When professional investors discuss how they decide what to buy and when, terms such as intrinsic value and franchise value are often mentioned. These terms sound highly technical and scientific, suggesting that the manager is using some well-defined method to calculate, without a doubt, a company’s value.
Unfortunately, there is no such science available. In fact, some investors will openly discuss the difficulty of valuation. For example, at a recent luncheon, Tim Hartch of BBH Core Select Fund (BBTEX) related a story from early in his career, when he was working in a mergers and acquisitions role, that had a material impact on his understanding of valuation.
It seems that Hartch was overseeing an auction of a private business with three sophisticated bidders. Two of the three produced nearly identical bids, while the third offered materially more (twice as much, per Hartch’s memory of the event). The manager recounted believing that the high bidder’s valuation was wrong. The story clearly displays that, to some extent, valuation is in the eye of the beholder.
Turning the tables on this story, I asked Hartch and co-manger Michael Keller how they figure out a company’s value. Since valuation was, to some extent, subjective, I wanted to know how these fund managers dealt with the issue. The response was candid—they use many different methods to identify the range of potential intrinsic value estimates and then select a base case estimate that they know is not exact.
Keller went into more detail, describing using such things as merger and acquisition pricing within an industry and complex modeling of a company’s potential future performance to derive revenue and earnings forecasts that could then be used to create a valuation. Hartch added that often such projections require multiple passes and scenarios, in an attempt to take into account potential market events and to figure out a most likely outcome.
The process outlined was a daunting one, and not one that an investor would take on whimsically. Thus, Hartch, Keller, and the third management member, Richard Witmer, first create a list of companies in which they would like to invest based on broader factors before rolling up their sleeves, and those of their team of dedicated analysts, and doing the math. The end result is a list of companies the managers like with general ranges in which a purchase would be appropriate for the team. For the BBH Core Select Fund team, something trading at 75% or below their valuation is the sweet spot.
All of this leads to the obvious question, “As an individual investor, how can you use the concept of intrinsic value?” The answer is that Value Line equity reports offer several different ways to assess the value of a company. We’ll use blue chip Hewlett-Packard (HPQ – Free Value Line Research Report on Hewlett-Packard) as an example.
Perhaps one of the most unforgiving measures of valuation is a company’s book value, which can then be compared to its market valuation. Book value is, effectively, a company’s assets minus its liabilities. Intangible assets may or may not be subtracted as well, depending on the company. Value Line often chooses to include intangible assets, as these items can have a material impact on a company—for example, Coca-Cola (KO – Free Value Line research report on Coca-Cola) wouldn’t be the same company without its ubiquitous Coke brand, which is a highly valuable intangible asset.
Book value is easier to digest when it is broken down to Book Value per Share, which can be found in the Statistical Array of a Value Line Research report. The historical figures, which are presented in plain type, can provide an estimate of how the broader market has historically priced a company’s shares as compared to its Book Value per Share.
Though the past is interesting, estimates and projections for Book Value per Share are clearly the more critical figures when making an investment decision. To this end, Value Line’s analysts provide estimated figures over one- and two-year periods and projections over a three- to five-year period. These calculations are provided to the right of the array in bold. For Hewlett-Packard, Book Value per Share is projected to be about $40 by 2014-2016. With a recent price of about $41 per share, the company is clearly trading above this conservative level of valuation. (A company’s recent price can be found in the Top Label section of each Value Line report.)
The $40 versus $41 per share comparison might seem discouraging, except when considered against the historical figures. Even in the depths of the recent recession (recessions are displayed with gray bars in the Graph above the Statistical Array), the shares traded well above Book Value per Share. At its recession low in 2009, the price of HPQ was approximately $25 per share versus Book Value per Share of just over $17. (The yearly high and low prices run across the top of the Graph.)
