Value judgment

MARKET INSIGHT

Modern value investors have to deal with a lot more intangibles when taking a call on a particular stock. Here's why?

Value-investing is simple in theory. Judge the intrinsic value (IV) of a company and compare that to the prevailing share price. If the IV per share is higher than the stock price, buy.

You can easily generate buy signals. But you don't have implicit sell signals. Appreciation above IV may create a happy dilemma. What if the price drops? Do you average down, or do you set a stop loss and exit if that stop is hit?

The lack of an implicit sell signal may not be a problem if the original calculation has a large margin of safety built-in as Graham and Dodds advocated.

However IV calculations are fuzzy. There are many different methods. Coupled to the lack of sell signals, that lack of consensus means that this supposedly safe, conservative method of investing can actually carry quite large risks.

It wasn't so dangerous in Graham's time because he was studying manufacturing companies in a big bear market. Graham used book value as a proxy for IV. Book value is a reliable metric and plenty of companies traded below BV in the Great Depression.

In modern service economies, most businesses trade well above book value even in bear markets. While a low strike rate for a conservative investment method is okay, benchmarking to lower than BV would yield near-zero strike rates.

Most exceptional 21st century businesses are exceptional because of "intangibles" that are not captured on balance sheets. How you capture those intangibles is crucial. That is, if you assume an equation is Intrinsic Value = Book Value + Intangibles, you must try to calculate the intangibles.

There are several ways of doing that. The most common method is to estimate future earnings and discount them to net present value. The difference between that number and BV is the intangibles.

Future earnings estimates can be very unreliable, which is why Buffett sticks to the few industries, where he believes he can reliably estimate future EPS.

In the Indian context, projecting past EPS growth rates forward can give ridiculous results when the biggest companies regularly log large, fluctuating growth rates of 20-25 per cent or more in a very dynamic environment.

How for example, would you judge the future earnings of a telecom service provider or an engineering construction major moving into the power sector or a refiner integrating backwards into exploration and production? The current numbers offer few clues about the future.

Another method is to assume that intangibles are captured in higher (lower) than normal return on net worth. That is, if a company has a markedly higher (lower) RNW or NPM than peers, that is the effect of intangibles coming through. If it has a markedly lower ROC, the intangibles are negative. This concept of negative intangibles checks out if we look at PSUs, which have poor RNW compared to private sector peers.

Using this, it's further assumed that BV is the NPV of future earnings at the average peer RNW. The excess RNW will generate returns above the expected.

Say, a company has 30 per cent RNW when the peer average is 20 per cent and it has a book value of say, Rs 10 per share. Then the BV is taken to represent earnings generated by the average RNW of 20 per cent. The excess 10 per cent RNW should generate an extra EPS of Rs 1 in the next year. At an NPV of 7 per cent, that translates into Rs 14. So the intrinsic value is Rs 24 (BV+ Intangibles).

There are plenty of logical holes in this method "� you assume a big additional discount for excess performance. The advantage is that it doesn't depend on actual future earnings estimates.

Also, it can be easily computerised and applied to every listed company. The initial screens will eliminate the vast majority. But they'll still throw up large lists, which need to be fine-tuned through human intervention. You will need to filter further for liquidity, known news about the company and industry, other ratios, etc.

Given the subjectivity of the exercise, you should probably look for share prices, which are 20-30 per cent below the assumed IV. But despite the drawbacks, such a method of mechanically calculating intangibles could give modern value investors an edge.