Value errors are key to market

SHARE prices pitch and roll in reaction to all manner of influences, many of which have no real impact on the value of a business.

SHARE prices pitch and roll in reaction to all manner of influences, many of which have no real impact on the value of a business.

Even monitoring share prices over the short term can cause shareholders to lose both their appetite and hair.

In the long run, however, prices are more predictable. They follow intrinsic value, and over the years I have developed a formula to calculate this, which many ultimately achieve.

As an investor your job is to buy shares of extraordinary companies at prices lower than their appraised intrinsic value and whose intrinsic values are estimated to rise at a good clip.

Suppose I have a hypothetical bank account in the name of Roger's Valuations, in which $10 million has been deposited. This account earns an after-tax return of 20 per cent a year, fixed for 30 years. The interest cannot be reinvested. At current interest rates on bank accounts of 5 per cent (pre-tax), my $10m account looks very desirable. I suspect quite a few people would be willing to buy it.

Now suppose I offer the account for sale and I decide I am going to auction it.

What should you pay for it? Without any arithmetic, you know it is worth more than the $10m sitting in the account. If the money in the account represents my equity, or book value, the intrinsic value of this account is higher than that.

The world's greatest investor, Warren Buffett, said it took him a while to work that out, but his purchase of See's Candy at three times book value proves he did (Buffett is said to have made more than 2000 per cent on that investment).

How much more than the equity is the true value of the bank account? An auction would would be one way to discover what people are prepared to pay, but people can get carried away in an auction environment. If I marketed it really well I might be able to generate some excitement and extract a really dumb price from someone. But that price may not necessarily reflect what the account is worth, either.

So what would be a dumb price? As I mentioned, some banks are offering interest rates of about 5 per cent and they offer the benefit of reinvestment, thus compounding.

I would argue that someone would be paying a dumb price for the Roger's Valuations account if the interest from it amounted to less than 5 per cent. That's not to say it wouldn't or couldn't happen, just that it would be irrational.

To calculate this dumb price, we simply divide the after-tax return being paid by the bank account (20 per cent) by the return the investor would be content with - the dumb return (5 per cent) adjusted for tax, say, about 3.5 per cent after tax.

We then multiply this amount by the equity, or the balance of the bank account. In the above example, this would look something like: 20 per cent of 3.5 per cent by $10m equals $57.1m.

If someone paid $57.1m for this bank account, that would be a very high and very dumb price, because the return they would receive would be a low, non-cumulative 3.5 per cent after tax.

You can check it: a $10m account at 20 per cent earns $2m. Earning $2m on the $57.1m paid for the account is equivalent to a 3.5 per cent return.

As an aside, because the 20 per cent in the formula represents the return on equity, which in turn equals profit divided by equity, the two equity items in the formula cancel out and you are left with: $2m at 3.5 per cent equals $57.1m

Using the same formula from which the dumb price is derived, we can also use it to arrive at the bargain (low) price.

If you were to pay $10m - the amount of equity actually in the bank account - that would be a bargain because you would end up receiving a 20 per cent annual return after tax (let's leave inflation out of the discussion).

Applying the formula produces: 20 per cent of 20 per cent by $10m equals $10m.

Therefore, paying anything lower than $10m would be an even greater bargain.

It occurs to me that you might be thinking you could never buy this Roger's Valuations account at auction for $10m, so forget about buying it for less.

In a rational trade sale environment, you would be correct. With the vendor and purchaser in a locked room with only their lawyers and accountants attending, it is less likely that a real bargain could be obtained. But thanks to the continuous auction environment of the stockmarket, with its enormous liquidity and everyone focused on what the price will do next, irrational reactions to events unrelated to the bank account's earning power frequently push prices to both dumb and bargain levels.

Our job now is simply to wait for the market to do something dumb. Thanks to our estimate of a company's intrinsic value, it is easy to see when that is occurring and to take advantage of it. What a relief to be able to see the ebb and flow of ever-changing sentiment for what it is. Soon you will be an investor and you can turn your back on spectating forever.

Roger Montgomery is the founder of Montgomery Investment Management and author of Value.able: How to Value the Best Stocks and Buy Them for Less Than They're Worth, available at www.rogermontgomery.com