Intrinsic value of a business

In our previous article What is value investing?, we briefly introduced the idea of the intrinsic value of a business. Intrinsic value is one half of value investing, as value investing involves “the discovery of discrepancies between the intrinsic value and the market price” (Graham and Dodd, 1932). Market price is straightforward – such data is easily available online today. The tricky part of value investing is calculating the intrinsic value of a company. Graham and Dodd (1932) defined the intrinsic value of a business as the value “justified by the facts, e.g., the assets, earnings, dividends, definite prospects”. This is what we focus on: the facts about the business. Not what other people say about it, not how we think the market will treat the stock, and most definitely not how the share price has been moving recently.

We do not claim to be experts or professionals in business analysis. Rather, we will share some principles accumulated from reading about the topic as well as investing experiences over the past few years.

Intrinsic value depends on who is calculating it

The header above might sound like an oxymoron, but this is something that I have come to learn after the first few years trying my hand at value investing.

Let us consider a hypothetical example. Suppose that a bond was put up for sale, which offered a payment of $500 every month for the next 20 years. How much would you be willing to pay for this bond?

Given that this blog is targeted at Singaporeans in their 20s, your valuation of such a bond is unlikely to be high due to low current purchasing power and expected higher earnings over the next 20 years. Let us consider how much this bond might be worth to people at three different stages of life.

Name	Age (years)	Stage of life	Personal valuation of the bond
Ali	20	Just started university	Very low
Bala	60	Going to retire soon	Quite high
Charlie	100	Old folks’ home	Almost zero

Ali, with almost no savings and having just started university, would not want to lock in so much money. Furthermore, he would be expecting a regular and growing salary over the next 20 years, so the $500 a month would not be that much of a benefit to his future self.

Bala, having saved up during his working years, would be prepared to spend quite a bit of money on his financial security during retirement. A bond with fixed monthly pay-outs over the next 20 years can play a significant role in this, so he is likely to be willing to pay quite a bit for it.

Charlie, at age 100 in an old folks’ home, is not expecting to live for that many more years, so the bond with pay-outs spread over the next 20 years would be quite useless to him.

If something as straightforward as a bond with fixed pay-outs can have such drastically different valuations to reasonable, rational people, what more shares in companies, with varying levels of uncertainty?

The differences in valuation of businesses arise because different people have different goals. The good news is that disciplined value investors should have similar (but not identical) valuations of businesses. A true value investor would calculate the intrinsic value of a business in terms of the following priorities:

• Long holding period;
• Resilient business model; and
• Conservative financial position.

We only evaluate wonderful companies that we understand

Would 100-year-old Charlie in the previous section even bother to take his calculator out to value the bond paying monthly pay-outs for the next 20 years? Probably not. There is no point evaluating companies that you do not intend to invest in.

So, what do we require before we try to calculate the intrinsic value of a company? A resilient business model and a conservative financial position.

Economic moat

Why are some companies more profitable than others? The answer lies in pricing power. Pricing power refers to the ability for a company to raise prices while keeping costs the same, enabling it to grow profits.

Telecommunications companies (aka ‘telcos’) in Singapore currently lack pricing power. In the past few decades, the three main telcos (Singtel, Starhub, and M1) kept prices high and earned significant profits, but the recent introduction of a fourth telco (TPG) and a hoard of Mobile Virtual Network Operators (MVNOs) has led to a price war, driving mobile plan fees down. (I recently switched from Singtel to MyRepublic with significant savings on my monthly fees.) The profit margins of the three main telcos have been beaten down, along with their share prices. Starhub got kicked of the Straits Times Index in 2018 while M1 was privatised and delisted in the same year. Singtel’s share price (SGX: Z74) has fallen significantly in the past 5 years from $3.88 on 9 May 2016 to $2.45 on 9 May 2021.

New economy companies, such as Alphabet and Apple, on the other hand, have excellent pricing power. Those of you who are in Apple’s digital ecosystem would be all too familiar with the upwards price trend of iPhones over the years. Yet, consumers do not turn away. They repeatedly queue overnight to spend astronomical sums on the latest iPhones.

