The false security of 'intrinsic' value

I thought after playing with numbers for more than 9 months, I've got a little experience, however small, to talk about the perils of the calculation of intrinsic value. There are so many ways that we can evaluate the intrinsic value. In our need to place a certain number to our uncertain analysis, there could be a risk where the investor places too much confidence on what I call GIGO - Garbage In Garbage Out. However, armed with this magic number generated from fundamental data (that is, from the financial statements), the investor feels more confident than is justified and thus begins his (possible) sorrowful journey with the company.

I used to believe greatly on the certainty of the numbers, believing it will give me the ultimate decision to decide if a company's price is worthy of its value. It couldn't be further from the truth when the real test of investor - bear market - begins to maul down all the calculations made.

Here's an example of how an investor could 'justify' his purchase.

Company A had the following data:



Impressive! Pretty good ROE of around 17.5% averaged over 4 years, high gross margins of around 24%, PATMI margins of 20% and had very low debts ratio of 20 to 30% compared to equity. Closing at $1.750 today, the investor almost jumps out of joy when he realised that the company also gave dividend, amounting to a dividend yield of 8.5% (inclusive of specials and based on FY07)!

Mr. Investor immediately logged in to his online brokerage account and started keying in his order when he suddenly remembered that as an investor, he ought to at least do out a DCF or other forms of valuation so that he can find out the price to value discrepancy. Didn't Benjamin Graham and Warrent Buffett keep harping about margin of safety? How could he, a practioner of safe and long term investing, forgot to do that? Tsk tsk.

So on he went, opening his excel and begin putting in the numbers. Since long term is 5 years to him, he started putting in the DCF with EPS for the next 5 years, projected at an EPS growth rate of 20% and discount rate of 4%. Mr.Investor used an EPS growth rate of 20% because from historical data, the PATMI per share is growing at a CAGR of 19.5% over 4 years, so it's reasonable to project this for another 5 years. 4% discount rate is because the long term SG treasury bonds is around 4%. Since Mr. Investor did not do out terminal value, which accounts for a huge bulk of the value, he thinks that it's very conservative already.

Here's what Mr.Investor did:


The current closing price is $1.75 but the intrinsic value is $1.25. Company A is actually overvalued! Mr.Investor tried checking the inputs for any mistakes but couldn't find any. As such, he reasoned that there is no reason why the earnings will stop after 5 years, so he could be too conservative. He decided to extend his timeframe to 10 years.

Here's what Mr. Investor did after extending to 10 years:


Now, the intrinsic value changes to $3.82. With current closing price of $1.75, that represents a margin of safety of 54.2%! Being a skeptic, Mr. Investor started thinking. If it is grossely undervalued, why is everyone not buying it? He started to feel insecure about his figures. Perhaps the EPS growth rate of 20% is too high. Over 10 years, it's highly unlikely that earnings will continue to grow at such a high rate, he reasoned. As such, he decides to do another valuation. This time, the EPS growth rate is changed to 10% (though the historical CAGR over 4 years is 19.5%) - conservative estimate!

Here goes:


Ahh..this sounds more reasonable, at $2.21. The current price gives a margin of safety of nearly 20%. For such a high quality company with low debts, strong margins and good yields, it's worth it! Besides, Mr. Investor already had 3 layers of safety margin:

a. The valuation assumes that the company folds over in 10 years. Since it is unlikely, the intrinsic value is supposedly higher than the calculated one. There is no perpetual or terminal value, which forms the bulk of the DCF value. As such, the value erred on the conservative side.

b. EPS growth rate of 10% is so much lower than historical growth rate of 19.5%. Conservative again.

c. Mr. Investor bought at a 20% discount to intrinsic value. As such, he had a 20% buffer against unforeseeable adverse circumstances.

Mr. Investor happily bought it, satisfied of having done a thorough analysis to Company A before buying. He can sleep soundly everyday knowing that he had done his valuation and bought with several layers of margin. So what's wrong with this?

With the right combination of earnings growth rate, discount rates and period of investment, DCF can make any purchase at any price justified, even with a margin of safety built into it.