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Intrinsic Value Calculator

I am sure you must have heard about the famous fable of the 'Elephant and the Six Blind Men'.

It's a story about how a group of six blind men are taken to an elephant enclosure and made to touch a big, full-grown elephant.

Now, obviously, they are touching a giant elephant for the first time and since all of them are well spread out around the elephant, they are each touching and feeling a different part of the elephant.

So, the first blind man is touching the trunk of the elephant and starts assuming that the elephant is nothing but a big, fat snake.

No, it's a spear, shouts the second blind man who's obviously got hold of the elephant's sharp tusks.

Are you all crazy, says the third blind man, who's standing close to one of the legs and obviously thinks of the creature as a huge tree.

The fourth, fifth and the sixth blind guy think of the elephant as a wall, rope, and fan respectively as they feel its body, tail, and ears.

elephant

So, six blind men imagining an elephant as six different things. It goes without saying that an intense argument follows with each blind person trying to make his case.

The Different Dimensions of Value

Soon, a wise man who's watching all this action unfold from a distance, approaches the group and asks all the six men to calm down.

He then tells them that all of them are right as they were all touching different parts of the elephant. The elephant, in reality, is the sum of all of these parts. Instead of arguing with each other, all they had to do was consider each other's perspective and arrive at a unified picture.

Interesting, isn't it? There are a lot of lessons that one can learn from this story. In fact, there is a very important lesson around investing as well.

I'd like to believe the price of any a stock in the market is like the elephant in our story.

And all the other investors who are trying to value the stock are like the six blind men, each having its own opinion about what the stock's correct valuation should be and the price it should be trading at.

So, there's a stock price and there's a fair value or an intrinsic value of the stock that depends on what the individual investor feels about the future of the company.

An individual investor may be right based on his own assessment of the fair value of the company and yet, his value may be quite different than that of the other investor because the other investor is looking at things differently.

Let us try and understand this whole process better by using Maruti Suzuki India Ltd as an example.

The Famous Five

As far as I am concerned, there are 5 different types of investors.

The first one is a deep value investor. A deep value investor is interested in only those shares that are trading below or close to their book values.

They do not consider any shares that are trading at a significant premium to their book values. Maruti Suzuki's current book value stands at close to Rs 1,900 per share.

This translates into a buy price of Rs 1,420 after considering a margin of safety of 25%. What this means is that the share price of Maruti needs to fall by at least 85% before a deep value investor can consider buying Maruti shares.

Well, as things stand now, the possibility of Maruti falling to the buy price of Rs 1,420 per share in the near future is close to zero in my view.

Which is why a deep value investor should forget investing in Maruti shares and should consider those stocks that are trading below or close to their book values.

Given his valuation preference, a well-established market leader like Maruti is way out of reach for a deep value guy.

What about our second investor, a value guy. Yes, that's correct. Not a deep value guy but a value guy.

Now, what is the difference you may ask. Well, a value investor tries to value companies based upon its earnings power or earnings capacity and not on book value.

The earnings power of a company is the earnings per share that Maruti has managed to earn in a normal year. It can also be considered as the average earnings of the last 3-5 years provided the business conditions were normal.

Now, this number for Maruti comes to around Rs 230 per share in my view. There have been years where Maruti earned Rs 260 per share and there have been years where it has earned close to Rs 200 per share. Thus, Rs 230 per share looks like a good number as far as the earnings power is concerned.

The average PE multiple for Maruti has been in the 25-30x range the last few years. Here also, we consider an average of around 28x.

Therefore, multiplying the two and sticking a margin of safety of 25% on top of that gives us a fair value of Rs 4,830 per share, against the current share price of Maruti of 9,400 per share.

Hence, even for a value investor, Maruti is quite expensive and the stock may have to fall by almost 50% before a value investor can think of entering the stock.

Well, a 50% crash does look like a remote possibility. But please note that during the coronavirus crash in March 2020, the stock had fallen to as much as 4,000 per share, thus giving a huge opportunity for a value investor to buy the stock.

Whether the same may happen again is anybody's guess. But the possibility does not look as remote as it is for a deep value investor.

