Value investing theory: How do we assess the intrinsic value of a listed company?

II. Calculating Intrinsic Value Graham stated: "Security analysis is not intended to determine the intrinsic value of a security precisely, but rather to demonstrate that its intrinsic value is sufficient—e.g., adequate to secure a bond or justify purchasing a stock. Security analysis may also be used to estimate a security’s intrinsic value—or to determine whether that value is substantially higher or lower than its market price. To achieve this purpose, only a rough estimate of intrinsic value is required. As a simple analogy, we can often judge whether a woman has reached voting age merely by observation, without knowing her exact age; or determine whether a man is overweight without knowing his precise weight." Graham reiterates that intrinsic value needs only a rough estimate to support security analysis. This is what people commonly refer to as “judging at a glance”—buying a stock only when it is clearly trading far below its intrinsic value, i.e., when it is “obviously underweight.” Thus, intrinsic value is neither calculable like book value (from net assets) nor observable in real time like market price on stock-trading software. Estimating intrinsic value inherently involves expectations about the future and therefore aims only for “approximate correctness.” In his letter to shareholders, Buffett wrote: “The intrinsic value of a company is the present value of all the cash flows it will generate over its remaining life.” Hence, estimating a company’s intrinsic value hinges critically on two variables: the discount rate and future cash flows. Next, we introduce the method of valuing companies based on future cash flows. 1. Discounted Cash Flow (DCF) Method Its calculation logic can be broken down into three steps: ① Forecast future free cash flow: Free cash flow = Net operating cash flow − Capital expenditures. Typically, forecasts cover the next 3–5 years, after which a “perpetual growth rate” (e.g., GDP growth rate) is assumed to estimate long-term value. ② Determine the discount rate: The discount rate represents the “time cost of capital,” intuitively understood as “the minimum return you forgo by choosing this investment over others.” It is generally calculated as the risk-free rate (e.g., government bond yield) plus a risk premium (reflecting industry-specific risk), typically ranging from 8% to 12%. A higher discount rate lowers the present value of future cash flows. In *The Buffett Portfolio*, the author notes that Buffett commonly uses the current U.S. long-term Treasury bond yield—the risk-free rate—as his discount rate. Buffett explained: “We use the risk-free rate solely to make the two comparable.” I interpret “the two” here as Treasury bonds and stocks: Buffett treats stocks and bonds as equivalent investment instruments and applies the same discount rate, implying he views their future cash flows as equally reliable. ③ Sum the present values: Discount each year’s free cash flow to its present value using the chosen discount rate, then sum these values to arrive at the company’s intrinsic value. Illustrative example: Suppose a company’s free cash flows for the next three years are RMB 1 billion, RMB 1.2 billion, and RMB 1.5 billion respectively, with a discount rate of 10% and a perpetual growth rate of 3%. Then the present value equals the sum of the present values of the first three years’ cash flows plus the present value of the terminal value. ① Calculate the present value of the first three years’ free cash flows (PVFCF): PVFCF = 10 / (1 + 10%) + 12 / (1 + 10%)² + 15 / (1 + 10%)³ = 30.28

Investment Studies Chapter 11 Study Notes — Stock Market Valuation

Economic booms or recessions influence stock prices through their effects on the risk-free rate, risk premium, and corporate earnings. It is widely accepted that stock prices are negatively correlated with both the risk-free rate and the risk premium, and positively correlated with earnings growth. In this section, we convert macroeconomic forecasts into corporate cash flow forecasts and integrate those forecasts with an appropriate discounted cash flow model to estimate the stock market’s intrinsic value from a theoretical P/E ratio perspective. 1. Stock Market Valuation Investors commonly use the market P/E ratio to assess the outlook for future stock returns. Fuller and Hsieh developed a valuation model known as the H-model. In this model, the dividend growth rate over a finite horizon is assumed to decline linearly until it stabilizes at a constant, long-term rate—akin to an annuity or the final stage’s sustainable growth rate. This model incorporates: (i) the initial high dividend growth rate (gs), (ii) the number of years (N) over which the growth rate declines linearly, and (iii) the long-term, stable dividend growth rate (gl) prevailing at the end of period N or at the onset of the annuity phase. Assuming the initial annual dividend is D₀, the discount rate for the annuity is r, and the estimated value under the H-model is V₀, the model is expressed as follows. Originally designed to conveniently model situations where a high dividend growth rate gradually transitions to a lower, mature-stage growth rate, the H-model is less frequently applied to mature, developed equity markets—where no supernormal growth exists—and the Gordon Dividend Growth Model is more commonly used instead. 2. Forecasting Methods for Stock Returns There are two primary approaches: top-down and bottom-up. In top-down forecasting, macroeconomic forecasts are used to predict aggregate returns for broad-market stock indices. These predictions can then be refined to specific market sectors and industry clusters. Key steps include: • Market Analysis: Examine valuations across different stock markets to identify those offering excess expected returns. Compare relative valuation metrics of various stock markets against historical averages to identify relatively cheap or expensive markets. Analyze trends in relative valuation metrics across markets to gauge momentum. Compare the expected returns of markets anticipated to deliver excess returns against those of other asset classes (e.g., bonds, real estate, commodities). • Industry Analysis: Assess domestic and international business cycles to identify industries expected to outperform within the strongest-performing stock markets. Compare relative growth rates and expected profit margins across industries. Identify industries likely to benefit positively from expected trends in interest rates, exchange rates, and inflation. • Company Analysis: Within the best-performing industries of the strongest-performing stock markets, select the highest-performing individual stocks. Bottom-up forecasting begins with micro-level fundamental analysis of individual companies. Analysts use such information to forecast returns for each stock. Specific steps include: • Company Analysis: Identify the fundamental reasons why certain stocks may outperform the broader market—without reference to prevailing macroeconomic conditions. Determine why a company’s products, technology, or services are expected to succeed. Evaluate the company’s management, track record, business model, and growth prospects. Compute expected returns for each stock using a discounted cash flow model. • Industry Analysis: Aggregate the expected returns of stocks within an industry to identify the best-performing industries.

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H.B. Fuller shares are analyzed as undervalued via DCF model despite a five-year decline, following a board decision to reject an offer for a key business segment.

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