Value investors will typically speak of their intent to buy businesses below their “intrinsic value.” In our view, this is impossible.
We contend that there is no such thing as intrinsic value. Like the unicorn, it’s a myth.
Investors try to calculate intrinsic value in any number of ways, but most boil down to either a cash flow or asset-value approach. In the cash flow approach, an analyst forecasts a company’s future after-tax cash flows and then values that cash flow in present value terms. There are simple ways to express this using, for example, a relative price-to-earnings (P/E) or enterprise-value-to-earnings before interest, tax, depreciation and amortization (EV/EBITDA) ratio, which estimates the value the market places on current cash flows. There are also more comprehensive approaches, such as discounted cash flow analysis, which forecast long-term trends in profitability.
In an asset value approach, investors compare the company’s market value to some measure of book value. To offer a simple example, the market values of bank stocks are routinely compared with the book value of their equity. If we assume that intrinsic value is roughly equal to book value, it then follows that banks trading below book value are attractive, on the basis of this measure of intrinsic value.
No Crystal Ball, No Determining Intrinsic Value
In our view, both the cash flow and asset-value approaches lead to important insights, and can point us toward companies whose value we believe could be higher than the market’s current perception (i.e., price). This initial process must lead us to ask a more important question: What will cause the market to change its perception of value toward ours?
Because the “value” of a company is a function of future results, and none of us has a crystal ball, intrinsic value can never be known for sure; it can only be estimated (imagined).
Identifying a “cheap” stock is not overly difficult in most market environments. Multitudes of screening techniques can help us whittle down the universe to those companies that might be trading at a discount to our opinion of their intrinsic value.
The investment decision process, therefore, should focus on those factors that might favorably drive the market’s assessment of a company’s value. In other words, because intrinsic value cannot be known precisely, investors should focus on attributes that are most likely to impact the perception of value.
ROIC: Most Reliable Indicator of Profitability
Our research suggests that changes in perceived value occur when a company undergoes an unanticipated change in profitability. The most universal and reliable indicator of profitability is, in our view, Return on Invested Capital (ROIC). When ROIC improves unexpectedly, valuation multiples expand to better reflect the earnings power of a business.
For example, over the past few years, cruise operators such as Royal Caribbean Cruises Ltd. and Carnival Corp. have adjusted their business models to focus on ROIC rather than growth. Those companies previously had generated returns that were consistent with their weighted average cost of capital (WACC).1 Through prudent capital allocation and pricing discipline, Royal Caribbean and Carnival have been able to increase their margins, and, therefore, ROIC.
As a result, both companies saw significant positive changes to valuation. Over the three years ended June 9, 2017, the stock prices of both Royal Caribbean and Carnival have easily outpaced the broader Russell 1000 Index.
Prior to this change, the “intrinsic” value of these businesses reflected the reality at that time. Subsequently, the market had to change its perception.
In our view, focusing on the potential drivers of positive change is a better approach to identifying value because, just like the unicorn, intrinsic value exists only in our imagination.
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1Weighted Average Cost of Capital (WACC) is a calculation of a company’s cost of capital that proportionately weights each category of capital, including common stock, preferred stock, bonds, and long-term debt.
As of 5/31/17, 1.05% of Oppenheimer Value Fund’s holdings were in Carnival Corp.
As of 5/31/17, 0.76% of Oppenheimer Mid Cap Value Fund’s holdings were in Royal Caribbean Cruises Ltd.
The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000 Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the Russell 3000 Index. Indices are unmanaged and cannot be purchased directly by investors.