The Intelligent Stock Investing

A business is worth the present value of the future cash flows it generates from now until doomsday. Present value is in the eye of the beholder, for its realization is entirely in the future. People will disagree at virtually every step of the process of figuring present value, including the methods used and the different answers they yield.

Gazing into the cloudy crystal ball of valuation, you can never be sure of the accuracy of forecasts when you make them. Yet since your future wealth is at stake, you do not want to fly blindfolded even if you cannot predict the future. What you can do is minimize the hazards of your errors.

What drives cash flows are assets and earnings. These factors and historical cash flows are the best gauges for thinking about probable future cash flows. You could figure value based just on assets (something called book value), based just on earnings (what the earnings stream is worth), or from the cash flows (the worth of the dividends paid out to shareholders).

However, none of these separate valuation tools in itself is usually sufficient to determine the value of a business. Not only is none of them definitive, all of them together remain imperfect, for all share the inevitable and irremovable infirmity in any valuation exercise: using current and past information to forecast future cash flows. You'll need information about all these things to aid your judgment.

Some valuation tools are more useful for certain businesses than for others. For example, GE generates earnings and pays cash divi­dends, Microsoft generates earnings but does not pay cash dividends, and Amazon.com does neither. Obviously, you can value all three companies by using asset measures; you can value GE and Microsoft based on earnings, and GE based on dividends.

Less obviously, you could use all these tools—but in different ways—for all three companies. That is, estimated future earnings and dividends can be made for all three (relatively easy for GE, less so for Microsoft, and very hard for Amazon.com).

If these companies are within your circle of competence, you can do it. You can do it even if you are nervous about using the huge number of valuation techniques that are discussed in innumerable books or below because none of them will enable you or anyone else to pinpoint with precision what the value of any business is.

At best, these techniques produce a range of values that depend on your interpretation of history and prognosis for the future. These acts expose you and everyone else to risks of error, and those risks are precisely why Ben Graham insisted on getting a thick margin of safety between the price paid and the value one could reasonably expect to get. Every trading stock investor follows that principle.

In the most famous chapter of The Intelligent Stock Investor, Graham wrote: "In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, 'This too will pass.' Confronted with a like challenge to distill the secret of sound stock investing into three words, we venture the motto, MARGIN OF SAFETY." 1 Commenting on this passage over 40 years later, Warren Buffett said he still believes those are the right three words.

Getting a wide gap between the price you pay and the value you buy is the cornerstone of intelligent stock investing because as Buffett says, while "intrinsic value can be defined simply," its calculation "is not so simple." 3 Graham invoked the margin of safety principle to avoid the stock trading risk of error in calculating intrinsic value. And while Charlie Munger—Buffett's business partner and alter ego—has quipped that he has never seen Buffett do an intrinsic value calculation, the principles that follow are part of the mind-set that enables him not to.

ASSETS

The book value of a company is the excess of its total assets as set forth on the balance sheet over its total liabilities and any outstanding preferred stock, also as set forth on the balance sheet. The book value per share of a common stock of that business is simply that amount divided by the number of common shares outstanding.

This use of the word "value" is misleading. Balance sheets list assets at their cost when acquired rather than their current value (or in some cases at current stock market values if lower). The balance sheet report of the carrying amount of assets does not reflect increases in value under current market conditions. And while the long-term assets are shown less the depreciation on them, that is only an approximation of what it would cost to replace them rather than an exact figure.

The range of book values per share is as broad as the range of businesses itself, and all those values reflect historical acquisition costs rather than current values. The book value per share of our sample illustrates this. GE's is about $12; Microsoft's, about $6; and Amazon.com's, about $2. 4

These numbers correctly suggest that the usefulness of book value decays when more productive activity is performed with fewer rather than more tangible assets (as more production is generated not by, say, steel mills and other factories but by information tech­nologies and Internet distribution systems). The fact that GE's book value per share is six times Amazon.com's may reflect more the greater asset intensity of GE's business compared to Amazon.com's than the value of those businesses.

For a whole range of businesses, the current accounting system based on historical cost is handicapped in appraising present and future values. For example, GE's property, plant, and equipment if sold at current market prices would fetch a substantial multiple of the book value per share; Amazon.com's might fetch only about what the book value says, chiefly because all its assets were acquired within the past few years.

Not only does this cost principle mean that some assets listed on a balance sheet are worth far more than their listed amount, it also means that the opposite is true. Even if book value purports to reflect the amount for which a company could be sold (its liquidation value), it cannot reflect the circumstances under which a sale is held. A business liquidation conducted under or caused by adverse conditions may lead to assets such as inventory and equipment and machinery being sold at a loss compared to their balance sheet carrying amounts.

For some companies, losses on major assets such as plants and warehouses can be enormous. If Disney were liquidated, for exam­ple, there is reason to doubt that its theme park fixed assets—an important part of its book value—could be sold at their book value.

