Students of Roger Montgomery's (Buffett's) intrinsic valuation method

Re: Students of Roger Montgomery's CRAP intrinsic valuation method

Sharpenter said:

how can it not be good for the company to do a share buyback below the intrinsic value of its own shares even if it is at a price above equity per share?

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If this statement is correct then

Sharpenter said:

If a company that does a share buyback below the equity per share increases intrinsic value and a share buyback above equity per share decreases intrinsic value

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can't be correct unless intrinsic value = equity per share.

Do you believe intrinsic value = equity per share? If not you have answered your own question - Something here does not compute.

If you define IV as the output of a static calculation you will always end up with these circular references that defy common sense. What is your definition of Intrinsic Value?

Hi Craft,

What you point out shows that I need to expand upon the point that I am making.

You are correct to state there is a contradiction in the reasoning but that is precisely what I am finding hard to reconcile. In Value.Able, Roger states a summary of points that help to increase or decrease intrinsic value (as calculated and defined by his income and growth multipliers formula) and amongst them are those two points which are that intrinsic value will increase if a share buyback is done when the share price is below the equity per share figure and conversely, intrinsic value will decrease when a share buyback is done with the share price above equity per share. That much is stated in his book and I assume it to be correct.

However, the point of confusion I then have is that as a retail investor Roger advises that it makes sense to purchase shares when their price is below the company's intrinsic value per share. If this makes sense as good investment advice for me as an individual, why would the same logic not apply to a share buyback scheme such that as long as the share buyback is conducted when the share price is below intrinsic value (not simply the equity per share value) it would also increase the company's intrinsic value?

An example will help explain much better than lengthy explanations.

ABC Company has total firm intrinsic value = $1000.
100 ordinary shares outstanding
equity invested in the company = $500
equity per share = $5
intrinsic value per share = $10

According to the reasoning in the book, a share buyback scheme when the share price < $5 will increase total firm intrinsic value and > $5 will decrease total firm intrinsic value.

My logic would suggest that any buyback scheme when the share price < $10 would increase the total firm intrinsic value because each share is being bought back at less than the intrinsic value per share.

Does this reasoning make sense to you?

Sharpenter said:

Does this reasoning make sense to you?

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Yes. Using your example again...

ABC Company has total firm intrinsic value = $1000.
100 ordinary shares outstanding
equity invested in the company = $500
equity per share = $5
intrinsic value per share = $10

And assuming the company buys back and cancels 50% of its shares at $6 (ie above equity value but below IV).

What will the company look like after?

ABC Company has total firm intrinsic value = $700.
50 ordinary shares outstanding
equity invested in the company = $250
equity per share = $5
intrinsic value per share = $14

The participating shareholders' shares had an IV of $10. They only received $6, so the remaining $4 flowed to shareholders who did not participate in the buyback.

Of course no one will ever actually agree on what IV is, and therein lies the mystery!

Thanks that's really useful!

I just wasn't sure if share buybacks were validated only if they were below equity per share value or intrinsic value per share and it seems that any buyback below IV will increase the overall IV per share of remaining shareholders by your reasoning. That helps put my mind at rest.

Re: Students of Roger Montgomery's CRAP intrinsic valuation method

The problem you are having reconciling the two statements is because they can only reconcile when IV equals equity per share. If IV isn’t always equal to equity value then the only reconciliation possible to make is: At least one thing Montgomery is feeding you is wrong.

Sharpenter said:

That much is stated in his book and I assume it to be correct.

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Assumptions can be costly.

I think a lot of RM’s stuff is dangerously wrong but spelling it out in detail is no longer on my to-do list. Maybe somebody else will jump in and explain better than I have but if not just keep exploring the contradictions like this that your common-sense can’t reconcile and you might avoid some costly lessons.

Don't be surprised if the reconciliations turns out to be RM is full of ......

Re: Students of Roger Montgomery's CRAP intrinsic valuation method

Sharpenter said:

Thanks that's really useful!

I just wasn't sure if share buybacks were validated only if they were below equity per share value or intrinsic value per share and it seems that any buyback below IV will increase the overall IV per share of remaining shareholders by your reasoning. That helps put my mind at rest.

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Sharpenter

Are you relying on RM's IV calculation as your measure of IV?

Yes Craft as a general indicative measure, though I appreciate it only gives a rough idea.

McLovin above appears to have answered the specific concern that I had though, do you disagree with his point?

Sharpenter said:

Yes Craft as a general indicative measure, though I appreciate it only gives a rough idea.

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I don't even think it does that. It's been discussed at length in this thread, and is worth reading.

Sharpenter said:

Yes Craft as a general indicative measure, though I appreciate it only gives a rough idea.

McLovin above appears to have answered the specific concern that I had though, do you disagree with his point?