The Warren Buffett Way

The third type of investor can be called as a growth at reasonable price or a GARP investor.

This is Warren Buffett territory. The Oracle of Omaha made a switch in his investment philosophy when he changed from being a deep value investor to a growth at reasonable price investor.

What is the difference between the two you may ask? In my opinion, a growth at reasonable price investor does not seek a margin of safety.

He still invests based on the earnings capacity or the average earnings power, but he expects this earnings to grow at a decent rate going forward.

The value investor on the other hand does not expect the earnings to grow but remain stable or grow at a very slow rate.

The reason GARP investor has a lower margin of safety than value investor or does not have any margin of safety at all is because he believes that growth is his margin of safety.

Since a GARP investor is not paying anything extra for the growth in earnings, he is willing to pay the full price for current earnings.

Well, this is how a GARP investor will value Maruti Suzuki.

Everything is the same as a value investor except for the margin of safety. I have assumed a zero margin of safety versus a margin of safety of 25% that I assumed for a value investor.

Therefore, if you remove the margin of safety, you get a fair value for Maruti of Rs 6,440 per share, which is almost 30% lower than the current market price of Rs 9,400 or thereabouts.

Therefore, the stock will have to fall by 30% for a GARP investor to consider investing in Maruti Suzuki.

So, that was all about GARP investing.

Going One Up on Wall Street

Let us take a look at the fourth type of investor, the growth investor.

This is Peter Lynch territory.

Peter Lynch was of the view that he was willing to pay a high PE multiple for a stock if the stock had significantly better growth prospects than the one with the low PE.

Here, in order to value the company, I have not considered the current earnings power like I did for a value investor or a GARP investor.

Instead, I have assumed the future EPS of the company, expecting it to double over the next 3-4 years i.e. go from Rs 230 per share to Rs 460 per share. Keeping the PE at 28x, we get a fair price of Rs 12,885 per share which is almost 37% higher than the current price.

Therefore, from among the four different types of investors, it is only a growth investor that might consider investing in the company at the current price.

The fifth and the final kind of investor is the momentum investor. Well, momentum investing is actually trading in my view and momentum investors don't try to find out the fair value of a stock.

They only try to figure out whether the stock is witnessing a strong momentum currently. If the answer is yes, they jump aboard and stay as long as the momentum remains strong. Any sign of weakness of momentum and they get out of the stock, no questions asked.

A Quick Recap

Here are the five different kinds of investors again, for easy reference.

table

Isn't this like the blind men and the elephant all over again? All the 5 types of investors could be right in their own way and yet, their idea of the fair value of the company is so different from each other.

So, in the end, who should you follow? Should you follow the growth investor or the GARP investor or is it the value guy or the deep value guy?

The Key Takeaway

Well, the beauty of investing is that you can choose any of these approaches and still end up making good money over the long term, even market beating returns.

Yes, that's correct. Each of these approaches are proven approaches and you can use any of them provided you select the right stocks for each of these categories, try and assess their fair values correctly and last but not the least, have a proper exit plan in place.

You can't be a growth investor and then fail to predict the future growth of the stocks in your portfolio. A growth stock turning into a value stock or a deep value stock could be a big disaster for your returns.

Likewise, if you are a momentum investor and don't get out as soon as the momentum weakens, you are asking from trouble.

I have seen stocks go from momentum all the way down to deep value and destroying huge wealth in the process.

At the other end, if you invest when the stock is deep value or value and then keep holding on to it all the way up the momentum, you will end up with one hell of a multibagger.

However, such instances are rare and you'd be better off sticking to your zone of investing. So, if you are a deep value investor, you should look to make those quick 50-60% returns and then sell the stock. There's no point in practicing a buy and hold strategy in deep value investing.

Likewise, if you are a growth at reasonable price investor, you should exit once the stock becomes a momentum investor unless you are like Warren Buffett who has a buy and hold strategy.

The bottomline is that each of these approaches can make you money in the stock market provided you know the line that separates your investing style from the other investing styles.

As long as you operate inside your zone or what is also called as your own circle of competence, you should be fine in my view. So, pick a style of investing and stick to it.

Happy Investing.


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