INTRINSIC VALUE INVESTING
Defining intrinsic value is easy; measuring it is extremely
difficult. That's because an intrinsic value investor must look further into the
future when assessing a company's performance than the one to three year horizon of most
market investors. In today's stock market, a dollar's worth of a typical company's
stock will pay the investor about two cents in dividends the first year. If
dividends regularly increase at a 6% annual rate that means the investor will only receive
11 cents of his money back during the first five years he owns the stock. At least
89 cents of the initial value of the stock, then, must be based on the company's
performance from year six onward, farther than most stock market investors typically
extend their analysis. Bond investors are used to looking quite far into the future
when pricing bonds.  That's because the duration, or
time-weighted average maturity, of a 30-year bond is more than 11 years. But the
duration of an equity security is even greater for two reasons. First, an equity
investors equity coupons - annual free cash flow - hopefully increase over time, which
means they are more back-loaded, i.e., farther in the future, than bond coupon
payments. Second, the equity investor does not receive a lump-sum principal payment
at a given maturity date, as in the case of bonds. For these reasons, the duration
of an equity security is almost always longer than the duration of a long-term bond.
By our estimates, the duration of the average stock in the Standard & Poors
Industrial Index is 17 years, 1 1/2 times that of the long-term government bond.
This makes the intrinsic value of equities much more sensitive than bonds to changes in
the real cost of capital. And that's why long-term analysis is much more important
to an equity investor than to a bond investor.
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