Intrinsic Business Value
The one most important term for value investors, in my opinion, is "Intrinsic Business Value". Intrinsic Business Value is defined as the ability of the business to generate owner earnings in a consistent way for a foreseeable future. I detailed out various tools to use for DCF (Discounted Cash Flow) calculation of intrinsic business value in my previous blog post. In this post, I will be explaining further the parameters that go into the DCF calculation of intrinsic business value using the gurufocus calculator.
I will pick Apple(AAPL) stock as an example to walk you through the calculator. Below is the snapshot of the gurufocus calculator for AAPL ticker.
Growth Rate in the Next: It is always best to use 10 years as the time horizon. The growth rate is 20% and that is automatically calculated by gurufocus based on the previous 10 years data. Below is the snapshot of previous 10 years data that is shown on the same gurufocus webpage right below the calculator. "EPS without NRI Growth (%) is the growth rate that the calculator uses to estimate the growth for the next 10 years. As you notice below, the value of that growth % is 40.20. However, gurufocus puts a ceiling for growth at 20% if it's more than 20% for the last 10 years. That is a reasonable assumption in my opinion. A company can't keep growing at more than 20% rate forever. If that would have to be true then the fair value of the stock would be infinite. It is particularly true in the case of AAPL, the growth of AAPL in last 10 years is once in a lifetime event (at least my lifetime). iPhone launched in 2007 is the main driver of this tremendous growth. iPhone is one of the greatest consumer electronic devices invented in our lifetime. I don't think there will be another product from AAPL in the near foreseeable future that is so disruptive as iPhone.
Terminal Growth Rate: Terminal Growth rate is the estimated growth of the company after the growth period. It is relatively easier for a company to grow EPS from $1 to $10 as opposed to growing it from $10 to $20. Numbers come into play and the percentage of increase gets lower and lower as the company gets bigger and bigger. The recommended value to use for this parameter is a value above 3%. I recommend using 4%.
Years of Terminal Growth: Number of years that the company will have the stabilized growth before it hits a plateau. A reasonable timeframe to choose again for this is 10 years.
Discount Rate: Discount Rate is the time value of money. It can also be interpreted as expected rate of return. This is a very important parameter in DCF calculator. Using different numbers in this parameter will yield vastly different results. Stocks are a risky asset class of investments compared to say treasury notes. Treasury notes can be classified as almost zero risk investment because it is backed by US government. 10-year Treasury notes currently(April 2017) yield about 2% return. My risk premium for stock investment is 10%. So, the discount rate I would use is 12% (risk premium(10%) + 10-year treasury note yield(2%)). Let's say you only assign 5% as risk premium to stock investments, then your discount rate would 7%(5% + 2%). However, it is recommended to not use a value less than 10%. If the 10-year treasury note yield rises to 5%, then my discount rate would be 15%.
Business Predictability: Gurufocus assigns business predictability rating based on how consistent the business is. Higher the stars, the more predictable the business is for the next 10 years. I didn't find much value of this and you can ignore this for the moment.
Using all these parameters, DCF value is calculated and is shown to the right of the image above. As you see for AAPL, the fair value or intrinsic business value is calculated as $238.28. What that means is, if you buy AAPL stock today at that fair value, you will get an annualized return of 10% for the foreseeable future (20 years).
The stock price of AAPL as of market close on 04/07/2017 is $143.34. So, going by this number, AAPL is extremely undervalued. Buying the stock today at $143.34 will give you an annualized return much higher than 10%. It is a great investment. The difference of market price to fair value is shown in Margin of safety field. Margin of safety for AAPL at current market price is 40%. Higher the margin of safety, the more undervalued a given stock is. It also gives you a cushion if the company doesn't grow as expected.
Let's tweak the estimated growth rate and calculate the fair value again. The best case scenario is that AAPL grows at 20% for the next 10 years. The fair value or intrinsic business value of AAPL in best case scenario is $238.28. Playing devil's advocate, say AAPL doesn't grow at 20% but grows at 10% for the next 10 years. Below is the fair value for growth rate of 10%
As you see above, the fair value with 10% growth rate is $123.47. The intrinsic business value has fallen dramatically with 10% growth vs 20% growth. As an investor, you should be realistic and not wish for outright optimism nor downright pessimism. It's better to be on the middle ground. So, if you take the average of both 20% and 10% growth rates, you will arrive at an estimated intrinsic business value of $180. That still puts AAPL recent(04/07/17) closing price of $143 at a significant discount to the intrinsic business value of $180. No wonder Warren Buffett bought bulk load of AAPL shares recently. I won't be surprised if he buys even more. Not only that, AAPL pays an annual dividend of $2.28 per share. So, you can sit and collect dividend payments while waiting for AAPL stock to catch up to its fair value.
