
  principal.
• The tontine thus combined insurance with an
  element of lottery-style gambling.
• First Option pricing model!

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Abraham de Moivre (1667-1754)

• Mathematician (analytic geometry), physicist
• Friend of Newton, Halley
• Published Treatise on Annuities on Lives (1725)
• Valuation of joint annuities on several lives
  pricing tontines

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Johan de Witt 1625-1672

• Lawyer, mathematician ( analytic geometry),
  politician (political leader of Holland 1653
  settled two wars with England)
• The Value of Life Annuities In Proportion to
  Redeemable Annuities (1671)
• Derived a model for valuing a life annuity
• Crude approximation formula re how many people
  out of a group would die each year
• Calculated present value of each annuity and then
  priced it based on arithmetic average of all
  annuities

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Edmond Halley (1656-1742)

• Astronomer, mathematician
• Paid for publication of Sir Isaac Newtons
  Principia Mathematica
• 1695 predicted that comet of 1531, 1607 and 1682
  was periodic

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Edmond Halley (1656-1742)

• Mortality tables based on five years of data
  city of Breslau 1693
• One of first to relate mortality and age in a
  population
• A step re production of actuarial tables
• Edmond Halley Of Compound Interest (1761)
• Formula for present value of a regular annuity

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Early 1900s

• Accounting book values widely used re valuation
• Stock market crash
• DCF gains popularity re valuation approach
• Irving Fisher, John Burr Williams
• However not until 1951 that NPV accepted as model
  for in capital expenditure decision Joel Dean,
  Capital Budgeting 1951.

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Early 1900s Two Paths to Security Analysis

• Value Investing and the accounting approach
• Growth Models and The DPV approach

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Value approach 1920s-1930s

• 1929 The Great Crash Dow drops by 90 from high
  to low
• Benjamin Graham (1894-1976)
• 1926 founded Graham-Newman corp.
• 1928 taught course on security analysis at
  Columbia
• Observes Great Crash
• focuses on crunching numbers not on qualitative
  factors
• Techniques that could be universally applied
• Available from publicly available sources
• price-to-earnings (P/E) ratios, debt-to-equity
  ratios, dividend records, net current assets,
  book values, and earnings growth.

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Benjamin Graham

• Many common stocks do involve risks of
  deterioration. But it is our thesis that a
  properly executed investment in common stocks
  does not carry any substantial risk of this sort
  and that therefore it should not be termed
  risky merely because of the element of price
  fluctuation.
• The Intelligent Investor pp.121-122.

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What Value Investing Is Three characteristics
according to
Graham and Dodd

• 1. Prices of securities subject to significant
  and capricious movements
• Mr. Market -the Graham personification- willing
  to buy and sell every day
• Prices gyrate randomly Current price will
  diverge from intrinsic value
• 2. (Many) securities have fundamental economic
  value
• values that are stable, measurable
• Disciplined investor using metrics
• Price and value rarely equal in short term
• Market a voting machine in short term

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What Value Investing IsThree characteristics
according to Graham and Dodd

• 3. Appropriate investment strategy is to buy good
  companies but only when
• market price is significantly below calculated
  intrinsic value
• This is margin of safety
• Ideally should be 50 discount and not less than
  33 discount
• Intrinsic value is 10.00
• Want to buy at 5.00 no more than 6.67

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Value Investing The Bright Line

• Margin of safety!
• Graham and Dodd
• If price established by Mr. Market is lower than
  intrinsic value by a sufficient margin of safety
  stock is a buy for the value investor!

Intrinsic Value
Price
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Value Investing

• Why the growth skepticism?
• View that in many instances growth not worth
  anything at all!
• In a competitive environment all of the value of
  future growth may be consumed by additional
  capital necessary to fund the growth
• Profitable growth is that that produces returns
  in excess of excess capital needed

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Value Investing

• Why the growth skepticism?
• Profitable growth is that which produces returns
  in excess of excess capital needed
• True growth companies generally have barriers to
  entry that restrict competition and constrain
  pure competition from developing
• Growth primarily valuable in a protected
  franchise
• Hence value investors focus on strategic position
  of company and how sustainable the franchise is.

