Value Investing
Growth with Value has been created for the Value (or aspiring to be!) Investors out there. Growth with Value’s primary goal is to break down the complexity behind stock valuation as well as investing in general. We will look to explain how you can become a successful investor by giving you the necessary steps that a Value Investor will take when determining which businesses they would like to invest.
All intelligent investing is Value Investing – Acquiring more than you are paying for. ∼ Warren Buffett
For access to our eBook titled ‘How to Value a Business’ that has been written with the hope to simplify the valuation process for the novice investor by deciphering the sometimes confusing and complex information offered in many investment publications and setting out an easy to follow, step by step process in how to value a business. Then please click the link below to access the eBook.
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Overview of the Value Investing Approach
Value Investing – the intelligent approach
Value Investing is best described by Benjamin Graham in his book The Intelligent Investor first published in 1949. Benjamin Graham is known as the ‘Father of Value Investing’ and he describes the Value Investor as an Intelligent Investor, someone who understands the risks involved with investing and takes steps to mitigate these risks. The raw idea behind the Value Investor is for them to first perform a Fundamental Analysis of a business and then determine its Intrinsic Value (its actual worth as opposed to its market value or share price). If the Intrinsic Value is below the market value, the investor could see that as an opportunity to purchase shares in the company. The opportunity to purchase shares in a company below its Intrinsic Value is normally the cause of some market or company news which investors have overreacted to and sent the price down, even if the fundamentals have not changed. Read More An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business
 Remember that the stock market is a manicdepressive
 Always invest for the long term
 The critical investment factor is determining the Intrinsic Value of a business and paying a fair or bargain price
 You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right
 Be fearful when others a greedy and greedy when others are fearful
 Unless you can watch your stock holding decline by 50% without being panic stricken, you should not be in the stock market
 As far as you are concerned, the stock market does not exist. Ignore it
 Buy a business, don’t rent stocks. Wide diversification is only required when investors do not understand what they are doing
 Do not take yearly results too seriously. Instead, focus on four or five year averages
Please consider the following points listed below. They are what I believe to be the most important factors you must have a strong understanding to greatly improve your investment decisions whilst minimising your risk:
Checklists
This will be one of your most important tools when investing in a business. Having a checklist will ensure that you have all bases covered and have not forgotten anything. A checklist can also grow as you grow as an investor. If you make a mistake or one of your investments fail, you can perform an analysis of this investment to find any points that you may have missed in your original evaluation which you can now include in your checklist for the next time, ensuring not to make the same mistake again.
Understanding a business is essential when valuing that business, as it will help you in making forecasts of growth and earnings as well as establishing the business’s longterm viability.
 How well do I understand the business
 How strong is the economic moat of the business
 How recession proof is the business
 Does the business have multiple income streams
 Does the business have multiple income streams
 Has the business successfully expanded its business or product offering into multiple locations
 Is the business free from governmental influences
 What phase is the business in; Startup, Expansion or Mature Phase
 Is the business operating in a popular sector or field
Financial characteristics are considered when conducting a Quantitative or Fundamental Analysis of the business. To analyse the financial strength of a company you will be using the annual or biannual financial statements of a company. You will be analysing the company’s balance sheet, income statement and cash flow statements in particular. It is helpful to calculate your results on a per share basis; this will avoid any surprises in a company’s earnings due to changes in the number of shares it has on issue.
 Does the company consistently grow its earnings or earnings per share (EPS)
 Does the company consistently generate positive operating cash flow
 Free Cash Flow is increasingly growing at a consistent rate
 Is the company using shareholders’ money wisely
 Can the company maintain earnings growth after acquisitions
 Is the PEG Ratio less than 1
 Abnormal items are not consistently affecting the earnings
 Is the company able to maintain or improve it’s profit margins
 The company is consistently achieving high Returns on Equity (ROE), Invested Capital (ROIC) and its Assets (ROA)
 Is the shareholders’ equity rising on a regular basis
 Has the number of shares outstanding remained steady or decreased over time
 Is the inventory turnover remaining constant or increasing
 Goodwill is not excessive and requiring numerous write downs
 Does the company have a current ratio of greater than 1
 Does the company have a low debt to equity ratio
 Does the company have an increasing or high interest coverage ratio
 The company is not required to expend great amounts of capital just to remain competitive
 Are receivables decreasing as a percentage of revenue
Having great management may not be as important to a business as having great financials and an ability to generate cash. However, it still pays to assess how well the company is run and the competence of management. Also, to understand where management sees the business heading and if they have foreshadowed any major changes to operations which could have a big impact on the value of a company is very important to be across. Some of these points may be hard to find or research however, that shouldn’t prevent you in trying to gain an insight into the way management is thinking about the future of the business. You may find it helpful to read some of the CEO’s previous letters to the shareholders for any relevant information.
