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Determining Intrinsic Value and the Risk-Free Rate

IntrinsicValue
July 15, 2016

As captives have watched their book yields steadily decline over the last decade, the natural inclination has been to look for ways to arrest this fall.

A June 17, 2016, article by Jason Zweig of the Wall Street Journal, titled "Everything Is More Expensive Than It Looks,is the basis for this cautionary tale. However, as Mr. Zweig points out in his blog, investors need to consider the intrinsic value of the asset they are purchasing. For those of you who may need a refresher on intrinsic value, "The Simple Concept of Intrinsic Value," written by John Huber and published on the Base Hit Investing website is a good primer. 

Warren Buffett defined intrinsic value in his booklet, "An Owner's Manual," which was issued in June 1996 to Class A and Class B shareholders, in this manner: 

Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. [Emphasis added.]

A key component of this definition is the "discounted value" that relies on the use of a "risk-free rate" to be able to discount the cash flows back to present value. The problem arises today in determining what a true "risk-free rate" should be. With government bond yields hitting new lows in the United States and in negative territory in much of the developed world, the true risk-free rate is a matter of debate. All things being equal, the lower the risk-free rate the more future cash flows are worth today. Hence, as Mr. Zweig notes, everything looks expensive today. For investors, including captives, the trick comes in trying to determine what the true value of an asset is in today's turbulent markets.

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