Book vs. intrinsic value -- what's the difference?
By Bruce Jackson (TMF Googly)
Kilburn, London -- There's an article in the Financial Times today titled "A year of reflection for Berkshire Hathaway." This is the company chaired by arguably the world's greatest investor, Warren Buffett. The article is very fair, showing that an investment in the company's shares at the beginning of 1996 would have seen them only marginally outperform the index over a period of 3 years. There's no arguing with the facts.
A look at the company's growth in book value per share from 1995 to 1997 highlights the vagaries of the stock market over the shorter term. During 1996, Berkshire's book value per share grew by 31.8%, and in 1997 it grew by 34.1%. For any company, that is an excellent performance. However, this appreciation obviously wasn't reflected in the company's share price.
Book value is a relatively simple concept. Firstly, forget a company is quoted on the stock exchange, because market value has no bearing on book value. Say you are starting a company and you issue 100,000 shares at 100p each. This gives the company a book value of £100,000 and a book value per share of 100p.
Five years down the track, you've struggled by, managing to make a total net profit of £50,000. From this surplus, you pay yourself a total of £20,000 in dividends, leaving £30,000 to be invested back in the business. At this point, the company's book value is £130,000, and book value per share is 130p. Depending on the make up of the company's balance sheet, this £130,000 may be represented by assets like motor vehicles, furniture and fittings, stocks, bank balances and debtors outstanding. It will be reduced by things like creditors payable and bank loans. In theory, if you sold off all the assets and paid off all the creditors, you'd be left with a total of £130,000.
Is the business worth £130,000? That depends on many factors -- things like the profitability of the business, the future growth prospects and whether the company is solvent. Arguably, it is worth what anyone is prepared to pay for it. That's effectively what a stock market listing does for a company. It places a market value on a company. If our company's shares were listed at 130p each, the company would be trading at book value. At 260p, it would be trading at twice book value. I think you get the idea.
The true value of any business should be the discounted value of the cash that can be taken out of a business during its remaining life. They are not my words but those of Warren Buffett, and it is his definition of intrinsic value. That is how any company should be valued. Doing it is a very subjective thing, and different investors will come up with vastly different values depending on how they perceive the growth prospects of the company.
In his 1995 letter to shareholders, Buffett said that in recent years Berkshire Hathaway's gain in market value (i.e. share price) had outstripped its gain in intrinsic value, and he didn't view the shares in the company as undervalued. In the 1996 letter, Buffett said that the impressive gain in the company's intrinsic value that year was not matched by a rise in the company's market value, and hence he saw the price to value relationship as being more appropriate.
Buffett then went on to neatly sum up the relationship between a company's share price and its underlying growth.
"Over time, the aggregate gains made by Berkshire shareholders must of necessity match the business gains of the company. When the stock temporarily outperforms or underperforms the business, a limited number of shareholders -- either buyers or sellers -- receive outsized benefits at the expense of those they trade with... the longer a shareholder holds his shares, the more bearing Berkshire's business results will have on his financial experience -- and the less it will matter what premium or discount to intrinsic value prevails when he buys and sells his stock."
From these comments, you can perhaps see why the underlying Berkshire Hathaway share price has not unduly outperformed over the past 3 years. As long as Berkshire can keep growing their intrinsic value, Buffett won't worry a jot, and nor should long-term shareholders.
On Wednesday, we looked at various valuation models for Dell Computer Corporation (Nasdaq: DELL). We concluded that it was a borderline decision as to whether they jumped our 15% per annum long-term growth target. On two measures they passed it easily, and on three others they fell short.
I've done a couple more calculations and reckon the fair value of the shares is between a low point of $US77 and a high point of US$121. It is worth saying that to get to these valuations, I've factored in some quite demanding growth projections, which may turn out to be way too optimistic. For example, it means Dell having 2009 sales of about £135 billion, up from about £20 billion for the year ending January 1999. It also assumes that Dell will keep throwing off huge amounts of free cash flow, well above reported earnings.
