The prices may coincide or they may not.
The two values are intrinsic value and market value. In theory they could be the same, but history teaches us that there is no necessary connection. What we do know is that you cannot fool Mother Nature. Eventually market value will tend to fluctuate around the real value.
Intrinsic value is a function of what the business can earn. When you think about it, that’s what you buy or create a business for. A return on your money. The value of a business then is the sum of what you can earn during your holding period, plus what you can sell it for at the end. All discounted for time and an appropriate return on your investment.
You can use arithmetic to get an answer.
You will need to consider how predictable your variables are. Cash flow will go up and down as the business succeeds in its market. The effects of management, competitors and the market itself will all affect that. You cannot know how exactly, but you can still do a worthwhile calculation.
You can use the calculation as a template and you can revise it as you learn more.
Market value is the price at which you could buy or sell your position at any instant in time. Useful to have that ability. Liquidity is a huge value added.
The problem with market value is it is created in an auction environment. The price someone will pay must match the price someone else will demand. Bid and Ask in market terms. There is no arithmetic that lets us calculate an amount. It is or is not a number you like.
You must use psychology and other factors to get a value
Market prices are affected by much more than intrinsics and measurables. Market value is the price a willing seller can get and a willing buyer will pay. No one knows what their factors set is to create the number. It could change daily.
For example, someone may have a 1,000 shares of Wells Fargo that they intend to hold for the dividends. Today, however, they need the cash to pay off their ex-spouse. They are a price taker on that day and the special circumstance of their sale has nothing whatever to the underlying value of Wells Fargo. Similarly someone trying to take over a business pays a premium. The underlying value is important, but they are a special buyer that day.
Joining the two values.
Your intrinsic value may be different than mine and that’s okay. I might be willing to live with a lower rate of return than you or I might be willing to wait longer for the eventual sale. No matter. The template is based on what you want from an investment.
We each have a template that works for us.
The template tells us when the market is offering us a business for a price that is attractive. Or possibly when it is demanding a price we think is too high. Each of those conditions provide us with tactical advantage.
If the market says Widget Corp shares are worth $40 and our template says $60, then we should immediately assess our vision of Widget Corp. We could be wrong after all. If it is still sound, buy some more. If we think $60 and market says $90, possibly we should sell. Again after assessing the validity of our idea and considering taxes.
What’s so hard about that.
Nothing really, except analyzing the value of a business from its financial statement is not simple. You can make it a little easier by dealing with stable and responsible businesses, and by making a single recognition.
Cash flow and income are not the same thing.
In a financial statement, liabilities, cash, and cash flow tend to be real. Everything else is opinion. No one knows how much their inventory is worth really, or how fast they should depreciate their airplanes, or how fast they should write off research or advertising. Best guess only and you might quibble.
Cash flow and cash are more durable. You cannot fool with either of those without going to jail. There are a whole range of generally accepted accounting principles that manage the rest.
Eventually common sense prevails.
Businesses that make more cash get worth more because they have more options. Just like you.
Don’t overcomplicate the decision.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.
In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772