Warren Buffett calls this an ‘economic moat’. He looks for companies with a certain competitive advantage that allows it to maintain above-average profit margins.

What we’re trying to find is a business that, for one reason or another – it can be because it’s the low-cost producer in some area, it can be because it has a natural franchise because of surface capabilities, it could be because of its position in the consumers’ mind, it can be because of a technological advantage, or any kind of reason at all, that it has this moat around it.

Warren Buffett (1995), Berkshire Hathaway shareholders’ meeting

Financial strength

Almost all companies nowadays have debt. Some have less debt, which they take on in the ordinary course of business (for example, bills not yet paid to suppliers or a mortgage on a factory building), while others have more, which they utilise to leverage up.

I have a strong preference for net cash companies. A company is said to be net cash if its cash and cash equivalents is greater than total liabilities. This means that even if the business suddenly and unexpectedly comes to a standstill (for example, cinemas or airlines during the Covid-19 pandemic), the company can continue to pay its creditors without having to raise additional cash. Clearly, such companies have a strong financial position and are very unlikely to run into financial distress. A further perk is that they can afford to be picky on loans and only borrow money if they get a good interest rate, rather than out of necessity. This minimises their finance costs, which can seriously cut into cash flow.

Unfortunately, net cash companies are relatively rare in Singapore, largely due to the culture of regular, sizeable dividend pay-outs here. Nevertheless, I do generally try to look for companies which appear unlikely to run into financial distress even if revenue were to plunge (this is called stress-testing).

Focus on earnings, not assets

On to the main crux of this article – what is the main determinant of the intrinsic value of a business?

Graham and Dodd’s initial interpretation of intrinsic value was that it primarily arose from tangible assets. For instance, Graham, in his 1932 article Inflated Treasuries and Deflated Stockholders, analysed a company called White Motors and found it to be valued by the market at “only one-fifth of the net quick assets”. Net quick assets are today called net current assets, and basically assets that can be easily converted into cash within a year (including cash itself) minus all debt. Linking this to the previous section, it should be clear to the reader that a company with positive net current assets is net cash.

Net current assets forms a lower bound on liquidation value (the amount of money you can get by closing down the company and selling all the assets), since it is the amount of money left over after using cash and liquid assets to pay back all the debt the company owes. Theoretically, net current assets should therefore be a lower bound on market valuation, since investors would surely be willing to pay at least as much for shares as they would get back in cash if the company shut down and returned all the excess money to investors (that is, underwent liquidation). Graham argued that investing in companies at a price less than net current assets is the ideal value investing strategy.

the true value of their stock should under no circumstances be less than the realizable value of the business, which amount in turn would ordinarily be not less than the net quick assets.

Benjamin Graham (1932), in Should RIch but Losing Corporations be Liquidated?

There are two major problems with this approach. First, net cash companies are rare, especially so in the Singapore context, in which shareholders expect regular and large dividend payments. Among those net cash companies, those which trade at prices less than net current assets would be exceedingly rare. In fact, I seriously doubt that you would find any companies with shares traded on the Singapore Exchange for less than the net current assets. This is largely due to improved access to financial data in the past few decades. Free online sources (Yahoo Finance, Bloomberg, FT.com, etc.) with stock screeners make it easy to find companies based on pre-set criteria such as net current assets, so it is highly unlikely for such market dislocations to occur in the first place. Based on this alone, if we were to limit ourselves to only investing in companies at a price less than net current assets, we would not be able to invest at all.

Second, even if we were to find a company with net current assets exceeding market valuation, it does not guarantee outsize returns because the company’s management may refuse to liquidate the company. Graham himself understood this. In his 1932 article Should Rich But Losing Corporations Be Liquidated?, Graham pointed out that a company with operating losses is nevertheless unlikely to liquidate because its managers and directors, who collect large salaries from the company, would not want to lose their income.

the issue involves a strong conflict of interest between the officials who draw salaries from the business and the owners whose capital is at stake.

