A lot of money has been lost in the stock market over the past year. But those who have lost the most were speculating in the shares of companies which were priced far above any justifiable value. These losses were inevitable. It was just a matter of time before the laws of valuation once again applied to stock prices.
The purpose of this writeup, an outtake from my book Low Risk Rules, is to revisit the basics of traditional stock valuation.
Basic principles of valuation
In the short run, the market is a voting machine but in the long run, it is a weighing machine.
—Ben Graham
Remember to ask yourself: am I buying a stock, or a business?
Yes, a stock is a piece of a business, but what I’m talking about here is your intention in making the purchase.
A stock has a price. That price can bounce all over the place.
A business has a value. That value is the present value of future cash flows. Full stop.
What the hell does this mean, you ask?
Let’s say we have a “business” that is going to pay you $100 one year from today. That’s it. Assuming there is no risk to receiving that money, and that a ten year government bond is paying you 5%, you would be willing to pay $95.24 for that business, and not a cent more. Why? Because if I invest $95.24 in a risk free government bond that promises a 5% return, at the end of one year I’d have that same $100.
If, instead, that “business” would pay me $100 in ten years, I’d be willing to pay $61.39 for that (assuming the same 5% discount rate).
So one variable is time. All things equal, I’m willing to pay more for cash in the near future vs cash far off.
Now let’s assume that there is some risk that you won’t be getting the full amount at the end of 10 years. In that case, you would likely demand a return in excess of the 5% “risk free” government bond. Let’s say you expect to be paid an additional 5% to compensate you for the risk involved. Now your discount rate is 10%, and you’d be willing to pay $38.55.
Play around with any variable above and it changes what you should be willing to pay for a business today.
The company’s tax rate goes down, increasing after-tax cash flows? Adjust the price up.
There is a delay in realizing anticipated cost savings from a merger? Push back that cash flow, adjust the current price down accordingly.
A potential change in government regulations jeopardizes a significant, profitable line of business? The certainty of your profits has declined, so you’ll want to increase that discount rate, knocking down the price of the stock.
The further that cash flows are in the future, the more challenging it is to value the company. This makes high growth stocks more difficult to value, because mathematically most of the company’s value is coming from cash flows being generated way out in the future. So you may want to increase the “discount rate” (that is, the hypothetical bond yield in the examples above).
Conversely, if I’m trying to value a company with near-term cash flows and a high degree of certainty in those cash flows (think of something like a regulated utility), I can value it with a lot more confidence, and therefore should be willing to pay more for those cash flows.
As an investor (not a speculator), your estimate of the value of a company is what keeps you sane. It’s what grounds you in your conviction to make decisions—buying, selling or holding a potential investment.
The quote that opens this section explains why price eventually gravitates to its true value. In the short run, market prices reflect the whims of participants rather than the true value of the underlying business. The challenge for most fundamental value investors is that the “short run” often lasts far longer than you expect it to, and can persist for so long that investors become convinced that it’s become the long-term. But inevitably, reality eventually wins out.
You might be able to fool the voters, but you can’t fool the scale.
The math underlying company valuations is like gravity, and gravity always wins.