Before We Start
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Why Care About Intrinsic Value?
Mohnish starts his chapter on intrinsic value by quoting Peter Lynch: “It’s a real tragedy when you buy a stock that’s overpriced; the company is a big success and you still don’t make any money.” It is critical to be able to quickly calculate a businesses rough intrinsic value.
Resources:
I used the following resources as a guide for this blog post.
Mohnish Pabrai — Intrinsic Value (Chapter 25, Mosaic)
Valuation Method 1: Relative Valuation
One of Mohnish Pabrai’s rules is that he doesn’t use spreadsheets to find a businesses intrinsic value. Buffett doesn’t even use a calculator. So how do they do it?
He starts out with a quick relative valuation — comparing the PE of our bank with competitors in the industry and industry averages:
- First, we need to find our businesses PE ratio. In this example, he uses a bank in India and it is trading at a PE of 6.
- He also asks what our business earns a year. In the example, our bank earns $100M a year.
- Since the PE is 6, we know the market cap of our bank is $600M.
- Then, we must ask “is this PE cheap and what should the PE multiple be?”. He says a bank should have a PE of 10–15X.
(Here, you can look at the PE of other banks, and the businesses own historical average PE ratio to get a sense. Then you can quickly see if a PE of 6 is below or above average.)
Next, he compares the growth rate to GDP, knowing that if GDP grows, the bank will grow with it.
5. He then links the bank’s growth to growth of the overall economy of India. He states that “banks typically grow at 2X GDP”. We can find this by looking at the growth rate of our business vs the GDP growth rate over time. We can also find the same metrics for competitors of our business.
(This is something Bruce Greenwald also teaches where he shows the impact of organic growth on a business. A metric like earnings as a multiple of GDP growth is a very solid, reusable yardstick and one that is often appropriate.)
6. He then asks, “what do you expect the growth of India’s GDP to be?” He estimates that GDP should grow at about 7.5% a year. He then reasons that since banks typically grow at a multiple of 2X GDP, it seems reasonable that our bank will grow their earnings at 15% per year. (2 X 7.5%).
Next, he uses the rule of 72 to forecast what earnings will be 5 years from now at our assumed growth rate.
7. He then asks what the bank will be earning 5 years from now, if it is growing at 15% a year. The student does the math and finds out that in 5 years, the business will be earning $200M a year.
Here, we can use the rule of 72. We simply divide 72 by 15 (72/15) and we get 4.8. We round it up to 5. We then see, the businesses earnings will double every 5 years. So if it earns $100M now, it will earn $200M in 5 years. That is why there is no need for a calculator.
8. Mohnish then finds a range of PE multiples the bank COULD theoretically be valued at in 5 years.
- If you put a 20X multiple on 200M of earnings, that is $4B
- If you put a 15X multiple on 200M of earnings , that is $3B
- If you put a 10X multiple on 200M of earnings, that is $2B
9. Ask yourself, “If I invest $600M now and in 5 years, I get $2B is that good? How about $3B? How about $4B? Are any of these outcomes acceptable answers?” Even a PE of 6 still in 5 years would give us $1.2B
Note: All of the three outcomes are good.
At a PE of 10, you get $2B, which is a 3.3X return over 5 years, or 66% a year
At a PE of 15, you get $3B, which is a 5X return over 5 years, or 100% a year
At a PE of 20, you get $4B, which is a 6.6X return over 5 years, or 132% a year
Mohnish then points out that none of this involves complex math, and we don’t need to rack our brains on what PE the bank will be trading at in the future. If earnings double in 5 years, we will do well. The PE doesn’t really matter.
He then goes on to mention that the bank could grow at 20% a year, or maybe slower at 12% a year, and you could do the math on those too, but still, all these outcomes would be good.
The Most We Can Lose
Since we know that if the bank can grow at 15% a year, and is likely to do so, and could even go as high as 20% a year, the upside of our bet is covered. We stand to gain a low.
But what can we lose?
Here, Mohnish starts asking about book value, in order to find the “floor” on intrinsic value (the most he can lose). He asks:
- What is the price to book multiple? It is 1X. That means the book value is $600M.
- So basically, as long as the bank isn’t exposed to business risk by having too many bad loan losses, or if they can absorb those loan losses with the $100M in earnings, the downside is protected.
- This is because the business is unlikely to be worth less than the $600M it has in book value.
Mohnish likes this example because can’t lose much but he can win a lot.(He is paying $600M, but the lowest it is likely to go down is to $600, so he would lose $0. But, his upside is potentially a 3–6X or higher). Therefore, heads, he wins and tails he can’t lose much — or in this case, tails, he is unlikely to lose anything since he is only paying $600M in book value and it is unlikely to be worth less than that.
Pabrai would likely spend the rest of the time analyzing the bank’s competitors, moat, and history to ensure it can actually grow at 15% a year. This is because he knows his investment return can’t be greater than the businesses return on invested capital.
Valuation Method 2: Discounted Cashflow Valuation
In this example, Pabrai shows us how to value Microsoft in 2001, using a simple Discounted Cashflow Valuation (DCF for short).
