Building and managing a portfolio
Value is what you get
In this post I discuss the seriously misunderstood expression ‘market value’. We can start with the well-known Warren Buffett quote from the 2008 Berkshire Hathaway annual report: “Price is what you pay. Value is what you get.”
Buffett is making a clear and critical distinction between price and value. Investors all know that what you pay to buy a stock on the stock market is a price. What you get may be another matter.
According to Buffett, a stock you buy may not be worth what you paid. Of, if you bought at a very attractive price, what you bought might be worth more than what you paid.
The question for todays post is whether it can be said, in any sense, that the stock market values stocks. It the answer is no, the term market value is an absurdity. For many investors, the answer to the question in not free of doubt.
Before we go further, let’s define the term ‘intrinsic value’.
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. (Emphasis added)
So, according to Buffett, the stock you bought at a particular price may have an intrinsic value different than the price you paid.
Now it gets interesting
Let’s go back to what the stock market does. Benjamin Graham is often quoted as having said “in the short run the market is a voting machine and in the long run it is a weighing machine.” People have tried to track down the source of this quote in both Graham’s classis 1934 book Security Analysis and also in the 1973 edition of Graham’s The Intelligent Investor, fourth revised edition.
They couldn’t find it because the words actually come from Warren Buffett, paraphrasing Graham.
The reason I’m digging into this is because of the question whether the stock market “in the long run …is a weighing machine.”
We can rephrase this. When you buy a stock, price is what you pay. Value is what you get, which may be more or less than you paid and may only be revealed in the market over the long run.
In this context, the expression ‘market value’ is misleading nonsense when we look at stock market prices today.
Back to Warren Buffett
On December 10, 2001 Carol Loomis’ report on the CNNMoney website contained an essay written by Warren Buffet based on a speech he had given the previous July. (Buffett W. , 2001) It may be found here.
Here, in part, is what Buffett wrote: “But I think it is very easy to see what is likely to happen over the long term. Ben Graham told us why: “Though the stock market functions as a voting machine in the short run, it acts as weighing machine in the long run. Fear and greed play important roles when votes are being cast, but they don’t register on the scale.”
Here’s what Graham actually wrote
Ben Graham wrote the following in 1934: “In other words, the market is not a weighing machine, in which the value of each issue is registered by an exact and impersonal mechanism, in accordance with its specific qualities. Rather we should say that the market is a voting machine, whereon countless individuals register choices which are partly the product of reason and partly the product of emotion.” (Graham and Dodd,1934 Security Analysis) He says nothing about the long run. This was Buffett gloss.
Why is this important? It revolves around the expression ‘market value’.
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.
The term market value probably has a useful purpose in relation to collectables like diamonds, paintings and also in relation to real estate that doesn’t generate income.
Can we ever rely on the stock market to express the value of a stock, even in the long run?
Now it gets confusing
The CFA Institute is a global association of investment professionals. Read and weep over what they say in their professional development refresher reading material:
“Most empirical evidence supports the idea that securities markets in developed countries are semi-strong-form efficient; however, empirical evidence does not support the strong form of the efficient market hypothesis.” See here.
Investopia tells us: “The semi-strong efficiency EMH [Efficient Market Hypothesis] form hypothesis contends that a security’s price movements are a reflection of publicly-available material information. It suggests that fundamental and technical analysis are useless in predicting a stock’s future price movement. Only material non-public information (MNPI) is considered useful for trading.
For present purposes we don’t need to get into the supposed difference between the strong and the semi-strong EMH. For this discussion they are essentially the same. It is incredible to think that investment professionals around the world are fed this craziness and I suppose a lot of them believe it.
Over to Warren Buffett
Warren Buffett: “Most institutional investors in the early 1970s, on the other hand, regarded business value as of only minor relevance when they were deciding the prices at which they would buy or sell. This now seems hard to believe. However, these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore calculation of business value – and even thought, itself – were of no importance in investment activities. (We are enormously indebted to those academics: what could be more advantageous in an intellectual contest – whether it be bridge, chess, or stock selection – than to have opponents who have been taught that thinking is a waste of energy?)” (Buffett, W. E. (1998). The Essays of Warren Buffett: Lessons for Corporate America. New York: Lawrence A. Cunningham) p63
What we have learned is that investment professionals today are taught the same nonsense.
The long run
Let’s briefly come back to the question whether the stock market values stocks in the long run, whether it is a weighing machine in the long run.
The best way to come at this is with a chart showing both prices and intrinsic value. This chart of Apple Inc. AAPL, is from Morningstar, a financial research firm. The black line shows prices over a ten-year period and the red line shows their estimate of fair value. Fair value means the same as intrinsic value.
Nobody knows for sure what the fair value of a stock is at any time. The red line is simply Morningstar’s best estimate. The two lines intersect from time to time, perhaps a dozen times over ten years. We might say that prices and values are the same from time to time. But that is not saying much.
Does this chart support Warren Buffett’s suggestion that the stock market ‘acts as a weighing machine in the long run’? I think the answer is yes but with a huge qualification. The two lines tend to travel very generally in the same direction over the long run. But, very seldom do market prices reflect intrinsic value; a dozen times in ten years does not suggest that market prices are the same a intrinsic value.
Conclusion
The conclusion has to be that the expression ‘market value’ is a contradiction in terms. The market prices stocks. It does not value them. Even in the long run, stock market prices only move generally in the same direction as intrinsic value.
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To dig a bit deeper into the subject of value take a look at some of the sections in the Motherlode Chapter 38. The Problem of Determining Intrinsic Value which includes the following sections:
38.02 DCF calculation – the inputs
38.03 The cash that can be taken out of the business during its remaining life
38.07 What discount rate would Buffett use today?
38.08 Changes to intrinsic value
38.09 An amusing quote on DCF from Warren Buffett
38.10 Conclusion regarding DCF assessments of value
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right hand side of this page to find references in both blog posts and also in the Motherlode.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
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