Intrinsic Value vs. Market Price: The Excess Return Period And That Elusive Margin Of Safety

Abstract

The principle of convergence is well understood and most accept that in the long-term, market price and intrinsic value will converge. At any point in time, however, one may expect to see significant divergence between price and value. This analysis features a cross-sectional examination of 460 of the S&P 500 companies at a time when the market is under extreme duress. Of interest is the extent to which the market prices and intrinsic values of these firms are convergent, the value drivers responsible for the convergence/divergence, and the extent to which changes in the excess return period may influence valuations and, in turn, an investors margin of safety. A discriminant analysis provides a basis for distinguishing between those firms priced above and those priced below their respective intrinsic values and for identifying those variables that account for most of the between-group separation. Subsequently, intrinsic values are derived using different excess return periods and the resulting effect on the margin of safety is observed. Intrinsic values for the sample firms are derived from an estimate of free cash flow to the firm using Rappaports (1998) model.