To be a successful investor you need to know two things – How to Value a Business, and How to Think About Market Prices. Buffett wrote about this in his 1996 letter to shareholders. To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools , whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses— How to Value a Business, and How to Think About Market Prices.
1. How not to value a business
Our ability to process information is limited and we adapt to this limitation by developing heuristics that focus on few pieces of summary information. One such summary information is P/E ratio. Stock price has two components to it. One of them is the actual earnings per share and the other one is the multiple people are willing to pay for $1 of earnings. This multiple is called as P/E ratio and it tells a lot about market expectations for a stock. But using P/E to value a business is incorrect. Why is that? Price is what you pay and value is what you get. Price and value are not the same and value should be calculated independent of price. One of the component of P/E ratio is price and using that to calculate value creates circular dependency. In the book Accounting for Value Stephen Penman wrote about this.
PRICE IS WHAT YOU PAY, VALUE IS WHAT YOU GET. Unlike the efficient market investor, fundamental investors do not accept price as necessarily equal to value. Price is what the market is asking the buyer to pay, value is what the share is worth. Fundamentalists entertain the notion that prices can “deviate from fundamentals.” So they approach prices skeptically and they challenge prices to understand whether prices are justified by value received. They understand that one buys a business and the business can be a very good business—like Cisco Systems and Dell Computer—but they also know that good businesses can be bad buys—like Cisco and Dell in 1999.
WHEN CALCULATING VALUE TO CHALLENGE PRICE, BEWARE OF USING PRICE IN THE CALCULATION. If one seeks to challenge price, one must refer to information that is independent of price; price is not value, so do not refer to price in calculating value. An investor who estimates a value by applying a P/E (price-earnings ratio) observed in the past or from “comparable” firms is using price to calculate price. Analysts who increase their earnings forecasts because the price has gone up are on a slippery slope if they use those same forecasts in their valuations. And accounting that introduces prices into the financial statements—by marking to market, for example—is in danger of basing value on price. The analyst craves an accounting that is independent of price, an accounting that gives insights about value that can be used to challenge price.
2. A bird in hand is worth two in the bush
Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).
The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush — and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.
Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota — nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.
Money Never Sleeps