The importance of Intrinsic Value for a long-term investor
Extracts from First Water's article in Moneycontrol on intrinsic value.
What is intrinsic and extrinsic value and how do they differ?
Intrinsic value is what a company is inherently worth and should be viewed independently of what the market values it at. Every analyst has their own different set of tools and perceptions to value a company. There is no one size fits all and it is as much an art as it is a science.
Our preference is to look at a number of valuation metrics. One can look at prior M&A transactions in the same industry, adjusting for differences such as size, geography, company-specific data, and leverage amongst others. This is important as it establishes what someone has actually paid for a similar company and includes a premium if the acquirer is buying the majority. However, as time passes, the valuation may become less relevant/outdated.
Another useful tool we use is comparable company analysis. This is when you look at relative trading multiples of other similar listed companies or the industry as a whole and again adjust for differences. Multiples include Price/Earnings, Enterprise Value/EBITDA, and others. This method provides an easier way to value a company by establishing a rough value based on what other listed businesses' multiples are. The logic is that businesses in the same industry should have similar multiples.
The most detailed of the 3 is by modeling a discounting cash flows in excel. Here we forecast future cash flows based on various data points and assumptions including historical data, future expansion plans and our understanding of the business and its cycles. Sources of data include historical financials, discussions with the management as well as other analysts. We then discount these future cash flows by the Weighted Average Cost of Capital (WACC), which calculates the present value of the cash flows to establish the current valuation. The higher the risk of the certainty of the cash flow/business, the higher the discount rate.
Extrinsic value is the price that the stock market is currently valuing the company at i.e. the share price/market cap. It is our belief that the market is occasionally inefficient and hence that is where the opportunity for us lies - where the market undervalues a company compared to our perceived intrinsic valuation.
Here is why intrinsic value outweighs extrinsic value in Indian stocks
The title of this implies that all Indian stocks are undervalued compared to the market, which any seasoned investor will know is definitely not true. The current situation seems like there is a ‘Tale of Two Cities’, both in India and abroad.
Looking for opportunities
We believe that some stocks can be considered as frothy with some valuations at fancy multiples of revenue, even while being loss-making. Passive flows have also helped sustain certain stocks at elevated levels, often taking valuations to well above their intrinsic values.
On the other hand, stocks that are non-index constituents or have lost their place in the indices have tended to often remain undervalued with limited interest from market participants. There are also several sectors and individual stocks that represent good value, perhaps due to the market not perceiving its asset base and business franchise appropriately. This presents an excellent opportunity for a value-focused funds like ours.
Intrinsic value as an anchor for investors
We firmly believe that understanding the intrinsic value of a stock is very important, primarily for the long-term investor. The reason for this is, that this intrinsic value will act as an anchor for investors to hold on to, even while there is volatility in the market.
As long as there are no significant changes in the structural story, a company’s intrinsic value should remain robust even in bear markets and provides comfort to the investor to hold and even build up their position as long as their analysis is correct.
Factors to consider besides intrinsic value
While intrinsic value is an important factor for the long-term investor to rely on in choppy waters, it is not the only factor that he should consider. Other factors one may look at, but not limited to:
Relative value –While a company may be perceived as having good value relative to the market, others in the same industry or otherwise may offer a better relative value.
Liquidity – Some stocks, especially those in the mid to small caps, may offer less liquidity to transact. While they may have good value, they simply are not practical to enter or exit.
Volatility – Again this can impact the small to mid-caps relatively more. Given the size, market engagement/ coverage and perception of strength/ robustness for mid to small caps, their share price maybe more volatile than large caps and may not suit an investor’s temperament.
Corporate Governance and ability to unlock value – Some stocks may be undervalued, but due to an inability or unwillingness of the management/promoter to release value or manage the company properly, they receive a permanent discount until there is a change.
LEGAL INFORMATION AND DISCLOSURES
This article expresses the views of the author as of the date indicated and such views are subject to change without notice. The author and First Water Capital has no duty or obligation to update the information contained herein. Further, the author makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.
This article is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services. Certain information contained herein is based on or derived from information provided by independent third-party sources. The author believes that the sources from which such information has been obtained are reliable; however, he cannot guarantee the accuracy of any of the information provided above and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Use information provided above at your own risk.