# Valuation in Motion: The Intrinsic Value Puzzle: Components and Case Studies

What is the ‘Intrinsic Value’ of a Stock? What are its components? How do they affect the way the company’s Stock is likely to behave? We will attempt to answer these seemingly daunting questions in simple terms and with relevant, real world examples.

## Intrinsic Value – What is it Anyway?

If you have been reading my blog posts, by now you should have come to the conclusion that I rely exclusively on a Discounted Cash Flow / Dividend Discounting sort of models to estimate the intrinsic value of stocks. The world’s foremost authority on Discounted Cash Flows, is in my opinion, none other than Mr. Warren Buffett, the billionaire investor and the Chairman of the half-a-trillion-dollar entity that is Berkshire Hathaway. He’s as good a teacher as he is an investor. Sure enough, he has talked about ‘Instrinsic Value’ in a number of places. In one of those interviews, he put in candidly:

To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate. If we could see in looking at any business what its future cash flows would be for the next 100 years, and discount that back at an appropriate interest rate, that would give us a number for intrinsic value. It would be like looking at a bond that had a bunch of coupons on it that was due in a hundred years. Businesses have coupons too, the only problem is that they’re not printed on the instrument and it’s up to the investor to try to estimate what those coupons are going to be over time.

Warren Buffett.

Think about what he’s trying to say. In a Government Bond, you have pre-determined cash flows (Coupon Payments and Principal Repayment), a time period in which the cash flows will be credited to your bank account (Maturity) and a Risk-free Rate, which allows you to account for the Time Value of Money.

Now consider a Stock. How is it different from a Government Bond? You still have Cash Flows (Dividends and/or Free Cash Flow to Equity), but they’re not pre-determined. Businesses do not produce results in a straight line. You do have a time period, but it’s generally very long. In other words, this will be the entire Business Life Cycle of a company. You also have a Discounting Rate, which is usually the Risk-free Rate + a Risk Premium you charge to account for the fluctuation in the results (Fluctuation which does not exist in a Government Bond). That’s it. These are the differences. So, if you are in agreement that a Bond should be valued at the Present Value of all its Coupons and Face Value, you should have no qualms in accepting that a Stock should be valued in a similar fashion too — except, it takes more time to value a Stock than it does a Government Bond.

## Components of Intrinsic Value

I personally believe that the intrinsic value of a company (And consequently, its Stock) is composed of the following six components:

Without further ado, let’s take a look into each of them and why I think they matter when it comes to Value.

## Explicit Drivers

Explicit Divers of Value are those factors which are readily considered by amateur investors while investing in a stock. In fact, most Analysts trying to sell their reports highlight the ‘Explicit Drivers’ the most, because they are easily understandable by the common man. Management Teams also mostly flaunt their Explicit Drivers in order to boost their rapport with the shareholders. It’s made up of two sub-components: Growth and Margins.

### Growth

The easiest of all the drivers. We know for a fact that as a company sells more of its products and services, the more it is known and the more revenue it produces. While thinking about how a company can grow, it has to be tied to reality. For example, a while back, I valued D-Mart, the famous Indian retail chain. In it, I had assumed that the company will grow its Revenues at the rate of 35% in the initial years, and dropping to 25% for the farther years. Here is how I attempted to ‘justify’ my assumptions.

I took the Invested Capital of D-Mart from 2009-2018 and used it to calculate Capital Required per Store, based on the CEO’s comment that D-Mart had been growing at a pace of 10 stores per year. I also calculated the Growth in the Cost of Acquisition per store for the period.

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This allowed me to project the Capital Invested per store from 2019-2028. Then, working backwards with this information and my own assumptions of Invested Capital, I calculated that from 2019-2028, D-Mart will grow at an average of 19 stores per year. This coincides with the CEO’s vision of boosting D-Mart growth from 10-ish to 15-20-ish in the next decade or so. Hence, my set of assumptions for Sales Growth stood justified.

However, not all growth is good. Sustainable Growth Rate is the rate at which a company can grow its Revenue without resorting to raising additional capital, which is detrimental to Shareholders. Therefore while valuing a company, it is advisable to restrict oneself to the SGR, unless there’s a very good reason that the company’s products will suddenly become more desirable.

