Getting to the fair price of the company is part of the daily job for millions of analysts around the world, but how do they do that or how would we do that? Well, it is a very hard question. Let’s firstly look at a simple example.
Imagine that you have a friend, Oskar, who manages a small business that produces customized, nicely framed USB drives. He is the only guy who produces them and sells them at the university. He also has been earning a stable cash profit of 101 $ per year for the last 2 years. Suddenly, he needs some money for a living and he decides to sell his business. Let’s assume that Oskar will stay in the business as a manager at least for 10 years for the symbolic salary of 1 $ as he has outstanding abilities to create USB drives. How much would you pay for this business?
Well, the facts say the following:
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Oskar managed to get 101$ during the last 2 years;
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He has outstanding skills in customizing USB drives;
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He will stay with the business during the next 10 years minimum;
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University students is a stable source of revenues for Oskar;
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Assume that as soon as you buy business from Oskar, he, as a manager, will pay you out all the profits that he will make during the next 10 years.
Now, to value the business you may start asking questions like:
Will Oskar make 100$ per year for the next 10 years? If yes, then during 10 years I will get 1000 $, so should I pay 1000$? Wait, but what are the benefits for me? I can go to the bank, make a deposit for 10 years, get, say, 2% percent =20 $ per year and then 1000$ back after 10 years *. This operation will be much safer because my return is certain and more profitable. Here we have to say a couple of words about the principle of uncertainty. Basically, it means that you never know how much the company will earn in the future and guess what?… no one knows it.
At the same time, you can estimate it fairly close if you analyze some major factors which account for the profitability of the company. In this case you make a sort of assumption that in the long run (periods from 3-5 years an on) minor good and bad factors will cancel each other out and only major factor will affect the direction of company’s price movement. Such factors include uniqueness of business, current conditions in economy, customers’ flow, competitors, managers’ abilities and many-many more. But still, your estimations are only estimations. Still, you bear some risks of being wrong. Of course, it’s much more pleasant if you were underestimating the company’s potential, but what if it is the other way around?
Ok, so how much would you pay Oskar for his business? Do you think that the demand for USB-drives will stay the same during the next 10 years? Do you think that Oskar will be able to sell these drives for the same price to make 100 $? Do you believe that Oskar can come up with some substitutions for USB’s? Do you believe that he can sell these drives at other universities? Are there any other opportunities for you to invest 1000$, like maybe another friend of yours, Arturs, who has just invested in a time-machine and offers you a share in his business? These are the questions that you might ask yourself when offering the price to Oskar.
Personally I would pay Oskar 500$: I know him as a good manager with sharp entrepreneurial feeling, I have heard that very similar businesses with customized iPhone cases were sold for 650$… but still there are too many uncertainties that might decrease the demand for Oskrar”s current product. This, basically, means that in the worst case scenario I would expect his business to bring on average 50$ of cash profits per year during the next 10 years. The question now is whether Oskar agrees to that price or not.
Most probably the example above brought to you more uncertainties than you had before, but uncertainty is what you will have to learn how to deal with while analyzing the company. In the example above, I, as a close friend of Oskar, know about his potential, so I valued his skills and product at 500$. Of course, if you had some better information about the demand for USB drives, you could offer 600$ or maybe 400$. This is the time when bargaining should take place and this is what happens in the stock market. As far as you see, there is no such a strict definition as the “fair value” or the “intrinsic value” of the company. Rather, there is an interval of values that should be considered as a fair price in the current situation. Some people say the market price already reflects the fair value, others would definitely object (we will elaborate more on that in the next article), but for now leave it as you understand.
So, what if Oskar’s shares traded on the stock market?
The beauty of the stock market is that sometimes it offers you a lower price for the company than it should be. Though, recently such situations have become rather rare in the real world, you can still find them. For example, the sellers in the stock exchange might ask for a price of 300$ for 100% of Oskar’s business. This is the point where I will step in and buy shares, because I believe their value to be 500$. As you can see, the difference between my estimations and seller’s estimations are quite substantial. Provided that I am fairly close to the true value of the company, I get a very good deal and a very good margin of safety. In simple words, the margin of safety means that I have a space for making a mistake. For example, you can also be a very good friend of Oskar, but you might have some more information about future potential development of USB-products, so the price that you estimate is 400$. In this case, I don’t have such information, but still I am insured against it, because I buy for 300$.
Why anybody would sell for 300$? Various reasons: the seller might urgently need a cash for personal expenses, so he doesn’t bother much about careful estimations; the speculator who bought shares a month ago hoping for an immense growth of value during the month and who now tries to get rid of them seeing another speculative issue; some foreign investor who bought them for 270$ a year ago and now he needs to adjust his portfolio by selling out some stocks from it, so he finds 300$ as an appropriate price and so on.
That was basically a short introduction to the value investing approach based on the simple example similar to the one in Joel Greenblatt’s book on stock market beating (for those who are interested I would suggest to look it up further).
Still, the question is opened: how did I arrive to the value of 500$ besides comparing with similar iPhone cases business?
Honestly, I looked through multiple examples in various books on investments, but none of them gave me the definite answer. Why? I conclude that there is no definite answer and if there was one, I doubt that somebody would share it. There are dozens of investment strategies, models for evaluation and in all of them you use your personal judgment and experience to arrive at the company’s value simply because the future is uncertain. We’ll share some examples of models similar to those that are done by financial analysts so that you can get the feeling about what we are talking about here. Some people (like Ben Graham) base their investments decisions on a set of seemingly simple rules; others focus on the present capacities of the company without digging into its future. We will talk about these things as well in other posts.
To wrap up and conclude:
· it’s hard to value even such a simple business as a USB-drive retailing, and now imagine how tough and interesting it is to value a company with hundreds, thousands of products, numerous assets on the balance sheet, creditors, active competitors and changing economic environment;
· if you got too scared but still want to invest in stocks– you can buy so called index funds or funds of funds which offer you multiple benefits of the stock market. However, with such funds you won’t be able to outperform the market;
· if you evaluated the company on your own, “buy” decision should be done with the margin of safety. Here I mean that it’s better to buy the company for 300$ if your calculations show the true value of 500$ instead of 330$.
· if you got excited, read more on investment evaluation, articles and books of Warren Buffet, Joel Greenblatt, Ben Graham and many other investors who give you a good piece of advice how you can tackle the company evaluation and improve your portfolio performance;
For more information look up for books and articles of Warren Buffet, Joel Greenblatt, Ben Graham; margin of safety; ways to value the company; index funds; our upcoming article “ Is it worth to pick companies on your own”;
* Look up for “time value of money”
