Building and managing a portfolio
Value is what you get
This post is not about how to value companies. It’s about the concept of value.
A couple of basic concepts
First, the concept of intrinsic value. The idea that a security may have a value different from the price determined in the stock market is central to the investment philosophy followed by Ben Graham, Warren Buffett and many other very successful investors. I use the terms ‘intrinsic value’ and ‘fair value’ interchangeably.
In my eyes the word value always denotes intrinsic value. There is an absolutely crucial distinction between price and value. Investors should keep in mind Warren Buffett’s words in the 2008 Berkshire Hathaway annual report: “Price is what you pay. Value is what you get.”
Warren Buffett has written: “[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.” (Buffett W. E., The Essays of Warren Buffett: Lessons for Corporate America. 1998) p. 187.
At a meeting with University of Maryland MBA Students on November 15, 2013, Warren Buffett explained the concept in the simplest possible terms. This is from notes taken by Professor David Kass.
“We generally think the value of a company is the PV [present value] of cash flows until judgment day.”
Discounted Cash Flow (DCF) valuation is a standard approach taught in business schools and is used by professional business valuators. It has been used for at least eighty years.
In Berkshire’s 1989 Annual Report, Buffett notes approvingly that the DCF approach to estimating the value of income earning assets was described by John Burr Williams in The Theory of Investment Value (North Holland, 1938). It is an enduring approach to valuing shares.
From the foregoing we see that the value of a stock or any income earning asset can be estimated. Of course there is a skill in doing it. The most important thing to keep in mind is that it can only be done approximately, not accurately.
In his 1986 Chairman’s letter to the shareholders of Berkshire Hathaway, in discussing the valuation of companies Warren Buffett wrote: “We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.””
The point is that a properly done estimate of fair value is nothing more than vaguely right but, at least, it is coming at the problem the right way. So, when an analyst’s report says that the fair value of a stock is $38 this number is only vaguely right. Also, keep in mind that sell side analysts’ reports containing ‘target prices’ are not estimates of fair value. They are, what they say, ‘target prices’ based on simplified metrics, typically a price ratio to some number. One should place very little weight on them.
Since everything is vague and uncertain, we can also be comforted in the fact that we don’t need to value businesses perfectly. We just have to be good enough at it. In fact, since we let someone else, an analyst, do the legwork, we can take a more objective view of the estimate. The analyst who has carried out the DCF calculation has a vested interest in its accuracy. As a user of independent financial analysts’ work we investors can accept or reject the opinions expressed.
We simply must accept that there are tremendous inherent uncertainties in valuing a business. That is one reason we insist on buying with a margin of safety.
Book value represents the value of a company’s assets based on their original cost less accumulated depreciation, amortization and write offs. It is shown on the balance sheet. For some strange reason some people like to remove goodwill and intangible assets and treat the book value of a company’s assets as limited solely to its tangible assets. See also 35.03 Book value of equity.
In a world where intangible assets have gradually replaced tangible assets as the main source of company value, book value is becoming misleading and hence obsolete for investors.
The book value of equity is the company’s total assets minus its liabilities and also minus outstanding preferred shares. Some investors also subtract goodwill and intangible assets, which is a mistake. Since many companies trade at many time their book value of equity per share, we need to examine why. Much of it turns on the issue of intangible assets, accounting goodwill and economic goodwill.
A hated expression
Many in the investment industry use the expression ‘market value’ when talking about stocks. This is both confusing and wrong. In a similar vein, people use the term ‘overvalued’ when they really mean ‘overpriced’. To avoid confusion, I always use the term ‘overpriced’ rather than ‘overvalued’. I only refer to ‘market price’ not ‘market value’.
In fact, there are three words all investors should ban from the investment lexicon. They are: market value, overvalued and undervalued. Overvalued and undervalued are simply meaningless words when thinking about the stock market. The stock market does not value anything.
Diamonds, paintings and real estate
Many assets like diamonds, paintings and residential real estate are worth what people will pay for them. For these kinds of assets it is sensible to use the term ‘market value’. To make an assessment of the value of a house one must look at the price that comparable properties sell for. This is not the case with stocks. The stock market prices stocks. It does not value them.
As for income real estate, valuations are more complex. They can be valued using discounted cash flow methods based on funds from operations. As a cross check, for the building, a depreciated replacement cost can be used. For the land, only comparable market sales will do.
One subspecies of growth investing is GARP. This refers to growth at a reasonable price. It sounds reasonable enough. The notion is that one must keep in mind the danger of overpaying for growth. When we look at Benjamin Graham’s and Warren Buffett’s principle of buying with a margin of safety it will be apparent that one should never pay a reasonable price for any stock no matter what its growth prospects. One should only buy at a very attractive price which will give a margin of safety.
With misleading terms like ‘market value’ floating around it’s no wonder people get confused. Successful investor have a laser focus on intrinsic value. As we have noted, fair value can be vaguely, but correctly, assessed by looking at the present value of future cash flows.
Investors need a sound investment process. This post has not been about process. I have written a number of posts about process. See here for posts about value investing:
Investors need the resources (information and analysts reports) to decide what companies to buy. This post is not about that. I’ve written about this. See here.
Investors need to know how to go about buying stocks. I’ve written about this. See here.
To dig a bit deeper into the subject of value take a look at some of the sections in Chapter38. The Problem of Determining Intrinsic Value:
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