### Margins

This refers to the Net Margins of a company. Prof. Sanjay Bakshi often quips that the best kind of value creation happens with a ‘Margin Expansion’ i.e. When a company is able to charge more from the customer for the same kind of products or services they have been selling for so long. Warren Buffett also claims that the best measure of a Durable Competitive Advantage is to ask whether the company will be able to raise prices tomorrow without affecting sales. Of course, it is also not hard to imagine how a company can save more on its Margins by simply being cost-efficient.

Clearly, a steady or increasing Net Margins is a favorable feature in a company. As Prof. Bakshi was so apt to note, indeed Margins contribute a whole lot to Value creation. One only needs to look at some of the biggest Multibaggers to realize this truth (Say, Symphony, Eicher Motors etc).

But this means that the opposite is also true. Take the case of Lupin, for instance. In the last five years, Lupin’s Sales has grown by 10.38%, but its Profits have decreased by 26% and change. This is because their Net Margins have fallen from 18% to 1% in the same period. In fact, Lupin has created very little value for someone who bought its stock 5 years back. It’s currently trading at almost the same level as it was half a decade back.

So while attempting to value a company, one has to ask the question “Will this company be able to charge more prices for the same kind of product/service in the future?” or “Will this company be able to spend less for producing the same kind of product/service in the future?” and depending on the answer (Based on research and groundwork), the Margin assumptions can be made.

## Implicit Drivers

Implicit Drivers are those factors which are considered in line with the Explicit Drivers by good investors. They know for a fact that the Explicit Drivers are superficial if the Implicit Drivers are not up to the mark. Reinvestment and Risk are the two Implicit Drivers of a Stock’s Value.

### Reinvestment

Remember earlier when I said ‘All growth is not good’? While a part of it has to do with the concept of the SGR, a bigger part of it lies with the concept of ‘Reinvestment’ or the amount of Assets a company has to reinvest to a certain level of growth.

Let me provide you with two investment opportunities. Company A, which may produce Rs. 100 in Profit, but has to reinvest Rs. 50 in order to end up with that profit. Company B, which may produce Rs. 10 in Profit, but has to reinvest Rs. 3 in order to end up with that profit. If you are a smart investor, you will choose Company B, because they are more productive, that is to say they only require 30% of their profits to be ‘reinvested’, while Company A requires 50% of their profits.

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The efficiency is Reinvestment is usually measured via the Return Ratios (Return on Capital Employed, Return on Invested Capital, Return on Equity). Charlie Munger, Warren Buffett’s investing partner, loves companies with massive Returns on Invested Capital. It is almost guaranteed that for a stock to grow multi-fold, the company has to temporarily or permanently boost their productivity.

On the other hand, look at any company in a flailing industry (Say, Telecom) and you will realize that they haven’t created any value in the last decade because they found it more and more difficult to retain customers without investing in advertising or some sort of new technology. Bharti Airtel has grown its Sales by 10% over the last decade, yet it has destroyed value for its shareholders over the same time (Imagine having to hold a stock for 10 years, only to end up with a loss). In fact, it took a massive disruption in Jio to make the entire industry re-think how they can invest better to create value.

### Risk

Risk is very personal and it’s not quite easy to explain. In fact, I wrote an entire blog post attempting to explain the fact, but I am pretty sure I didn’t even scratch the surface with understanding Risk. Without getting into complex monsters such as the Capital Asset Pricing Model or the Fama-French Five Factor Model, the most logical definition of ‘Risk’ is an opportunity foregone.
In Finance, ‘Risk’ is usually measured as an interest rate (Termed the ‘Discounting Rate’), because the Time Value of Money demands that we do. So when it comes to investing in stocks, one needs to ask “If I do not invest in this stock, what is my next best investing option and how much am I likely to earn from investing in that option over the long term?”

I personally use a Discounting Rate of 15% for most of my valuations, because that is the median long term returns on Mutual Funds investments in India (The actual figure is 14.88%, if you are curious). So my ‘next best option’ to investing in any stock is investing in a Mutual Fund scheme.

