Time value of money : A dollar tomorrow is worth less than a dollar today, because one dollar today can be invested, yielding more than one dollar in the future. Because of the time value of money, a cash flow in the future must be discounted to the present to give its net present value. For example, if I am able to invest in a safe bond yielding 10% a year, a dollar a year from now would be worth only 91 cts to me today, because that is the amount of money that will give one dollar if invested in a riskless investment.
NPV (net present value) : The value of a future stream of cash, discounted to present dollars using an appropriate discount rate. The discount rate is composed of the riskless interest rate plus an equity risk premium. The riskless rate is typically taken as the yield of a long-term Treasury bond, because the US government has never defaulted on its loans.
Equity risk premium : The excess return over the riskless return that an investor demands for investing in a stock, in compensation for the additional risk. According the CAPM (capital asset pricing model) theory, risk in a stock can be divided into systematic risk and specific risk. Systematic risk is risk which affects the entire stock market and cannot be diversified away (wars, interest rate hikes etc.), and specific risk is company-specific risk which can be diversified away. Thus, the equity risk premium can also be divided into a systematic component, and a stock-specific component. Stocks with greater earnings variability has a higher equity risk premium compared to stocks with stable earnings.
PE (Price to earnings) ratio : The PE ratio of stocks vary depending on the prevailing interest rate, the rate of earnings growth, as well as the stability of earnings. The PE ratio is a reflection of the discount rate that has been used to discount future earnings to the present. A higher riskless interest rate results in a higher discount rate, which in turn gives a lower PE. A positive earnings growth implies more earnings in the future, and gives a higher PE. Increased earnings stability implies a less volatile stock price, reducing the equity risk premium, giving a higher PE. Thus, companies in commodity industries, which have little to no pricing power, and companies whose earnings fluctuate greatly depending on the business cycle both have historically low PE ratios.
Owner’s earnings : A term first coined by Warren Buffett, referring to the portion of the company’s cash flow that belongs to shareholders. He defined owner’s earnings as reported earnings + depreciation, amortization and other non-cash items – average annual spending on plant, machinery, equipment and research. I feel that this is a superior measure of earnings compared to other commonly used measures such as EBITDA (earnings before interest, taxes, depreciation and amortization), which leaves out very real business expenses such as interest and taxes, and net income, which includes one-time charges and non-cash items that do not reflect true business operations.
Intrinsic value : The true value of a company. This can be the net present value of the company’s future earnings, or the asset value of a company. The intrinsic values of most companies will derive mainly from their earnings and not from their assets, because their assets are required to support operations and cannot be liquidated. However, very occasionally, a company’s intrinsic value may derive largely from its assets, such as when a company owns assets worth far above its book price which can be realized through bankruptcy or a spin-off (asset plays are trickier because the return depends on the timing of asset liquidation, which can be unpredictable). When considering a company’s intrinsic value, the long-term debt carried by the company should be deducted from the NPV of its earnings. (Theoretically, any valuation based on earnings has already taken into account interest expenses, and the company can carry the debt forever as long as it can afford to pay interest, so deducting LTD from the intrinsic value is double-counting. However, practically speaking, most debt has to be refinanced at some point, incurring interest rate risks, so double-counting is a more conservative valuation appropriate for the added refinancing risk. In essence, I am expecting that the company will repay the debt in full in the future, which would save interest costs and boost earnings. The alternative method, to deduct LTD from intrinsic value but to exclude interest expenses from earnings is potentially dangerous, as management may make a bad deal on interest rates that will severely impact the earnings.) The intrinsic value of a company can deviate substantially from the market price, and a value investor capitalizes on this deviation.