He starts by reminding us of a quote by John Burr Williams, Ben Graham and Warren Buffett:
“Any business is worth the sum of free cash flow it will generate from now to eternity, discounted to present value using a reasonable risk-free interest rate.”
Microsoft in 2001
Microsoft was trading at $70, almost 70% off recent prices, and had traded as low as $40, down from a previous high of $119.
He wanted to know:
Is Microsoft a good buy at $70 a share?
What about at $40 a share?
What is the true value of Microsoft (What is the company really worth)?
What type of annualized return would he get from buying the stock today?
Simple Data Inputs To The DCF Model
Pabrai needed the following information to build his DCF
- The Market Cap — $380B
- The Free Cash Flow — $4.5B
- How much it could sell for in 10 years (normally between 10–15, 15 for a great business and 10 for a lower quality one) — he picked a 15X sales price of year 10’s cashflows
- The value of Microsoft’s excess assets and capital (the assets Microsoft could sell and still continue operating and competing effectively)— he picked $41B
- He then forecasted a growth rate for Microsoft — growth from $4.5B to $6.3B in year 1, then 10% growth for 4 years, and 8% growth for 6 years after that.
- He then found the present value of each of those cash flows for year 1 thru 10 and also of the sales price in year 11
- The total present value of the free cashflows was $127B
- He then added the value of the extraneous assets ($41B) to the free cashflows ($127) to get $168B.
- He found there were 7.3B shares outstanding
- He divided 168/7.3 to get the value per share — $23 per share
Important Note:
These are pretty optimistic growth projections for Microsoft as 10 years is a long time. If you bought the stock at $23, you would only make 10% the first 4 years, and 8% the next 6 years if everything went according to plan. That is not a great return for everything going perfectly.
So even at $23, which sounds much cheaper than Microsoft’s previous low of $40, it is still not a good deal.
Add A Margin Of Safety
Mohnish mentions that a good margin of safety is 40–50%, and I noted that he used 45% in his example.
At a 45% margin of safety, you can afford to pay 55% of $23, or $13 a share.
At $13 a share, you would earn 20% in years 1–4 and 18% in years 5–10 if everything went according to plan. This would make it a safer buy and Mohnish mentions at the end of the article that he would consider Microsoft a “buy” in 2001 at under $13 a share. I believe this is because it meets Mohnish’s minimum threshold of earning 15% a year, plus some extra room just in case.
It is important to remember that in the long run, all stocks will trade around their intrinsic values
All you get as an investor is the earnings a business produces, discounted back to account for the time value of money. Therefore, make sure that you can still make a lot of money by purchasing the business at its current price, without the business having to accomplish amazing feats to do it.
Math From Another Angle
Mohnish also gave the math from another angle, which I found really helpful.
Let’s say Microsoft has a market cap of $235B and you wanted to get a 20% annualized rate of return for investing.
To get 20% over 5 years, the market cap would need to go to $600B in 5 years.
To justify a valuation of 600B, you’d expect a PE of 10 to 12.
That means at a PE of 10, FCF would need to be $60B a year. At a PE of 12, FCF would need to be $50B a year.
The Problem with this is at the time, in 2001, no company had ever generated $50–60B a year, so that’s very unrealistic.
It was also very unrealistic FCF would grow from $6.3B to $60B in the next 10 years.
Pabrai then went on to say that you should only buy if businesses are available at a deep discount from intrinsic value.
What Happened With Microsoft?
Mohnish was right about the free cashflows. Microsoft’s free cashflows now are about $45B a year, 20 years after writing. It took twice as long as his projection and the goal of $50-$60B was still not hit. This was with Microsoft accomplishing some pretty amazing feats and successfully navigating one of the greatest turn-arounds in business history under Satya Nadella.
Having said that, the current market cap is at $2.12T. If you had invested at the time Mohnish wrote this article you would have turned $235B into $2.12T in 20 years, a 9X total return or 45% a year. Having said that, most of the gain would have been in 2018 onward, one of the greatest bull markets of all time, with a fairly unlikely turnaround. Additionally, you would have had to wait for almost 15 years while the stock remained basically flat.
Summary
There is no difference between growth investing and value investing. Value investing is all about getting more value than what you pay and growth can be an important element of that. A DCF like Pabrai uses gives you a fairly quick way to test your assumptions. His relative valuation model gives an even faster way.
I also have been listening to Warren Buffett’s annual shareholder meetings and he uses the exact same approach to valuation as Pabrai. In fact, I am pretty sure he only uses Pabrai’s very fastest method, the relative valuation method since he never uses a calculator, spreadsheets, etc.
After learning about other valuation models, I am not convinced they are more sophisticated than Pabrai and Buffett’s DCF, or their relative valuation model.
As Buffett says, its better to be roughly right, than precisely wrong and the illusion of precision can be dangerous.
As such, I’d recommend learning a few simple concepts like present value, DCF, margin of safety and then spend the rest of the time thinking about why a business will be stronger and bigger in 10 years, or weaker and smaller.
Buffett mentions he is like a journalist, investigating why businesses succeed and fail and what makes them last or die, and I don’t think reporters spend all day inputting numbers on spreadsheets with formulas.
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