 Has management made any announcements about growing the business
 Does management deliver on its promises
 Are dividends consistent and not excessive
 Is management being fairly paid
 Do directors own shares in the company
 Are directors buying shares
If your only concern is to receive high returns, then the ethical standards of a business will not be of great concern and will have little impact on your final investment decision. I do believe however that it doesn’t hurt to still include some sort of ethical checklist in your final decision. Just like changes in technology, changes in community ethical beliefs can have a major impact on a particular sector and its possible future returns. Below are some checklist items that I personally use; you can adapt these to suit your own situation.
 The company does not exploit its workforce
 Animals are not used as a commodity or profited from in any way
 The environment is not negatively impacted by the company and its operations
 The products which the company produce does not take advantage of its customers
 The company and its products do not negatively impact the health of the public or its customers
No wise pilot, no matter how great his talent and experience, fails to use his checklist. ~ Charlie Munger
Margin of Safety
A Margin of Safety should be used when valuing a business for potential investment. A Margin of Safety is just as it sounds; the difference or margin between two values allowing for any unforeseen pricing errors or misjudgement. When it is used in the process of purchasing shares, it is the difference between the market price and the calculated Intrinsic Value of the business. Intrinsic Value is calculated using the business’s financial statements to arrive at a per share value of the real worth of a business.
Basically, the Margin of Safety is the difference between the value of a business (Intrinsic Value) and the price which you pay for that business (market price). It is different from the Investor’s Required Return / Discount Rate and can vary, depending on the perceived risk of the investment. The Margin of Safety is there to; absorb the impact of any unforeseen events that may adversely affect the business or the market in general, minimise the impact of any miscalculations made during the valuation process, allow for small declines in the company’s future earnings power, as well as taking into account your own risk tolerance. It is imperative not to use the Margin of Safety to justify the purchase of undervalued stocks if their fundamentals aren’t sound.
As a general observation of the market, investors are happy to buy when prices are high, and they see less perceived risk in the market. Then in turn, when the market crashes and prices plummet, they perceive this situation as high risk and sell. Logically, the margin of risk has now greatly reduced as prices are much lower than they were. If you were to purchase quality businesses at this time, your Margin of Safety has greatly increased.
To further increase your Margin of Safety (but not just by purchasing at a lower price) you should stick to businesses that you know and understand. By doing this your evaluations and future earnings predictions will have more meaning and certainty behind them. After all this, have confidence in your knowledge of the business and in your valuation and act on it.
To know what Margin of Safety to apply can be difficult. Generally, the riskier the investment the higher the Margin of Safety required. I like to set my desired Margin of Safety after first completing my checklist. I will give each checklist item a rating from 0 to 5, with 5 being excellent, 3 being average, 1 substandard and 0 being nonexistent. From here I sum my checklist results to give me an overall rating and then divide that rating by the sum of the total points. For example, say we have 30 checklist items; each item can achieve a maximum score of 5 points, which would give a total of 150 points (30 checklist items x 5 points for each item). If, after conducting my analysis of the business and giving each checklist item a rating, I arrive at a total of 110 points, I would divide my score of 125 by 150, which equates to 83.3% and by inverting that number I get a Margin of Safety of 16.7%. I will then discount my calculated Intrinsic Value of a company by 16.7% which will equate to my preferred purchase price for that company. For example, if I have calculated the Intrinsic Value of a company to be about $10 per share, I will then discount this price by 16.7% to give me my purchase price for that company, which is now $8.33.
Note: The minimum required Margin of Safety which I use is 20%, so in this circumstance I would apply a 20% Margin of Safety instead of 16.7%.
Purchase Price = Intrinsic Value (Intrinsic Value × Margin of Saftey)
= $10 – ($10 × 16.7%)
= $8.33
I believe this approach is a simple and relatively accurate way to asses a company’s risk and thus allowing me to incorporate a Margin of Safety into my Intrinsic Value calculation. To further express how applying a Margin of Safety works please see the graph below. It is a repeat of the graph above but this time I have included the Purchase Price (Intrinsic Value – Margin of Safety).
