How do we calculate Intrinsic value?
The intrinsic value shown on Screener is based on Graham number.
The formula is defined as below:
Intrinsic value = sqrt of (EPS * Book Value * maximum PE * maximum PBV) Maximum PE = Median Sales growth of 5 years x 1.5 Maximum PBV = ROCE of 5 years / 8
The concept of intrinsic value is an abstract idea. There is no standard formula for it.
History and reasoning behind the calculation
Graham suggested that an investor can pay a higher price to book value (PBV) if the price to earnings multiple (PE) is lower; and vice-versa. However, this multiple of PBV x PE shouldn't be more than than 22 times.
The number of 22 was the maximum PE he was willing to pay (16 times) x maximum PBV he was willing to pay (1.5 times): 16 x 1.5 = 22
This maximum PE of 16 and maximum PBV of 1.5 might be too conservative in modern times. It has been 100 years since Graham suggested those values. It was the time of the Great Depression when the growth was moderate. It was the time when the businesses rarely had any intangible value.
In today's era, the value of intangibles in the form of brands, patents, technologies and distribution is quite high. Keeping these in mind, we tweaked the Graham Formula a little bit. It is still conservative but retains the core intent of Graham.
Our formula for Graham Number
We have defined the formula for Graham number as:
Intrinsic value = sqrt of (EPS x our max PE x Book Value x our max PBV) Our max PE = median sales growth of 5 years x 1.5 Our max PBV = ROCE of 5 years / 8
Reasons for our max PE formula
Investors are usually willing to pay higher PEs for higher growths.
Taking the median sales growth makes this number conservative. Graham also suggested taking averages of 5 years instead of a single year value.
The range of this multiple is restricted between 8 and 100.
Reasons for our max PBV formula
The fair value of our assets is dependent on the returns they can generate. A business that generates 8% returns on its book value represents fair returns. But a business earning consistent 40% returns on its book value probably has some intangible value in it. Another business would have required 5 times the investments to generate those same returns.
Thus we have linked the PBV multiple to the extra ROCE that a business generates.
The range of this multiple is restricted between 1 to 10. The maximum PBV we will be willing to pay is 10 times.