To achieve these numbers, Dell will have to keep growing ahead of the 15% rate of the overall PC market. Many forecast the demise of the PC as we know it, and this is obviously a risk for Dell. Computers are commodity products, and price is often the buyer's main consideration. Although Dell is currently the low cost operator, if it loses that mantle and a competitor can get close to its level of customer service, the current and potential valuation would soon look pretty rich. Also, prices of PCs are falling, meaning Dell has run fast just to stand still as revenue per unit sold falls.
The shares currently hover around the US$83 mark, towards the lower end of our valuation scale. As I said on Wednesday, this is a borderline decision. I remember back to the Rentokil Initial (RTO) buy decision, when I was a little undecided whether to go for them. I took the plunge and never regretted it. It doesn't always work that well, because Unilever (ULVR) were a borderline valuation decision, we went for them, and the shares have subsequently fallen. They have, however, largely matched the movement of the market since we bought them.
You can only sit on the fence for so long, and to defer a decision would not achieve anything. I like the company, its products and its management. I know the risks, which are very real for a company trading at such a high level.
With the shares currently trading at a forecast January 1998 price to earnings ratio (P/E) of 78, they look very expensive. In five years' time, if they compounded their earnings at 15% per annum, Dell could be trading at a P/E of 15, in which case the shares would be US$32, a far cry from the US$83 they hover around at the moment.
Knowing all that, we're going to take the plunge. In accordance with the Fool's trading rules, over the next 5 trading days, we're going to pick up £2000 worth of shares in Dell Computer Corporation. I've set up my US based discount broker account, and it has some dollars deposited and is "good to go." With the current exchange rate about £1 = US$1.65, that means we're going to spend about US$3,300. There is obviously a currency risk involved here, but I happen to think it is pretty minimal. Remember, we're not talking Brazilian real or Italian lira here -- this is steady US dollars. As for how to record this purchase in the portfolio reporting, we'll cover that after we've done the deal.
In the next week I'll put together a full buy report for Dell, which will sit in the trading history archives. In the meantime, here's hoping the technology market falls 20% in the next few days and we're able to pick up Dell shares a bit cheaper than their current price. I can but dream.
Qualiwatch companies -- Vodafone (VOD) and Glaxo Wellcome (GLXO). Valuations to follow.
Have a great weekend. I know a few Fools will disagree with the decision to buy Dell, and there's nothing wrong with that. With the Qualiport placing a large emphasis on valuation, many will think we're completely barmy to buy a commodity product company at a P/E of 78. The Qualiport message board is the place to air your opinion. See you there.
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22/1/99 CloseCompany Change Bid EMA -0.12 11.10 IIG -0.10 2.37 MKS -0.02 3.31 PIZ -0.07 7.43 RTO -0.23 4.52 ULVR -0.17 5.94 Qualiport Stocks Last Rec'd Total # Company In At Current Change 19/12/97 783 RTO 2.55 4.52 77.3% 04/11/98 245 PIZ 7.93 7.43 (6.2%) 17/04/98 169 EMA 11.85 11.10 (6.3%) 27/10/98 755 IIG 2.58 2.37 (8.1%) 17/07/98 298 ULVR 6.72 5.94 (11.6%) 11/05/98 368 MKS 5.54 3.31 (40.2%) Last Rec'd Total # Company In At Value Change 19/12/97 783 RTO 2046.53 3539.16 1492.63 17/04/98 169 EMA 2052.57 1875.90 (176.67) 04/11/98 245 PIZ 1966.34 1820.35 (145.99) 27/10/98 755 IIG 1972.64 1789.35 (183.29) 17/07/98 298 ULVR 2052.54 1770.12 (282.42) 11/05/98 368 MKS 2054.11 1218.08 (836.03) Cash: £4,007.60 Current Total : £16,202.56 Total Invested: £16,184.62 Profit/(Loss) : (£ 164.06) Value Per Share Day Month Year Qualiport -2.14% -4.69% -4.69% FTSE 100 -2.68% -0.36% -0.36% FTSE All Share -2.33% -0.32% -0.32%
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