The margin of safety is there to act as a buffer for any unforeseen circumstances and events.
Investor's Required Return / Discount Rate
By including an Investor’s Required Return (also known as a Discount Rate) in your Intrinsic Value calculation, you provide yourself with a buffer against things like inflation. By purchasing a company at its Intrinsic Value, you should expect to receive a minimum return which includes an offset against inflation and allowing for the inherent risk associated with the purchase of equities. It could be a good idea to have a minimum Required Return of at least 8 – 10%, depending on the fundamental health of the company, e.g. low debt and ability to repay its loans. Warren Buffett suggests a minimum required return should be at least 10%, whereas I apply a minimum required return of 12%.
One of the components of your Required Return should reflect the return that is available from a riskfree investment. Investors will generally think of a riskfree return as being the return available from investing in long term government bonds (usually 10year duration). These days there is an alternative to investing directly into government bonds which is afforded by low cost broad market index funds (ETF’s) which are listed on the stock exchange. This too could be seen as a good basis to decide what your discount rate will be, however at a higher risk than a government bond due to the fact that your return is not guaranteed.
Personally, I like to include a mix of inflation costs, long term government bond yields, and an equity risk premium. I will explain further in this chapter what each of these are and where you can find the data.
I would also like to note that the Discount Rate (Investors Required Return) is what we will be using to calculate a company’s Intrinsic Value. A Discount Rate is used to discount the projected future cash flow of the business to a present value. Basically, one way to calculate the Intrinsic Value of a company is to forecast future earnings for each year for the life of the business, then add these together to give us the Intrinsic Value of the business. But if we don’t discount those future earnings into the present value, the valuation will be grossly overpriced. As we know, due to inflation and other factors one dollar today does not buy you as much as it did 20 years ago.
For an example, let’s use a hypothetical company called ‘Leo’s Lemonade’. After the first year in business Leo produced $100 of free cash flow from selling his lemonade. Remember that free cash flow is the money that is left in the business after all expenses have been paid like taxes, wages, interest expenses, maintenance etc. Leo expects to grow his business and expand his free cash flow at a rate of 10% a year for the next 10 years when finally, the company will be sold as Leo has to move away to attend University. We will use a Discount Rate of 12% (you will see how to calculate the Discount Rate later in this chapter). Running these figures using a Discount Cash Flow (DCF) valuation method, we believe that when Leo sells his business in ten years’ time his business will be worth about $1,750. But that is the value of the business in 10 years’ time, so to express that into today’s dollars we will need to discount that valuation using the 12% Discount Rate. This gives the business a current Intrinsic Value of about $900.
Summarised below is an overview of the three main components used in establishing the Investor’s Required Return (Discount Rate).
Inflation is basically the rate at which the value of your cash is decreasing each year due to the costs of goods rising (loss of purchasing power). The Investor’s Required Return should take into account expectations of inflation, which has averaged 3% per annum over several hundred years. At the conservative end an inflation rate of 5% would be appropriate. It is important to include inflation in your discount rate as not to do so would mean that the calculated future returns would be overstated when expressed in today’s dollars.
This link will take you to the International Monetary Fund website which has historical inflation data for each country.
You can view and download historical inflation rates from our website HERE
The Investors Required Return (Discount Rate) should also take into account a compensation for risk, or an ‘Equity Risk Premium’. The Equity Risk Premium is the difference between what you expect to receive on your investment compared to a long term ‘no risk’ government bond. To obtain the equity risk premium you simply calculate the expected return on an investment, minus the riskfree rate, usually a government bond. This figure is included in your Discount Rate to ensure that the price you pay can be expected to exceed the returns you would have otherwise achieved from a riskfree bond. The market’s Equity Risk Premium over the last few decades has ranged between 4% and 6% per annum.
You can calculate it for each individual company, as not all companies carry the same level of risk. Otherwise this site (Click Here) is a helpful tool to use when deciding on an appropriate Equity Risk Premium. The site uses the current equity market return as a whole and deducts the current risk free rate from that. This is the site that I use to establish the current Equity Risk Premium for my calculations.
