Intrinsic value is completely subjective. Everyone has their own methods of calculating, and thus different intrinsic values.
The NBS intrinsic value is very simple. The required return we want our companies to achieve is 10%. Our intrinsic value formula is as follows:
ROE/Required Return% X equity per share
ROE: Return on equity. The most important metric as it effectively summarises the earnings power of a business
The required return of the NBS Fund is 10%
Equity per share: the equity of a company is calculated as assets-liabilities. The total level of equity is divided by shares on issue.
The first half of the equation calculates our multiplier. Find a companies return on equity & divide it by your required return.
We multiply equity per share by our multiplier, to get the share price needed in order to achieve a 10% return.
Here’s a worked example
Required Return= 10%
Equity per share= $5
Share price= $25.
If we look at this in the simplest form, consider this to be a newly listed company. The business has raised capital through an equity issue, they issued 1 million shares, and raised a total of $5 million.
The business is able to generate a return on this equity of 25%. So, the original $5 per share would have grown to $6.25 at the end of year one (retained profits are recorded as equity).
Now let’s look at the share price. The share price is $25, we know equity per share is $5. The $20 difference is a premium.
Now that the shares have been issued, the publicily traded share price is simply a price tag for the earnings power of the business; which is the 25% return on equity.
People in the secondary market want to buy shares in this company, because this 25% return on equity is better than many other business’s in the market. What price should they pay?
It’s very simple maths. If we want the full earnings power (25%), we would simply pay $5 (equivalent to equity per share). But this is ridiculous; who in their right mind would sell their shares at that price.
Given the share price is trading at $25, lets have a look at how much of the 25% earnings power an investor would get buying the company at this price.
25% ROE divided by ‘x’, multiplied by $5 equity per share= $25.
= 5% return.
Paying $25 for this company would only yield us a 5% return, which is not a good enough return.
Let’s try the formula again, to determine what price we would pay for this company to allow us for 10% returns out of the ROE power of 25%.
25% divided by 10%, x $5.0
The above example is what the NBS investment philopshy is built upon. We are searching for excellent companies, who through strong barriers to entry will be able to sustain high returns on equity for a long time.
But ultimately, the price we pay (share price) determines how much of this return on equity we actually get.