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THE S&P 500 STOCKS are up roughly 100% since March 2020’s market low. I’m 100% clueless about how much longer this remarkable run will last. But I’m 100% confident that, when the next downturn comes, many investors will rush for the exit, fearful that their stock holdings will soon be worth little or nothing.
Which brings me to one of the most important investment concepts: intrinsic value.
No, intrinsic value isn’t a simple notion and, no, it can’t be calculated with any precision. Still, if we want to be more tenacious investors, I believe we should keep the idea front and center in our investment thinking.
Count the cash. How do we calculate intrinsic value? Perhaps the most widely used technique is the dividend discount model. The idea is to figure out how much cash companies will return to shareholders in the years ahead through dividends and stock buybacks, and then calculate the value of that cash in today’s dollars. What about share price gains? Those are effectively captured by the calculation: When we sell a stock, we get the current share price, but we give up any further claim on cash paid out by the company.
It might seem quaint to focus on cashflow to shareholders in an era when the S&P 500’s dividend yield is a tiny 1.3%. But the dividend discount model carries with it an important reminder: Almost all companies eventually disappear and, if history is any guide, a majority will deliver negative returns during their lifetime. The implication: Shareholders of many companies will collectively suffer share-price losses, but those losses can be partly or entirely offset—if these companies return cash to their investors before they shuffle off their mortal coil.
The fleeting existence of most companies has been discussed by no less than Jeff Bezos, founder of highflying Amazon. “I predict one day Amazon will fail,” he told employees in 2018. “Amazon will go bankrupt. If you look at large companies, their lifespans tend to be 30-plus years, not 100-plus years.”
To be sure, Amazon doesn’t currently pay a dividend, and nor do many other fast-growing companies, including Alphabet, Facebook, Moderna, Peloton Interactive, Tesla and Zoom Video Communications. For now, investors are fine with that because they want these companies to use their cash to finance their fast growth. But that rapid growth won’t last forever. The expectation is that someday these companies will indeed return great gobs of cash to their shareholders, and that’s the basis for their intrinsic value.
Dollars now are better than dollars later. How much is this stream of future cash worth? Enter the so-called discount rate. The dividends that a company will pay over the next 12 months are more highly prized than those that it might pay, say, 10 years from now. After all, we get to spend or invest today’s dividends immediately, plus who knows whether the company will be around 10 years from now?
To reflect this, investors discount those future dividends. What discount rate do they use? Nobody knows for sure, but it might be around 8% a year. In other words, investors might value a $100 dividend that they’ll potentially receive 10 years from now at just $40 to $50.
If investors are discounting future dividends at 8% a year, they’re effectively demanding that sort of annual gain as compensation for risking their money in the stock market. In other words, if we could figure out what the discount rate is, we’d have a handle on the return that stock market investors are collectively expecting.
We can only estimate intrinsic value. When we buy stocks, the hope is that earnings will grow, allowing companies to pay ever-larger dividends and buy back lots of their own stock, thus returning heaps of cash to investors. But we can’t be sure how fast earnings will grow, nor what the discount rate is or will be.
On top of that, stock buybacks are an iffy proposition. Many companies trim their buyback programs during rough economic times, such as early 2020, when stocks are on sale and investors should want companies to aggressively buy back their own shares. In addition, companies often finance large buyback programs by taking on debt—and that debt could put them in financial peril.
Currently, the S&P 500’s so-called buyback yield, which combines dividends with corporate spending on buybacks, is around 3%. If the amount of cash returned to shareholders grows at 5% a year and we apply a discount rate of 8%, we get an intrinsic value for the S&P 500 that’s fairly close to the index’s current level. What if the discount rate is higher or we lower the assumed yield to reflect the uncertainty surrounding buybacks? Today’s market would appear overvalued. On the other hand, perhaps the pandemic has temporarily depressed dividends and buybacks—and the buyback yield will jump sharply in the year ahead, making stocks seem relatively cheap.
Share prices fluctuate far more than intrinsic value. If intrinsic value can’t be calculated precisely, why waste time discussing it? Fear not: There is a point to all this.
I believe the stock market is fairly efficient, meaning that most of the time share prices are a reasonable reflection of underlying value. For proof, look no further than the dismal record of most professional money managers. Clearly, finding mispriced stocks isn’t easy.
That said, the stock market isn’t always rational. Suppose an economic catastrophe forced companies to nix all dividends and stock buybacks for three years. That would be an extraordinary development, one that might result in roughly an 8% drop in intrinsic value. Yet last year, during the early days of the pandemic, the S&P 500 plunged 34%. That didn’t make any rational sense, as HumbleDollar contributors Adam Grossman and John Lim have both pointed out.
The crucial lesson here: We may not be able to calculate intrinsic value precisely, but we should never forget that intrinsic value changes far more slowly than share prices. What if stocks plunge 30% or 40%? There’s a good chance that a slew of shareholders are having a brief moment of collective insanity—and offering more courageous investors a chance to buy at bargain prices.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.
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It’s taken me a long time to get comfortable with market declines.
Enduring or even ignoring them is one thing. Making them your friend is another.
Understanding intrinsic value is a solid step on the road to making market declines your friend. It can help you hold on to your investments despite large price declines. It can also give impetus to further investing when fear rules the day.
There is a hierarchy of knowledge in the understanding of intrinsic value. It ranges from the fellow who runs his own business, who knows exactly what sales and expenses are each month and how much money he is making, all the way to the fellow who invested his 401K in the S&P 500 because he read a few Boglehead articles saying you can’t beat the market.
Does the fellow buying the S&P 500 know what stocks are in the index? Does he have any idea what their business strategies, cash flows, and balance sheets look like? Does he even know that the S&P 500 is cap-weighted, and 30% of what he is buying consists of 6 high-priced tech companies? Probably not.
So over the past decade, he has racked up impressive profits without having to know much about corporate finance or stock trading. He may have put in $200K from his salary, and now he’s sitting on $800K. If the market started to go down over an extended period, he’d probably shrug it off at first…..$700K, no problem, $600K, this doesn’t look so good, $500K, what the heck is going on?….$400K GET ME OUTTA HERE! Yes, the most unsophisticated investors sell a the bottom, because they don’t know what they’re invested in. That’s why there’s total capitulation at bottoms.
I would say that if they’ve made their way to Boglehead forums, they’ve probably read things that make sense to them, like how counter-productive it is for the average investor to try and beat the market. They probably understand market caps and how easy it is to look at the Top 10 holdings in an index fund. They probably understand that while they are invested heavily in those top 10, perhaps more than they realized, “the S&P is the greatest momentum strategy in the world because it buys more of the best ones and kicks out the bad ones.” Sure, it may not hurt to add in some diversification, and you can likely find time periods where overweighting to small caps, etc. outperforms, but the average investor would probably not have time to do all of the necessary rebalancing just to possibly eke out a tiny margin over the S&P.
They probably know that a consistent drop in their retirement balance doesn’t signal a time to sell, but rather a time to buy more. And really, this is the only thing they need to know. This average “dumb” investor who knows nothing about their S&P500 index fund will still be richer than the average “smart” investor who thinks he knows how to “find value” with their market beating strategies.
When thinking about intrinsic value I sometimes review Buffett’s analogy:
You can gain some insight into the differences between book value and intrinsic value by looking at one form of investment, a college education. Think of the education’s cost as its “book value.” If this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college rather than a job.
For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education.
Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn’t get his money’s worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.