In case the link didn’t work copy the site address below.
http://www.marketriskpremia.com/marketriskpremia.html
The riskfree rate is accepted as being the current yield of a longterm government bond, generally of 10 years or longer duration. Value Investors deem this as the highest riskfree return that you could receive from an investment. That is why it is used in calculating your Discount Rate, for it wouldn’t make any sense to invest in a highrisk investment like the stock market, if you didn’t take into consideration other returns that are available to you that have next to no risk. The reason it is deemed ‘Risk Free’ is because it is backed by government, so the chances of the government defaulting and not repaying your investment is slight, although not unheard of.
You can view and download historical riskfree rates from our website HERE
We now understand the importance of calculating the Investor’s Required Return, to help mitigate the risk of equity investing. By including Inflation we cover the losses inevitably incurred by the continuing rise in the price of goods (loss of purchasing power); having an Equity Risk Premium insures that we will only take on those investments that can achieve high enough returns to compensate for the risk of equity investments and finally, the Risk Free Rate will ensure that we include, as a component of the Investor’s Required Return, a return that is available from a ‘risk free’ investment which is usually represented by the yield from a 10 year government bond.
Basically, our Discount Rate is the sum of these three figures, Inflation, Equity Risk Premium, and the RiskFree Rate. So, let’s take the longterm average Inflation of 3%, and say an Equity Risk Premium of 6% plus the current 3% yield on the government bond and we get a Discount Rate of 12%.
Discount Rate = Inflation + Equity Risk Premium + Risk Free Rate
= 3% + 6% + 3%
= 12%
Intrinsic Value
Intrinsic Value is a term you will hear regularly when talking to investors who understand there is a difference between the price you pay for an investment and what it is actually worth (its Intrinsic Value). Intrinsic Value may be different from the price which you could potentially pay. The difference in the price paid for an investment (in our case a business listed on a Stock Exchange) from its Intrinsic Value, can be caused by many differing scenarios, most of which are short lived and in the long run are of little consequence to the real value of a business.
These fluctuations between price and Intrinsic Value illustrate the importance/necessity of calculating the Intrinsic Value of a business. If you were to invest in a company at an inflated price, you run the risk of greatly diminishing your potential profits or even losing money in the future. This is due to the short term, unpredictable nature of the stock market, as Benjamin Graham describes in his ‘Mr Market’ analogy. In the short term the market fluctuates with the 24/7 news cycle, market hype and any other short term impacts on price, that in the long run may have little impact on a company’s performance.
Investing in the share market has consistently proved over time that it can be a great way to increase your wealth. By purchasing only great companies at a discount to their Intrinsic Value, you not only have a greater chance of achieving above average market returns, but you will also greatly reduce your risk of overpaying for your investment. Remember ‘price is what you pay, value is what you get’ – Warren Buffett.
There are many different valuation methods and each method may have more relevance when valuing some companies compared to others. They can also result in different Intrinsic Values and sometimes this difference can be quite large.
Below is a list of some of the different methods which I use to help me establish the Intrinsic Value of a company. The results from these methods include various assumptions, some of which are personal, and these assumptions can cause your calculation of Intrinsic Value to vary from another investor’s calculation. For this reason it can be difficult to calculate an Intrinsic Value for a company which will be accepted universally.
The methods which I use include:
Where:
V  =  Intrinsic Value 
EPS  =  Trailing 12 month Earnings per Share[1] 
8.5  =  Graham’s assumption of the P/E Ratio for a mature (stagnant growth) business[2] 
2g  =  2 x the company’s projected earnings growth rate for the next 710 years 
4.4  =  Graham’s estimate of a risk free rate 
Y  =  Today’s AAA Corporate Bond Rate[3] 
References:
[1] For a more conservative valuation or to avoid abnormal numbers that could occur in the trailing 12 months EPS, you can instead use an average of the Earnings over a 23 Year period.
[2] Investors may wish to modify this number to better reflect the current economic situation. Lowering it will result in a more conservative valuation. Between 7 and 8.5 is a good range to maintain.
[3] You can use the Discount Rate described earlier in place of the AAA Corporate Bond, for a more conservative result
The Discount CashFlow Method (DCF) is one of the most popular and widely used valuation techniques. It is basically the addition of all future free cash flows which have been discounted annually at the Discount Rate / Investors Required Return. This will give us the present value of the future free cash flows. The sum of these free cash flow figures is the company’s Intrinsic Value. As you will see, it is basically the same formula as the Dividend Discount Method (DDM) and the Residual Income Valuation Method (RIV) Intrinsic Value calculations.
