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Why you should take an intrinsic value approach to investing

There are many ways to value a stock, but one legendary investor swears by this valuation metric.

By: VIKRAM BARHAT

Date: April 23,2015

Every investor knows that to make money in the market they need to buy low and sell high. Some, however, don’t have a good grasp of how exactly to do that.

Many investors and advisors tend to look solely at price-to-earnings ratios – generally the lower the P/E, the cheaper the stock. However, a better ratio to use is intrinsic value, which involves determining the fair value of a stock by looking at a company’s future cash flows and expected growth.

It’s argued that intrinsic value is a better gauge of a company’s value than P/E, because earnings can sometimes be abnormally high or low due to unusual short-term events and circumstances. This can distort assumptions about earnings growth.

Discount buying

Joel Tillinghast, a legendary investor who co-manages Fidelity Investments’ NorthStar fund, has been buying cheap stocks and selling them at a higher price for more than 25 years. He’s big believer in the intrinsic value approach to stock-picking.

Mr. Tillinghast wants to find companies that are trading at a discount to that intrinsic value, and the greater the gap, the more attractive the pick.

“It’s a forecast about the present value of the future earnings and cash flows from a company,” he says, adding that intrinsic value helps him determine a company's long-term potential.

Such projections, though, only work if the manager can reliably predict the longer-term prospects for the business. That’s why Mr. Tillinghast prefers operations that are fairly predictable, aren’t changing too rapidly and have something that gives them an edge over the competition.

When picking stocks, Mr. Tillinghast taps into Fidelity’s wide network for ideas. The company has more than 800 investment professionals worldwide who share research and many take a similar research-based, bottom-up fundamental approach to investing.

While there's a lot he can choose from, he's ultimately looking for long-term money making operations.

“It [should be] reasonable to think they will still be profitable years from now,” he says.

Focusing on future cash flows

Intrinsic value calculations are often based on discounted future cash flows. A fund manager would take future cash flows – what the company is expected to generate minus what it needs to invest in its own business – and put a discount on those cash flows in the present.

In other words, if a fund manager had $90 today, he or she could it invest it for five years and have it grow to $100 over that time. If $100 is expected in the future, the manager would need to discount that back to today, to that $90. If it was uncertain whether the investment could reach $100, then the value would be discounted more to, say, $80, says Stephan Horan, managing director and education co-lead with the CFA Institute.

The manager is accounting for not having the opportunity to invest those future cash flows today and the risk associated with them potentially not being realized, he adds.

Mr. Tillinghast, though, is quick to point out that intrinsic value is not an exact number.

“It’s always a range,” he says. “Do not give me an earnings-per-share estimate to the penny. If you get it within a nickel or a dime I consider you’ve got that right.”

Moving metrics

Calculating intrinsic value can also be tricky, because it’s a moving target. It’s not uncommon for these assessments to have a short shelf life. Ideally, the number should grow – perhaps a company introduced a new product, merged with another business, or opened new stores – so it’s important to recalculate the figures once or twice a year to see if that metric has moved.

It is easier to come up with an intrinsic value for stocks in some sectors than in others. For instance, it’s harder to peg down the value of technology and biotech companies, where new products can make a huge impact on future business growth. It’s relatively easier to do for companies in defensive sectors, like consumer staples, where markets aren’t markedly violent.

“Seeing the future is just too difficult for some businesses,” says Mr. Tillinghast. “I prefer businesses that aren’t changing too fast. You always know you will be wrong, but you’ll be less wrong with businesses like Kraft, whose cash flows and sales are easier to project, than you would be with [online taxi-hailing service] Uber.”

Once he has determined the intrinsic value of a stock, Mr. Tillinghast will then compare it with the current stock price and similar companies that may also be on his radar. If he’s faced with making a choice between two businesses, he’ll generally pick the cheaper one.

That’s not to say companies that are trading at their fair value or higher aren’t worth considering. A company that’s close to its fair value could still trade, say, two times higher before they enter bubble territory, he explains.

However, the more expensive a stock is, the less margin of error a manager has. Higher-priced stocks tend to fall harder than inexpensive ones if something goes awry. If a fund manager doesn’t want to buy a business now, because the intrinsic value is too high, he’ll likely put it on a watch list of businesses he likes. He’ll then regularly recalculate that value and buy when the price is right.

The best businesses, though, aren’t just inexpensive. Future profitability is key and they must offer other attractive features, too.

“Look for company that has a strong balance sheet so the fund holders and banks won’t take away the business in moments of cyclical weakness,” says Mr. Tillinghast. “As a securities analyst, I’m interested in trying to make sure I believe those assumptions about the future.”

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