The Search For Intrinsic Value: Some Selected Moments in the History of DPV

1. The Search For Intrinsic Value: Some Selected Moments in the History of DPV Professor Eric Kirzner June 2006

2. Security Valuation What people are willing to pay for it Risk contribution to a portfolio The consensus of the crowd Discounted present value of future dividends

3. Intrinsic Value  Price = Value Efficient Market? Security prices reflect all available information Security prices efficiently adjust to new information

4. Random walk Intrinsic Value  Price = Value

5. Intrinsic Value: Security Analysis 2. Fundamental: the Search for Intrinsic Value Prices and value can diverge: search for intrinsic value: compare to actual price Asset based; cash flow (earnings-based)

6. Intrinsic Value: Security Analysis Accounting Oriented Long history Ratios and relative valuation Value school Growth oriented Evidence re models back to 16th century Projecting Future cash values Search k and g

7. Security Analysis 3. Technical Analysis Prices reflect all available information Analysis of price and volume trading history used to predict future price directions Charts and patterns: momentum Dow Theory 1895 Edwards and Magee �Technical Analysis of Stock Trends:, 1952

8. Intrinsic Value The holy grail of investing is the search for intrinsic value From Roman Times to the present

9. Discounted Present Values DPV concept at least over 2000 years old �Annua� traced back to ancient Rome Annual stipends In return for a lump sum payment, these contracts promised to pay the buyers a fixed yearly payment for life, or sometimes for a specified period of term. Often bequests to non first-borns Life annuities! The Roman Domitius Ulpianus was one of the first annuity dealers and is credited with creating the first life expectancy table. Wadsworth, Findlater, and Boardman (2001) C 200 A.D., the Roman jurist Ulpianus had compiled the first recorded life table for the purpose of computing the estate value of annuities. The Roman Domitius Ulpianus was one of the first annuity dealers and is credited with creating the first life expectancy table. Wadsworth, Findlater, and Boardman (2001) C 200 A.D., the Roman jurist Ulpianus had compiled the first recorded life table for the purpose of computing the estate value of annuities.

10. Annuities! 1600s and 1700�s: governments in several nations, including England and Holland, sold annuities in lieu of government bonds lifetime annuities purchased with a single premium became a popular method of funding the nearly constant wars that characterized that period. See Charles Dickens and Jane Austen annuities were �all the rage� in European high society.

11. Tontines! Named for Lorenzo Tonti who first recommended a tontine form of government financing in 1652 special annuity pools: In return for an initial lump-sum payment, purchasers of tontines received life annuities. amount of the annuity was increased each year for the survivors who received the payouts that would otherwise have gone to those who died. When the last participant in a tontine pool died, the sole survivor received the entire remaining principal. The tontine thus combined insurance with an element of lottery-style gambling. First Option pricing model!

12. Abraham de Moivre (1667-1754) Mathematician (analytic geometry), physicist Friend of Newton, Halley Published �Treatise on Annuities on Lives� (1725) Valuation of joint annuities on several lives; pricing tontines

13. Johan de Witt 1625-1672 Lawyer, mathematician ( analytic geometry), politician (political leader of Holland 1653; settled two wars with England) �The Value of Life Annuities In Proportion to Redeemable Annuities� (1671) Derived a model for valuing a life annuity Crude approximation formula re how many people out of a group would die each year Calculated present value of each annuity and then priced it based on arithmetic average of all annuities

14.  Edmond Halley (1656-1742) Astronomer, mathematician Paid for publication of Sir Isaac Newton�s �Principia Mathematica� 1695 predicted that comet of 1531, 1607 and 1682 was periodic

15. Edmond Halley (1656-1742) Mortality tables based on five years of data: city of Breslau 1693 One of first to relate mortality and age in a population A step re production of actuarial tables Edmond Halley � Of Compound Interest� (1761) Formula for present value of a regular annuity

16. Early 1900�s Accounting book values widely used re valuation Stock market crash DCF gains popularity re valuation approach Irving Fisher, John Burr Williams However not until 1951 that NPV accepted as model for in capital expenditure decision Joel Dean, �Capital Budgeting� 1951.

17. Early 1900s: Two Paths to Security Analysis Value Investing and the accounting approach Growth Models and The DPV approach

18. 1929: The Great Crash: Dow drops by 90% from high to low Benjamin Graham (1894-1976) 1926 founded Graham-Newman corp. 1928 taught course on security analysis at Columbia Observes Great Crash focuses on crunching numbers not on qualitative factors Techniques that could be universally applied Available from publicly available sources price-to-earnings (P/E) ratios, debt-to-equity ratios, dividend records, net current assets, book values, and earnings growth.

19. Benjamin Graham �Many common stocks do involve risks of deterioration. But it is our thesis that a properly executed investment in common stocks does not carry any substantial risk of this sort and that therefore it should not be termed �risky� merely because of the element of price fluctuation.� The Intelligent Investor pp.121-122.

