With stock market prices plunging, this seems a fit time to look at Anurag Sharma’s discussion of value, intrinsic value, valuation and market prices.
In chapter 11 of his 2016 book “Book of Value: The Fine Art of Investing Wisely,” Sharma explores the distinctions and interactions between value and price. He started by telling us that price and value are two distinct things, and that we can know one of them (price) but can only estimate the other (value).
He wrote, “The key to investing wisely is engaging in the process of valuation in order to make reasonable estimates of approximate economic worth.” In addition, he noted that we find good investment opportunities when value and price diverge significantly.
With that in mind, what are we experiencing in March 2020? For many investors who went into the market without valuation benchmarks, this period is exceptionally distressing. They saw value as the price they paid, and now that the market price is collapsing, their value is being destroyed.
On the other hand, value investors, who separate value and price, likely will understand what is happening now. Over the past half-dozen years, roughly speaking, price left value behind, as is shown in the graphs of the Buffett Indicator, which measures how total market cap compares to GDP. If total market cap is higher than GDP, it indicates that the stock market is overvalued. The following 10-year graph is from the close of trading on Thursday, March 19, 2020:
Now, price is being pulled back toward value, and if past corrections are any guide, this reversion will likely overshoot and price will drop below the value line for a brief time. When or if that happens, value investors will enjoy the best shopping season in a decade.
The meaning of price is quite clear, but what about the meaning of value? Sharma addressed that by noting that value in an investing context means economic worth based on utility. In the case of stocks, utility refers to potentially increased wealth, whether through income or capital gains. More specifically, he pins the investment value of an asset to its net present value (NPV) of future cash flows.
It’s important to recognize that estimates based on NPV are approximations at best and hard to do. That’s because they are based on assumptions as well as data. Assumptions presume subjective judgments that will vary among investors.
Speaking of net present value, what assumptions would you make if you were doing an evaluation in this third week of March 2020? No doubt you would have different assumptions this week than you had just a month ago, before the novel coronavirus began seriously hobbling economies around the world. Personally, I’m not sure what I would assume if I had to do an analysis this week. Anyway, the current experience should help us understand the subjectivity of assumptions and net present value.
Sharma sees an even deeper meaning in the idea of valuation. He cited Edgar Lawrence Smith in observing that value is not like a yardstick with its fixed units of measure. Instead, is an "elusive concept" that waxes and wanes with the moods of the market. Put another way, the author reported that psychological and mental conditions have a significant influence on estimates of value.
In this context, I’m reminded of Benjamin Graham’s character, Mr. Market. As you will likely recall, Mr. Market was meant to reflect the continuous mood swings of the market as a whole.
While price and value are recognized as separate entities, price can affect value, according to Sharma. The author informed us George Soros (Trades, Portfolio) saw a rising stock price as increasing a company’s debt capacity and its capitalization capacity, both of which can lead to larger cash flows in the future, provided the new capital is used productively.
From all of that, Sharma concluded that intrinsic values do not remain stationary. Instead, they fluctuate according to circumstances. That’s borne out by the fact that even the best of companies can have their prices pulled down when there is a mad exit from the market. Check out this three-month chart of Coca-Cola (KO, Financial), a company where operational and financial results have not changed to any noticeable degree:
Why is this happening? Sharma answered that question five years ago, well before any inklings of the new coronavirus appeared:
“Every so often, however, the subtle dynamic balance between price and value ruptures because of an internal or external shock.” This time around it is an external shock.
The author has made his case that value is an "elusive concept," yet he still maintains that analysis of value is critically important. He noted that the very process of analyzing a stock leads us to consider the forces that will affect future cash flows and discount rates. Simply trying to get to the intrinsic value of a stock will focus our attention on the facts and processes behind the creation of wealth.
Apropos of what’s going on in March 2020, Sharma wrote that prices are affected by the forces of supply and demand. The supply of shares for any given company is limited to the number outstanding, but demand can and does vary. In the current environment, we are seeing demand retreat while supply remains the same. In such a situation, prices must inevitably go down, as they have for about three weeks now.
Adding to his earlier comment about the value of analysis, he wrote that it also forces investors to consider the facts, which should help them control their impulses and slow down. Analysis can remove the impetuous buying and selling that gets so many investors into trouble. It is particularly effective if the process involves attempts to negate or falsify an investment thesis, as Sharma describes in chapter 10.
Conclusion
Valuation is the foundation of value investing. However, this critical factor is often more vague than we would like or expect. Sharma pointed out that value is always being pushed and pulled by our assumptions, the mood of the market, supply and demand and even prices themselves.
Despite the vagaries of valuation, analysis of value is always worthwhile because it uncovers facts and opinions that will help us understand the companies we are buying. Analysis also acts as a brake on what might normally be impetuous buying and selling.
Sharma’s discussion provides a helpful platform for understanding what is happening in the crashing market of March 2020, with its rapidly shifting price and value relationships.
Disclaimer: This review is based on the book, “Book of Value: The Fine Art of Investing Wisely”, by Anurag Sharma, and published in 2016 by Columbia Business School Publishing. Unless otherwise noted, all ideas and opinions in this review are those of the author.
Read more here:
- Book of Value: Imitation, Analysis and Falsification
- Book of Value: Generating and Sorting Investment Ideas
- What Is the VIX?
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