Perhaps more obviously, if Coke were liquidated, its inventory of syrup and concentrate would undoubtedly fetch far less in a fire sale of those goods than the amount at which they are carried as inventory on its balance sheet.

This does not mean that the balance sheet is useless. It is a starting point for analysis. All the historical numbers can be adjusted to reflect prevailing economic conditions. On the upside, inflation and appreciation in market values can be acknowledged to arrive at a current measure of the financial value of assets. Guides to this adjusting of old numbers to new conditions include sales prices of similar property and increasing asset amounts based on changes in the consumer price index.

On the downside, the historical amount of assets recorded on a balance sheet can be reduced to the amount they could be sold for in a fire sale upon liquidation of the business. How much to reduce the amounts for things such as inventory and accounts receivable would depend on their respective turnover rates. Amazon.com's inventory, for example, turns so quickly (24 times a year) that even in a fire sale the company would probably be able to get rid of it at pretty close to cost (the amount listed on its balance sheet). Some of GE's inventory, which turns only eight times per year, might have to be sold at a loss.

Even those adjustments may not serve as an accurate basis for financial valuation, however, because of another accounting principle: the principle of economic or monetary exchange. A business enterprise may have financial value derived from intangible assets that are not recorded in the financial statements because they were not attributable to any discrete economic exchange. For example, only the cost of development of intellectual property (such as patents, trademarks, and copyrights) is recorded as an asset on the balance sheet even if the property is worth billions of dollars in the form of brand recognition or customer loyalty.

You undoubtedly recognize the GE brand name, for instance, and collective consumer recognition is certainly valuable, but you will not see any line item for GE's brand names and associated intellectual property on its balance sheet. The same is true for company know-how, employee capital and education, and similar items increasingly crucial to many companies in a wide variety of businesses, particularly but not exclusively companies such as Microsoft and Amazon.com.

These sources of value are referred to as economic goodwill, a bundle of intangible assets that enable a business to generate superior returns on equity,stock investment, and assets. They can, as was noted before, create a franchise or branding power that enables a business to increase prices without hurting total sales volume. Disney, for example, can raise ticket prices to Disneyland without hurting attendance.

Another sort of goodwill is called accounting goodwill. This is a record of prices paid for businesses a company acquired at a premium to book value. The economic value of accounting goodwill is even trickier to appraise. If the purchase was a prudent one, the value of the economic goodwill obtained is usually greater than the amount of accounting goodwill. That is especially true because another accounting rule requires that accounting goodwill be amortized—reduced annually by specified amounts over future decades. But again, if the businesses were smartly bought, the goodwill value should rise over those years rather than, as the amortization suggests, fall.

Sidestepping the need for these adjustments to the balance sheet, an old-fashioned rule of thumb championed by Ben Graham says that a common stock carries a sufficient margin of safety if it can be bought at a price equivalent to less than the company's net current assets, 5 that is, a price equal to per share working capital. This means that the buyer would pay nothing for the business's fixed assets. Such companies are so rare today that this tool in its pristine form is of little use.

But a modest variation retains the old rule's conservative rigor while still catching some fish. A business still qualifies if it can be bought for its net current assets plus, say, half the original cost of its fixed assets. Thus, the stock investor pays for net working capital at the stated value and gets a 50% discount for all the other assets. In the case of most companies today this would still be quite a low figure, but some companies—particularly smaller ones—end up in your nets. 6

The potential trouble with these approaches is that they relegate you to being a bottom fisher—the person trolling for very low priced businesses. That is fine, but you need to be careful not to buy a dying fish. Bargain hunting leads to disaster if all you get is a burst of economic return but nothing in the long term. Prudent stock investors hunt for stocks with fair rather than cheap prices and strong rather than modest economic characteristics. As Warren Buffett advises, it is better to buy a great business at a fair price than a fair business at a great price.

A neophyte stock investor's mistake, in any event, is to assess business value solely on the basis of the balance sheet, even after overcoming the limits imposed by accounting principles. Unless you are indeed valuing a company for purposes of liquidating it, what you really want to know is not what its assets could sell for but what earnings and cash they spin off.

Graham recognized the limits of a balance sheet. Noting that it is quite useful with respect to working capital position, Graham cau­tioned that it is of less use concerning the carrying amount of fixed assets, which he said "must not be taken too seriously," and the figure at which intangible assets are listed, to which he said "little if any weight should be given." 7 He advised:

It is true that in many individual cases we find companies with small asset values earning large profits, while others with large asset values earn little or nothing. Yet in these cases some attention must be given to the book value situation, for there is always a possibility that large earnings on the stock invested capital may attract competition and thus prove temporary; also that large assets, not now earning profits, may later be made more productive. 8

Accordingly, Graham concluded that "book value is of some importance in analysis because a very rough relationship tends to exist between the amount invested in a business and its average earnings," where the real money is.