BATTLECALL GUEST EXPERT: Robert J. Abalos, Esq., InvestingInLand.com

Calculating the intrinsic value ("IV") of any equity or asset before you buy it is the cornerstone of prudent investing. Many people tend to overcomplicate the notion of what IV is or how to calculate it but whether you are buying land, stocks, apartment buildings, whole businesses or fractional interests in one, an IV analysis is a MUST.

What is Intrinsic Value?

Every investor or textbook writer has their own individual definition of what intrinsic value really is but in the simplest way I can let me define it this way:

Intrinsic value is the economic worth of an asset.

There is an old Wall Street expression common among Graham/Dodd value investors like Warren Buffett that says "Price is what you pay for something, value is what you get in return." That pretty much sums up intrinsic value. The concept of IV comes from the "Firm Foundation Theory" of investing which says that all assets have a calculable value but the marketplace in which that asset may be sold might not always accurately assess that value. Legendary author Benjamin Graham in his classic book THE INTELLIGENT INVESTOR calls this factor "Mr. Market" in that sometimes extreme optimism or pessimism drives market prices of assets far above or below the actual intrinsic value of those assets.

A simple example illustrates IV perfectly. Everyone can understand that the IV of a one-dollar bill is, well, one dollar. The economic value of owning a dollar bill is that it can buy one-dollar's worth of anything you want. Put another way, if someone found a dollar bill in the street, how much would this find increase their net worth? One dollar. Simple, right?

Now, what if you were walking down the street and you saw a man with a sign saying that he would sell you brand new genuine U.S. Mint one-dollar bills for eighty cents? He might have a wide variety of reasons for doing this (more on this later) but this man is not mentally ill and those dollar bills belong to him. He has the legal right to sell them. How many of those dollar bills would you buy for eighty cents each? Let me answer my own question. I'd buy as many of them as he'd let me. And I'm sure you would too. Why? Because you instinctively realize that buying a dollar for eighty cents is a good deal. What you don't necessarily see as quickly is the mental calculation that went into this decision. A dollar bill has an economic value (or intrinsic value) of one dollar so buying it for less means locking in a sure profit with no real risk.

Calculating Intrinsic Value

Here is where most investors make a mistake when it comes to intrinsic value. They assume the calculations are more complex than they really are.

Instead of one-dollar bills as in the above example, let's assume this man on the corner with a sign is selling shares of Microsoft stock for $1 each. Is that a good deal?

Some basic facts may help your decision:

• As of today (October 8, 2003) there are 10.82 billion shares of MSFT outstanding. So if you paid this guy with the sign $10.82 billion you would own the entire company.
• Microsoft had revenues last year of $32.19 billion and a gross profit of $26.5 billion.
• Microsoft has about $40 billion in cash sitting in its corporate bank account collecting interest.

So, let's do a basic IV calculation.

If you paid this guy $1 per share for the entire company, you'd get $40 billion in cash plus at least $26.5 billion more in profits over the next year for just $10.82 billion. That sounds like a great deal to me. Common sense here suggests that the value of Microsoft as a company is well over $10.82 billion so the IV of each share must be well above one dollar.

Well, today as I write this, MSFT stock is trading at $28.93 per share. That guy with the sign on the corner has moved inside and now calls himself by another name. NASDAQ. Is $28.93 a "good" price for this stock? In other words, is the IV of MSFT higher or lower than $28.93?

At $28.93 per share, you would need $266.17 billion to buy the entire company. This would get you $40 billion in cash instantly (so you really would only have to bring $226.17 billion to the settlement table with you) plus $26.5 billion in profits over the next year plus all the money that could be earned in subsequent years. The key question here what is the yield on investing $226.17 billion now to hopefully earn $26.5 billion or more each year for the immediate future? This is a time-value-of-money question that can be resolved a number of ways but the important issue for this discussion is that each MSFT share has an IV which we all agree is well above $1 per share.

Intrinsic Value Calculations

From a technical perspective, the best calculation of IV comes from its father, author John Burr Williams in his seminal book written in 1938, THE THEORY OF INVESTMENT VALUE:

"The value of any stock, bond or business today is determined by the cash inflows and outflows discounted at an appropriate interest rate that can be expected to occur during the remaining life of the asset."

Real estate investors use cap rate analysis to determine the value of investment properties all the time, a very similar approach to IV calculations. Here the goal is determining yield and not necessarily value. For example, if someone can buy a home for $100,000 that will net them $10,000 a year in income before debt service, the cash-on-cash yield is 10%. Switching around the numbers, this means that an investor looking to earn $10,000 per year on a 10% investment will have to find a home with an value of $100,000. Here the calculation is only for the first year. To calculate the IV, you'd have to do a series of inflow/outflow calculations over a number of years (usually to the approximate date you'd sell the home), plugging in a number of variable such as how fast could rents rise and when would major expenses owning this house occur.

Notice that the William's definition above says that the cash inflows and outflows need to be "discounted at an appropriate interest rate." Appropriate to whom? To each investor making the calculation. Most investors compare the minimum equity yield they want against the risk-free U.S. Treasury rate on their capital and make a rough risk assessment. If you can earn 2% risk-free buying government bonds, how much should you earn when buying an apartment building with considerably more risk? This is a personal decision, based more on marketplace factors than anything else.

