The Value of Intrinsic Value

Originally, I was planning on this post being a condensed version of my most research report. Usually I’ll assemble an outline when I sit down to write, but today I neglected doing so since the plan was to use existing material. Fast forward an hour… I had written over 500 words, none of which had anything to do with Keweenaw Land Association. I’ll save that for another time, as today I ended up expounding a basic explanation of ½ of my investing philosophy: finding undervalued companies. This post is primarily aimed at those who have invested with me, as I hope it gives you better perspective on my approach.

 

Every transaction lies at the intersection of several questions: How badly do I want this? What can I afford? What is this thing truly worth? The first two are fairly personal questions, as the only relevant arbiter is the person asking them. The third question, however, is of particular importance, as it is the only one determined by outside forces.

Transaction Diagram

Answering the third question is as much art as a science. Amongst investors, the allure of knowing an investment’s precise value is tremendous. If we are 100% sure that Microsoft is actually worth $45, but is selling for just $35, we would certainly buy shares of Microsoft. To that end, investors have created many methods trying to find that quixotic value. Discounting future cash flows, comparing similar companies, examining relevant transactions, adding up the distinct parts of a company – all these methods are among those used in the attempt to assess a company’s worth.

There are some who are content with the notion that the market price inherently reflects a company’s true worth. This theory has been disproven so many times (such as here and here) that they gave the Nobel Prize in Economics to the economist who first proposed it. Luckily for us, there was another economist in the last century who had a better understanding of how to view the stock market.

When Benjamin Graham birthed the idea of Mr. Market – a parable for the stock market’s tendency to misprice equities, thus providing opportunities to enter or exit the market at advantageous times – he also refined our collective understanding of finding a security’s true worth. Calling it a stock’s intrinsic value (IV), he articulated the notion that although an exact IV was not calculable, creating a range of possible IVs was both possible and of tremendous utility. Since nobody knows exactly what the future holds, we can use fundamental analyses of a company to create a range of what it is likely to truly be worth. To paraphrase Graham, we don’t need to know exactly what a man weighs in order to tell that he’s fat.

Finding out a stock’s range of IVs is useful because of the flip side to Mr. Market; while he may be irrational on one day, he won’t stay that way forever. In other words, a company may be priced above or below its actual worth, but eventually it should return to a price more reflective of its IV. This process is explained thoroughly by Oddball Stocks, which substitutes the idea of gravitational pull in place of Mr. Market.

The need for finding an approximation of a company’s intrinsic value casts light on the difference between speculating and investing. Anyone can say that they expect a company to increase in price for qualitative reasons. Because said reasons are qualitative, they’re likely to sound convincing and be tough to refute. As humans we love the concept of the narrative.  Once we’ve chosen one, however, we typically seek factual sounding statements to support this narrative, even if that means dismissing facts supporting the other side. This helps explains why conservatives tend to watch Fox News, and why liberals tend to watch MSNBC; we enjoy hearing reasons why we’re right from figures that sound authoritative. Our tendency to do so violates another of Graham’s philosophies, as he realized the danger in investing based on a company’s story instead of its numbers. Stories can be twisted, altered, created or erased. Numbers can be interfered with (such as Enron), but they themselves do not lie, and therein lays the difference.

As I’ve alluded to before, I have no idea what the future holds. Furthermore, I caution you when a person speaking to you says that they know what’s going to happen, as it’s either insider trading or they’re full of s&%! (either way you should steer clear). But it’s because I concede that I’m uncertain about the future that I follow Graham’s advice. The range is there to accommodate our uncertainty about the future. Use it wisely!

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