Hypothetical Company A - Intrinsic Value

If you have ever worked with me, you have probably experienced my rants about investing in companies when their market values trade below their intrinsic value. This can drastically help us in the long run concerning returns but also in regard to risk.

For this example, let us refer to the chart I created above. This (hypothetical) company's conservative intrinsic value is forecasted at $10/share (which is where we will make our initial purchase of 100 shares) but the share price is currently $15/share. This means our hypothetical company is trading 50% above its intrinsic value. Within the next year, fear about macro-economic conditions pushes investors to fear sell this company to a new low of $7. Let's assume that the company is of high quality from a balance sheet perspective with minimal debt and that interest costs are heavily covered by operating expenses. Let us also assume that we had priced in a recession in our valuation model which projects reduced revenues than historically would be the case.

• Had we purchased 100 shares of this hypothetical company at its intrinsic value, we would see a -30% decline in our market value!

  • However, from a relative perspective, this is much better than the max drawdown (-53.3%) seen by those who didn’t value the company and purchased at the top. Given that nothing has changed with the company, we should not be concerned because if we were happy purchasing at $10/share, we should be ecstatic about purchasing at $7/share. That means you could purchase the company 30% below its intrinsic value. Let’s say we had a little extra cash on hand that we didn't need, and we were able to buy another 25 shares (bringing our total owned shares to 125).

• Our average cost per share would be {(100@$10/sh)+(25@$7/sh)/125} $9.40/share.

Over the next year & a half, the macro-economic fears that had originally pushed that market value of our hypothetical company down have subsided and the market value of our company goes to $20/share. We, however, have a restriction in our mandate to sell our position in any company after the market value is above 25% calculated intrinsic value. At this point (1.5 years later), the intrinsic value has increased to $15/share • This means we would have sold our position at $18.75/share for a total return of 99.47%!

Let's say our value blind friend purchased the market value peak 1.5 years ago at $15/share but followed our advice to purchase at $7/share like we did.

• His average cost would come to {(100@$15/sh)+(25@$7/sh)/125} $13.4 o Our friend doesn't value his companies and therefore isn't concerned about selling when the market value is 25% above a conservative intrinsic value. So instead of selling at $18.75, he still has his stock when it is at its peak of $20/share.

  • This gives him a return of 49.25%.

    • By being less conservative, this investor missed out on 52.22 percentage points.

This is a completely hypothetical example, but not necessarily a rare or foreign one. I wanted to give this example because I often hear the term "more risk, more reward" which in general is true when you are considering low (or no) risk investments such as AAA government of Canada bonds, but when we are looking at a risk asset such as stock ownership in a company, it pays off to be conservative in your mindset and projections.

Don't buy solely into an idea. Purchase a company because they have a great idea, great management team, they are financially healthy, and their company is trading at or below what could be considered a conservative intrinsic value. This is difficult in many ways.

• It's difficult to value a company.

• It's difficult to not purchase a company when the market value seems to never stop climbing.

• It's difficult to sell a quality company when its market value becomes too expensive to justify holding it.

• It is difficult to go the path with most resistance, but when the market falls out from under you, you will be glad you did because:

1. Even though your company's market value has fallen -30%, you understand that it is likely to be financially fine due to all of the research you did when valuing the company pre-purchase. This may give you the conviction to purchase more, when everyone else around you seems to be selling.

2. You can sleep at night knowing you have done your research and that you did not overpay for a company (relative to the conservative intrinsic value calculated).

3. You gain comfort in knowing that you did not overcome to FOMO (fear of missing out) and as long as this newfound confidence does not lead to a hubris attitude, it can give you the strength to follow your financial plan through the good and the bad.

Do not fall into the trap of taking on unnecessary risk. You work hard for your money, do not throw it at any and all opportunities because not all will be good. Some will be expensive (which drives down the future return), some will be of low quality (which could lead to bankruptcy and total loss of capital), and some will be both!

• However, a select few will be of high quality and a great price.

Patience, humility, & risk aversion are what will help you generate true long-lasting wealth into the future.