Sunday, September 1, 2013

INTRINSIC VALUE AGAIN – Part II

The intrinsic value of a company can be expressed as the NPV (Net Present Value) of its net earnings. Net Present Value is a variable used when calculating the ‘time value of money’.  It is a bit like inflation – a dollar earned today is only worth 50 cents 15 years from now (depending on the inflation rate). If the inflation is 10% a dollar may only be worth 50 cents in less than seven (7) years.

You can also look at it another way – rather than putting money into a new investment opportunity, you have already a 100% safe investment that brings you 10% return. For you to switch into another, possibly riskier investment you want to make a higher return rate than 10%. The 10% is considered to be the (opportunity) costs of your money - all other investments have to make at least 10% for you to break even with the opportunity you already own. We say then that the new opportunity has to be discounted at a rate of 10%. If the discounted investment has a value of zero (Net Present Value) then it is equivalent to the investment you already have.
Thus, with a discount rate of 10% (a rate that many businesses also use) $1 earnings seven (7) years from now are worth $0.50 today. Earnings 100 years from now discounted at 10% are worth nothing. The longer it takes to get your money the less it is worth. Thus the net present value of net earnings of say $12 some 100 years from now are worth zero today.

By adding up the net present value of all earnings from an investment until the time that the net present value of the earnings is (approximately) zero you’ll get the intrinsic value of that investment. Let’s illustrate that on the spreadsheet(s) below.
Fig 1 - Microsoft Earnings 2009-2012  (as EBIT and Net Earnings). Linear regression was used to determine the slope and intercept of the resulting line. Slope and intercept are used to extrapolate earnings until year 100 in figure 2.

We’re taking Microsoft’s net earnings for the past five (5) years (Fig. 1) and plot it on a graph. Lo and behold, it forms a nearly perfect linear trend that increases over time. If nothing goes wrong, you’d be able to extrapolate those earnings over the next 100 years. That is exactly what Excel spreadsheet below does in the Net Earnings column using ‘Linear Regression’. The more predictable Microsoft’s earnings are the more confidence we will have in the reliability of this ‘earnings forecast’(Fig. 2).
 
Fig 2. Microsoft Earnings extrapolated to Year 100, The far right column converts the nominal Net Earnings into Net Present Value earnings discounted at 10%

In the column on the far right, we have calculated the NPV for each year’s earnings in ‘Year 5 dollars’ (the year when we make our share purchase). Next we calculated the NPV until year 100 around which time the NPV is close to zero.  If you use a higher discount rate the number of years it takes to reach a NPV of zero is less, while if you use a lower discount rate it will take a longer.
Thus, now you the investor are in charge. You determine the minimum rate of return you want (say 10%) and then using it as the discount rate in your NPV calculations, the intrinsic value will give you the maximum price you should pay for a share. In our example the sum of all NPVs for 100 years (minus the first five for which we have the real earnings) adds up to an intrinsic value of $58.92.  Now you know that when you buy Microsoft shares at the spreadsheet’s current price of $28.04 you will receive earnings worth $58.92 and based on a purchase price of $58.92 you’d still collect earnings at a compound rate of return of 10%.

Is that good or what?

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