So the market, in recent years, appears to generally have priced the stock at a premium to its Book Value. Examining the past five years of annual lows versus Book Value per Share suggests that recent trading implies a worst-case scenario of about a 50% premium over Book Value per Share, implying a current target price of $60 per share. Averaging the multiplies over the five-year span yields an average of about 95%, which creates a Target Price of nearly $80 per share (note that the recession value premium creates a major drag on the average). This, of course, is the low range. Looking at a potential high valuation simply does the same calculations with the high prices for each year. The high-end projection in a worst-case scenario is about $120 per share, with the average resulting in a top range of about $125 per share.
It’s worth noting that an exception to this premium valuation tendency occurred in 2002, in the midst of the dot.com technology crash’s aftermath, when HPQ shares traded below Book Value per Share. The low price in 2002 was about $11 per share ($10.80) and Book Value per Share was about $12 ($11.91). Of course, it would have been difficult to make a purchase decision during that difficult time period, but, in hindsight, it appears to have been a very good buying opportunity.
Another tool for valuation available to Value Line subscribers is the analyst’s earnings projections and the historical premium investors are willing to pay for those earnings. Price to earnings is the way this relationship is often described. Calculating a P/E is simple math, dividing the Price by a company’s earnings per share. The logic is that investors are willing to pay the resulting multiple for each dollar the company earns. Average Annual P/E is available in the Statistical Array.
A similar worst-case scenario/best-case scenario can be used with the historical Average Annual P/E figures and Value Line’s three-to-five-year earnings projection of $6.25 per share, producing a high price of about $100 per share and a low of about $75.
Value Line analysts also create a projected P/E multiple for each company, basing the estimate on historical P/E levels. In the case of Hewlett-Packard, analyst Theresa Brophy projects that the Average Annual P/E will be 15, which results in a Price Target of close to $95 per share. A range is then computed using a propriety model based on a company’s Safety rank (which can be found in the Ranking box at the top left of each report). The better the Safety rank the tighter the range. This model produced a price range of $85 per share to $105 per share, which is visually represented on the Graph by the horizontal dotted lines and in number form in the Projections box to the left of the Graph
Note that the price range created by Ms. Brophy is within the range created using the Book Value per Share method noted above, but above the five-year best and worst P/E over that time period. This is largely because over the past five years, HPQ shares have traded at a lower multiple than they had historically been afforded, leading Ms. Brophy to her projected Average Annual P/E of 15, compared to just 12.9 in 2010.
An additional method of valuation available on the Value Line report is the Cash Flow Line, which appears on the Graph. This line is created by taking a company’s Cash Flow per Share and multiplying by a value that allows for a “best fit” with the company’s pricing information. It is a rough gauge of how the market has valued the company’s cash generating ability over the longer term. The multiple used is displayed in the Graph Legend.
Creating this line is not a science and relies heavily on an analyst’s perspective of the company’s valuation. However, it can reveal interesting relationships between price and valuation. For example, in the 2002 period, at the time when the company traded below Book Value per Share, it also traded materially below its Cash Flow Line. The same dislocation occurred in 2004/2005 and during the recession years of 2008 and 2009.
While historical figures are interesting, it is the estimates that provide the most relevant information for buy and sell decisions. The estimates in this case are presented on the Graph as a dotted extension of the solid Cash Flow Line. At present, the HPQ shares are well below the estimated Cash Flow Line, suggesting that the shares have ample room to rise. Although specifically presented on the page, subscribers can use the Cash Flow per Share projection from the far right column of the Array to create a three-to-five-year projected price. In the case of Hewlett-Packard, the resulting price is about $100 per share—in line with the two other valuation methods discussed above.
Although valuation is both in the eye of the beholder and a soft science, a Value Line research report can provide investors with a collection of tools to create a range of possibilities using both historical and estimated and projected data points. In the case of Hewlett-Packard, it appears that the shares are trading below intrinsic value. For the record, Hewlett-Packard isn’t a holding in BBH Core Select Fund, though Coca-Cola, noted above for its intangible assets, is—the valuation methods discussed here could just as easily be applied to this beverage giant and fellow blue chip member of the Dow 30.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.