The DCF formula comprises two parts; the first part is used to calculate the Intrinsic Value during what is generally referred to as the High Growth Period, where the company may have higher but potentially inconsistent free cash flow growth rates. This period is usually calculated out to 10 years. The second part is used for the Terminal or Stable Growth Period of the company. This is generally a more conservative estimate of a consistent rate of growth that is expected for the remaining life of the company. A stable growth rate just above inflation is usually acceptable, between 4% – 6%.
The first part of the DCF formula which is used to calculate the Intrinsic Value of a company’s High Growth Period is as follows:
Where:
V  =  Intrinsic Value 
CF1, CF2, CF3  =  Cash Flow for years 1, 2 and 3[1] 
r  =  Investor’s Required Return / Discount Rate 
^{n}  =  Continuing number of years[2] 
References:
[1] You can continue to calculate the Free Cash Flow annually as far into the future you believe higher growth rates are sustainable. As a general rule, 10 years is accepted as an appropriate length of time.
[2] For example, if you were to forecast 4 years rather than 3 we would replace the n with 4, and so on.
To calculate CF1, CF2 and CF3 etc. we will use the formula below which is calculating the forecasted future free cash flow of the company, which will then be entered into the DCF formula above.
CF1=CF×(1+G)
CF2=CF1×(1+G)
CF3=CF2×(1+G) and so on…
Where:
CF1, CF2, CF3  =  Cash Flow for years 1, 2 and 3[3] 
G  =  Growth rate (CAGR) of High Growth Period 
References:
[3] You can continue to calculate the Free Cash Flow annually as far into the future you believe higher growth rates are sustainable. As a general rule, 10 years is accepted as an appropriate length of time.
The Terminal Value (the period of consistent growth) is calculated as follows:
Where:
V  =  Intrinsic Value 
r  =  Investor’s Required Return (Discount Rate) 
G  =  Constant growth rate for stable period 
CFn  =  Cash Flow from the last year of constant growth 
^{n}  =  Starting year of stable growth 
The two formulae are used in combination to give you a final valuation of the company using the Discount Cash Flow method:
The Dividend Discount Method (DDM) is another method used to calculate the Intrinsic Value of a company. It takes the forecast dividends and discounts them back to a present value. It is best used for companies that are forecast to pay a dividend into the future.
There are two methods we can use to find the Intrinsic Value of a business using the Dividend Discount Method (DDM). The first method is a simple calculation that is best suited for companies which pay a dividend that is forecast to grow at a consistent rate into the future. The second is a variation of the Discount Cash Flow (DCF) method but instead of using free cash flow, we use a company’s dividend payments.
The first Dividend Discount Method (DDM) mentioned above which is best used for companies that have a constant growth rate has three key inputs; next year’s Forecast Dividends per Share (D1), the Investor’s Required Return or Discount Rate (r) and Dividend Growth Rate (G).
The formula is as follows:
This formula makes the assumption however that the Dividend Growth Rate will be constant, which may not be realistic in some circumstances. You should also note that the Discount Rate (r) must be larger than the Dividend Growth Rate (G). If not, this formula will not work.
Where you cannot assume a constant Dividend Growth Rate, a second formula as detailed below can be used instead.
Where:
V  =  Intrinsic Value 
D1, D2, D3  =  Forecast Dividends for years 1, 2 and 3[1] 
r  =  Investor’s Required Return (Discount Rate) 
^{n}  =  Continuing number of years[2] 
This formula, when used on its own, can be limiting as you need to know the expected life of the company due to the fact the formula calculates each year on an individual basis and will not account for the perpetuity of a business. Conversely, in the previous DDM method which is used for a company with constant growth, it results in the present value of an infinite series of future dividends at a constant growth and thus does not account for changes in dividend growth which is often prevalent in a growing business.
References:
[1] You can continue to calculate the dividends on an individual basis as far into the future as practicable, but forecasting greater than ten years may become difficult given the increase in economic uncertainty.
[2] For example, if you were to forecast 4 years rather than 3 we would replace the n with 4, and so on.
