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Book value is a company's earnings since inception that have been reinvested back into the business in the form of working capital, fixed capital, or other assets, rather than paid out as dividends or used to buyback shares. In other words, this is your money! So, add book value to operating value (sum of present value of earnings during the forecast and terminal periods) when estimating intrinsic value.

Of course, if book value consists entirely of goodwill, the company has lots of debt, and free cash flow is heading south, then you may never get your piece of the pie. Also, before you buy a stock, verify all numbers using the 10-K and or 10-Q. Yahoo makes mistakes.

My PIV-ER spreadsheet tells me the percentage of a firm's intrinsic value that comes from book value, the percentage from the forecast period, and the percentage from the terminal period (all adding up to 100%). The bigger the percentage of book value as a percentage of intrinsic value, the more carefully you want to inspect the quality of the firm's assets.

One of the classic mistakes investors make when using pro forma's to estimate real worth is buying a company where a large percentage of intrinsic value is from the terminal period. When you use a sanity test like the one I described in the preceding paragraph, you can see how much of intrinsic value is explained by current assets and earnings during the forecast period. The closer this percentage is to 100%, the better.

Consider Chesapeake Energy (CHK), which is mentioned in some posts above. If we believe a) its TTM earnings of $1.89 billion is what the company can earn across an entire cycle (business, commodity), b) analysts are correct about the five-year growth rate of 13.6% (which we'll use in our High forecast for years 1-5), and c) the $18.85 of book value does not need to be reduced by contingent liabilities like operating leases, employee stock options, etc. (it may, I need to check), then d) 17% of its $109 intrinsic value is due to the $18.85 of book value, 59% is due to earnings over the next ten years, and 24% due to terminal period growth. When I see that 77% of a company's intrinsic value is due to current assets and/or earnings over the next ten years, then I am confident the stock represents good value.

(I use a 10% discount rate above. If I used an 11% rate, then IV is $97. A 12% discount rate yields an IV of $88.)

A further point about book value…sometimes a company has hidden assets. In CHK's case, the per-share book of $18.85 may be understated if the market value of its natural gas reserves is higher than the amount listed on the balance sheet. If so, then CHK's corporate net worth rises, pushing intrinsic value up with it. (Phil Durell has done some good work on CHK for Inside Value, so if you are a subscriber read his write-up and check out the discussion board.)

For CHK, I get an intrinsic value of $109, PIV of 27%, and an ER of 264%, based on data from Yahoo Finance. I want to emphasize this is just a drive-by valuation, and is subject to revision after further study. But if this PIV-ER estimate is approximately right and since my portfolio's current PIV-ER is 49%-136%, then I should sell my worst-scoring PIV-ER stock and buy CHK. Like you, I want to keep pushing my portfolio towards the best possible risk-reward score.


Hewitt

p.s., Thanks for all the recs. It is gratifying to learn so many people find this idea useful.
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All of this stuff is really fascinating, really !!! It seems though that it is more "Inside Value" oriented than "Hidden Gems," of which I am a member. I also liked the Little Book concept by Joel Greenblatt, so I have been trying to rectify all these concepts in my mind to understand what I really believe, which will determine how I invest. I asked the AAP question on the other board and am now trying to calculate the PIV-ER of my Hidden Gems mainly portfolio. I have attempted to use the calculator that Dean provided, but for some reason it doesn't calculate for me - it says I must enable macros, but not sure if that is the problem or not because I couldn't find where to do that. Thanks Dean, I'll figure it out somehow. Keep up the good work though because I have really learned a lot. Thanks, Bob
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Bob,

When it asks you if you want to enable macros, you just need to click on the button that says "enable macros". If you do that, Dean's spreadsheet should work for you.

Huk
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What formula do you guys use for residual value? From a book I have, it's 1/DR*FCF*DF (this does not include any residual growth). From Dean's worksheet using Jim Gillie's DCF, it looks like he uses (1+g)/(DR-g)*FCF*DF (which includes residual growth).

DF=discount factor for that year (year 10)
FCF=free cash flow or earnings (year 10)
g=growth rate
DR=discount rate

In the CHK example above, I can't get up to 59% from years 1-10 without increasing my discount rate a whole lot or decreasing near-term growth or long-term growth rates. I'm using earnings of $4.35/share, BV of $18.85/share, and growth rates 13.6% first 5 years, then 1/2 that for next 5 years, then 3% indefinitely, with a discount rate of 10%.

Thanks,
Colin
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What formula do you guys use for residual value? From a book I have, it's 1/DR*FCF*DF (this does not include any residual growth). From Dean's worksheet using Jim Gillie's DCF, it looks like he uses (1+g)/(DR-g)*FCF*DF (which includes residual growth).

I use Jim Gillie's residual formula. Broken down, (1+g)/(DR-g) is the perpetuity formula. You multiply it by the beginning cash flow (in this case, the cash flow for year 10) to get the total cash flow for years 11 through forever. You then multiply that by the discount factor (which is 1/(1+discount rate)^years, where years is how many years out until the residual period begins, to get the current discounted value of the residual cash flow.

Paul
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Thanks, it looks like I'm doing it correctly then.
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