To gain a better understanding into Applied Finance’s Intrinsic Value Factor® , let’s first review traditional approaches to “Value”.
The traditional approaches to finding undervalued stocks use a simple ratio such as P/E or P/B, or a mix of them. These common approaches to value come with many shortcomings:
- They Rely on noisy accounting data
- They look at a static point in time, assuming world stays constant.
- There is no link to Intrinsic Value. Having a low multiple might just mean the stock is in financial distress.
- They are commodity factors, available to everyone on Yahoo! Finance.
Efforts made by well intended managers using traditional Discounted Cashflow Models (DCF) have their own shortcomings:
- Perpetuity assumptions Ignore the fact that companies will face competition
- Such models are highly sensitive to changes in discount rates or growth rates, leading to drastic variance in values
- Up to 70% of NPV of estimated cashflows typically come from perpetuity assumptions,
- Growth, Risk, and Competition estimates are subjective and inconsistent from one analyst to another.
With this in mind, nobody should be surprised by the fact that the majority of money managers underperform.
In contrast, the Intrinsic Value Factor® is distinctly different and superior.
Unlike traditional valuation approaches that utilize highly sensitive perpetuity assumptions, the Applied Finance approach incorporates the widely accepted economic reality of competition by estimating a company specific Economic Profit Horizon™. This essentially eliminates the excess spread a firm generates above or below its cost of capital to then discount those cashflows without a perpetuity.
Economic Profit Horizon™
Applied Finance summarizes this information in their Intrinsic Value Factor® report, which is available for 20,000 companies worldwide. Below is an example intrinsic value report of Micron.
2015 Intrinsic Value Factor™ score: Top 30%
Intrinsic Value Factor®
• The Intrinsic Value Factor® ranks companies from 0 to 100 (0 is the most overvalued and 100 the most undervalued)
• The Blue Bars represent the high and low trading range for a stock for 1 year.
• The dotted line represents our default Intrinsic Value through time.
• When the dotted line (Intrinsic Value) is above the blue bars (trading range) the company looks to be undervalued.
• When the dotted line (Intrinsic Value) is below the blue bars (trading range) the company looks to be overvalued
.• In 2015, the Intrinsic Value Factor™ identified MU as an investment opportunity because it was in the top 30% of undervalued names.
Each week we perform 20,000 valuations, over 20 million since our founding, to calculate an stock’s Intrinsic Value Factor™ score to help identify our portfolio’s best investment opportunities.