To overcome the problems related to each formula, the first being only for a company which has constant growth and the second being the need to know the expected life of the business, both formulae can be combined. The benefit of combining the two formulae is that you can incorporate both the growth (expansionary) phase of a business with the long term (mature) constant growth phase. As seen with most businesses, there can be more prosperous periods where the company is expanding and increasing its market share. As the company matures these growth rates generally reduce and become relatively consistent.
To combine these two formulae, you must first modify the original constant growth formula by discounting the dividend back to a present value as follows:
Where:
V  =  Intrinsic Value 
r  =  Investor’s Required Return (Discount Rate) 
G  =  Constant growth rate for stable period 
Dn  =  Dividend from the first year of constant growth 
^{n}  =  Starting year of stable growth[1] 
Finally, combining the modified Constant Growth formula with the second formula from above will give us our multistage formula as shown below:
References:
[1] This is calculated by counting the number of years (High Growth Years) leading up to the year of stable growth and is not the actual year e.g. 2025.
You should be aware that the Dividend Discount Method (DDM) ignores any retained earnings, which may not matter, unless the company is able to reinvest these earnings and generate high returns on them. Therefore the higher returns generated on the retained earnings will be ignored in this method and may result in an underestimation of the Intrinsic Value of the company.
The Residual Income Method (RIV) is very similar to the previous discount methods, but this time, rather than using estimated future dividends or free cash flows of the business, we will use what is known as the Residual Income of a business. Residual Income is basically as it sounds, money that remains in a business after accounting for the cost of capital or the opportunity cost, which is the same as the Discount Rate or the Investor’s Required Return. The Investor’s Required Return or Discount Rate is applied to the company’s equity, or in this instance we will use Book Value, which is basically equity per share. This will be the company’s cost of equity and will then be taken from the earnings of the business where we will be left with the Residual Income of the business.
The formula to calculate Residual Income is:
RI = EPS – r × B
Where:
RI  =  Residual Income 
EPS  =  Earnings per Share (EPS) 
r  =  Discount Rate 
B  =  Book Value per Share 
Now that we know how to calculate the Residual Income, we can input the data into the Residual Income formula. The actual formula to calculate the Intrinsic Value of a business using the Residual Income Method (RIV) is much like other discount methods e.g. Discount Cash Flow (DCF) and Dividend Discount Method (DDM):
The difference here is we now also include Book Value. This is calculated from the last financial year’s Balance Sheet[1].
Where:
V  =  Intrinsic Value 
B_{0}  =  Book Value per Share 
RI1, RI2, RI3  =  Residual Income for years 1, 2 and 3[2] 
r  =  Investor’s Required Return/Discount Rate 
^{n}  =  Continuing number of years[3] 
RIn  =  Continuing Residual Income 
G  =  Residual Income Stable Growth Rate 
RIt  =  Starting Residual Income of Stable or Terminal Growth Period 
^{t}  =  Starting year for Stable or Terminal Growth Period 
References:
[1] Book Value=Shareholders Equity/Shares Outstanding
[2] You can continue to calculate the Residual Income on an individual basis as far into the future as practicable, but forecasting greater than ten years may become difficult given the increase in economic uncertainty.
[3] For example, if you were to forecast 4 years rather than 3 we would replace the n with 4, and so on.
Compared to the Discounted Cash Flow methods and the Benjamin Graham formula above, Balance Sheet valuations are relatively simple and require little mathematical knowledge or calculations. By using figures that can be taken from the Balance Sheet of a company we can fairly simply calculate the Intrinsic Value. Using assets and liabilities recorded on the Balance Sheet will provide an estimate of the company’s worth. This is done by adding the value of its ‘hard’ assets and current assets such as cash and receivables and deducting all debts and liabilities. This does however rely on the accuracy of the figures reported in the Balance Sheet and the likelihood of those assets realising the values ascribed to them if they were to be sold today. Also the Balance Sheet Methods make no allowance for intangible assets such as intellectual property, patents, copyrights or business brands nor do they reflect future growth projections or earnings power which could positively impact on the business. Due to these factors this method will generally give a valuation that is well under the market price and other Intrinsic Value methods outlined earlier in this chapter.
A Balance Sheet valuation would be best applied to a business that is facing liquidation or has suffered a major drop in price and faces the possibility of heading into administration, in which case you may have the opportunity of purchasing shares which are trading under ‘Net Asset Value’. The difference between the Discount Methods and the Balance Sheet methods can be seen as the value given to the earnings power of the business, its future growth prospects and any intangible assets and goodwill which are inherent in the Discount Method calculations. It may not make sense using the Balance Sheet methods for companies that have little requirement for ‘hard’ tangible assets to generate its earnings.
