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The ‘Intrinsic Value’ Growth Vs Your Required Rate Of Return

The Y-o-Y growth in intrinsic value of your business from your investment perspective, will NOT be equal to the growth rate in earnings (or more appropriately cashflows)…it will simply be equal to YOUR discount rate

Chatting with some of our subscribers over the last few days, it has become clear to me that there is a lot of confusion that exists in people’s mind about

  1. What is the intrinsic value of a business?

  2. How does that intrinsic value grow year over year?

  3. How does that relate to the price we pay for the stock?

  4. How is our expected investment return related to all the above?

I will try to explain these concepts using the intelligent problem one of our colleagues posted on our Investment Group the other day.

“Imagine a business is trading at $100, with intrinsic value $80. The business is expected to grow (earnings) at 30% compounded rate in near future and your opportunity cost of capital is 24%“

The first piece of information that I will use is that the intrinsic value of a business is $80 where my opportunity cost of capital is 24%

Definition of Intrinsic Value:  It is the Present Value of all future cash flows from a business. 

Now, to calculate the Present Value, John might use a different discount rate as compared to Jim and that might be different from what Mary uses. It all depends upon their respective ‘Required Rate of Return’ based on their Opportunity Cost of Capital. (Some of you might be wondering …’But I read Buffett uses the 10 year govt. bond rate for calculating the Present value’… Remember, he does not pay the ‘Present Value’ that he arrives at by discounting at 10 year bond rates, he pays a lot lot less… so stay with me for the moment, it will all fall in place)

Let’s assume a business generates the cashflows as shown in Column B of Fig 1 . So the cashflows grow @ 30% Y-o-Y.  Using the 24% cost of capital (Your Opportunity Cost), we discount all the future cashflows to the present year (Year 0)…and then add up these present values to arrive at the (Your) Intrinsic value of the business …which works out to $80. To keep things simple, I have just assumed an aggressive growth rate of 30% Y-o-Y for the next 10 years and assumed that the business closes after that. In reality the business will probably go on, but the growth rate will in all likelihood reduce over the years…and higher your discount rate is, the lower is the impact of the distant (> Y10) cashflows on your intrinsic value calculation…so you can safely ignore them for the sake of this exercise.

Also I make a simplistic assumption that this capital-light business manages to translate it’s entire earnings into Free Cashflows, and there is no leakage due to any working capital changes, or growth capex over and above the depreciation amount…so I will be using the terms ‘earnings’ and ‘cashflow’ interchangeably.

Now appreciate one thing…as your opportunity cost is 24%, it means you have alternative avenues to invest your capital and earn a 24% return … so there is no reason for you to settle for anything less than 24% here…so that 24% is your Required Rate of Return. This simply means, irrespective of what  the Y-o-Y growth in the cashflows from the business is, since you have used a 24% discount rate to arrive at your appropriate fair value, the value of your investment in the business (IF and ONLY IF you purchase at that fair value of $80) will grow to 80*(1.24) after Y1 and 80*(1.24)^2 after year 2. This is no different from a bank account or a zero coupon bond which starts with $80 and earns an interest of 24%…and that interest is fully reinvested at  the same rate…so the value grows to $80 * (1+24%) after Y1 and $80 * (1+24%)^2 after Y2.

The Y-o-Y cashflow growth rate of 30% is already built into the calculation of the intrinsic value of $80, since you have used that growing cashflow sequence to arrive at the intrinsic value…so your investment value WILL NOT GROW BY 30% Y-o-Y, even if the business grows by 30%…purchased at $80, it will only grow by a compounded rate of 24%, as long as the business growth exactly tracks your assumptions.

Providing the link of the google sheet if anyone is keen to play around and get a better understanding of how the calculation works

           Fig 1

What if you invest at today’s market price of $100?

However if you buy the business from the market at today’s price of $100, that works out to an expected rate of return of 19.5% (instead of 24%)…simply because if you discount all the future cashflows by 19.5%, you would arrive at a present value of ~$100 which is same as today’s share price.

Fig 2 (rounded off)

What do you need to do to achieve the same investment return as the business growth rate?

To be able to achieve an expected return of 30% (same as the growth rate of Y-o-Y cashflows/earnings), you need to see what the fair value works out to be if you use a 30% Required Rate of Return (discount rate) to discount the future cash flows…and that figure works out to $61 (Fig 3)

Fig 3 (rounded off)

Now if someone thinks that they can pay whatever the market price is and still expect to benefit from the 30% Y-o-Y growth of the business in their investment, they are deluding themselves. If for example you pay $128, then you are effectively settling for a required rate of 15% (Fig 4)… and ceteris paribus, your long term rate of return will still be 15% … as long as the (actual growth rate of the business) = (your assumptions while calculating the intrinsic value)…even if you expect the the business to do amazing wonders like setting up ‘full condo facility residential estates on Mars’, your investment value will still only grow by your discount rate.

Remember we are not talking stock prices here…we are talking about business value!

Fig 4

So while the stock price shooting up in the short term is very exciting and makes us come up with all kinds of crazy assumptions about the ‘growth in the business’… in the long run no one can escape this simple math of compounding involving this ‘Time Value of Money’

And please keep in mind that in MoneyWiseSmart, we are not exactly looking for ‘cigar butts’….we like to find and invest in high quality businesses with long growth runways…but we will never take our eyes off the compounding math while doing our estimates. We know that no one can escape that.

Can the Intrinsic Value Grow faster than the discount rate?

Ofcourse it can. In the above example, the intrinsic value of the business (your cost of capital being 24%) will grow faster than 24% Y-o-Y, only if the actual growth rate of earnings/cashflows exceed the 30% that was built into calculating the intrinsic value…This can arise from improvements which are not already discounted. For example increased revenue growth rate, better operating margins, higher ROIIC, better working capital management etc etc, which leads to a higher than 30% growth rate in cashflows. However this is double edged….if you have assumed a 30% growth rate while calculating the intrinsic value, and if the actual growth rate falls below that 30%, the growth in the value of your investment purchased at $80) will be a lot lower than 24%

One of our subscribers asked: Many people use risk free rate (say Singapore Central Provident Fund return of 4%) as the discount rate, and this would mean that if you buy the business at the intrinsic value given by that risk free rate, your investment theoretically gives you the risk free rate return of 4% right? My response: Yes, that is exactly what will happen. There is absolutely nothing wrong with taking a 4% discount rate, if someone thinks that is their opportunity cost of capital…then the person is perfectly justified paying $254 for the same business…and achieve their required 4% p.a. return.(Fig 5)

Ofcourse, another way of thinking could be…’based on the risk free discount rate of 4%, my estimate of the intrinsic value of the business is $254…but as I will get a 4% return anyway from my CPF, so why should I settle for a 4% return from a business?….I will not be happy with anything less than 24% return,so I will only pay $80 … OR … I will not be happy with anything less than 15%, so I will pay $128 max’ etc etc. It all depends upon what is our Required Rate of return.

Fig 5

Hope this article helped you to understand the relationship between Intrinsic Value calculation and your actual rate of return. 

You would have heard me pester you a quadrillion times to go over and master the concept of Time Value Of Money, which is available both in our Option Series Program (https://learn.moneywisesmart.com/p/option-series/) as well as the Investing Fundamentals program (https://learn.moneywisesmart.com/p/investing-fundamentals-financial-statement-analysis-valuation/)…and this is the reason. It will help you to approach problems like these using first principles.

 
 
 

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