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1950s

• Chairman Sen. William Fulbright
• Fulbright Q What causes a cheap stock to find
  its value?
• Graham A
• That is one of the mysteries of our business,
  and it is a mystery to me as well as to everyone
  else. But we know from experience that eventually
  the market catches up with value.
• Benjamin Graham testimony to the Committee on
  Banking and Commerce, 1955

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Growth Approach 1920s-1930s

• T. Rowe Price ( 1930s)
• (1) high quality R D
• (2) limited competition
• (3) few government regulations
• (4) well-paid employees but low labor costs
• (5) a strong possibility of high return on
  invested capital and
• (6) superior growth in earnings per share.

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NPVs Irving Fisher

• Fisher defined capital as any asset that produces
  a flow of income over time.
• A flow of income, said Fisher, was distinct from
  the stock of capital that generated it.
• Separation of production and financing
  decision
• Capital and income are linked by the interest
  rate.
• Specifically, the value of capital is the present
  value of the flow of (net) income that the asset
  generates.
• (Maybe) first to propose that capital project
  should be evaluated by present value

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NPVs John Burr Williams

• Studied at Harvard Business School
• Security analyst
• Found stock valuation elusive disenchanted with
  accounting based measures
• 1932 enrolled in Ph.d program at Harvard
• Joseph Schumpeter suggested intrinsic value focus
  for dissertation

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John Burr Williams

• John Burr Williams, Theory of Investment value
  1938
• (before completing thesis)
• One of first to interpret stock prices as worth
  intrinsic value using discounted dividends
• Future dividends can be forecast by algebraic
  budgets
• Estimates re earnings, growth, capital structure
• Williams models
• General DCF declining dividend discount constant
  DDN, increasing DDM, sudden growth

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John Burr Williams

• Williams book contains the derivation of the
  constant growth model

Gordon and Shapiro restated as k d1/p g
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John Burr Williams

• The last word on the true worth of any security
  will never be said by anyone but men sic who
  have devoted their whole lives to a particular
  industry should be able to make a better
  appraisal of its securities than any outsider
  can.

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Discounted Cash flow

• Discounted cash flow
• Value today of a series of two or more future
  cash flows

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Models1. Perpetuity Case
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Models2. Constant growth Williams, Gordon Model
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Derivation

• Basic Cash flow

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Derivation
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Growing annuity Model

• Williams VALUATION MODEL
• Gordon DISCOUNT RATE MODEL

LONG RUN CAPITAL GAINS YIELD
DIVIDEND YIELD
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Models3. Variable growth
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Models4. Variable growth with transitionWells
Fargo et al.
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Current Issues

• Factors affecting value
• Risk re expected cash flows
• Selecting appropriate discount rate
• Adverse selection and moral hazard

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The Key To Long Horizon Investing

• Estimating k and g

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Present value models

• Present value of dividends
• Need to calculate growth rate and discount rate

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Cash Flows

• Free Cash Flow
• Net Income Non-cash revenue and expenses
  changes in net working capital capital
  expenditures property dispositions
• Recognizes that some investing and financing
  activities are critical to firm
• These necessary expenditures must be made before
  firm can use cash flow for other purposes such as
  paying off debt or repurchasing equity
• Key measure for valuation models such as free
  cash flow to firm and economic value added
• Not a totally objective measure!

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Discounted Present Values
Challenges

• ko
• How estimated?
• Forecasters k or estimated market k (Keynes's
  beauty contest)
• Fixed or variable?
• Risk premium approach stability?
• f (risk-free rate? expected inflation)
• Cft and growth
• how estimated?
• Short long-term historic data?
• Reliability
• Growth sustainable protected franchise