The Book Value per share is generally calculated by first subtracting the total liabilities from total assets and then dividing that figure by the total shares outstanding, or in other words, Shareholders Equity divided by total shares outstanding. Another form of Book Value is known as Tangible Book Value which is very similar to Book Value but excludes intangible assets. Tangible Book Value is calculated by deducting intangible assets and total liabilities from total assets and dividing the resultant number by total shares outstanding.
Book Value provides a value per share of the business if it was to close down and liquidate all of its assets. It can also be seen as an indication of how much you could potentially lose if the business was to go into administration. If it is trading close to its Tangible Book Value, say within 20%, this should give you some confidence that your investment will have a potential loss of no greater than 20%. In this case the assumption is the assets have been fairly valued on the Balance Sheet and will achieve the stated price at a time of crisis such as when the business is being liquidated.
Book Value:
Or
Tangible Value:
Or
The Graham Number is calculated as follows:
Where:
V  =  Intrinsic Value 
EPS  =  Current Earnings per Share 
22.5  =  Derived from Grahams belief that the Price to Earnings Ratio (P/E) should be no more than 15 and a Book Value of no more than 1.5 (15 multiplied by 1.5 equals 22.5)

The result would give an Intrinsic Value of a business, which does not take into account future growth and other fundamentals that can be incorporated in the Discount Methods shown earlier.
The Liquidation Value is a method Benjamin Graham developed to estimate a value of the assets of a business if it was to be liquidated. It is basically the Tangible Value of a business but adjusted to better represent the liquidation value of its assets. When a business is trading near its Liquidation Value, it obviously has some problems. It would be amiss of someone to expect a struggling business to be able to sell its assets and inventory at Book Value, or the value quoted on the company’s Balance Sheet. This could be due to the company’s products not being as desirable or in such high demand as it used to, or the industry in which the business operates becoming obsolete. Unless you have the ability to analyse each asset and individually estimate the current market value of the assets, you can instead refer to estimates of the recovery rates for each asset class as determined by Benjamin Graham in his extensive research. The table is as follows:
Type of Asset  Percentage of Recovery Rate  
Recovery Rate  Median Recovery Rate  
Cash Assets  100%  100% 
Receivables  75% – 90%  80% 
Inventory  50% – 75%  66.5% 
Fixed Assets  1% – 50%  15% 
Breakdown of each asset class
Cash Assets – Assets which include cash, government and other high grade bonds and marketable securities. These are highly liquid assets that can be bought and sold at face value.
Receivables – Assets which include moneys owed to the business (debtors). We can expect a high recovery rate from these items as customers can be held accountable for what is owed.
Inventory – Assets which include products or raw materials for sale (trading stock). Inventories can bring a lower recovery rate as growing inventories are often a precursor to the liquidation. If the products being sold were still in high demand, then chances are the company would still be in business and not facing liquidation.
Fixed Assets – Assets which include plant, property and equipment. Often the plant and equipment is specialised to cater for that particular product or business and therefore if that product has become unfashionable or obsolete and the industry as a whole is struggling, then so too the business would struggle to sell its fixed assets at Book Value.
Liquidation Value of Assets = Assets × Recovery Rate
Liquidation Value = Liquidation Value of Assets – Total Liabilities
Net Current Assets Value approach is quite simple and very similar to the other Balance Sheet methods previously described in this chapter. Net Current Assets Value (NCAV) is calculated by adding up all the current assets whilst ignoring the noncurrent assets, then deducting total liabilities. More often than not this approach will give a negative result and will rarely exceed the current share price of the business. Benjamin Graham liked to use this method to value his businesses and then build his portfolio with undervalued businesses. He would have very diversified portfolios of up to 100 stocks to protect the portfolio from the obvious volatility that you could expect from such undervalued businesses. You would be hard pressed to find such undervalued businesses today, especially in those volumes.
If you would like to find out more about calculating the Intrinsic Value of a business you can purchase my eBook ‘How to Value a Business’ here.
Two people looking at the same set of facts, moreover – and this would apply to Charlie and me – will almost inevitably come up with slightly different Intrinsic Value figures ~ Warren Buffett
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