This weekend it is the turn of John Authers–a key member of the FT’s resident brains trust–to nail his colours to the mast regarding market valuation. He believes that it is overvalued but that the timing of when this will be rectified is as unknowable as ever, i.e. this is not necessarily a market top.
I haven’t the slightest interest in attempting to guess what is and isn’t a market top because I intend to hold shares up to and (hopefully) through my retirement, but I do want to avoid over-paying, if at all possible. So, with that in mind, I think it is time to turn back to Ben Graham’s quick and dirty formula to suggest what intrinsic value might be for some of the key positions that I am still adding to in my portfolio, and for a few of the companies I would like to buy into, if I thought they were fairly priced. (Incidentally, I first looked at this formula in a post about a year ago: see here.)
Oh, and I know well the advice to be wary of geeks bearing formulas, but I will trust Ben Graham above other geeks in this respect. He spent many years thinking about how mechanical valuation techniques could be used by amateur investors to secure decent returns and this one–although it should never be used in isolation–I believe can provide useful clues.
The Formula
Disclaimer out of the way, this was Ben Graham’s updated formula for intrinsic value:
Where:
V = Intrinsic Value
EPS = Current (Normal) Earnings
2g = Twice the expected annual growth rate. I have used Morningstar’s 5- year average analyst estimates but reduced these by 15% to make sure the forecasts are relatively conservative.
4.4 = the average yield of high-grade corporate bonds in 1962, when the formula was devised
Y = the current yield on long-term (20-year) AAA corporate bonds. I will use 3.9, as per Yahoo Finance.
Diageo
Intrinsic value: (95.5 * (8.5 + (2 * 6.375) * 4.4) / 3.9 = £2289.55
Current price: £1762.5
RGV (Value/Price see here): 1.30
Verdict: Good value
Hershey
Intrinsic value: (3.75 * (8.5 + (2 * 7.73) * 4.4) / 3.9 = $101.40
Current Price: $90.87
RGV: 1.12
Verdict: Reasonable price for a dream company
Disney
Intrinsic value: (4.65 * (8.5 + (2 * 9.775) * 4.4 / 3.9 = $147.15
Current Price: $110.3
RGV: 1.33
Verdict: Good value for another dream company
IBM
Intrinsic value: (11.99 * (8.5 + (2 * 3.4) * 4.4 / 3.9 = $206.97
Current Price: $167.4
RGV: 1.24
Verdict: Good value for a highly profitable and very unfashionable company
JP Morgan
Intrinsic value: (5.46 * (8.5 + (2 * 7.39) * 4.4 / 3.9 = $143.40
Current Price: $67.42
RGV: 2.13
Verdict: Still in no-brainer territory, and will benefit from rate rises if and when…
Wells Fargo
Intrinsic value: (4.09 * (8.5 + (2 * 3.49) * 4.4 / 3.9 = $71.38
Current Price: $56.61
RGV: 1.26
Verdict: Solid value and Buffett bought more in Q1
Rolls Royce
Intrinsic value: (65.6 * (8.5 + (2 * 6.2) * 4.4 / 3.9 = £15.47
Current Price: £9.72
RGV: 1.59
Verdict: Clear value in a sector with strong long-term growth prospects and stable, long-term service contracts
GlaxoSmithKline
Intrinsic value: (95.4 * (8.5 + (2 * 1.19) * 4.4 / 3.9 = £11.71.02
Current Price: £13.99
RGV: 0.84
Verdict: Not in the buying zone due to its moribund growth.
Imperial Tobacco
Intrinsic value: (203.4 * (8.5 + (2 * 9.35) * 4.4 / 3.9 = £62.42
Current Price: £31.85
RGV: 1.96
Verdict: Clearly undervalued, but how sustainable is this growth in the very long-term? (I am aware that this question has been asked many times over the last few decades.)
Loews
Intrinsic value: (1.69 * (8.5 + (2 * 7.48) * 4.4 / 3.9 = $44.73
Current Price: $40.13
RGV: 1.11
Verdict: Not so cheap after all–intrinsic value pulled down by its low earnings.
Berkshire Hathaway
Intrinsic value: (8.66 * (8.5 + (2 * 5.61) * 4.4 / 3.9 = $192.67
Current Price: $140.76
RGV: 1.37
Verdict: Good value
Conclusion
The obvious variable in this formula is the future growth projection. Hopefully, after reducing the analyst consensuses by 15%, the projections used (taken from Morningstar’s average broker five-year estimates) are not too excessive. I am not that frightened by the current prices of my target list–of course, given a bear market their prices could see 20 or 40% price drops, but that doesn’t necessarily make an investment at a higher price a bad investment, if you are comfortable holding onto it for long enough for the value to emerge. In the meantime, lower prices just enable you to lower your average entry point.
So, this quick screen flags JP Morgan, Imperial Tobacco, and Rolls Royce as very strong candidates. My instinct is to be wary of Imperial, given the percentage of my portfolio that I already have in tobacco, but a few more JP Morgan might make sense. I am also pleased to see that Diageo and Hershey look reasonable at the moment, because I have added to both recently and hope to keep building bigger positions in these fantastic companies over the coming year.
Disclosure: Long BRK.b, HSY, IMT, GSK, DGE, IBM, JPM, and RR.
Disclaimer: This post is not a recommendation to either buy or sell. Please consult your investment advisor.