Podcast Transcript

Today I will provide a brief overview of valuation and why we need to calculate a business’s intrinsic value. In later episodes I will delve further into some of the different valuation techniques such as the discounted cash flow model, providing you with more detail on how to value a business. In this episode we will primarily focus on the difference between price and value.

Intrinsic Value is the calculated value of a business based on its fundamentals such as its level of risk. For example, if the business is carrying too much debt or if the industry under which it operates does not have a foreseeable future, this would greatly increase the risk of the business. Another fundamental item is how much cash flow the business is currently producing or can be expected to produce into the future and also is the business expected to grow and by how much.

Intrinsic business value and market price are not always the same. Market price is the quoted stock price you see on exchanges such as the ASX. This difference in price can be due to many reasons, such as; market hype from investors overreacting to news, a difference in valuations and business expectations between investors and also a lack of volume.

Market hype and the resultant fluctuations in price is best described using Benjamin Graham’s ‘Mr Market’ analogy. Benjamin Graham is believed to be the founder of value investing and in depth company analysis based on the business’s fundamentals.

He describes ‘Mr Market’ as having similar characteristics to a manic-depressive person, who is very emotional, temperamental and often irrational. Basically ‘Mr Market’’ is offering you, each day, the opportunity to purchase shares in a business. Some days he is very optimistic and asking inflated prices for his shares of the business, and other days he is very pessimistic about the business he is selling, and this is reflected in the discounted price he is asking for his shares.

It also is important to note that Benjamin Graham states that ‘Mr Market’ is there to serve you, and will never be offended, even if you keep refusing his offers day after day. Instead, you wait patiently for him to be in one of his pessimistic moods and present you with the opportunity to buy shares in a business at discounted prices. After all, the market in the short term is a voting machine and in the long run, a weighing machine. Meaning that in the short term the market can be quite inefficient and volatile, however in the long term the market will eventually reflect the true fundamental value of a business.

Differing business valuations can also be a reason why the market price does not reflect your own Intrinsic Value. This is because there are many different valuation methods all of which are likely to result in different Intrinsic Values which can sometimes be quite large. Warren Buffet sums this up nicely in his quote

“Two people looking at the same set of facts, moreover – and this would apply to Charlie and me – will almost inevitably come up with slightly different Intrinsic Value figures”. – Warren Buffett

So basically, one person may think the current market price is fairly valued, but another may have a differing opinion on the company in terms of its future growth prospects for example and see the current price as undervalued and a good buying opportunity.

Volume, or the number of shares traded day to day, can also play a large role in price fluctuations. This is because when there is only a small amount of shares available to trade for any given stock, it can result in quite large spreads between the buy price and the sell price. It comes down to basic supply and demand, if there are more people wanting to buy a share than those willing to sell it, the sellers will be able to demand a higher price as a result in the scarcity of shares available for purchase. This is something to be wary of when investing in micro cap companies which tend to trade infrequently.

Another example similar to low volume can be in times of panic, such as the recent crash due to the Coronavirus. You will find many people rushing to sell their shares in fear with few people willing to buy them. During these times of panic, volume is usually up but skewed to one side, meaning, when the market is crashing their will be more sellers than buyers, which again falls back to the supply and demand theory, if there are more sellers than buyers then the sellers will have to be prepared to offer lower and lower prices to find a willing buyer. This can often have a snowball effect, as people who focus too much on prices will watch their shares fall, begin to panic and then sell, which forces prices down further and entice more people to sell in fear. It is in times like these you must overcome your fear and back your investment thesis and buy when there is blood in the streets. Another famous quote by Buffett is

“to be fearful when others are greedy and greedy when others are fearful”. – Warren Buffett

We have now established the importance in understanding what a business is actually worth and the reasons why the market can often be so wrong when it comes to pricing a business. If we don’t consider value before making an investment, you could end up making a poor investment decision. No matter how wonderful the business, it can still be a poor investment if you pay too much for it.