Thursday, October 17, 2019

What is intrinsic value?

The value of a business to a buyer in a going private transaction is its intrinsic value. In other words, if a business is acquired by another entity, the amount exchanged for that business is its intrinsic value.

Quite often, investors confuse price and value. The price of a business is readily available throughout the day on the internet. On the other hand, the value of the business to an acquirer is not quite easy to determine. It takes some analysis, before coming up with an estimate of the intrinsic value in a going private transaction.

The price of the shares will fluctuate above and below the intrinsic value of the business, driven by the fear and greed of market participants. The market price is just based on the amounts that stock investors are willing to pay. The price is just their guesstimate of intrinsic value, but these opinions vary widely from day to day. In fact, these opinions vary more than the changes in a company’s intrinsic value. It is interesting to observe that even for large and mature large cap companies there is a large gap from year to year between the high and low prices investors are willing to pay for a security. This is why Warren Buffett and Ben Graham refer to the stock market as a manic-depressive individual.

For example, Johnson & Johnson (JNJ) has traded between $121 and $149 over the past 12 months. I would think that this is a high variation, driven by short-term news. I do not believe that the intrinsic value fluctuated that much over the past twelve months. This is why I prefer to look at dividends, since they are not the opinion of stock traders, like share prices. Dividends are the only direct link between company’s fundamental performance and investor returns. While everyone these days seems to believe that dividends are useless because share prices are adjusted downwards on the ex-dividend date, I disagree. I have long argued that dividends unlock value, as evidenced by special dividend announcements. Dividends accrue to share prices in between ex-dividend dates. And since dividends are directly linked to fundamentals, they are more stable and predictable than share prices.

Another way to unlock the true value of an enterprise is when it is acquired by someone else.

This was very evident with Versum Materials, which is a company whose stock I owned. The company was acquired for $53/share in cash in early October.

The company was a spin-off from Air Products & Chemicals (APD) in 2016. The stock fluctuated in price between a low of $22 in 2016 to a high of $53 in 2017, before dropping down to $25/share in late 2018.

Versum Materials initiated a quarterly dividend of 5 cents/share in 2017. It then raised it to 6 cents/share in 2018, before raising it again to 8 cents/share in late 2018 after two quarters. Shareholders received 15 cents/share in 2017, 24 cents/share in 2018 and 24 cents/share in 2019.

The company earned $1.93/share in 2016, $1.77/share in 2017 and $1.80/share in 2018.

In January 2019, the company was in talks to merge with Entegris, which resulted in an increase in the share price to almost $40/share.

By February 2019, Versum received an offer by Merck of Germany for $48/share. The company rejected it. Ultimately, Merck of Germany ( not to be confused with Merck (MRK), although both companies were connected before WWII)) had some wiggle room and managed to win Versum for $53/share. The intrinsic value of Versum was therefore $53/share.

It is interesting to note how shares fluctuated, but never really exceeded the intrinsic value. Anyone who ever purchased shares in Versum, and never sold, made money. Investors who held on to their shares after the spin-off from Air Products & Chemicals made money too.

I have seen examples where companies share prices sold above their intrinsic values. When these companies were acquired, many investors lost money on the transaction. This was evident with the acquisition of Whole Foods by Amazon in 2017. My conclusion was that you should not overpay for securities, hoping for future growth. That’s because if the stock is acquired, you may not be able to participate in the future growth of the enterprise. It is also possible that the rich valuation today is driven by opinion of future growth, which is a little too optimistic.  So investors should try to avoid overpaying for future growth.

The other lesson is to hold on to your spin-offs. And to trade as little as possible. In the age of zero-commission investing, it is easy to tinker too much with your portfolio.

Relevant Articles:

Price is what you pay, value is what you get
Does Paying a Dividend Reduce a Company’s Value?
Dividend income is more stable than capital gains
Financial Independence Is Easier to Model with Dividends

Popular Posts