At the peak of pessimism between Feb to Mar 2020, many investors were worried about the headlines on how COVID-19 will destroy the economy. During times of great uncertainty, the market tanked at break-neck pace, dropping more than 33% in about 30 days and freezing many investors in their tracks.
“The present value of the stream of cash that’s going to be generated by any financial asset between now and doomsday.”
Warren E. Buffett on valuing a business
Impact on Intrinsic Value
It is important to understand that the intrinsic value of a business is the present value of all the cash generated over its lifetime. Most would agree that COVID-19 will be a temporary event. It would be silly to sell your stocks or to hold on to your investable cash because this year’s earnings would show a drastic decline due to COVID-19-induced lockdown.
In performing a discounted cash flow (DCF) analysis, the loss of 12 to 24 months of cash flow due to a complete shutdown would generally reduce a company’s intrinsic value by no more than 5% to 10%. However, we have seen many stocks crash more than 30%.
For those who love numbers, you may check out the DCF illustration here.
In this example, we will assume that the market has earnings of $12 per share with a discount rate of 4% and a multiple of 25x (4%) as the residual value.
Based on this illustration, if a company has no earnings for three months, its intrinsic value should decrease by no more than 1%. And in the worst-case scenario of four years of no earnings, the intrinsic value should drop by no more than 15%. However, by Mar 2020 we have seen most stocks decline between 30% to 60% even for high-quality companies. In other words, Mr. Market went into a major depressive mood and assumed that most businesses will have no earnings for more than four years.
If we believe that COVID-19 is going to cause a temporary dent to companies’ earnings, then Mr. Market definitely has served up some compelling bargains. Beyond my usual requirements, additional questions I focus on during this period would be:
- Is the company’s future earning power going to be permanently affected?
- Can the company survive this downturn?
Cutting through the Noise
As investors, we have to train ourselves to cut through the noise and focus on what is important. The media and headlines are written to capture readership and would more often than not, cloud our judgment. While these are legitimate concerns, here are some of the common reasons that kept investors from investing during the decline:
- The Shiller-PE ratio isn’t historically low yet
- We have not seen the bottom yet
- Unemployment rates are at a historical high
- Airlines are going bankrupt
- US debt level is exploding
- Interest rate is too low
- Oil prices are tanking
- And many more..
“I don’t think about the macro stuff. You know, I just – the important – what you really want to do in investments is figure out what’s important and knowable. If it’s unimportant or unknowable, you forget about it. What you talk about is important but, in my view, it is not knowable.“
Warren E. Buffett, on Macroeconomics (amongst other things)
I think it pays a lot for investors to remember this diagram when it comes to investing. And in this situation, the only things that matter are whether the company can survive and whether they will emerge stronger. What we can control is to invest in high-quality companies and ensure that we have sufficient emergency funds to tie us through this period.
To end off, here is an interview by Yahoo Finance around Feb 2020 with Warren Buffett on how he approach COVID-19, oil prices and politics. Enjoy!