As you can see the calculation itself is fairly simple and straight forward. What is not easy when it comes to doing Intrinsic Value calculation is doing the fundamental research and figuring out which inputs to use. A slight deviation in any of the variables above can have a huge impact on your overall Intrinsic Value calculation and your subsequent valuation estimate.
For example, are you 100% confident in your management team analysis? Are you sure they will be able to turn the company around? Is your estimate of $0.50 EPS in 2015 and a growth rate of 11% thereafter really valid or is it full of holes? Are you sure the company turns around and what about the competition?
These are the real variables and the real questions that determine the Intrinsic Value. Yet, none of them can be known with 100% certainty. They can be very well researched and you can make very accurate estimates, but they are not exact. In many cases these are guesses at best. That is the point I want to drive home. You will NEVER have an exact Intrinsic Value, it will always be an estimate.
That is why Margin Of Safety plays such an important role. Let’s say you have worked very hard on determining RadioShacks Intrinsic Value at $10.72. With today’s stock price of $3.75, it gives you a 70% Margin of Safety. That is exactly what you are looking for. This type of a large margin of safety will protect you on the downside should your analysis fail to deliver.
If the management team has failed, if the growth rate or the P/E ratio don’t materialize the chances of this stock going much lower is small. Why? Because it is already selling at 70% discount from what a reasonable fundamental research and valuation work indicate. Should you make a mistake your losses will be limited. Yet, should the company surprise to the upside your return will be significantly higher. A low risk and high return setup.
Can the stock still go to zero? Absolutely. The company can still fail and file for bankruptcy, but if you have done your work right and continue to follow the company on the daily basis you should be well aware of that long before it happens. That is what value investing is all about. Finding these undervalued gems, doing a lot of fundamental research, valuing companies and trying to identify investment opportunities that sell well below their intrinsic value. That in return provides you with a low risk and a high return type of a setup.
Chapter Summary: If you take anything away from this section of the book, take away the fact that no Intrinsic Value calculation can be exact. Even complex models used by investment banks and Quants yield best guess estimates. There are just too many unknown variables that depend on future events that comprise the calculation.
That is why you will be very well served by doing your own fundamental research and concentrating on stocks that provide your with the biggest margin of safety and plenty of upside.
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