Benjamin Graham (1932), in Should Rich but Losing Corporations be Liquidated?

Rather, managers and directors seem to prefer to let operating losses drag on rather than liquidate, resulting in the erosion of assets. As such, we cannot count on net current assets as a lower bound on intrinsic value.

If you owned a grocery store that was doing badly, you wouldn’t leave it to the paid manager to decide whether to keep it going or to shut up shop.

Benjamin Graham (1932), in Should Rich but Losing Corporations be Liquidated?

What is really important, rather, is earnings. Companies exist to make money. A company should be adjudged based on its ability to earn profits. If you could have the choice between a gold ring with no special powers and a copper ring that gave you $100 a day for the rest of your life, which would you choose?

Putting it all together – an example

DISCLAIMER: This article does not constitute advice to buy or sell any specific security. You should do your own research and exercise caution when dealing in securities.

We will now apply the above principles to the analysis of a specific company: Koda Ltd (SGX: BJZ). Koda is a furniture manufacturer started in 1972. It is headquartered in Singapore and has factories in Malaysia and Vietnam. Koda manufactures furniture for other brands (as an ‘Original Equipment Manufacturer’) and also designs, produces, and sells furniture directly to consumers under its Commune brand (I recently visited the Commune store at Millenia Walk and was reasonably impressed). With established relationships with brands around the world, its own growing consumer brand, and resilient demand for its product (the Covid-19 pandemic actually increased the demand for household furniture), I found Koda to be in a favourable market position.

According to the latest half-yearly results, which you can view here, as of 31 December 2020, Koda had US$22,227,000 in cash and cash equivalents against US$22,474,000 in total liabilities. These numbers are quite close, but once you add in trade receivables (money its customers owe it and need to pay soon) and other receivables (other debt that it expects to receive soon), the current assets (excluding inventories, which I am not comfortable including as current assets) of US$29,049,000 significantly exceed total liabilities. Hence, Koda is essentially a net cash company, because even if revenues suddenly drop to zero, it will be able pay its creditors without needing to raise additional funds.

Cash and cash equivalents (US$’000)	Trade and other receivables (US$’000)	Current assets excluding inventories (US$’000)	Total liabilities (US$’000)
22,227	6,822	29,049	22,474

There are other reasons why I think Koda is a wonderful company, which I will not go into now (I do intend to post a fuller analysis of Koda soon). Now for the valuation. I will use earnings figures from Koda’s 2020 Annual Report, which you can view here.

	2020	2019	2018	2017	2016
Net Profit (US$’000)	4,336	5,309	5,413	4,050	1,641

Looking at these numbers, what annual profit level would you be confident of Koda earning for the next 5 or 10 years? A reasonable lower bound would perhaps be about US$3,800,000. Now, at the prevailing exchange rate of about 1 USD to 1.32 SGD (8 May 2021), this translates to S$5,016,000. As of the latest half-yearly results, there are about 82,635,000 Koda shares outstanding. I generally value companies at 10 to 20 times their sustainable profit level. For Koda, I would say about 15 (this involves some guesswork, taking into consideration size, financial position, market dynamics, management, growth prospects, etc.).

To find my estimate of the intrinsic value of one share in Koda, I just take (S$5,016,000 / 82,635,000) × 15 to get S$0.91. Shares of Koda last traded at $0.62 at the week’s close on 5 May 2021, which appears to be a decent margin of safety, making Koda Ltd shares (SGX: BJZ) a viable value investing opportunity. (I bought Koda Ltd shares on two previous occasions: at $0.355 on 21 May 2020 and at $0.44 on 21 September 2020.)

To sum up

• Calculating the intrinsic value of a business is an art, not a science.
• We only bother to value wonderful businesses with solid economic moats and strong financial positions.
• Most of the work in the investment process is in deciding whether a business is worth owning as an investment or not; the actual calculation of value is relatively straightforward.
• Calculate intrinsic value using earnings, not assets.