But this point illustrates a key component of IV calculations. How much do you want to earn on your investments? In the above example, an investor wanting to earn $10,000 a year on a 10% investment would have to find a $100,000 rental home. But another investor who required a minimum 20% yield to invest in real estate would have to find a $50,000 property, something that may not be possible in their market.

Why is it important to define the yield just as much as the income stream received from the asset? Because you can earn $10,000 off a wide variety of investments, the key is how much money do you need to invest to earn that sum. If you invest $1 million at 1%, you still get the same $10,000 per year but you have to invest ten times as much money to earn it. Therefore, it is better to earn more on a smaller investment than less on a larger one. To be blunt, I'd rather own a $50,000 business that yields 20% than a $50 million business that yields 10%. Why invest more money to earn a smaller yield?

How This All Relates to Land Investing

You want to buy land selling for below its intrinsic value. Land, just like all other assets, has an IV that is quite easy to calculate, in fact, my Course simplifies the matter greatly by teaching that you should be buying land you can sell QUICKLY and not holding for the long-term. This means that all the time-value-of-money and discounting mathematics used when calculating the buy-and-hold yields of long-term investors is ELIMINATED. There is no IRR ("Internal Rate-of-Return") or other type of variable analysis necessary. What you as a land investor using my Course needs to care about alone is the CURRENT IV of a parcel of land because you will only be owning this land for a short period of time anyway. Buy-and-hold investors like Warren Buffett have to make rough calculations on what the dividend rate and earnings of a stock will be ten years into the future. You as a land investor using my Course only need to concern yourself with the current value of the land you are thinking about buying because hopefully in ten weeks (or less) you won't own it anymore.

How do you calculate IV on land? Simple. What is the economic value of the land you are thinking about buying? If the land is for single family homes, any homebuilder can tell you what the value of an individual lot should be for any particular type of home. The same is true with commercial properties of all kinds. In my area, for example, on average priced homes ($200,000 or less) in subdivisions, the land cost should be about 20% of the total price of the home. So if a builder was going to buy some land from you where they could build ten $200,000 homes, the IV of this land would be $400,000 ($200,000 x 20% is $40,000 x ten homes). So if you could buy this land for $350,000 you'd have a great deal. At $450,000 not so good a deal.

Yes, But How Do You Calculate Intrinsic Value To the Penny?

Intrinsic value is a concept of value. It suggests that all assets have an economic value that is not reflected by their market prices. In fact, most assets rarely sell at their intrinsic value. Most sell ABOVE their IV. People who have dollar bills to sell always try to get $1.03 or $1.05 for them. Markets by their nature are routinely more optimistic than pessimistic.

You don't have to calculate IV to the penny to have an excellent measure of value. You just need to have a pretty good guess on IV when making offers on the assets you want to buy.

As Benjamin Graham and David Dodd put it PERFECTLY in their classic book, SECURITY ANALYSIS:

"The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is ADEQUATE---e.g., to protect a bond or to justify a stock purchase----or else that the value is considerably higher or lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his exact weight."

(Original 1934 Edition, p. 18-19)

Let's say you do a number of IV calculations on a stock using many different variables and conclude that the IV of that stock is between $20 and $40 per share. That's a 100% difference in values. But what if this stock is currently selling for $5 per share? Or $85 per share? It is easy to see how your calculation, however imprecise, can send very strong buy or sell short signals. Just because the actual mathematical calculation cannot be made with greater accuracy doesn't mean the calculation itself has no value. It just needs to be placed in its proper context.

Buying Assets Like Land Below Intrinsic Value

Assets routinely sell for below their IV for a number of reasons. The most common reason in my experience is that investors just don't know what the IV really is so they think they are getting a great price when any price is offered! Other common reasons are market panics and selling hysterias, motivated sellers needing quick cash to pay bills or avoid foreclosure, market fluctuations on cyclical assets (like buying condos when they are in oversupply), and the narrowing of yields between various classes of assets due to changes in factors like interest rates, the value of the dollar, and others. The common theme here is that owners of land, properties, stocks, bonds, and whatever else will occasionally dump them regardless of the price they get for their own individual reasons. As an investor, those are the deals you MUST find to be successful over the long-term. Most assets sell above the IV, in fact, sometimes many times their IV. It is rare for great deals to be found but given the large number of stocks, pieces of land, houses, and all else that exist in the world finding bargains is quite common. If I told you that only 1% of all real estate properties in your area will ever sell at or below their intrinsic value you might get discouraged. But think of how many properties exist in your area in gross number terms? In my area it is in the tens of thousands.

When you buy assets like land below their intrinsic value, you accomplish two things at once. You instantly profit and you eliminate all risk of the transaction. You turn the conventional statement of "High Yield means High Risk" on its head. You earn a HIGHER yield with LOWER risk.

The key to building great wealth as an investor is to always trade one dollar of cash for more than one dollar of equity. Ask Warren Buffett. That's what he has been doing for nearly fifty years and he's done quite well for himself.

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