Robert W. Bruce Lectures 2004-2007 to Bruce Greenwald's Columbia ClassVW Staff
Robert W. Bruce Lectures 2004-2007 to Professor Bruce Greenwald’s Value Investing Class.
The saying is: “To try to teach you how to fish rather than handing you a fish.”
Value investing is simply the search for bargains. Value investing involves determining a value of a company and then investing when the price is significantly below the value of the firm to allow for a margin of safety. Simple to say, but not easy to do.
I want to define some key terms as I use them. We may think we mean the same thing, but I want you to understand exactly what I mean when I use the terms: Value Investing, Intrinsic Value and Margin of Safety.
Value Investing: Appraising the intrinsic value of businesses and purchasing fractions of those businesses at significant discounts to those appraisals. Buying bargains.
That is what value investing means when I use the term. What is not to like about value investing? How many people wouldn’t wish to be considered value investors? That is why I want to define terms as I understand them.
The definition of Intrinsic Value (“IV”) is the Present Value of all distributable cash flows whether operating or non-operating over the entire life of the business. Or another way of defining IV is the price at which a buyer and seller—equally knowledgeable and neither one operating under duress—would agree to a transaction for cash. Both of these definitions are easy to articulate, but not so easy to implement or to determine. For example, there are some businesses for which no one can ascertain their value within a tight enough range to be useful to make decisions.
What type of companies are those? A company where the future prospects are so uncertain both good or bad, that no one knows what the long term future or cash flows will be. Then again there are businesses that we, I, or you do not have the knowledge to project the future cash flows and discount them back–that is a very important element of humility which you should take into this work.
The Margin of Safety is, of course, the discount from intrinsic value of the business. Needless to say, in the case of margin of safety, the bigger is better. Margin of safety is typically determined by the price discount but the concept may be embodied in the conservativeness of your assumptions and estimates.
What is your investing edge? Who is on the other side of your trade?
Combined in this idea of Intrinsic Value and a Margin of Safety is the idea of having an edge. An edge, being the circumstances, that is the opposite of operating on a level playing field. We are all looking for an insight or knowledge edge that allows us to perceive value perhaps where others are incapable of doing that. Find your competitive advantage.
This gets to the question of defining intrinsic value. One thing I want to make sure that you understand is that for some businesses, the intrinsic value is simply not knowable. The array or ranges of possible future cash flows are so wide, so unpredictable, that discounting them back is a fruitless exercise. Additionally, some businesses lend themselves to appraisal by me and not by other people. And for other businesses, some other people are better qualified to assess intrinsic value than I am to make the appraisal. Certain businesses and industries, I feel, I am better able to forecast the cash flows than other people.
There are many, many industries that I am very unqualified to come up with intrinsic value. Or the range of value is too wide to be helpful to me. In those instances I can’t come up with an intrinsic value that would be helpful to me.
EXAMPLE OF Microsoft Corporation (NASDAQ:MSFT) DCF
This is another way of saying, stick to what you know—this is Warren Buffett’s idea to stay within your circle of competence.
I try to be very humble and modest. I think the investment business is full of very bright, hard working people. I never would be so presumptuous to say I could compete with any of them on any subject. I think I am quick to acknowledge that there are other people who know more about certain things than I do. And I try not to be so egotistical as to try to play their game on their terms. Therefore I avoid being where I don’t have the edge.
Interrelationships between Intrinsic Value and Margin of Safety
It has to do with the usefulness of the appraisal of intrinsic value. If I conclude that the Intrinsic Value is somewhere between $100 to $300 a share, that is probably not a useful appraisal. If I can’t refine it more than that, then I should move on. If the stock is trading at $150 and the range is $100 to $300, then what do I know? I don’t know anything of value. If it turns out it (the company) is worth $200 to $300 then there may be a big margin of safety there. But if I can’t be sure the company won’t be worth $100 or not, move on to where the odds seem more attractive–where determining the tighter range is something that I am qualified to determine.
One of the old stories about giving a talk on value investing is you come in, stand up and say intrinsic value, margin of safety and then sit down. The talk is over. I wanted to pass over it quickly because I am sure you have heard it from others.
Buffett’s Definition of IV: Intrinsic Value (Owner’s Manual 2005 Annual Report of Berkshire Hathaway pg. 77 – 78.
The calculation of intrinsic value, though, is not so simple. As our definition suggests, Intrinsic Value is an estimate rather than a precise figure, and it is additionally an estimate that must be change if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts moreover will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. What are annual reports do supply, though, are the factors that we ourselves use to calculate this value.
I. What is the definition is value?
Value investing is one of those terms like Motherhood and Apple Pie. Everyone is for it. Determine the valuation of a company then invest if the market price is less than the value. What is the definition of value?
The intrinsic value has two (2) definitions:
- The NPV of all future distributable cash and the assets sold outside of the normal operations.
There are some companies, which have valuable assets that are not intrinsic to their operations,
which can be sold for cash. An investment analyst should properly recognize those assets that
can be converted to cash—then value the NPV of that cash stream.
- The other definition of value is the price at which an equally knowledgeable buyer or seller would negotiate under duress a transaction for cash. All those words are important especially the last two. The transaction is for cash that sets comparable values for looking at similar investments. When transactions are not for cash as many acquisitions have been in recent years, there is much less informational content for investors in terms of determining comparable values. When there are acquisitions made with securities, you often get a $10 dog for two $5 cats. It doesn’t tell you anything about evaluating other cats. If, on the other hand, you see what an investor has paid in dollars for a cat.
Now, you say we should go out and look at all the companies and value all companies. Usually