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I agree with McLovin. (except for the math $250 closing equity

Buybacks don’t create any value* but they can however re-distribute benefit depending on how they are priced compared to IV (whatever that may be). If priced below IV then continuing holders benefit at the expense of exiting investors and the reverse is true for buybacks over IV, exiting investors gain at the expense of continuing holders.

Also agree that RM’s formula is not useful as even an indicative indication of IV. In fact I suspect that exact thought has cost plenty of people a lot of money. Only if you understand all the implied assumptions of the formula could it be a suitable shortcut for some situations.

RM has done his best to cloud the formula in secrecy for his own ends rather than highlighting the underlying assumptions and their limitations. – I think you would be better off with a really simple valuation model as a rough guide that you understand the assumptions of.


*except maybe to the extent that they can differentiate tax benefits to varying holders

Well it is interesting that you say consider using another valuation method because I remember watching a Bruce Greenwald lecture and he destroys the discounted cash flow model and its variants by saying that bad information added to good information ends in bad information. i.e. the inaccurate inputs mean the outputs become gibberish

Do you think that a simplistic p/e ratio approach has become valid now simply on the basis that many investors consider it to be useful?

Sharpenter said:

Well it is interesting that you say consider using another valuation method because I remember watching a Bruce Greenwald lecture and he destroys the discounted cash flow model and its variants by saying that bad information added to good information ends in bad information. i.e. the inaccurate inputs mean the outputs become gibberish

Do you think that a simplistic p/e ratio approach has become valid now simply on the basis that many investors consider it to be useful?

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Bruce Greenwald is a very smart man and I agree completely - Its not what valuation that a DCF spits out that counts its the thinking about value driving assumptions that matters and then the ongoing monitoring of how reality unfolds in relation to the assumptions that you made.

A P/E valuation model will do just fine initially to control 'valuation risk' ie the risk of you overpaying given current earnings, as a far bigger risk you face on most stocks is 'earnings risk' and you would be far better of trying to understand what drives earnings and in fact you have to have your head completely around this before a DCF valuation becomes even remotely accurate.

Sharpenter said:

Do you think that a simplistic p/e ratio approach has become valid now simply on the basis that many investors consider it to be useful?

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Any valuation approach that includes the price in the equation is flawed, in my view. I agree with Bruce Greenwald that the most accurate valuation approach is the asset-based approach because it involves the least amount of speculation about the future. The only problem with this approach is that it does not lend itself very well outside of deep value situations, i.e. to companies trading at or below net current asset value.

Rainman said:

Any valuation approach that includes the price in the equation is flawed, in my view. I agree with Bruce Greenwald that the most accurate valuation approach is the asset-based approach because it involves the least amount of speculation about the future. The only problem with this approach is that it does not lend itself very well outside of deep value situations, i.e. to companies trading at or below net current asset value.

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Another approach to valuation that does not speculate, not as much, is to invest in well established and dominant companies that are well managed.

These are companies whose business and industry is not likely to be affected by rapid technological and other changes, and whose assets and capital invested is so large that it's unlikely to be challenged by new arrivals etc.

These tend to be the top 3 in their industry... and once you studied them, happy with their current and previous performance and position, happy that the next 5 to ten years will be as they are (and most likely better)... price it and if the market price is reasonable or not, act accordingly.

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Asset-based valuation could also be misleading - say an asset that's $1 on the books may very well fetched 10 cents in a liquidation sale. I've picked up a few office suite for $10, $20 at auctions - sometime they just want to pay you to take it away to save them from having to dump it.


In my not so humble opinion, if you know enough about the business, valuation doesn't take very much effort. If you find that you're spending way too much time trying to value a business, it's either because you don't know enough about the business or be because you're trying to justify yours or the market's price - either way it's not a good way to invest.

I've spent the past few days trawling my way through Commsec financials and attempting to build a spreadsheet to calculate IV's for my shortlist (I assure you this is the very last step in my value analysis).

In this current climate I'm curious to compare IV's to current SP as one final point of reference.

I'm admittedly not great at maths and whatever I'm doing wrong may be glaringly obvious to some but I have spent hours and hours trying to figure out IV's on different stocks and I'm getting widely varying nonsensical results. I'm very thankful if anyone has any tips on what I'm doing wrong?

As an example IV on Pro Medicus:
Shares on Issue 103.6 (m)
Shareholder Equity 49.3 (m)
EQPS (book value) 0.48 ($)
ROE 38.8 (%) EOFY 2019 (rounded to 40% line in RM's table)
EPS 2020 0.237 ($)
DPS 2020 0.120 ($)
Payout Ratio 51%
RRR 10%
(0.48 x 4.00) *0.51 + (0.48 x 12.126) *0.49

IV= $3.84 Current SP: $15.50 (down from $38)

*Note no need for caveat emptor comments I realise this IV is not a silver bullet and I need to average RoE's etc. but for now I'm just trying out RM's method and can't get anything close to common sense answers.