This is where it gets ‘personal’. Some people may not consider investing in a Mutual Fund as their next best option. For a Hedge Fund specializing in Start-ups, 15% may be chump change, so they may demand anywhere between 50–60% on their investments. At the same time, for a retired pensioner, even a 8% return from a Post Office scheme would look amazing. However, even a retired pensioner can invest in an index fund and earn close to 12–13% over the long term (In India). So it’s not wise for anyone to demand anything lesser than the long term index returns in their country (For instance, in the US, it is about 8–9%). But some academics consider the Risk-free Rate (Usually the 10-year local Government Bond yield) as the true Discounting Rate for any valuation.

## Hidden Drivers

These are Value Drivers which can be ascertained only by master investors. They aren’t found in Management Commentary, Financial Statements or Analyst Reports. They require additional research to be uncovered.

### Redundant Assets

These are mostly Real Estate or some sort of Patent/Right held by the company, which has been long since written off from the books. However, if they were actually sold in the market, they might fetch a fortune for the shareholders of the company.

In the Indian context, Wonderla would be a good example. The company is currently trading at about Rs. 1550 Crores, but the company has unused land parcels of around Rs. 1000 Crores. Of course, this doesn’t mean that the company automatically demands supreme valuation. It simply means that if an investor finds the company’s intrinsic value to be Rs. 600 Crores only, he can go ahead and purchase the stock, because the intrinsic value is actually Rs. 1600 Crores, thanks to the ‘Redundant Asset’ in unused land.

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But finding this bare fact isn’t really useful all the time. Take the case of Binny Mills. Binny Limited, the listed entity which holds Binny Mills, also holds several land parcels and real estate (Mills) in Chennai. But they hold these properties in North Chennai, which is crowded and used to be a trading hub decades back (When ‘street shopping’ was famous). Nobody wants these properties, because of them being located in an archaic trading community. If it was possible to sell these off, some rich investor would have bought out Binny Mills and sold it for parts. thereby netting himself a cool profit via a Special Dividend. The fact that this hasn’t happened tells us the follies of betting on companies simply because the company has a hidden “land bank”.

I saved the best for the last. This relates to the most sought-after four-letter magic word in investing: Moat. Before giving my views on this, you should check out Michael Mauboussin’s paper on this topic. It’s bloody brilliant.

It is economic truth that if a specific kind of business is profitable, competitors will emerge to get their own piece of the pie. ‘CAP’ measures how long a company can fend off the competitors, while keeping most of the pie for themselves. This is often too difficult to measure or even see, because the beauty of a good moat is realized over very long time periods. Left unattended, some competitors will breach the moat and run off with a piece of the pie. Let unattended for a long time, the moat will dry up and the survival of the company itself will become a concern.

Once again in the Indian context, I think Eveready Industries would be a great example. Post its initial success as a battery-maker, Eveready’s profits started to dwindle from 2007–2012. But the company still had an amazing ‘Moat’—the brand name, which is known to almost every Indian who’s ever used battery-run appliances. Post 2012, the new management levered the brand name into several new divisions, especially the consumer electronics space, where their products have picked up with little to no investment, thanks to the company’s brand name. The profits in the last 5 years have ballooned at an amazing pace of 56% and more. One could argue that Eveready Industries’ CAP has been lengthened dramatically, which led to the sudden spike in their stock price.
I usually use a 10–20 year projection period, based on a company having no moat, having a thin moat or having a massive moat. The truth stands that very good moats can make companies have CAPs in excess of 20 years (Think Coca-Cola). However, the Time Value of Money will make sure that profits earned 100 years from now aren’t as important as the ones earned, say, 15 years from now. I still adjust for this by demanding a lesser Margin of Safety for companies that have a proven operating model and a Moat.

In the end, this is just the theory behind why I do what I do when I Value a company. To put it lightly, Value is a marriage of numbers and stories. One cannot do without the other. Only when these ‘stories’ are grounded in reality using ‘numbers’, does the Valuation get complete. This is exactly what I strive to do in every Valuation I perform.

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### Dinesh Sairam

Dinesh: Investor | Risk Consultant | Finance Geek | Writer @Quora | Blogger | Poet | MBA from XIME