20. What Value Investing Is: Three characteristics according to Graham and Dodd 1. Prices of securities subject to significant and capricious movements Mr. Market -the Graham personification- willing to buy and sell every day Prices gyrate randomly: Current price will diverge from intrinsic value 2. (Many) securities have fundamental economic value values that are stable, measurable Disciplined investor using metrics Price and value rarely equal in short term Market a voting machine in short term

21. What Value Investing Is:Three characteristics according to Graham and Dodd 3. Appropriate investment strategy is to buy good companies but only when� market price is significantly below calculated intrinsic value This is margin of safety Ideally should be 50% discount and not less than 33% discount Intrinsic value is $10.00 Want to buy at $5.00; no more than $6.67

22. Value Investing: The Bright Line Margin of safety! Graham and Dodd If price established by Mr. Market is lower than intrinsic value by a sufficient margin of safety stock is a buy for the value investor!

23. Value Investing Why the growth skepticism? View that in many instances growth not worth anything at all! In a competitive environment all of the value of future growth may be consumed by additional capital necessary to fund the growth Profitable growth is that that produces returns in excess of excess capital needed

24. Value Investing Why the growth skepticism? Profitable growth is that which produces returns in excess of excess capital needed True growth companies generally have barriers to entry that restrict competition and constrain pure competition from developing Growth primarily valuable in a protected franchise Hence value investors focus on strategic position of company and how sustainable the franchise is.

25. 1950s Chairman Sen. William Fulbright Fulbright Q: �What causes a cheap stock to find its value?� Graham A: �That is one of the mysteries of our business, and it is a mystery to me as well as to everyone else. But we know from experience that eventually the market catches up with value.� Benjamin Graham testimony to the Committee on Banking and Commerce, 1955

26. T. Rowe Price ( 1930�s) (1) high quality R & D; (2) limited competition; (3) few government regulations; (4) well-paid employees but low labor costs; (5) a strong possibility of high return on invested capital and (6) superior growth in earnings per share.

27. NPV�s: Irving Fisher Fisher defined capital as any asset that produces a flow of income over time. A flow of income, said Fisher, was distinct from the stock of capital that generated it. � Separation of production and financing decision� Capital and income are linked by the interest rate. Specifically, the value of capital is the present value of the flow of (net) income that the asset generates. (Maybe) first to propose that capital project should be evaluated by present value

28. NPV�s: John Burr Williams Studied at Harvard Business School Security analyst Found stock valuation elusive: disenchanted with accounting based measures 1932; enrolled in Ph.d program at Harvard Joseph Schumpeter suggested intrinsic value focus for dissertation Hansen on committee was cheesed offHansen on committee was cheesed off

29. John Burr Williams John Burr Williams, � Theory of Investment value� 1938 (before completing thesis) One of first to interpret stock prices as worth intrinsic value using discounted dividends Future dividends can be forecast by �algebraic budgets� Estimates re earnings, growth, capital structure Williams models General DCF; declining dividend discount constant DDN, increasing DDM, sudden growth Hansen on committee was cheesed offHansen on committee was cheesed off

30. John Burr Williams Williams book contains the derivation of the constant growth model:

31. John Burr Williams � The last word on the true worth of any security will never be said by anyone but men [sic] who have devoted their whole lives to a particular industry should be able to make a better appraisal of its securities than any outsider can.�

32. Discounted Cash flow Discounted cash flow� Value today of a series of two or more future cash flows

33. Models1. Perpetuity Case

34. Models2. Constant growth: Williams, Gordon Model

35. Derivation Basic Cash flow

36. Derivation

37. Growing annuity Model Williams: VALUATION MODEL Gordon: DISCOUNT RATE MODEL

38. Models3. Variable growth:

39. Models4. Variable growth with transition:Wells Fargo et al.

40. Current Issues Factors affecting value Risk re expected cash flows Selecting appropriate discount rate Adverse selection and moral hazard

41. The Key To Long Horizon Investing Estimating k and g

42. Present value models Present value of dividends Need to calculate growth rate and discount rate

43. Cash Flows Free Cash Flow Net Income+ Non-cash revenue and expenses+ changes in net working capital+ capital expenditures � property dispositions Recognizes that some investing and financing activities are critical to firm These necessary expenditures must be made before firm can use cash flow for other purposes such as paying off debt or repurchasing equity Key measure for valuation models such as free cash flow to firm and economic value added Not a totally objective measure!

44. Discounted Present Values Challenges ko How estimated? Forecaster�s k or estimated market k (Keynes's beauty contest) Fixed or variable? Risk premium approach: stability? f (risk-free rate?; expected inflation�) Cft and growth how estimated? Short; long-term historic data? Reliability Growth: sustainable: protected franchise