An important point to note is that the intrinsic business value or fair value we are calculating here is merely an estimate. It is not an exact science. Even Charlie Munger and Warren Buffett might arrive at two different estimates of fair value though they are business partners for the last 50 years.
I will pick Apple(AAPL) stock as an example to walk you through the calculator. Below is the snapshot of the gurufocus calculator for AAPL ticker.
Earnings per Share: This is the earnings per share in the last trailing twelve months(TTM). Annual Earnings per share.
Growth Rate in the Next: It is always best to use 10 years as the time horizon. The growth rate is 20% and that is automatically calculated by gurufocus based on the previous 10 years data. Below is the snapshot of previous 10 years data that is shown on the same gurufocus webpage right below the calculator. "EPS without NRI Growth (%) is the growth rate that the calculator uses to estimate the growth for the next 10 years. As you notice below, the value of that growth % is 40.20. However, gurufocus puts a ceiling for growth at 20% if it's more than 20% for the last 10 years. That is a reasonable assumption in my opinion. A company can't keep growing at more than 20% rate forever. If that would have to be true then the fair value of the stock would be infinite. It is particularly true in the case of AAPL, the growth of AAPL in last 10 years is once in a lifetime event (at least my lifetime). iPhone launched in 2007 is the main driver of this tremendous growth. iPhone is one of the greatest consumer electronic devices invented in our lifetime. I don't think there will be another product from AAPL in the near foreseeable future that is so disruptive as iPhone.
Terminal Growth Rate: Terminal Growth rate is the estimated growth of the company after the growth period. It is relatively easier for a company to grow EPS from $1 to $10 as opposed to growing it from $10 to $20. Numbers come into play and the percentage of increase gets lower and lower as the company gets bigger and bigger. The recommended value to use for this parameter is a value above 3%. I recommend using 4%.
Years of Terminal Growth: Number of years that the company will have the stabilized growth before it hits a plateau. A reasonable timeframe to choose again for this is 10 years.
Discount Rate: Discount Rate is the time value of money. It can also be interpreted as expected rate of return. This is a very important parameter in DCF calculator. Using different numbers in this parameter will yield vastly different results. Stocks are a risky asset class of investments compared to say treasury notes. Treasury notes can be classified as almost zero risk investment because it is backed by US government. 10-year Treasury notes currently(April 2017) yield about 2% return. My risk premium for stock investment is 10%. So, the discount rate I would use is 12% (risk premium(10%) + 10-year treasury note yield(2%)). Let's say you only assign 5% as risk premium to stock investments, then your discount rate would 7%(5% + 2%). However, it is recommended to not use a value less than 10%. If the 10-year treasury note yield rises to 5%, then my discount rate would be 15%.
Business Predictability: Gurufocus assigns business predictability rating based on how consistent the business is. Higher the stars, the more predictable the business is for the next 10 years. I didn't find much value of this and you can ignore this for the moment.
Using all these parameters, DCF value is calculated and is shown to the right of the image above. As you see for AAPL, the fair value or intrinsic business value is calculated as $238.28. What that means is, if you buy AAPL stock today at that fair value, you will get an annualized return of 10% for the foreseeable future (20 years).
The stock price of AAPL as of market close on 04/07/2017 is $143.34. So, going by this number, AAPL is extremely undervalued. Buying the stock today at $143.34 will give you an annualized return much higher than 10%. It is a great investment. The difference of market price to fair value is shown in Margin of safety field. Margin of safety for AAPL at current market price is 40%. Higher the margin of safety, the more undervalued a given stock is. It also gives you a cushion if the company doesn't grow as expected.
Let's tweak the estimated growth rate and calculate the fair value again. The best case scenario is that AAPL grows at 20% for the next 10 years. The fair value or intrinsic business value of AAPL in best case scenario is $238.28. Playing devil's advocate, say AAPL doesn't grow at 20% but grows at 10% for the next 10 years. Below is the fair value for growth rate of 10%
An important point to note is that the intrinsic business value or fair value we are calculating here is merely an estimate. It is not an exact science. Even Charlie Munger and Warren Buffett might arrive at two different estimates of fair value though they are business partners for the last 50 years.
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