Rising intrinsic value
Pop quiz everyone: if a company’s market value reflects what is considered to be its “fair value”, will this value change over the long run?
The short answer is it definitely will change, but this concept of changing intrinsic value can be a tricky concept to get your head around. If a company is currently trading at its fair value, which means that the value reflects all of its potential earnings, then how can its value change over time?
At Montgomery Investment Management, we advocate that investors should seek companies that have rising intrinsic values, as this will put you in the best position to grow your wealth over time. But how does this concept work? Let’s explain with a simple comparison.
For the purposes of the comparison we’ll assume that a company begins with total equity of $100 million. Let’s also assume that this company generates $10 million in profit during the year and pays out all of its earnings in dividends. Finally, we’ll assume that in each case, the earnings growth rate adopted is constant for the remainder of the company’s life, and we begin the analysis by adopting a required return of 10 per cent.
Example 1
Assume that the company’s earnings growth rate is zero. This means it will earn $10 million each year into perpetuity. To value this company, you may decide a discount rate of 10 per cent is appropriate – being the required return (10%), minus growth (0%). You can see from the table below that the value of the company won’t change over time. If you bought the asset today, it would be worth $100 million in a year’s time, and $100 million in 2 years’ time.
|
Today |
+ 1 year |
+ 2 years |
|
| Equity |
100 |
100 |
100 |
| Profit |
10 |
10 |
10 |
| Return on Equity |
10.0% |
10.0% |
10.0% |
| Long term growth |
0% |
0% |
0% |
| Required Return |
10% |
10% |
10% |
| Discount Rate |
10% |
10% |
10% |
| Intrinsic Value |
100.00 |
100.00 |
Example 2
What if the company has a sustainable competitive advantage, allowing it to raise prices and generate a long term earnings growth rate of 3 per cent? For this type of investment, the discount you might apply is 7 per cent – this is the beginning required return of 10 per cent, minus the growth rate of 3 per cent.
|
Today |
+ 1 year |
+ 2 years |
|
| Equity |
100 |
100 |
100 |
| Profit |
10 |
10.3 |
10.609 |
| Return on Equity |
10.0% |
10.3% |
10.6% |
| Long term growth |
3% |
3% |
3% |
| Required Return |
10% |
10% |
10% |
| Discount Rate |
7% |
7% |
7% |
| Intrinsic Value |
147.14 |
151.56 |
The fair value of this asset today is $147 million. But you will notice that the “fair value” of this investment will continue to rise over time – in year 2, the investment should appreciate by 3 per cent to $151.56 million. Note also that the Return on Equity of this business is also rising, because the earnings are all being paid out, and despite the lack of reinvestment, profits are increasing. It’s one of the reasons why the ability to raise prices is so valuable. If you buy a share of this company today and hold for the long term, you can see how this rising intrinsic value will increase your wealth.
Example 3
It is equally important to note that a company’s intrinsic value can fall. To illustrate, let’s assume that the company is in a terminal state of decline, and its earnings are falling by 3 per cent each year. The discount that you might apply to this investment is 13 per cent (if you decided to invest in it at all) – or the required rate of return (10%) plus the rate at which earnings are expected to decline (3 per cent). At the current time, this business is only worth $74.62 million. In a year’s time, the value of the business will have fallen to $72.38 million. Note also the declining Return on Equity.
|
Today |
+ 1 year |
+ 2 years |
|
| Equity |
100 |
100 |
100 |
| Profit |
10 |
9.7 |
9.409 |
| Return on Equity |
10.0% |
9.7% |
9.4% |
| Long term growth |
-3% |
-3% |
-3% |
| Required Return |
10% |
10% |
10% |
| Discount Rate |
13% |
13% |
13% |
| Intrinsic Value |
74.62 |
72.38 |
Of course, there are many other factors that should be considered with your investments. But hopefully this simple comparison has provided some insight into why it is so important to seek companies that can grow their profitability and intrinsic value over time.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
INVEST WITH MONTGOMERY
