Save Research Time With PIV-ER

If Wal-Mart's stock price is $48 and its intrinsic value is $71, then its price-intrinsic value (PIV) is 67%. This means we can buy a dollar's worth of value (part current net worth, part future earnings) for 67 cents. When you buy a company for less than it is worth -- its intrinsic value -- you give yourself a margin of safety to protect yourself against what Ben Graham called "miscalculation or bad luck." The lower the PIV, the bigger your margin of safety -- provided, of course, that your intrinsic value estimate is solid.

Having quantified risk, let's estimate upside potential. Wal-Mart's expected return (ER) is 48%, which I calculate by subtracting the stock price from intrinsic value and dividing that result by the stock price -- i.e., ($71-$48)/$48. Expected return tells us how much profit we can expect, in percentage terms, if we bought Wal-Mart at that price and the market immediately bid the Bentonville, Ark.-based retailer to fair value. The bigger the expected return, the better.

As mentioned, PIV-ER is conservative. Two of the three scenarios used in the test are based on growth rates below analysts' consensus, growth in all three scenarios is modeled to fall 50% in year six, terminal growth begins just 11 years from now, and 75% of intrinsic value is based on the Low and Medium scenarios.

I built these safeguards into PIV-ER because analysts' earnings forecasts are unreliable. In Contrarian Investment Strategies, legendary contrarian investor David Dreman found that the average error was 44% annually, based on a study of 500,000 quarterly estimates of more than 1,500 companies from 1973 to 1996. Given this deficient track record, a hopeful but cautious pro forma is the best policy.

How to Use It

Now that you can build a PIV-ER, here's how to use it to improve your productivity: Run every company in your portfolio through this test and then put their PIV and ER results into a spreadsheet. Then calculate your portfolio's PIV and ER. Assess every new investing idea's PIV and ER, and compare them to your portfolio average.

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At the time of publication, Heiserman had no, although holdings can change at any time.

Hewitt Heiserman conceived the Earnings Power Chart and the Earnings Power Staircase. A graduate of Kenyon College with distinction in history, Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. He also authored It's Earnings That Count. For additional information, please visit www.earningspower.com. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback; click here to send him an email.

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